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Creeping Inflation: How much of a concern? What should the response be?. XXVII Meeting of the Latin American Network of Central Banks and Finance Ministries. Alberto Torres Banco de México. May 8th, 2008. Outline. 1. Real Food and Oil Price Changes 2. Implications for Monetary Policy

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may 8th 2008

Creeping Inflation: How much of a concern? What should the response be?

XXVII Meeting of the Latin American Network of Central Banks and Finance Ministries

Alberto Torres

Banco de México

May 8th, 2008

outline
Outline
  • 1. Real Food and Oil Price Changes
  • 2. Implications for Monetary Policy
  • 3. Additional Considerations
slide3

1. Real Food and Oil Price Changes

Commodity Price Indexes

(Index Jan 2003 = 100)

Source: IMF.

slide4

1. Real Food and Oil Price Changes

Real Food Price Changes

(Annual % Change of Real Price)

Source: IMF. Calculations by Banco de México.

slide5

1. Real Food and Oil Price Changes

Distribution of Real Food Price Changes

(Annual % Change of Real Price)

40

20

0

-20

Jan.81-Nov.85

Dec.85-Jan.97

Feb.97-Dec.99

Jan.00-Aug.02

Sep.02-Mar.08

Source: IMF. Calculations by Banco de México.

slide6

1. Real Food and Oil Price Changes

Real Food Price Changes

(Proportion of Time Above Threshold)

Source: IMF. Calculations by Banco de México.

slide7

1. Real Food and Oil Price Changes

Real Food Price Changes

(Mean Above Threshold)

Source: IMF. Calculations by Banco de México.

slide8

1. Real Food and Oil Price Changes

Real Crude Oil Price Changes

(Annual % Change of Real Price)

Source: IMF. Calculations by Banco de México.

slide9

150

100

50

0

-50

Jan.81-Jan.87

Feb.87-Jul.91

Aug.91-Mar.99

Abr.99-Mar.08

1. Real Food and Oil Price Changes

Distribution of Real Crude Oil Price Changes

(Annual % Change of Real Price)

Source: IMF. Calculations by Banco de México.

1 real food and oil price changes
1. Real Food and Oil Price Changes

Food

(Annual % Change of Real Price)

Crude Oil

(Annual % Change of Real Price)

outline1
Outline
  • 1. Real Food and Oil Price Changes
  • 2. Implications for Monetary Policy
  • 3. Additional Considerations
2 implications for monetary policy
2. Implications for Monetary Policy
  • As is well-known in the economic literature (e.g. Clarida, Gali and Gertler, 1999; Walsh, 2003; Woodford, 2003; and others) the optimal monetary policy response to any shock is the solution to a problem where:
    • The policy maker minimizes a quadratic loss function that reflects society’s preferences for inflation and output stabilization.
    • This optimization is made subject to the structure of the economy, which is typically assumed linear (or log-linear).
    • In addition, shocks are assumed to follow an AR(1) process with white noise disturbances.
  • The solution to this problem provides an optimal feedback rule for the monetary policy instrument which will be a linear, time-invariant function of all the variables and shocks that form part of the economy.
2 implications for monetary policy1
2. Implications for Monetary Policy
  • However, we are not currently in this type of framework:
    • For many central banks, high inflation may be more costly than low inflation.
    • The economy seems to behave differently in recessions than in booms (e.g., Hamilton (1989)).
    • The shocks we are currently facing, as shown above, follow a very complex stochastic process, with regime shifts, time varying variances and extreme values.
    • In addition, there is uncertainty about the duration of the “high inflation regimes” in commodity prices.
  • In this context, the optimal response of monetary policy is likely to be non-linear and time-varying, and will tend to focus on risk management.
2 implications for monetary policy2
2. Implications for Monetary Policy
  • Following the risk management approach, the response to this environment should be preemptive, significant and transparent:
    • Failure to act timely may lead to a contamination of the price-setting process; in particular, may affect the formation of inflation expectations.
    • The response has to be strong, as central banks may prefer to insure against low probability, costly outcomes.
    • The central bank has to clearly explain the rationale for its policy actions.
  • But, as we will now see, how preemptive and strong the response should be, depends on the particular circumstances of each economy.
slide15

