5- Inflation targeting

Question 1

What happens when the Bank of England misses inflation target by +/-1%?

Answer 1

They must write a letter to the government explaining why they’ve missed the target and what’s being done to correct

Question 2

Outline 3 main reasons central banks don’t want deflation

Answer 2

-Lost tax revenue
-Downward wage rigidity
-Avoiding the ZLB

Question 3

Why does deflation lose the government tax revenue?

Answer 3

For example the same rate of VAT will generate less tax if a good falls from $100 to $90

Question 3

What are 2 main reasons prices are sticky in the short-run?

Answer 3

-Time dependent price setting: firms decide to adjust prices at given periodic intervals
-State dependent price setting: firms make measured assessments of appropriate prices given economic conditions (this is intensive and cannot be continuous)

Question 3

Why is downward wage rigidity problematic for deflation?

Answer 3

Deflation means salary contracts become more expensive so firms may be forced to reduce nominal wages

Question 4

What is the short-run Fisher equation?

Answer 4

Nominal interest rate = Real interest rate + Inflation expectations
i = r + πᵉ

Question 5

What does short-run price rigidity mean for inflation expectations (πᵉ)?

Answer 5

Inflation expectations can be seen as a constant in the short-run

Question 6

What do constant inflation expectations mean for interest rate policy?

Answer 6

Changes in the nominal rate have a direct impact on the real interest rate which is how saving and investment can be manipulated to control the economy

Question 7

What is the neutral rate (r*)?

Answer 7

The real policy interest rate consistent with full employment, zero output gap and stable inflation

Question 8

When are central banks taking monetary policy stances?

Answer 8

When the nominal rate (i) is set such that:
r < r* (expansionary) or
r > r* (contractionary)

Question 9

Why does the Zero Lower Bound (ZLB) mean central banks want to avoid deflation?

Answer 9

Central banks can only cut nominal rates (i) to zero, if inflation target is too low, the extent to which central banks can cut real rates (r) to stimulate the economy is limited

Question 10

What happens to the real interest rate in the long-run?

Answer 10

The obsoletion of cyclicality in the long-run means the real interest rate is constant and independent of monetary policy r = r* = r̄

Question 11

What does a constant real interest rate (r̄) in the long-run mean for the neutral nominal rate (i*)?

Answer 11

In the long-run there is a direct relationship between the inflation target (πᵀ) and the neutral nominal rate (i*) such that it determines how far above the ZLB policy rate will be in neutral state

Question 12

Outline the basic reasoning behind the 2% inflation target?

Answer 12

Low enough that inflation at this level is not detrimental to the economy. Far enough away from ZLB that monetary policy has room to cut rates if needs to stimulate economic activity

Question 13

What fundamentally drives the neutral real rate (r*)?

Answer 13

Structural supply and demand for money i.e. higher propensity to save (supply↑) or lower propensity to invest (demand ↓) makes money cheaper (r*↓)

Question 14

Outline 3 main determinants of the neutral rate (r*)

Answer 14

-Economy’s potential growth rate
-Demographic trends
-Risk appetite

Question 15

How does the economy’s potential growth rate affect r*?

Answer 15

-Weaker growth lowers the marginal return on capital, decreasing investment.
-Weaker growth lowers expected incomes so households save more in response

Question 16

How do demographic trends affect r*?

Answer 16

-Higher share of working age population leads to more saving
-Increasing life expectancy means people have to save more for a longer retirement

Question 17

How does risk aversion affect r*?

Answer 17

Higher risk aversion increases savings and reduces investments which have uncertain returns

Question 18

How does the target control inflation expectations?

Answer 18

The target serves as a nominal anchor, it is a number easily understood by the public who trust the central bank will do what it takes to achieve it

Question 19

What do anchored inflation expectations look like in practice?

Answer 19

-Price and wage setting consistent with target
-Long term contracts assume target inflation

Question 20

Why do well anchored expectations help achieve monetary policy goals?

Answer 20

If there’s an exogenous inflationary shock, well anchored expectations mean agents will continue
behaving according to the target and won’t exacerbate it through distortionary behaviour

Question 21

Briefly outline why central banks were slow to respond to inflation in 2021

Answer 21

Assumed transitory inflation and well anchored expectations when actually they were below target

Question 22

What are the consequences of de-anchored inflation expectations?

Answer 22

-Behaviour makes inflation self fulfilling by higher expectations for contracts etc
-Economically costly to reconvince people central bank will do what it takes to achieve target

Question 23

Outline the ‘Capital of Inattention’ towards inflation in the 2010s

Answer 23

Consistently low inflation meant agents became used to it and adjusted behaviour accordingly e.g. index linked loans became largely obsolete

Question 24

Describe the main structural supply-side reason for low inflation in the 2010s

Answer 24

Globalisation meant competitive international markets limited inflation in traded goods and labour intensive factor inputs could be outsourced to cheaper countries

Question 25

What were the 2 main demand-side reasons for low inflation in the 2010s?

Answer 25

-Sluggish recovery meant low demand
-GFC scarring led to risk aversion amongst lenders and borrowers

Question 26

How did central banks respond to the great recession?

Answer 26

Lowered policy rates to near zero and had to implement QE to further stimulate

Question 27

What is the main reason QE did not cause inflation post-GFC?

Answer 27

Central banks increased liquidity through the banking sector via reserves, this didn’t increase lending because of heightened risk aversion so wasn’t translated into broad money

Question 28

Why is changing the inflation target problematic?

Answer 28

Changing the target jeopardises credibility so a very convincing reason is required to avoid de anchoring expectations

Question 29

What is Flexible Average Inflation Targeting (FAIT)?

Answer 29

Seeking inflation that averages the target over an unspecified time frame

Question 30

What is the main benefit of FAIT?

Answer 30

If credible, inflation expectations stay at target even if there are under/overshoots because policy will ensure there is a compensating effect over the long run