Credibility Constraints on Flexible Inflation Targeting or Anchoring ...

Credibility Constraints on Flexible In‡ation Targeting or Anchoring In‡ationary Expectations in a Forward Looking Economy Under Discretion and Asymmetric Information - A Rational Expectations Benchmark Alex Cukierman and David Vestin 1/5/2008 Preliminary and Incomplete Abstract Potential output is a notoriously elusive concept. It leaves some freedom for ‡exible in‡ation targeting central banks to conduct policy in ways that are observationally equivalent to a regime in which the output target of the central bank changes over time, and about which the public is not fully informed. With rational expectations this haziness forces the CB to take into consideration the impact of its current policy choices on future in‡ationary expectations even under discretion, limiting the ability of the bank to stabilize output and in‡ation around their respective targets. The paper demonstrates those claims in a version of the Clarida, Gali and Gertler (1999) forward looking economy in which the public is not fully informed about the moving output

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target of the central bank, but in which it learns optimally and gradually how this target evolves over time and adjusts its in‡ationary expectation accordingly. The paper identi…es some of the factors that are conducive to tight anchoring of in‡ationary expectations. A main result is that the higher the degree of ‡exibility in targeting in‡ation the looser is the anchoring of in‡ationary expectations.

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Introduction

Real life central bankers worry a lot about the anchoring of in‡ationary expectations. This suggests they believe that their credibility as guardians of price stability is imperfect. Although current rates of in‡ation ‡uctuate substantially less than in the past, central bankers recognize that even when credibility is high it cannot be taken for granted. In particular, a typical western type central bank (CB) internalizes the fact that credibility has to be maintained over time by appropriate policy actions even under discretion. Real life central bankers invariably operate under discretion since they possess the ability to reoptimize their objectives in each period.1 However, the fact that monetary policy is discretionary does not necessarily imply that real life central bankers do not take into consideration the impact of current policy actions on future in‡ationary expectations, and through them on in‡ation and real economic activity as emphasized by forward looking models of the economy. Although they highlight the central role of in‡ationary expectations for the evolution of actual in‡ation as well as for aggregate economic activity such models assume that the CB takes in‡ationary expectations as given under discretion (a prominent example appears in Clarida, Gali and Gertler (1999) - CGG in 1

A terminlogical clari…cation is in order here. Policymakers often state that they are committed to price stability. But this does not mean that the regime is one of commitment in the sense of the modern academic literature on committment versus discretion. In terms of those concepts such pronouncements should be interpreted as meaning that, within a discretionary regime, policymakers are committed to produce a low (implicit or explicit) in‡ation target on average.

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the sequel). This creates a tension between real life central bankers that do worry about the impact of their policy choices on in‡ationary expectations even under discretion and between what such central banks are assumed to do under discretion within conventional forward looking models. This tension arises because the prototype model posits symmetric information between the public and the CB. Under symmetric information and a perfectly known discretionary regime the policy actions of the CB do not a¤ect future in‡ationary expectations because the public already knows everything that the CB knows that might be relevant for future policy decisions and in‡ation. In order to deal with credibility issues and the impact of policy actions on future in‡ationary expectations in a systematic manner it is necessary to relax the assumption of symmetric information between the CB and the public. In the presence of asymmetric information about some policy relevant variables (or about the nature of the regime) policy actions and economic developments contain new relevant (possibly noisy) information about future policy actions and through them on future values of in‡ation and economic activity. This paper explores the consequences of private information about the CB forecast of potential output and about its output target for the nature of policy choices under discretion. In such a framework, it is natural for the CB to take into consideration the impact of its current policy choices on future in‡ationary expectations since, in the presence of asymmetric information, the public learns from past economic developments about future values of the CB output target and future in‡ation. This fundamentally alters the CGG CB optimality condition, in the face of a cost shock under discretion. In addition to setting policy so as to equate the current marginal cost of in‡ation to the current cost of the output gap, the CB also takes into consideration the impact of its current policy choice on the future value of its objectives through the impact of current policy on future in‡ationary expectations. There are several reasons to believe that the notion there is private information about the CB forecast of potential output and about its output target is realistic. Potential output is not a 3

