Inflation Targeting Framework for Jamaica: An empirical exploration

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Inflation Targeting Framework for Jamaica An
empirical exploration
Bosede Nelson-Douglas Research Economic Program
ming Division Bank of Jamaica The Role of Infl
ation Targeting, Federal Reserve Bank, Atlanta
October 4-5, 2004
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Presentation Outline

• Brief Discussion on the conduct of Monetary
  policy in Jamaica
  
• The Rational for Inflation Targeting for Jamaica
• Brief Highlight on the Prerequisites for
  Inflation targeting
  
• Testing the prerequisites of IT for Jamaica.
• Survey approach to determine Bank of Jamaicas
  independence
  
• Test to determine level of seigniorage and
  Financial market depth in Jamaica
  
• Issues of design and implementation of IT for
  Jamaica.
  
• Definition of the price index,
• Evaluation of the Monetary Control lags within
  the framework of a VAR model
  
• Monte Carlo Simulation of how IT could work for
  Jamaica and the determination of the optimal
  inflation target horizon
  
• Policy implications and recommendations

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The Conduct of Monetary Policy in Jamaica

• The challenges to Base money Management
  includes
  
• The Liberalization of the foreign exchange market
  in 1990 and capital account in 1991
  
• The Financial System crisis in 1997/1998
• The continued deterioration of the fiscal
  accounts and the heavy debt burden
  
• The rapid financial innovation in the financial
  institutions
  
• Adverse terms of trade and external shocks,
  particularly from oil prices and other commodity
  prices.

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The Conduct of Monetary Policy in Jamaica
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Rationale for IT as a framework for Monetary
policy in Jamaica

• The Weakening of the link between monetary
  aggregate and inflation due to financial
  innovations of the 1990s and other challenges to
  base money management
• Monetary aggregates have not been able to provide
  an adequate signal about the stance of MP, which
  makes it difficult to serve as a communication
  device
• Base money targeting has generally not been a
  good guide for assessing accountability of the
  central bank, particularly in light of the need
  for more credibility given the huge fiscal
  burden

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Highlights of the fundamental Prerequisite for IT

• IT is defined as a monetary policy operating
  strategy that includes the following elements
  
• A commitment to price stability as the primary
  goal
  
• Accountability of the central bank for attaining
  its monetary policy goal
  
• The public announcement of the inflation target
• A policy for communicating to the public, the
  rationale for the decisions taken by the Bank
  
• The ability to carry out an independent monetary
  policy
  
• A quantitative framework linking monetary policy
  to inflation
  

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Testing the Prerequisite of IT for Jamaica

• Two major tests are conducted to determine the
  feasibility of IT for Jamaica
  
• The First test involves a survey approach based
  on a set of indicators to test the degree of
  BOJs independence. The method involves
  
• Classifying independence into political and
  economic independence, the former including 29
  indicators and the latter, 7 indicators.
  
• The indicators of political independence broadly
  includes the relationship between board members
  and the Governor at BOJ and the extent of Board
  members intervention in the decision making
  process

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Comparative Results of CBI for Jamaica and France
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CBI for Other Selected Countries
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Testing the Prerequisite of IT for
Jamaica,continued

• The Second Major test involves the determination
  of the level of Seigniorage and financial market
  depth in Jamaica.
  
• Seigniorage and 3 indicators of financial market
  depth was calculated, these include the average
  and standard deviation of the real interest rate
  on domestic deposits, and the average ratio of
  broad money to GDP
• Heavy use of seigniorage is a common indicator of
  fiscal dominance, while positive real rates are a
  precondition for substantial financial deepening
  which enhances the financial intermediation
  process. The degree of monetisation is captured
  by the ratio of broad money/GDP

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Issues of design and implementation
Definition of the price index

• Headline vs. core inflation
• The BOJ in 1997 developed a measure of core
  inflation (the trimmed mean approach) which it
  publishes, along with headline inflation
  
• For IT, the appropriate choice of the index is
  critical, and headline inflation rather than core
  may be advantageous, given the familiarity of
  this index to the public
• Since CPI carries a heavy weight for volatile
  items such as food, the approach to determine
  which index to use entailed using a 3 variable
  VAR model of food prices, headline and core
  inflation to ascertain the effect of this
  volatility on inflation and how quickly these
  shocks dissipate.

