How Does Monetary Policy Change?

Evidence on Inflation Targeting Countries

Jaromír Baxa, Charles University, PragueRoman Horváth, Czech National Bank Bořek Vašíček, University of Barcelona

The 7th Norges Bank Monetary Policy Conference, 24 June 2010

The views expressed here do not necessarily represent those of the CNB.

2

Road Map

• Motivation• Related Literature• Data and Empirical Methodology• Empirical Results• Concluding Remarks

3

Motivation

• How and when does monetary policy change?• Does inflation targeting represent a major change in

monetary policy?• When do central bankers respond more aggressively on

inflation?• To what degree the policy is smoothed?• How persistent is inflation process?• How important is financial stress for interest rate setting?

4

Related Literature –Monetary policy rules and inflation targeting

• Most studies available for the Bank of England (1992): Clarida et al.(1998, 2000), Adam et al. (2005), Davradakis and Taylor (2006), Assenmacher-Wesche (2006), Trecroci and Vassalli (2009)

• Reserve Bank of New Zealand (1990): Huang et al. (2001),Karedekikli and Lees (2007), Ftiti (2008)

• Reserve Bank of Australia (1993): Bouwer and Gilbert (2005), Leu and Sheen (2006)

• Bank of Canada (1991): Demers and Rodríguez (2002), Shih and Giles (2009)

• Sveriges Riksbank (1993): Jansson and Vredin (2003), Kuttner (2004), Berg et al. (2004)

5

Related Literature – Time variance in monetary policy rules (1)

• Sub-sample analysis with forward-looking policy rules (Clarida et al., 1998, 2000)

• Endogenous regressors addressed by GMM • Strong assumption that monetary policy is subject to

structural breaks when the FED chairman changes• Structural stability within sub-sample assumed

6

Related Literature – Time variance in monetary policy rules (2)

• The Markov-switching VARs with time variance in coefficients and residual variances (Assenmacher-Wesche, 2006,

Sims and Zha, 2006) • Time variance in coefficients and residual variances to deal

with changing monetary policy and economic stability• Monetary policy forced to exhibit sudden switches from one

policy regime to another one• Forward-looking element in monetary policy not explicitly

addressed

7

Related Literature – Time variance in monetary policy rules (3)

• The Kalman filter to estimate time-varying coefficient model (Boivin, 2006,Trecrocci and Vasalli, 2010, Gorodichenko and Coibion, 2010)

• Time variance in coefficients and residual variances to deal with changing monetary policy and economic stability

• Endogenous regressors typically not addressed (Kim and Nelson, 2006)

• Endogeneity even in forward-looking rules with real-time forecasts, if forecasts not derived under assumption of constant nominal interest rates within the forecasting horizon

8

Our econometric framework

• Time-varying coefficient model with endogenous regressors

• The policy may change gradually as well as abruptly• Heckman-type two stage procedure that corrects

endogeneity in time-varying model (Kim, 2006)• Small sample issues: Moment-based estimator that has

slightly better statistical properties in small samples than traditional Kalman filtering (Schlicht and Ludsteck, 2006)

9

Empirical methodology

• Monetary policy rule

• Time-varying coefficients follow random walk

• Endogenous regressors and instruments (Z)

11t t t t t i t t t t t t tr y x r

,

,

1 1t t t , 1

2~ . . . 0,t i i d N

1 2t t t , 2

2~ . . . 0,t i i d N

1 3t t t , 3

2~ . . . 0,t i i d N

1 4t t t , 4

2~ . . . 0,t i i d N

1 5t t t , 5

2~ . . . 0,t i i d N

't i t j tZ , ~ . . . 0,1t i i d N

't t j ty Z , ~ . . . 0,1t i i d N

10

Empirical methodology (cont.)

• Estimates of the coefficients in the monetary policy rule are obtained in two steps

1. Endogenous regressors regressed on the instruments and standardized residuals and saved

2. Standardized residuals included as endogeneity bias correction terms in monetary policy rule

t t

11t t t t t i t t t t t t ν,ε ε,t t ,ε ε,t t tr π y x r κ σ ν κ σ

2 2 2, , ,~ 0, (1 )t v tN

11

Varying Coefficients

• “Varying coefficients” method (Schlicht and Ludsteck, 2006) for estimation

• Minimal assumptions on the variance of error terms• Generalization of OLS, minimizes the weighted sum

• Weights inverse variance ratios of the regression residuals and the shocks in time-varying coefficients balancing the fit of the model and the parameter stability

2 2 2 21 1 2 2 n n

1 1 1 1

T T T T

t= t= t= t=

+θ +θ + θ

12

Data

• Quarterly data• UK 1975:1Q -2007:4Q, Australia 1972:4Q - 2007:4Q, Canada 1975:1Q -

2007:4Q, New Zealand 1985:1Q - 2008:2Q, Sweden 1982:2Q - 2007:3Q• The dependent variable is the short-term interest rate closely linked

to monetary policy• The inflation rate is measured as year-on-year change of CPI (RPIX

for the UK and CPIX for NZ)• The output gap is from OECD: production function method based on

NAWRU (HP filter for NZ)• The nominal effective exchange rate (USD/CAD for CAN) used in its

deviation from HP trend• Foreign interest rate – German rate for EU countries, US for the rest

