Inflation Target Uncertainty and Monetary Policy Yevgeniy Teryoshin - PowerPoint PPT Presentation

Inflation Target Uncertainty and Monetary Policy Yevgeniy Teryoshin Department of Economics, Stanford University Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 1 / 37

Introduction Inflation Target Uncertainty A lack of commitment to a path for the inflation target creates uncertainty Historically inflation targets change Uncertain optimal inflation rate Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 2 / 37

Introduction Inflation Target Uncertainty A lack of commitment to a path for the inflation target creates uncertainty Historically inflation targets change Uncertain optimal inflation rate US inflation target recently called into question Response to perceived decline in r ⋆ Williams (2009), Blanchard et al. (2010), and Ball (2014) Creates uncertainty around the future inflation target Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 2 / 37

Introduction Inflation Target Uncertainty A lack of commitment to a path for the inflation target creates uncertainty Historically inflation targets change Uncertain optimal inflation rate US inflation target recently called into question Response to perceived decline in r ⋆ Williams (2009), Blanchard et al. (2010), and Ball (2014) Creates uncertainty around the future inflation target Why could this uncertainty matter? Uncertainty in the future inflation target changes expected inflation Individual, firm, and central bank decisions respond to such changes Affects current outcomes regardless of the eventual resolution Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 2 / 37

Introduction Janet Yellen (June 2017) ”So it’s that recognition that causes people to think we might be better off with a higher inflation objective. That is an important set, this is one of our most critical decisions and one we are attentive to evidence and outside thinking. It’s one that we will be reconsidering at some future time... But I would say that this is one of the most important questions facing monetary policy around the world in the future.” Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 3 / 37

Introduction This Paper Questions How does π ⋆ uncertainty affect current inflation, output, and welfare? 1 How should the central bank respond to inflation target uncertainty? 2 What happens if the central bank commits to changing the inflation target? 3 Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 4 / 37

Introduction This Paper Questions How does π ⋆ uncertainty affect current inflation, output, and welfare? 1 How should the central bank respond to inflation target uncertainty? 2 What happens if the central bank commits to changing the inflation target? 3 Approach Model inflation target uncertainty in a standard New Keynesian model Policy rule with a regime specific inflation target Exogenous Markov process determines regime Analytically solve the model without any additional uncertainty Numerically solve the stochastic model for full quantitative evaluation Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 4 / 37

Introduction This Paper Questions How does π ⋆ uncertainty affect current inflation, output, and welfare? 1 A potential increase in π ⋆ usually generates stagflationary dynamics But may qualitatively differ depending on the current monetary policy rule How should the central bank respond to inflation target uncertainty? 2 A trade off in levels between inflation and output Optimal policy adjusts the current inflation target What happens if the central bank commits to changing the inflation target? 3 Anticipated change in π ⋆ usually results in cyclical dynamics Under an optimal time varying policy rule inflation monotonically adjusts Approach Model inflation target uncertainty in a standard New Keynesian model Policy rule with a regime specific inflation target Exogenous Markov process determines regime Analytically solve the model without any additional uncertainty Numerically solve the stochastic model for full quantitative evaluation Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 4 / 37

Introduction Literature Regime switches Monetary policy uncertainty and optimal policy: Davig and Leeper (2007), Choi and Foerster (2016), Foerster (2016) DSGE estimation: Schorfheide (2005), Liu, Waggoner, Zha (2011), Bianchi and Melosi (2016), Bianchi (2012a,b), and Davig and Doh (2014) Solution methods and determinancy: Leeper and Zha (2003), Davig and Leeper (2007), Farmer, Waggoner, Zha (2009), Farmer, Waggoner, Zha (2011), and Foerster, Rubio-Ramirez, Waggoner, and Zha (2013) Uncertainty shocks Bloom (2009), Baker et al. (2016), and Creal and Wu (2014), Ulrich (2012) Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 5 / 37

Model Model: Representative Household Preferences 1 − v M t ) = C 1 − σ 1 − σ − N 1+ ϕ u ( C t , N t , M t t t P t 1 + ϕ + P t 1 − v Composite consumption good � 1 et − 1 et C t = ( et di ) C et − 1 it 0 Budget constraint � 1 1 P it C it d it + M t + B t ≤ M t − 1 + B t − 1 + W t N t + D t 1 + i t 0 Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 6 / 37

