ISSN 1561081-0 9 771561 081005 WORKING P APER SERIES NO 756 / MA Y 2007 MAINTAINING LOW INFLATION MONEY, INTEREST RA TES, AND POLICY ST ANCE by Samuel Reynard In 2007 all ECB publications feature a motif taken from the €20 banknote. WORKING PAPER SERIES NO 756 / MAY 2007 This paper can be downloaded without charge from http://www.ecb.int or from the Social Science Research Network 1 The views expressed in this paper do not necessarily reflect those of the Swiss National Bank. This paper was prepared for the Carnegie-Rochester Conference Series on Public Policy: “Mainstream Monetary Policy Analysis Circa 2006: Are There Reasons for Concern?”, Pittsburgh PA, November 10-11, 2006. I am grateful to Marvin Goodfriend, Robert Lucas, Ben McCallum, Ed Nelson and an anonymous referee, as well as CRCSPP, ECB Monetary Analysis Workshop and Econometric Society 2007 Winter Meeting participants, for helpful discussions and comments. John Cochrane kindly provided me with data on bonds excess returns, and euro area data were kindly provided to me by the ECB Monetary Policy Stance Division. 2 Swiss National Bank, Research Unit, Boersenstrasse 15, 8022 Zurich, Switzerland; Phone: +41 44 631 3216; e-mail: samuel.reynard@snb.ch MAINTAINING LOW INFLATION MONEY, INTEREST RATES, AND POLICY STANCE 1 by Samuel Reynard 2 electronic library at http://ssrn.com/abstract_id=985126. © European Central Bank, 2007 Address Kaiserstrasse 29 60311 Frankfurt am Main, Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main, Germany Telephone +49 69 1344 0 Internet http://www.ecb.int Fax +49 69 1344 6000 Telex 411 144 ecb d All rights reserved. Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the ECB or the author(s). The views expressed in this paper do not necessarily reflect those of the European Central Bank. The statement of purpose for the ECB Working Paper Series is available from the ECB website, http://www.ecb.int. ISSN 1561-0810 (print) ISSN 1725-2806 (online) 3 ECB Working Paper Series No 756 May 2007 CONTENTS Abstract 4 Non-technical summary 5 1. Introduction 8 2. Empirical weakness of interest rate rules and stance measures 14 2.1. Interest rate stance and inflation objective 15 2.2. Implicit vs. realized inflation and equilibrium interest rate assumption 18 2.3. Implications for monetary policy analysis and practice 20 3. Money, prices and output 22 3.1. Monetary aggregate choice and adjustments 22 3.2. Characterizing the money-output-price empirical relationship 26 3.3. Money usefulness in policy and inflation dynamics analyses 33 4. Monetary analysis, Phillips curves, and apparent changes in inflation dynamics 40 5. Conclusions 44 Appendix A: Money demand 46 Appendix B: Equilibrium velocity adjustment 48 References 49 Tables and figures 53 European Central Bank Working Paper Series 69 Abstract This paper presents a systematic empirical relationship between money and subsequent prices and output, using US, euro area and Swiss data since the 1960-70s. Monetary developments, unlike interest rate stance measures, are shown to provide qualitative and quantitative information on subsequent in- flation. The usefulness of monetary analysis is contrasted to weaknesses in modeling monetary policy and i nflation with respectively short-term interest rates and real activity measures. The analysis sheds light on the recent change in inflation volatility and persistence as w ell as on the Phillips curve flattening, and reveals drawbacks in pursuing a low inflation target without considering monetary aggregates. JEL classification: E52; E58; E41; E3 Keywords: Monetary policy; Monetary aggregates; Inflation; Output; Tay- lor rule; Equilibrium int erest rate 4 ECB Working Paper Series No 756 May 2007 Non-Technical Summ ary No w adays mainstream monetary policy analysis is done without reference to m on- etary aggregates. M oneta ry policy is described with a short-term in terest rate, as proposed by Taylor (1993), and it is usually argued that, ev en with a stable money demand, m onetary aggregates are not useful for monetary policy. In this paper I discuss the usefulness of monetary aggregates versus interest rates for modeling mon- etary policy and measurin g mon eta ry policy stance, using stylize d facts observed o ver the past 30-40 y ear s in the US, the euro area, and Switzerland. I first show that using in terest rates as a measure of policy stance, i.e. the gap bet ween th e o bserved 3-mo nth interest rate and t he p r escribed Taylo r r