Monetary policy and interest rates under inflation targeting in Australia and New Zealand

One advantage cited for formal inflation targeting is that by anchoring inflationary expectations this policy framework would aid in the pricing of long-term securities. Long-term interest rates would become less sensitive to temporary shocks to the economy including policy-induced changes in short-term interest rates. This paper examines the experience in this regard of New Zealand and Australia, two countries that have been inflation targeters for many years. Our results are consistent with inflationary expectations having become more firmly anchored after the move to inflation targeting in each country. There is no evidence that the credibility of the inflation-targeting regime in either country weakened during the recent world financial crisis. © 2014 New Zealand Association of Economists Incorporated

What to Aim For? The Choice of an Inflation Objective When Openness Matters

Inflation targeting countries generally define the inflation objective in terms of the consumer price index. Studies in the academic literature, however, reach conflicting conclusions concerning which measure of inflation a central bank should target in a small open economy. This paper examines the properties of domestic, CPI, and real-exchange- rate-adjusted (REX) inflation targeting. In one class of open economy New Keynesian models there is an isomorphism between optimal monetary policy in an open versus closed economy. In the type of model we consider, where the real exchange rate appears in the Phillips curve, this isomorphism breaks down; openness matters. REX inflation targeting restores the isomorphism but this may not be desirable. Instead, under domestic and CPI inflation targeting the exchange rate channel can be exploited to enhance the effects of monetary policy. Our results indicate that CPI inflation targeting can deliver price stability across the three inflation objectives and will be desirable to a central bank with a high aversion to inflation instability. REX inflation targeting does well in delivering output stability and has a relative advantage in economies where demand shocks are predominant. In general, the choice of the inflation objective affects the trade-offs between policy goals and thus policy choices and outcomes

Real-Exchange-Rate-Adjusted Inflation Targeting in an Open Economy: Some Analytical Results

Policymakers in small open economies around the world are increasingly concerned about the undesirable consequences of sudden increases in U.S. interest rates. This paper demonstrates that in a small open economy a central bank can successfully ward off sudden changes in foreign interest rates and risk premium shocks – portfolio shocks - by choosing a core rate of inflation, real-exchange-rate-adjusted (REX) inflation, as its inflation objective and adding the real exchange rate to a Taylor-type rule. 1 The Taylor-type rule with a prescribed exchange rate response becomes a Monetary Conditions Index (MCI). From a welfare perspective the Taylor-type rule, with (the MCI) or without the exchange rate response, delivers welfare losses that are substantially greater than under optimal policy with commitment. But the performance of the properly designed MCI relative to other Taylor type rules improves with portfolio shocks becoming a more important source of disturbances

What to Aim for? The Choice of an Inflation Objective when Openness Matters

Inflation targeting countries generally define the inflation objective in terms of the consumer price index. Studies in the academic literature, however, reach conflicting conclusions concerning which measure of inflation a central bank should target in a small open economy. This paper examines the properties of domestic, CPI, and real-exchange- rate-adjusted (REX) inflation targeting. In one class of open economy New Keynesian models there is an isomorphism between optimal policy in an open versus closed economy. In the type of model we consider, where the real exchange rate appears in the Phillips curve, this isomorphism breaks down; openness matters. REX inflation targeting restores the isomorphism but this may not be desirable. Instead, under domestic and CPI inflation targeting the exchange rate channel can be exploited to enhance the effects of monetary policy. Our results indicate that CPI inflation targeting delivers price stability across the three inflation objectives and will be desirable to a central bank with a high aversion to inflation instability. CPI inflation targeting also does a better job of stabilizing the real exchange rate and interest rate which is an advantage from the standpoint of financial stability. REX inflation targeting does well in achieving output stability and has an advantage if demand shocks are predominant. In general, the choice of the inflation objective affects the trade-offs between policy goals and thus policy choices and outcomes