concept that lends itself to obvious statistical measurement. It is meant to capture the productive capacity of the economy under "normal" conditions and is usually approximated empirically by some smooth version of actual output. Although many central banks publish estimates of potential output that are based on such smoothers there is little doubt that, when setting policy, central bankers use information beyond those published …gures to arrive at estimates of the policy relevant output gap.2 Although we agree with Blinder (1998) view that, on average over long periods of time, the output target is equal to potential output as perceived by the CB, we believe there may be persistent deviations from this benchmark in the short and intermediate run for several reasons. First, actual policies are decided by committees or Councils whose members have di¤erent views about what is "normal" output as well as about the functionning of the economy. Changes in the composition of committtees or in the e¤ectiveness of di¤erent members in persuading other members lead the entire committee to behave as if its output target has changed. Second, the CB is involved in decision making under uncertainty and its decisions and pronouncements re‡ect both the probability distribution, as well as the shape of its loss function. There is evidence that some central banks are more averse to negative than to positive output gaps of a given size and that the extent of this asymmetry changes over time. There is also evidence that, during periods of in‡ation stabilization central bankers are more averse to positive than to negative in‡ation gaps of a given size, and that the extent of this asymmetry also ‡uctuates over time (Ruge-Murcia (2003), Cukierman and Muscatelli (2007)). Fluctuations in those degrees of asymmetry may be modeled as changes in the (possibly implicit) output target of the CB At the methodological level this paper extends and modi…es the CGG analysis of discretionary policy in a forward looking economy to account for private CB information about 2 A discussion of the reasons for this state of a¤fairs as well as of the discrepencies between Woodford (2003) notion of potential output and that utilized by central bankers appears in Cukierman (2007).

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its output target and its (full) forecast of potential output. The public observes past economic outcomes and, knowing that they partially re‡ect past persistent output targets, utilizes those observations to forecast future in‡ation. Although the public utilizes this information in an e¢ cient manner it cannot fully disentangle between persistent changes in the output target and between the CB forecast of innovations to potential output. As a consequence the public learns optimally, but gradually, about changes in the output target of the CB. The framework of the paper makes it possible to study factors that are conducive to better or poorer anchoring of in‡ationary expectations. Those expectations are said to be better anchored (and the reputation or credibility of the CB better) the smaller the impact of current policy actions on future expectations.3 Obviously, better anchoring of future expectations is bene…cial since it allows the CB to focus more on stabilization of current output and in‡ation around their respective targets. A main result of the paper is that the anchoring of in‡ationary expectations is better the lower the degree of ‡exibility in targeting in‡ation. There is thus a tradeo¤ between a high relative preference for stabilization of output and the anchoring of in‡ationary expectations. At the extreme, under strict in‡ation targeting, in‡ationary expectations are perfectly anchored. Section 2 introduces asymmetric information into CGG model and speci…es the structure of information. Section 3 derives a rational expectations equilibrium in which the CB policy rule and the public’s signal extraction problem are simultaneously determined. The nature of equilibrium and preliminary comparative static results are presented in section 4. 3

Note that in CGG there is perfect anchoring of expectations in this sense by assumption. Faust and Svensson (2001) use a framework with private information about the CB output target to investigate the desirability of transparency. But economic structure in their model is characterized by a Friedman - Lucas expectations augmented Phillips curve, rather than by a forward looking economy of the type considered here.

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2

The model economy, the structure of information and central bank objectives

2.1

Economic structure

The structure of the economy is given by a variant of the forward looking economy exposited in Clarida, Gali and Gertler (1999) (CGG). The behavior of the economy is described by

xt

yt

zt =

t

'(it

Et

= xt + Et

t+1 )

t+1

+ Et xt+1 + gt

(1)

(2)

+ ut

Here yt and zt are respectively (the logarithms of) the deviations of actual and of potential output from a long run deterministic trend, xt and Et xt+1 and Et

t+1

t

are the output and the in‡ation gaps,

are the expected values of those variables conditioned on the information

available in period t, it is the short term nominal rate of interest, gt is a demand shock, ut is a cost shock and ';

and

are positive coe¢ cients. The stochastic behavior of the deviation of

potential output from its long run trend and of the two shocks is stationary but persistent, and is given by

zt =

zt

1

+

t

0