Explicit and implicit targets in open economies

Abstract

Under a flexible inflation targeting regime, should policymakers avoid any reaction to movements in the foreign exchange market? Using data for six advanced open economies explicitly targeting inflation, this article examines empirically whether real exchange rate disequilibria systematically affect the conduct of monetary policy. Estimates indicate that monetary policy responses in inflation-targeting, open economies have changed significantly, as the institutional framework for the conduct of monetary policy has evolved. In particular, an explicit target for core inflation and a greater use of the expectation channel of monetary policy appear to be the key features of the newest policy framework. In this context, central banks are unlikely to react to regular fluctuations in the exchange rate.

Notes

¹ Over the 1990s, Australia, Canada, New Zealand, Sweden and the United Kingdom, all changed the institutional framework under which monetary policy was conducted, by shifting to an inflation targeting regime. Norway and Iceland followed suit in 2001. The literature on the institutional aspects of inflation targeting in industrial countries is extremely vast. For a recent review, see Bernanke and Woodford (2005) and references therein.

² Svensson (2000), e.g. analyses the properties of a ‘flexible’ inflation targeting regime in an open economy context.

³ On recently introduced measures enhancing the transparency of Norway's monetary framework and related discussion, see IMF (2005a). Analogous discussions for Sweden and the UK can be found in IMF (2004, 2005b), respectively.

⁴ See, among others, Taylor (1993, 2000), Clarida et al. (1999) and Woodford (2001).

⁵ See, e.g. Taylor (1999) and references therein.

⁶ On this point, see Galí and Monacelli (2002).

⁷ See, for instance, Engel (1993, 1999, 2002) and Rogoff (1996).

⁸ Corsetti and Pesenti (2001) and Monacelli (2003) show that, with incomplete pass through, optimal monetary policy is not purely inward looking.

⁹ See, e.g. Clarida et al . (1998) and Chadha et al. (2004).

¹⁰ See, among others, Bernanke and Woodford (1997) and Svensson (1997).

¹¹ Christiano and Gust (2000) emphasize that a high inflation expectations trap may arise if policy accommodates inflation.

¹² Sack and Wieland (2000) provide an in-depth discussion of interest rate smoothing. On the issue of gradualism as optimal response to uncertainty, see Brainard (1967) as canonical reference on the theory side, Woodford (1999) and Levin et al. (2003) for recent applications, and Walsh (2003) for an exhaustive review.

¹³ See, among others, Cecchetti et al. (2000), Taylor (2001), Goodhart (2001), Bernanke and Gertler (2001), Bordo and Jeanne (2002) and Rigobon and Sack (2003).

¹⁴ In the case of Australia and New Zealand, both inflation measures correct the large effects of the goods and services taxes (introduced in 2000 in Australia and in 1986 in New Zealand). As a result, headline inflation in these countries tends to resemble more closely, core inflation.

¹⁵ Our measures of activity refer to the whole economy. As such, they do not correct sizable supply-side shocks to the agriculture sector.

¹⁶ In all cases, pairwise correlations between the Hodrick–Prescott output gap (y ^HP) and the growth gap measure (y ^DGAP) are statistically significant, ranging between 0.46 (for the United Kingdom) and 0.65 (for New Zealand). For all countries, the adjusted real unit labour cost (y ^ARMC) exhibits the least synchronized behaviour with the other two gap measures; in the case of Sweden and the United Kingdom, it appears to be uncorrelated with the HP filter, although positively and significantly correlated with the growth gap.

¹⁷ For the United Kingdom, this holds true in five out of six specifications, while the estimate of γ becomes significant when the output gap is proxied by the HP filter and price changes are measured by core inflation. The same exception remains valid in Table 2, when deviations from PPP are also allowed.

¹⁸ On this point, see also Bayoumi and Sgherri (2004a, 2004b).

¹⁹ A similar argument is suggested by Chadha et al . (2004).