ule interest rate, does not provide useful i n forma tion regarding subsequent inflation. Focusing on in terest rate develop m ents relative to a “ neu tral” interest rate is thus not helpful for centralbankerswhowanttoachieveagiveninflation objective. M oreo ver, the paper points to em pirical weak nesses of New Keynesian m odels linear ized around a given trend inflation and w here inflation swings a re attributed to policy o bjectiv e changes. In con trast, moneta ry developments pro vide qualitative and quantitative inform a- tion on subsequen t price and output developments. Two elements hav e to be taken in to account however. First, m on etary aggregates must be adjusted by equilibrium in terest rates, w hich can be approximated by a b ackw ard -looking filter, to accou nt for the fact that people hold relatively more real mo ney ba lances w h en in flation and in terest rates decrease, and vice versa. Not accou nting for these equilibrium velocity c ha nges blurs the m on ey/p rice relation sh ip an d results in th e less than one-for-on e (except in short disinflatio n or accelerating inflation samples, where this results in more than one- for-one) and o ften insignificant relationship s between m o ney grow th 5 ECB Working Paper Series No 756 May 2007 and inflation rates found in the literature. Second, an important stylized fact is that in the econ omies and periods considered, in con trast to money levels, p rice levels do no t d ecrease. This asym m etr ic p rice behavior induces a source of b ias i n l inear econom etric estimates of studies assessing the effect o f money gro wth on inflation and comp licates the use of money grow th rates to assess inflation risks. Therefore, a n aly- ses of money and price lev els are necessary for short-term policy purposes. Findings are robust to differen t m oney d efinitions and money demand specifications. It is commonly argued that the long-run relationship between money growth and inflation stems only from a mon ey demand relationship and is of no r eleva nc e for the h or izon of interest of central ban ks. It is also claimed that sho r t-term velocit y mov em ents due to implicitly accommodated m o n ey demand sh oc k s — i.e. through an in terest rate based policy — or to monetary policy r eactin g to other f un dam ental eco- nom ic shocks blur the short-term relationship between money and prices, especially in low inflation econom ies. It is further argued th at, as a result, w ith a su ccessful inflation targ eting strategy the link between money g rowth a nd in flation should van- ish. In co ntrast to those claims, the presen t paper sho ws that when the relationship bet ween p rices and m on ey is characterized in a way that a ccounts for equilibrium v elocity changes and prices’ asymmetric behavior, significant monetary developments are in every case follo wed by corresponding price developments. Furthermor e, w e do not observe significant price movem ents not preceded by corresponding m on etary movemen ts. The considered velocity “shocks” pro vide informa tion on subsequent prices and output, pointing to a weakness of m odels that r epresent policy actions with a short-term interest rate only. Moreover, the quantitative importance of other economic shocks to inflation is sm a ll in the samples c o nside red . Conseq u ently, a 6 ECB Working Paper Series No 756 May 2007 successful inflation targeting strategy would result in mon ey (adjusted by poten tial output) and pr ices gro w ing at the same rate. In s ummary, monetary dev elop m ents can be used to cha racterize inflationtrendsaswellasfluctuations around these trends, and provide early information on these inflation developmen ts. Monetary regularities are t h en used to assess th e forecasting efficienc y of Phillips curves and to shed light on recent chang es in inflation pattern s, especially on inflation reduced persistence a nd v olatility as w ell as on the flatt ening of the Phillips curve. Seen from the angle of monetary aggregates, monetary policies since the early-1990s have been rather restrictive in term s of lo w money lev els relative to price lev els. Given theasymmetricpricebehavior,thishaskepttheinflation ra te at a relatively constant low value while output has m ostly been belo w poten tial, con tributing to a w eak er relationship between output gaps an d inflation. In other w ords, more liquidity could have been provided to sustain real ac tivity w itho u t resulting i n significantly h igh er inflation. Giv en that w e observ e price increases when policy is expansive but do not observe price decreases when policy is restrictive, a focus on a low inflation target without considerin g mon etary aggrega tes runs the risk of being too restrictiv e on averageaspolicyeffects on output appear to be symmetrical. 