A re-evaluation of the choice of an inflation target in the wake of the global financial crisis

ABSTRACT

Through an appropriate choice of inflation objective – a real-exchange-rate-adjusted (REX) inflation target – the central bank can limit fluctuations in real economic activity which has become a cause of great concern in recent years in many small open economies. REX inflation targeting dominates CPI targeting from the standpoint of output gap stabilization. CPI inflation targeting dominates REX inflation targeting from the standpoint of stabilizing inflation, nominal interest rates and real exchange rates. These results help inform ongoing discussions of possible alternatives for the existing flexible inflation targeting framework.

KEYWORDS:

• CPI
• REX
• domestic inflation targets
• broad vs. narrow mandate

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No potential conflict of interest was reported by the authors.

Correction Statement

This article has been republished with minor changes. These changes do not impact the academic content of the article.

Notes

1 An amendment to the Reserve Bank Act in New Zealand in 2019, for example, added the goal of ‘supporting maximum sustainable employment’ to its Policy Targets Agreement. For discussion of background to this change, see Orr (2019) and McDermott and Williams (2018).

2 The relevance and suitability of CPI inflation targeting as a monetary policy strategy since the Global Financial Crisis is discussed in Is Inflation Targeting Dead? (2013). Various aspects of this issue with relevance to small open economies are discussed in Central Bank Frameworks: Evolution or Revolution? (McDermott and Williams (2018)).

3 Svensson (2011) and Faust and Henderson (2004) discuss best-practice aspects of inflation targeting. The preference for a headline CPI target is not universal. The U.S. Federal Reserve targets the core personal consumption deflator.

4 The Reserve Bank of Australia, whose monetary policy ‘Statement’ recognized a dual mandate even before the financial crisis, included an ‘articulation of the financial stability objective’ after the crisis (Debelle (2018, p. 55)).

5 Mishkin (1999) emphasizes this point in the context of the Asian Financial Crisis. The lack of adequate hedging also became a problem in non-Euro member countries (or associate members) of the European Union during the Global Financial Crisis and the period thereafter. Domestic residents in these countries had borrowed extensively in Euros (or Swiss Francs) in the firm belief that the domestic currency peg (or stable exchange rate) would be maintained. This proved fallacious. Foreign currency loans to households and non-financial corporations ranged from more than 80 percent of total loans outstanding in Latvia to about 30 percent in Poland (Financial Stability Review, ECB (2010)).

6 Smets (2014) reviews the debate on the scope of a central bank's mandate in a closed-economy context. A broader mandate for a central bank is proposed by advocates of both the ‘Leaning against the Wind’ view Woodford (2012) and ‘Financial Stability is Price Stability view (Brunnermeier and Sannikov (2014)).

7 Exchange rate stability is, of course, only one aspect of financial stability. We return to this issue in Section 1.

8 See Pereira da Silva (2015) for an account of how both advanced and emerging countries have coped with the massive shifts in capital flows that have been triggered by unconventional policy measures in the United States, Europe, and Japan. A few advanced small open economies such as Australia and New Zealand were less affected by these policy developments abroad. In New Zealand, however, RBNZ repeatedly voiced its concern in 2014 about the unsustainable und unjustifiably high NZ dollar-US dollar exchange rate.

9 In previous work Froyen and Guender (2017) evaluate the performance of CPI, domestic and REX inflation targeting under optimal discretionary policy. They don't distinguish between a broad and a narrow central bank mandate. Froyen and Guender (2018) compare optimal policy under the timeless perspective with Taylor rules for both types of mandate. They consider only CPI and domestic inflation targeting.

10 We also consider a domestic inflation target. Results with this specification are discussed at a later point.

11 Support for this responsiveness in provided by survey evidence for the United Kingdom in Greendale and Parker (2012) and for New Zealand in Parker (2017). Additional support for the influence of exchange rate changes on price setting in the United Kingdom is provided by Bunn and Ellis (2012a, 2012b). For the derivation of the open-economy Phillips Curve see Froyen and Guender (2017).

12 In Equation (4) γ is the degree openness of the economy. Assuming uncovered interest rate parity and perfect exchange rate pass-through help simplify the analysis.

13 Ratcliffe and Kendall (2019) list ‘unnecessary instability’ in interest rates or the exchange rate as among secondary policy objectives for the Reserve Bank of New Zealand.

14 There are additional rationales for inclusion of exchange rate stability in the central bank objective function. Blanchard et al. (2010) argue that appreciations in the real exchange rate ‘squeeze the tradeable sector.’ This point was echoed by the Brazilian Finance Minister Mantaga ‘We’re in the midst of a currency war … This threatens us because it takes away our competitiveness.’ Aizenman, Jinjarak, Estrada, and Tian (2017) motivate exchange rate volatility in the central bank objective function via an effect on potential output. DePaoli (2009), within a framework with a utility-based loss function, motivates a role for the real exchange rate via a terms of trade externality. Within this framework, real exchange rate volatility may be either too low or high for optimality under the standard dual mandate (output and domestic inflation).

15 Ball (1999) calls his real-exchange-rate-adjusted measure ‘long-run inflation.’ It is defined as overall (domestic and imported) inflation purged of the effect of the lag (not the change) of the real exchange rate.

16 Both a₁ and a₂ depend on the degree of openness γ. See Guender (2006) or Svensson (2000).

17 A straightforward Interpretation of the CPI inflation target rule is made impossible by the presence of undetermined coefficients. These coefficients are instrumental in determining the effect of the state variable, the lagged real exchange rate, on the forward-looking expectations of the three choice variables. In addition, the weights on the target variables cannot be signed unambiguously in all cases. One clear result that emerges is that history-dependence matters more compared to REX inflation targeting as do parameters that characterize the demand-side of the economy.

18 This assessment of course rests to some extent on the specific values chosen for the parameters of the model and the variances of the shocks. In their study of the performance of inflation targeting strategies, Froyen and Guender (2017) carry out multiple robustness checks without overturning any of their reported findings. In Section 3.3 we report further on the robustness issue.

19 A third strategy to consider is domestic inflation targeting. Under a narrow mandate, its stabilization performance lies between that of REX and CPI inflation targeting but closer to the former. A broader mandate causes further convergence between the performance of domestic and REX inflation targeting. Domestic inflation targeting is slightly better at stabilizing ‘rates’ while REX inflation targeting retains a modest edge in stabilizing the output gap.

20 Such a pattern, albeit less clear, is also visible in Table 2.