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Issues of design and implementation Definition
of the price index, contd
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Issues of design and implementation Monetary
control lags,

• To determine the monetary lags the paper uses a
  reduced-form VAR which provides the basis to
  stage a series of simulation that shows the
  potential effects of adopting IT in Jamaica
• The variables in the VAR were guided by previous
  work done at the Bank. The data spans the period
  199301 to 200312

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Issues of design and implementation Monetary
control lags,

• VAR Model

Mt is the log of the growth rate in the value
of imports Tbt is the log of 180-day Treasur
y bill rate Pt is the log of Consumer price i
ndex Bmt is the log of base money St is th
e log of the weighted average selling exchange
rate Yt is the log of output gap using a Nelson
-Beveridge decomposition of actual from Trend
?i are the shocks from the model
C(L) are the lag polynomials
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Issues of design and implementation Monetary
control lags, - impulse Response
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Issues of design and implementation Monetary
control lags, - impulse Response
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Issues of design and implementation Monetary
control lags, contd
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Issues of design and implementation Monetary
control lags, contd
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Monte Carlo simulation to determine how MP will
evolve under an IT framework

• The Setup for the Inflation targeting Regime for
  BOJ is as follows
  
• BOJ decides to adopt IT and meet monthly to
  update their inflation forecast from January 2001
  to December 2003
  
• The inflation forecast is the intermediate target
  of monetary policy
  
• The Inflation target is 5.0 percent
• The Horizon is set between 12 and 24 months
• The Inflation target band is 1.0 percentage points

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Monte Carlo simulation to determine how MP will
evolve under an IT framework

• Assumptions are
• Equation 1 is a true representation of the
  Jamaican economy
  
• The monetary transmission lags are stable
• The simulation setup
• is derived from subjecting the model to both
  external and domestic shocks, which are drawn
  with equal probability from the reduced form
  model. These shocks are taken from relatively
  stable period and apply to all variables in the
  VAR
• Based on shocks from the previous period, the BOJ
  updates its inflation forecast each month

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IT simulation to determine the Inflation target
horizon

• The methodology
• Et ? th e? x Bh x Et ? t
• ? t mt, Tbt, pt, bmt, st,
  yt,
  
• Bh the coefficient associated
  with the hth lag
  
• The h-period ahead inflation forecast

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IT simulation to determine the Inflation Target
horizon

• Monetary Policy Rule
•   
•  
•   Is the inflation target
• is the
  contemporaneous money growth innovation
  
• .
• Is the width of the inflation target bank  

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IT simulation to determine the Inflation Target
horizon

• The Results show that
• a Lower volatility in macroeconomic variables is
  expected to occur over a shorter than a longer
  horizon
  
• the Optimal forecast horizon lies between 12 and
  18 months
  
• Given the objective of stability, the fact that
  supply side shocks dissipate in one year and the
  monetary transmission mechanism is 85 percent
  complete at 12 months, this horizon seems to be
  the viable choice
• An 18 months horizon is also a feasible
  alternative given the completion of the
  transmission process at this horizon
  
• A 24-month horizon is totally ruled out as it
  render monetary policy ineffective

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Conclusions and Policy Implications

• IT represents a feasible alternative for the BOJ
  to achieve its objectives, but issues relating to
  the Fiscal burden and reform of the legal
  framework governing the BOJ remains a critical
  element
• If IT is a desired alternative, the possible
  solution is to reform the legal framework to
  establish full autonomy of the bank or implement
  IT after sustained reduction in the fiscal
  deficit
• Other conclusions from the paper includes
• Headline inflation should be the index of choice
  under an IT regime
  
• It takes 21 months for the transmission
  mechanism to be 100 percent complete
  
• Given the relevance of a shorter horizon for IT,
  an 12 month Inflation target horizon is the
  preferred choice