7 ECB Working Paper Series No 756 May 2007 1. INTR OD UCTION There is nowadays a large gap bet ween mainstream monetary policy analysis and policymakers’ c oncerns. Most models curren t ly used for policy analysis or forecasting are linearized or no rm alized arou nd an in flation steady state or trend . In these m odels, the central bank announces an inflation t a rge t, the public believes in th e abilit y of policymakers to reach this target, a nd central bank ers know ho w to move a short-term in tere st rate as a function of unobservab le real equilibrium interest rate and economic shocks in order to remain on that target and conduct optimal cyclical policy. These “normalized” monetary policy analyses and estimations are in fact focusing on small inflation deviations from an exogenou sly given steady-state or “trend inflation”. In ord er to fit the data, which are c haracterized b y substantial and long-lasting inflation swings, differ ent assum ption s ha ve been ma de regarding “ trend inflation”. Som etime s, a consta nt steady-state inflation is assu m ed , w ith m ajor inflation fluctu- ation s “explain ed ” by “sunspot equilibria”. Sometimes , “trend inflation” is modeled as an exogenous random w alk or is identified as a model residua l once “stru ctural” restrictions have been imposed on the data, and is in terpr eted as a moving inflation target with ho wev er no evidence of a correspondence between the resulting “trend inflation” and a ctual central banks’ objectives. In em pirical w ork, inflation is u su ally detrended, in a d eterministic o r stochastic wa y. Analyses are thus trying t o explain only one p art of in flation mo vements, which m o reover ha ve been decomposed in an arbitrary w ay. At the other extreme of assuming a constant steady-state inflation, every inflation mo vemen t could be attributed to a c hange in policy target! An implication of those analyses is th at policymak ers’ preferences can be expressed in the form of a loss function : cen tr al banks in tha t world car e about m in imizing 8 ECB Working Paper Series No 756 May 2007 inflation deviations around a giv en target and output deviations around its poten- tial. Such a loss function has been explicitly deriv ed from theoretical models and is extensiv ely used in m on etary policy analysis. Such an analysis is at odds with policymak ers’ concerns and beha v ior. The main concern of central banks an d o f th e population in general, and what matters for wel- fare, is not small inflation deviation s aroun d a given steady state but rather a drifting away from low inflation tow ards higher inflation or deflation. Whether inflation is at 1.7 r a the r than 1 .3 percen t i s not o f mu ch importance. Mon etary policy c anno t fine-tune and contr ol suc h small orders of magnitudes, a nd inflation is not perfectly measu red anyway. No wadays, most central ba nks hav e, im p licitly or explicitly, an adm iss ib le range for inflation, and their concern is to preven t inflation from drifting substantially and persisten tly above or belo w that range. The position of the inflation ratewithinthatrangeisnotimportantaslongasitisandisforecastedtoremainin the desirable ran ge. Th us, the inflation developm ents w hich need to be explained are the high i nflation of the 1970s, th e subsequen t disinflation, the temporary inflation increase in the late 1980s / early 1990s, as well as the low and stable inflation there- after. It is h owe ver evident from policymakers’ pub lic sta tements tha t i t is neith er clear where the neutral inter est rate is, nor how far one should be from it in a giv en econom ic situation in order to obtain a desired inflation rate. Monetary policymakers need to have some quantitativ e guidelines regarding price developments after policy lags — which a re one re gular ity documented in this p aper — have taken effect, in order to a void the substan tial and long-lasting inflation swings c ha racterizin g any coun t ry’s time series da ta. A wait-and-see approach carr ies the risk of “being behind the curve” or, on the opposite, “overdoing it”. This paper assesses 9 ECB Working Paper Series No 756 May 2007 [...]