13

Results - Sweden

• Policy neutral rate falling from some 5% in 1980s to 3% in 2000s

• Response to inflation strong, but somewhat less aggressive under IT (anchored expectations)

• No response to output gap• IR smoothing somewhat

higher than in other countries

• 95% confidence interval

Policy neutral rate Response to expected inflation

Response to output gap Interest rate smoothing

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

82 84 86 88 90 92 94 96 98 00 02 04 06

RHO RHO_LB RHO_UB

-0 .8

-0 .4

0 .0

0 .4

0 .8

1 .2

1 9 8 5 1 9 9 0 1 9 9 5 2 0 0 0 2 0 0 5

UBGA MMA LB GAM MA G AMM A

-1

0

1

2

3

4

1 9 8 5 1 9 9 0 1 9 9 5 2 0 0 0 2 0 0 5

BE TA L BB ETA UBB ET A

0

2

4

6

8

1 0

1 2

1 9 8 5 1 9 9 0 1 9 9 5 2 0 0 0 2 0 0 5

AL PHA UB ALP HA L BA LPHA

14

Results – Monetary Policy Aggressiveness and Inflation Targeting

• Monetary policy less aggressive after IT adoption, if previous inflation record favorable

• Anchored inflation expectations under IT do not necessitate aggressive policy

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

0.7

0.8

0.9

1.0

1.1

1.2

1.3

AUS CAN NZUK SWE

IT Adoption

15

Results - Monetary Policy

Aggressiveness and Inflation Rate

• The response on inflation particularly strong during the periods, when central bankers want to break the record of high inflation

United Kingdom

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

0 4 8 12 16 20 24

Inflation

Aggre

ssiveness

New Zealand

0.7

0.8

0.9

1.0

1.1

1.2

1.3

-1 0 1 2 3 4 5 6 7 8

Inflation

Aggre

ssiveness

Australia

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

-2 0 2 4 6 8 10 12 14

Inflation

Aggre

ssiveness

Canada

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3

-2 0 2 4 6 8 10 12 14

Inflation

Aggre

ssiveness

Sweden

0.0

0.4

0.8

1.2

1.6

2.0

2.4

0 2 4 6 8 10 12

Inflation

Aggre

ssiveness

16

Results – Interest Rate Smoothing

• Time-varying estimates of interest rate smoothing are well below the time-invariant one of Clarida et al.

• Is omission of time-varying nature of policy another reason for the overestimation of smoothing coefficient?

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

AUS CAN Clarida et al.NZ SWE UK

17

Results - Inflation Targeting and Inflation Persistence

• Inflation less persistent after IT adoption

• Persistence measured as the coefficient on lagged inflation in backward-looking Phillips curve with time-varying coefficients

-0.8

-0.4

0.0

0.4

0.8

1.2

UK SWE AUSCAN NZ

IT Adoption

18

Follow-up paper

Time-Varying Monetary Policy Rules and Financial Stress

To what extent is financial stress important in interest rate setting?

To what extent financial stress mattered for conventional monetary policies during 2008-2009 crisis?

19

• Time-varying monetary policy rule estimation for main IT countries and US

• IMF’s Financial stress indicator (and its subcomponents) added as additional explanatory variable

• Do central banks respond to financial stress? • Which periods and type of stress are for central banks the

most worrying?

20

Results - The Effect of Financial Stress on Interest Rate Setting

• Central bank loosen policy in the face of high financial stress

• Financial stress explain 10-50% of interest rate variations during 2008-2009 crisis (50% for the U.K)

USA

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

1981

1983

1984

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

UK

-2.5

-2

-1.5

-1

-0.5

0

0.5

1981

1983

1984

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

Sweden

-1.2

-1

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1981

1983

1986

1989

1992

1995

1998

2001

2004

2007

Canada

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

0.4

0.5

0.6

1981

1983

1986

1989

1992

1995

1998

2001

2004

2007

21

The Effect of Financial Stress Components on Interest Rate Setting:Bank, Exchange Rate and Stock Market Stress

• Exchange rate stress of more concern in more open economies

• Bank stress and stock market stress dominant

USA

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

1981

1983

1984

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

Bank stress Stock market stress Exchange rate stress

UK

-2

-1.5

-1

-0.5

0

0.5

1981

1983

1984

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

Bank stress Stock market stress Exchange rate stress Sweden

-2

-1.5

-1

-0.5

0

0.5

1981

1983

1986

1989

1992

1995

1998

2001

2004

2007

Bank stress Stock market stress Exchange rate stress

Canada

-1.5

-1

-0.5

0

0.5

1

1981

1983

1986

1989

1992

1995

1998

2001

2004

2007

Bank stress Stock market stress Exchange rate stress

22

Concluding Remarks

• The evolution of monetary policy in main IT central banks over the last three decades examined

• Policy changes gradually rather than abruptly• The response on inflation more aggressive during the periods when

central bankers want to break the record of high inflation • The response on inflation less aggressive after IT adoption• Central banks loosen monetary policy in the face of high financial

stress

Thank you for your attentionDěkuji Vám za pozornost (in Czech)

www.cnb.cz

Contacts:Roman Horváth

Czech National Bankroman.horvath@cnb.cz

http://works.bepress.com/roman_horvath/