Uru

Bol

Ven

Pan

Nic

Par

Col

Chi

Ecu

Mex

Peru

Arg

Sal

Gua

Bra

CR

Jam

2. Implications for Monetary Policy

2005 – 2007 Inflation Change and Inflation Persistence

4

2

Sin

HK

Ire

Ger

Jap

Por

0

UK

Can

Tai

Ita

Gre

Mal

USA

Kor

Spa

Fra

Change in Inflation from 2005 to 2007

-2

Tha

Ind

-4

Phi

All Countries

-6

Only LA

-8

0.90

1.00

0.20

0.30

0.40

0.50

0.60

0.70

0.00

0.10

0.80

Inflation Persistence

Source: WEO, IMF. Calculations by Banco de México.

slide16

2. Implications for Monetary Policy

2005 – 2007 Inflation Change and Low Inflation Regime

4

Uru

Bol

Ven

2

Pan

Sin

HK

Par

Chi

Nic

Col

Ger

Ire

UK

Peru

Ecu

Ita

Jap

Por

Can

0

Kor

Tai

Spa

Fra

Gre

Mex

Mal

Arg

Sal

USA

Change in Inflation from 2005 to 2007

-2

Gua

Thai

Bra

-4

Ind

Phil

Bol

Jam

-6

All Countries

Only LA

-8

0

5

10

15

20

30

25

Duration of Low Inflation Periods (Years)

Source: WEO, IMF. Calculations by Banco de México.

slide17

2. Implications for Monetary Policy

2005 – 2007 Inflation Change and CPI Food Weights

4

Uru

Bol

Ven

2

Pan

Chi

Sin

Nic

Ire

Ger

HK

Par

Can

Col

Jap

Mex

Peru

Ita

Por

UK

Ecu

0

Kor

Fra

Tai

Gre

Mal

Spa

USA

Arg

Change in Inflation from 2005 to 2007

-2

Thai

Gua

Bra

-4

Ind

CR

Phil

All Countries

-6

Jam

Only LA

-8

0

50

60

20

30

40

10

CPI Food Weight

Source: WEO, IMF. Calculations by Banco de México.

slide18

2. Implications for Monetary Policy

Cumulative Change in Policy Target Rates and Inflation Persistence

300

HK

Uru

Col

200

Gua

Gre

Chi

Ire

Spa

Peru

100

Ger

Por

Mex

Kor

Mal

Ita

0

Jap

UK

Fra

-100

Can

Bra

Ind

Thai

-200

Points)

Cumulative Change in Policy Rate (Basis

USA

-300

-400

-500

All Countries

-600

Only LA

CR

-700

0.9

0.2

0.3

0.4

0.5

0.6

0.0

0.1

0.7

0.8

1.0

Inflation Persistence

Source: WEO, IMF. Calculations by Banco de México.

slide19

2. Implications for Monetary Policy

Cumulative Change in Policy Target Rates and Low Inflation Regime

300

HK

Uru

Col

200

Gua

Chi

Ire

Fra

100

Ger

Kor

Ita

Per

Jap

Gre

Por

Mex

Spa

0

Mal

UK

-100

Can

Bra

Cumulative Change in Policy Rate

Ind

Tha

(Basis Points)

-200

USA

-300

-400

-500

All Countries

-600

Only LA

CR

-700

5

0

10

15

20

30

25

Duration of Low Inflation Periods (Years)

Source: WEO, IMF. Calculations by Banco de México.

slide20

2. Implications for Monetary Policy

Cumulative Change in Policy Target Rates and CPI Food Weights

600

400

Uru

HK

Fra

200

Col

Gua

Kor

Spa

Ita

Gre

Chi

Per

Ger

Mex

Por

Ire

Jap

0

Mal

UK

Cumulative Change in Policy Rate (Basis

Points)

Can

Ind

-200

Tha

Bra

US

-400

All Countries

-600

Only LA

CR

-800

0

50

60

20

30

40

10

CPI Food Weight

Source: WEO, IMF. Calculations by Banco de México.