... inflation and a low real interest rate as a result of too soft an interest rate reaction to expected inflation increases ECB Working Paper Series No 756 May 2007 11 Section 3 presents a systematic empirical relationship between money and subsequent prices and output In contrast to interest rate stance measures, monetary developments provide qualitative and quantitative information on subsequent price level and. .. go below (above) 2 percent Moreover, there should be no substantial and 1 See McCallum (2001) ECB Working Paper Series No 756 May 2007 15 persistent increase in inflation above target if the observed nominal interest rate is at or above the rule2 Figure 1 displays the 3-month T-bill rate (TB3m) together with the Taylor rule (Taylor) from equation (1) and the Fisherian rate r∗ + π t (Fisher) r∗ and π... this paper, however, will show that these short-term velocity fluctuations contain additional information for price developments that non-monetary analyses miss ECB Working Paper Series No 756 May 2007 17 2.2 IMPLICIT VS REALIZED INFLATION AND EQUILIBRIUM INTEREST RATE ASSUMPTION If deviations from a rule associated with a given inflation target are not good signals of inflation going above or below that... refers to Friedman and Kuttner (1992) and Walsh (2003) ECB Working Paper Series No 756 May 2007 monetary level for a given potential output and equilibrium velocity A rise or fall of money above or below that level is followed, with a lag, by output and price adjustments18 These facts do not imply that every price movement is driven by money However, an exogenous price level shock has to be accommodated... considered are thus from low inflation economies, with however significant changes in inflation environments and monetary policy responses These characteristics allow us to address critiques that the relationship between money and inflation is weaker in lower inflation environments and depends on monetary policy regimes In section 2, I first show that using interest rates as a measure of policy stance, i.e the gap... claims, this 12 ECB Working Paper Series No 756 May 2007 paper shows that when the relationship between prices and money is characterized in a way that accounts for equilibrium velocity changes and prices asymmetric behavior, significant monetary developments are in every case followed by corresponding price developments Furthermore, we do not observe significant price movements not preceded by corresponding... a mismatch between implicit and realized inflation both in the 1970s and in the 1980-90s when the Fed policy has been characterized by Taylor rules This will be contrasted to a clear relationship between money and inflation irrespective of whether or not central banks used money in their policies 18 ECB Working Paper Series No 756 May 2007 patterns of deviations Potential candidates would have to have... averages Although not mentioned in their paper, 20 ECB Working Paper Series No 756 May 2007 the average real rate over the 1960-79 period is 0.5% There are two issues with this low real rate assumption First, it is unlikely that the monetary authority would have chosen such a low value as its assumed real rate during that period Second, the estimated less than one-for-one reaction of nominal interest rate... in non-monetary assets, thus affecting money demand via the extensive margins For more details on the measurement, causes and effects of extensive margin changes, see Reynard (2004) 24 ECB Working Paper Series No 756 May 2007 According to equation (3), the money level considered has been adjusted by potential output and equilibrium velocity, i.e by low- frequency changes in the opportunity cost of money,. .. on a low inflation target without considering monetary aggregates runs the risk of being too restrictive on average as policy effects on output appear to be symmetrical 2 EMPIRICAL WEAKNESS OF INTEREST RATE RULES AND STANCE MEASURES This section presents issues with modeling monetary policy with a short-term interest rate and with assessing monetary policy stance with interest rate deviations from interest . 1561081-0 9 771561 081005 WORKING P APER SERIES NO 756 / MA Y 2007 MAINTAINING LOW INFLATION MONEY, INTEREST RA TES, AND POLICY ST ANCE by Samuel Reynard In. samuel.reynard@snb.ch MAINTAINING LOW INFLATION MONEY, INTEREST RATES, AND POLICY STANCE 1 by Samuel Reynard 2 electronic library at http :// ssrn.com/abstract_id=985126. ©