Does Financial Structure Matter for the Information Content of Financial Indicators?

Of particular concern to monetary policy-makers is the considerable unreliability of financial variables for predicting GDP growth and inflation. As Stock and Watson (2003) find, some financial variables work well in some countries or over some time periods and forecast horizons, but the results do not show any clear pattern. This may be caused by the changing nature of financial structures within countries across time, or the differing types of financial structures across countries. The authors assess the extent to which financial structure across countries influences the information content of financial variables for predicting real GDP growth and inflation. Their assumption is that financial asset prices will dominate financial quantities in economies with highly developed market-based financial systems. The authors use standard methods to determine the predictive content of common financial asset prices and quantities for 29 countries. They find no systematic pattern between financial structure and whether financial asset prices or quantities are the best financial indicators for monetary policy. Importantly, financial quantities are sometimes the best financial indicator, even in economies with highly developed market-based financial systems. The authors conclude that it would be difficult to tell, a priori, whether a financial asset price or quantity would be the best indicator for monetary policy for a particular country at a particular point in time.Inflation and prices; Business fluctuations and cycles; Credit and credit aggregates; Monetary aggregates; Interest rates

Another Look at the Inflation-Target Horizon

The conduct of monetary policy within an inflation-targeting framework requires the establishment of an inflation-target horizon, which is the average time it takes inflation to return to the target. Policy-makers have an interest in communicating this horizon, since it is likely to help anchor inflation expectations. This article focuses on the determination of the appropriate policy horizon by reporting on two recent Bank of Canada studies. The evidence suggests that the current target horizon of six to eight quarters remains appropriate. It is important to note that the duration of the optimal inflation-target horizon varies widely, depending on the combination of shocks to the economy. In rare cases when the financial accelerator is triggered by a persistent shock, such as an asset-price bubble, it may be appropriate to take a longer view of the inflation-target horizon.

Uncertainty and Multiple Paradigms of the Transmission Mechanism

An important challenge facing central banks is making decisions under uncertainty about the dynamic effects of monetary policy actions. The authors stress the importance of explicitly recognizing uncertainty about the transmission mechanism when formulating policy advice. They argue that one way to manage monetary policy under uncertainty is to draw on both an output-gap paradigm and a money paradigm of the transmission mechanism to inform decision-making. Taking an eclectic, diversified approach to guide policy judgements could improve the policy outcome.Monetary policy framework; Uncertainty and monetary policy

Asset-Price Misalignments and Monetary Policy: How Flexible Should Inflation-Targeting Regimes Be?

The authors analyze the extent to which inflation-targeting frameworks should incorporate flexibility in order to respond to asset-price misalignments and other atypical events. They examine the costs and benefits of adding flexibility to the Bank's current inflation-targeting framework, and conclude that maintaining low and stable consumer price inflation is the best contribution that monetary policy can make to promoting economic and financial stability, although some flexibility in the target horizon may allow monetary policy to deal appropriately with asset-price bubbles and other atypical events. The authors suggest that monetary policy may, in principle, be better able to maintain low and stable consumer price inflation by leaning against an asset-price bubble (even though it may mean that inflation deviates longer than usual from its target), when such an event is well identified and likely to have significant real economic effects. This circumstance is likely to be rare in practice, however, because economists are far from being able to determine consistently and reliably when leaning against a particular bubble is likely to be successful. The authors also describe ongoing Bank research to better understand the transmission of asset prices to the real economy and the interaction between asset prices and optimal monetary policy.Monetary policy framework; Inflation targets