Monetary Policy and the Term Spread in a Macro Model of a Small Open Economy

Using a simple single-equation approach, many studies have shown that the term structure of interest rates or its approximation - the term spread - is a useful indicator of future inflation and/or future real economic activity. However, this paper argues that shortcomings of the single-equation approach may produce results that are biased, and that the predictive ability must be analyzed from within a model framework. We have elected to use a simple macroeconomic model of a small open economy and examine the predictive properties of the term spread from within its framework. The main contribution of this paper to the literature is threefold. First, we show that the predictive ability of the term spread is not structural but monetary-policy dependent. Second, we argue that the term spread's predictive ability with regard to future inflation (real economic activity) increases as more emphasis is placed on inflation (real economic activity) stabilization in the central bank's reaction function. Third, we show that understanding the way expectations are formed is an important prerequisite for using the term spread as an indicator. Apart from these general findings, the predictive power of the term spread is examined in the context of the Czech economy. It is shown that the term spread between one-year and three-month PRIBOR interest rates of one percentage-point indicates that agents expect inflation to be almost one percentage-point above the inflation target six quarters in the future.Term spread, Monetary policy, Macroeconomic modeling

Inflation Targeting: to Forecast or to Simulate

Inflation targeting is a regime based to a great extent on communication and, more specifically, on using and communicating assessments of future inflation. The central banking literature, however, devotes surprisingly little attention to some important issues connected with such assessments. There are some non-trivial choices that need to be made regarding future inflation assessments on three distinct levels: construction, decision making and communication. One of the most important choices relates to the treatment of the central bank’s behaviour within the assessment. We first differentiate between two basic ways of assessing future inflation: forecast and simulation. A forecast is the most likely picture of the future. In a forecast, all agents are assumed to behave in the most likely way. A simulation, on the other hand, is the most likely picture of the future if the behaviour of one agent follows a predetermined path or is generated using a selected reaction function. The path or reaction function ascribed to the agent does not have to be the most likely one. After differentiating between a forecast and a simulation, we discuss the pros and cons of using the two ways of assessing future inflation on the three abovementioned levels.inflation targeting, forecast, simulation, central bank, decision making, communication

The CNB's Policy Decisions - Are They Priced in by the Markets?

This paper asks to what extent the market prices in the future monetary policy decisions of the Czech National Bank (CNB), how this policy predictability has evolved over time, and whether the change in the central bank's forecasting methodology in mid-2002 had any impact. Using a sample up to mid-2004, the results are threefold. First, three-quarters of the CNB's decisions were in line with medium-term money market expectations. Notwithstanding this relatively high predictability of CNB policy, the average mistake in the expectations was biased upwards: over the entire IT period the market has priced in a higher repo rate than has actually turned out to be the case. Second, our analysis shows that the period in which forecasts with an active monetary policy (unconditional forecasts) have been used is characterized by smaller 'surprises' of the money market. On the one hand, this may be connected with a change in the CNB's communication of the forecast, including releases of verbal comments on the interest rate trajectory that is consistent with the outlook. On the other hand, it may reflect a different economic environment in the second stage of IT in the Czech Republic. Third, we analyze whether there is convergence or divergence between the central bank's forecast-consistent interest rate trajectory and market forward rates. We show that in most cases market rates converged toward the CNB's interest rate trajectory after the publication of the forecast.Financial market reaction, inflation targeting, monetary policy predictability, term structure of interest rates.

Inflation Targeting as a Stabilisation Tool: Its Design and Performance in the Czech Republic

The article focuses on the development and performance of the Inflation Targeting regime in the Czech Republic. It is shown that the regime design evolved throughout time from a rather specific setting towards a framework based on international best practices. The performance of IT is evaluated using three different methods. The results suggest that even though the inflation targets have been missed more often than met, the Inflation Targeting framework significantly contributed to the stabilisation of the Czech economy.Inflation Targeting Measuring performance of monetary policy

Inflation Targeting: To Forecast or to Simulate?

Inflation targeting is a regime based to a great extent on communication and, more specifically, on using and communicating assessments of future inflation. The central banking literature, however, devotes surprisingly little attention to some important issues connected with such assessments. There are some non-trivial choices that need to be made regarding future inflation assessments on three distinct levels: construction, decision making and communication. One of the most important choices relates to the treatment of the central bank's behaviour within the assessment. We first differentiate between two basic ways of assessing future inflation: forecast and simulation. A forecast is the most likely picture of the future. In a forecast, all agents are assumed to behave in the most likely way. A simulation, on the other hand, is the most likely picture of the future if the behaviour of one agent follows a predetermined path or is generated using a selected reaction function. The path or reaction function ascribed to the agent does not have to be the most likely one. After differentiating between a forecast and a simulation, we discuss the pros and cons of using the two ways of assessing future inflation on the three abovementioned levels.