2 implications for monetary policy3
2. Implications for Monetary Policy
  • The optimal monetary policy response to “creeping inflation” depends on each country’s particular circumstances:
    • The inflationary history of the country and, in particular, the extent to which a low inflation equilibrium has been sustained.
    • The weight that food and energy goods have on the CPI.
    • The degree of persistence that each economy’s inflation process exhibits to price shocks.
    • The phase of the cycle the country is located in.
    • The impact of the current environment on the country’s terms of trade.
slide22

2. Implications for Monetary Policy

  • The evidence suggests that the impact on inflation levels and inflation volatility of the worldwide shocks we have observed in the past years tends to be heterogeneous across countries. In particular:
    • Inflation seems to have responded more to the price shocks in countries that still exhibit a higher degree of inflation persistence.
    • Inflation volatility seems to be larger in those countries where the weight of foodstuffs in their consumer prices is higher, as well as in countries where the attainment of a low inflation equilibrium has been more recent.
2 implications for monetary policy4
2. Implications for Monetary Policy
  • Thus, the same external shocks may imply different monetary responses in different countries, given their own specific characteristics.
    • In particular, countries that face higher risks of suffering large inflation increases and price volatility (due to their consumption baskets and their inflation history) may have found themselves in the need to respond more aggressively to the current price shocks than other countries.
  • Indeed, the evidence does suggest that countries that are more vulnerable in these terms have acted accordingly, by restricting their monetary policy stance.
slide24

2. Implications for Monetary Policy

  • Given the evidence in the first part of this talk, a relevant question we should try to address with more research is: for how long will we be facing the current high commodity inflation regime?
  • Up to this point, the discussion has centered on the policy responses to the current environment, given the policy frameworks that the central banks currently have.
  • The answer to the question posed above could nonetheless have implications for the issue of whether central banks should rethink the definition of their monetary policy objectives.
outline2
Outline
  • 1. Real Food and Oil Price Changes
  • 2. Implications for Monetary Policy
  • 3. Additional Considerations
3 additional considerations
3. Additional Considerations
  • Creeping inflation from the current shocks to energy and food prices may imply a restrictive bias in the monetary policy stance:
    • This is especially true in countries where inflation is persistent, the low inflation equilibrium has not been sustained for a long time and where food and energy have a large weight in consumers’ spending.
    • This, in turn, reflects the high costs that a breakdown of expectations-based nominal anchors that sustain the low-inflation equilibrium may have on these economies’ performance.
    • Indeed, some countries may face a combination of the above mentioned features that may lead them to maintain a restrictive bias in their monetary policy, even when they may be currently facing the low phase of their business cycle.
3 additional considerations1
3. Additional Considerations
  • The issues raised above focus on the implications of this high inflation regime for monetary policy.
  • We have to ask to what extent we need to consider a more broad view of the policy response that we should undertake, given this environment. In particular we need to ask:
    • Which other policy instruments are available to face the current environment?
    • What is the optimal mix of policy responses to this environment, in order to minimize negative effects on welfare?
3 additional considerations2
3. Additional Considerations
  • The policy mix clearly depends on the structure of each economy and on the shocks that each country has faced:
    • Those who faced an improvement in terms of trade may use specific policies to redistribute the aggregate gains of the shocks to those groups that may have been hurt from price changes.
    • Those that have faced a terms of trade deterioration also need to determine the optimal policy mix to minimize the welfare costs of this shock.
3 additional considerations3
3. Additional Considerations
  • Fiscal policy
    • May be helpful to redistribute losses (or gains, if terms of trade have improved), across different economic agents.
  • Competition policy
    • A non-competitive environment may exacerbate the impact of price shocks on domestic markets. Thus, antitrust agencies should avoid collusive practices in this environment of high price increases.
slide30

Appendix

Real Crude Oil Price Changes

(Proportion of Time Above Threshold)

Source: IMF. Calculations by Banco de México.

slide31

Appendix

Real Crude Oil Price Changes

(Mean Above Threshold)

Source: IMF. Calculations by Banco de México.