Model Model: Firms Continuum of monopolistically competitive firms producing differentiated goods Technology Y it = A t N 1 − α it Calvo pricing: 1 − ω adjust prices each period, others keep price constant Robustness: non-adjusters increase their previous price by the inflation target Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 7 / 37

Model Monetary Policy Interest rates are set according to a regime specific rule i ( s t ) = φ π, s π t + φ π ′ , s E t π t +1 − ( φ π, s + φ π ′ , s − 1) π ⋆ s + φ x , s x t + µ I t Regime is determined by a time invariant Markov process with transition matrix   p 11 p 12 . . . p 1 k p 21 p 22 . . . p 2 k     Π = k = 2 , 3 . . . ...  . . .  . . .   p k 1 p k 2 . . . p kk Central bank loss function ∞ � β t − t 0 ( π 2 t + θ x x 2 t + θ i i 2 L t 0 = t ) t = t 0 EL = E ( π 2 t + θ x x 2 t + θ i i 2 t ) Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 8 / 37

Model Log-Linearized Model Phillips curve π + µ S π t = β E t π t +1 + κ x t + (1 − β )¯ (1) t , where ¯ π is current regime’s inflation target IS curve x t = E t x t +1 − σ − 1 ( i t − E t π t +1 ) + µ D (2) t Monetary policy i ( s t ) = φ π, s π t + φ π ′ , s E t π t +1 − ( φ π, s + φ π ′ , s − 1) π ⋆ s + φ x , s x t + µ I (3) t Autoregressive shock processes µ j t = ρ j µ j t − 1 + ǫ j ǫ j t ∼ N (0 , σ 2 t , j ) ∀ j (4) π is inflation, x is the output gap, i is the nominal interest rate Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 9 / 37

Model Solution Method Let Ω t be the full information set and Ω − s be the information set excluding t the current regime, then k � E t π t +1 ≡ E [ π t +1 | s t = i , Ω − s p ij E [ π jt +1 | Ω − s t ] = t ] j =1 k � E t x t +1 ≡ E [ x t +1 | s t = i , Ω − s p ij E [ x jt +1 | Ω − s t ] = t ] j =1 The model in regime contingent notation: k k � � p sj E t x j , t +1 − σ − 1 ( i s , t − p sj E t π j , t +1 ) + µ D x s , t = t j =1 j =1 k � π s + µ S π s , t = β p sj E t π j , t +1 + κ x s , t + (1 − β )¯ t j =1 k � p sj E t π j , t +1 − ( φ π, s + φ π ′ , s − 1) π ⋆ s + φ x , s x t + µ I i s , t = φ π, s π t + φ π ′ , s t j =1 Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 10 / 37

Model Quarterly Calibration Parameter Value Parameter Value .99 ρ I , ρ S , ρ D .5 β 2 1.5 σ σ S 1 2 ϕ σ D Ee t 5 σ I 2 α .33 θ x .0408 ω .66 θ i .25 Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 11 / 37

Theoretical Analysis Analytical Regime Switch Framework At t = 0, a surprise announcement that the central bank is considering permanently raising the inflation target to π ⋆ with probability λ each period Results are symmetric for a potential decrease in the inflation target If the inflation target is increased, it remains there forever � 1 � � 1 − λ � 0 λ Formally, the Markov process switches from to 0 1 0 1 Assume monetary policy in regime two is determinate Only shock is the realization of the Markov process Each regime is in a steady state Let x i denote the outcome in regime i Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 12 / 37

Theoretical Analysis Regime Switch Outcomes Prior to the announcement, zero inflation steady state x t = π t = 0 After the announcement (regime 1): level shifts in inflation and output gap Qualitatively depends on policy rule parameters Quantitatively depends on π ⋆ and transition probability After inflation target changes (regime 2): π ⋆ inflation steady state Yevgeniy Teryoshin Inflation Target Uncertainty and Monetary Policy 13 / 37