## 1. Central Bank Experiences with Inflation Forecast Targeting (IFT) ## Source details **Canonical URL:** [1. Central Bank Experiences with Inflation Forecast Targeting (IFT)](https://www.imf.org/-/media/files/publications/wp/2019/wpiea2019103.pdf) ## Other formats - [Markdown version](/-/media/files/publications/wp/2019/wpiea2019103.pdf.md) - [Structured JSON version](/-/media/files/publications/wp/2019/wpiea2019103.pdf.json) --- ### Introduction - Assessment focus: - Challenges facing monetary policy under inflation targeting (IT) since the Global Financial Crisis (GFC). - Argument that effectiveness can be enhanced by strengthening communications and the policy framework. - Paper structure highlights: - Review of Korea’s IT experience after the GFC as inflation fell below its target range. - Identification of key challenges: risk of de-anchoring inflationary expectations; declining equilibrium real interest rate (ERIR); exchange rate volatility; tensions between inflation and financial stability objectives. - Proposal of a two-pronged approach to enhance communications with a greater medium-term policy focus. - Simulations using a model calibrated to Korea illustrating benefits of a forecasting and policy analysis system (FPAS). ### Inflation Targeting Performance (Korea) - Historical and post-GFC trajectory: - Korea adopted inflation targeting in 1998 following 1997–98 Asian crisis reforms; IT framework agreed by government and Bank of Korea (BOK). - Pre-GFC: inflation remained relatively stable around its target, aided by the “great moderation” and steady appreciation of the won after its sharp fall in the Asian crisis. - After the GFC: - Growth remained relatively weak and below potential. - Output gap and a global deflationary shock from a fall in commodity prices pushed inflation below its target range in 2012. - In 2014, inflation expectations fell below the target range, indicating weakening of the nominal anchor. - BOK mandate evolved in 2011 to add a financial stability objective, increasing the need to balance inflation and financial stability objectives. - Policy tradeoff example: - When policy interest rates needed to narrow the output gap are low enough to exacerbate financial stability risks, conflict between objectives can arise. - Example: inflation fell below target and the policy rate was cut to a low of 1.25 percent — raising concern that the central bank might deviate from its inflation target to address financial stability, weakening credibility. ### Policy Framework Change and Credibility - June 2016 change: - BOK replaced the 2½–3½ percent target range with a point target of 2 percent — described as a percentage point cut relative to the midpoint of the previous range. - Rationale: part of the BOK’s regular triennial review; assessment that optimal inflation target had declined owing to structural changes (e.g., rapid population aging); aligned the target with the standard in most advanced economies. - Timing risk: - With inflation below target, the June 2016 change contributed to a perception that the target was cut to match the lower inflation rate rather than implying policy would aggressively return inflation to the old target. ### Box 1 — General Principles of Monetary Policy Operation: Core principles - Mandate excerpt: goal of monetary policy in the Bank of Korea Act is to “contribute to the sound development of the national economy through ensuring price stability, while giving due consideration to financial stability in carrying out its monetary policy.” - Core principles the BOK sets: - Inflation targeting: inflation target is currently set at a 2 percent rate of consumer price inflation (year-on-year). - Medium-term horizon: target to be achieved over a medium-term horizon, reflecting transitory/irregular factors and lags in transmission. - Forward-looking operation: policy conducted forward-lookingly and considering symmetrically the risks of inflation above or below target. - