Inflation Targeting and
Monetary Policy Rules:
Experience and Research
John B. Taylor
Stanford University
Presented at the 12th Meeting of the Latin American
Network of Central Banks and Finance Ministries
Inter-American Development Bank
May12, 2000
Outline
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Conceptual Issues
Recent experience in U.S. and other countries
Describing the decisions as policy rules
Research methodology
Research results
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Key threshold for response to inflation
Robustness
Inflation forecast based rules and forecast targeting
Exchange rates
Gap uncertainty
Asset price bubbles
Zero interest bounds
• Conclusions
Inflation targeting
• Choose an inflation target: *
– Explicit? Numerical? Implicit?
• Keep inflation rate “close” to the target
• In mathematical terms: minimize, over a “long”
horizon, the loss function:
w1(t - *)2 + w2 (yt – yt*)2 + w3 (et – et*)2
Does not imply that w2 = 0, sometimes called “strict”
Does imply that y* = “natural” rate of output
But inflation targeting is not enough,
need to say something about the
policy instruments
• Analogy:
– Targeting the destination for a sailboat versus saying
how to sail the boat to the destination in a short time:
• angle of attack, sail trim, contingency for wind change,…
• Many alternatives to achieve an inflation target:
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Fixed money growth
“Permanently” fixed exchange rate
“Active” crawling peg
Interest rate rule
Exchange rate rule
Monetary conditions index rule
Recent Experience: U.S.
• 2000 will be 18th year of the “Long Boom”
• First and second longest peacetime expansions in U.S.
history
– 1991- , 1982-1990
– Recession in between was short and mild
• Inflation has been low and stable
• No period of macroeconomic stability like this
before
– 17 years before this (1966-82) had 5 recessions
– Before 1982 in recession 35 percent of the time
– Since 1982 in recession less than 4 percent of the time
percent
20
Real GDP growth rate (Quarterly)
15
10
5
0
-5
-10
60
65
70
75
80
85
90
95
percent
4
2
0
-2
GDP gap with HP trend
for potential GDP
-4
-6
60
65
70
75
80
85
90
95
Why the Increased Stability?
• Good luck?
– No big shocks like the 1970s?
• But shocks were big several times
– Late 1980s credit crunch
– 1998 currency crises,
» Now viewed as favorable supply shocks
– Change in the economic structure?
• Services, inventories, high-tech “new” economy
• Good policy?
– Fiscal policy?
• Deficit reduction and elimination?
• Keynesian counter-cyclical policy?
U.S. monetary policy has changed
• More reactive to changes in inflation
– federal funds rate rises by twice as much when
inflation rises: 75 versus 150 basis points
• This more prompt, more reactive policy, has
kept inflation from rising, thereby preventing
recessions.
• For example, compare the funds rate changes in the
late 1980s and the late 1960s
12
Inflation rate
10
Smoothed inflation rate
(4 quarter average)
8
6
1968.1: Funds
rate was 4.8%
1989.2: Funds
rate was 9.7%
4
2
0
60
65
70
75
80
85
90
Many other Experiences
Inflation/Output Stability Before and
After Inflation Targeting (percent)
Source: Cecchetti and Ehrmann(1999)
Period
inf
growth
Before:1985-89 15.0
7.5
After: 1993-97 3.3
6.9
Difference
0.6
11.7
Australia
Canada
Chile
Finland
Israel
New Zealand
Spain
Sweden
U.K.
Describing Decisions for Policy
Evaluation Purposes
• Change overnight rate if:
– (1) Inflation moves away from target
– (2) Real GDP moves away from trend (potential)
• Little mention of money growth or exchange rates
• Decisions are pretty well described by Taylor rule:
Interest rate = inflation +.5(inflation – 2) + .5(GDP gap) + 2
Use of Policy Rules in Practice
• Of course, no policy rule can be followed
mechanically
– Special factors
– Need to estimate potential GDP growth
• But can be used as a guideline in many cases
• Or, more complex actions are approximated by a
simple rule.
• Example, inflation forecast targeting
• Useful for private sector too
Example: Interest Rate
Analysis of U.K.by
PriceWaterhouseCoopers
If growth was left unchecked it could lead to an
acceleration of inflation to over 4% in 2001. Using
a simple Taylor rule, we estimate that interest rates
would eventually need to be raised to around
7.5% by early 2001
In contrast, if the UK recovery stalls next year then
inflation is likely to fall further below target. Our
Taylor rule simulations suggest that interest rates
might then need to be cut to only around 4% by
early 2001
On November 4, the European
Central Bank raised the overnight
rate by 50 basis points from 2.5
to 3.0 percent.
Rationale:
- improved economic climate
- increased inflation risks.
Source: www.dglux.lu/en/505.htm
On November 12, the Swedish
Riksbank raised the overnight
rate 35 basis points from 2.9%
to 3.25%.
Rationale:
- Increased inflation forecast
- Stronger economy
Source:www.dglux.lu/en/505.htm
On November 3, the Reserve
Bank of Australia raised the
overnight rate 25 basis points
to 5% on 3 November,
Rationale:
- Inflation concerns
- Strong economy
Source: www.dglux.lu/en/505.htm
On January 19, the Reserve
Bank of New Zealand raised the
overnight rate 25 basis points
to 5.25%.
Rationale:
- Inflation increasing.
Source: www.dglux.lu/en/505.htm
Methodology for Research on
Monetary Policy Rules
• Stick a policy rule into a model
– Having models at the central bank is important
– eg; Brazil, Canada, Sweden, U.S.
• Solve the model
• Look at the behavior of the variables (inflation,
real output, exchange rate)
• Choose the rule that gives the most satisfactory
performance (optimal)
• Check for robustness using other models
Interest rate
Constant Real
Interest Rate
Policy
Rule
Inflation rate
Target
Important Threshold Result: Slope Should be Greater 1
Robustness of Simple Rules
Monetary policy rules of the form
it = gt + gyyt + it-1
where i is the nominal interest rate,
 is the inflation rate
y is the deviation of real GDP from potential GDP.
g
Rule I
Rule II
Rule III
Rule IV
Rule V
1.5
1.5
3.0
1.2
1.2
gy

0.5
1.0
0.8
1.0
.06
0.0 
0.0 
1.0
1.0
1.3
Inflation Forecast Based Rules
• it = g(Ett+j) for some j where E is the forecast
– Model or judgemental
– Can’t see future so based on current and lagged info
• A way to put weight on output: Choosing a longer
horizon (j) is like putting more weight on output.
• For j = 6 not as good as simple rules in ECB
simulations (Taylor, 1999)
• Optimal choice of j appears to be very small, and
too large a j is not robust ( paper by Levin,
Weiland, Williams presented at ECB conf.)
– For j>2 there is great uncertainty
• Not as robust as rules with j = 0 and output gap
Inflation forecast targeting
• Set it so that Ett+j equals * or approaches it
gradually over the time
• Much less formal research on this procedure
– not a rule
– hard to simulate
• Woodford’s Jackson Hole comment
• But in practice there is a role for forecasting
– Both inflation and real GDP growth
– Forecasting model at central bank needs to imbed
threshold result
– Inflation Reports as in U.K. and Brazil are useful
Exchange rate regimes
• Flexible exchange rates cum monetary policy rules
• Several models in research studies have the
exchange rate channel as part of the transmission
mechanism and perfect capital mobility
– But rule without exchange rate is still pretty robust
– My suggestion for a rule for the U.S. was based on a
multicountry model with exchange rate channel
• But much more research is needed
– Exchange rate variations are more costly in small open
economy with foreign currency denominated debt
– Using exchange rate to affect inflation directly
Put exchange rate in policy rule
One approach: Place exchange rate into interest rate rule
it = gt + gyyt + ge0et + ge1et-1 + it-1
where
it is the nominal interest rate,
t is the inflation rate (smoothed over four quarters),
yt is the deviation of real GDP from potential GDP,
et is the exchange rate (higher e is an appreciation).
Simulation results with exchange rate
Effect on inflation and output variability from adding
exchange rate terms to Taylor rule. (No exchange rate term
in loss function)
Set g = 1.5, gy = 0.5,  = 0, and
Ball
Svensson
Taylor
ge0
ge1
_________
-.37 .17
-.45 .45
-.25 .15
slight improvement
can’t rank
can’t rank
Uncertainty in Measuring
Potential GDP
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Uncertainty is very large:
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Gap range is now 0 to 3 for U.S.
Solutions:
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Add research funds to get better estimates
Reduce weight on gap (Frank Smets’ ECB
study)
Use growth rate rather than gap: big debate
here
Interest rate hitting zero problem
• Downward spiral…
• To estimate likelihood of hitting zero and
getting stuck, put simple policy rule in
policy model and see what happens:
– pretty safe for inflation targets of 1 to 2 percent
• Modify simple rule:
– Interest rate stays near zero after the expected
crises (Reifschneider and Williams (1999))
Interest rate
Constant Real
Interest Rate
Policy
Rule
Inflation rate
0
Target
The Downward Spiral Problem
Should central banks try to break
stock price bubbles?
• Add a stock price term to simple policy rule
– simulations show that reacting to this term
increases output and inflation variability
• But some sharp changes in asset prices may
require discretionary increases in liquidity
– 1987 stock market crash in U.S.
– 1998 reaction to change in risk premium...
Conclusion
• Inflation targeting is not enough
– Implementing inflation targeting in practice requires
analysis of how the instruments of policy should be
changed
• Interest rate policy rules are a way to implement
inflation targeting
– Lots of research about the form of policy rules
– Research needed on how policy rules are to be used:
• Guidelines? Part of IMF programs? Private sector monitoring?
• More research is needed on exchange rate issues
in highly open economies
– Flexible exchange rates with a monetary policy rules
provide a lot of room between the “corner solutions”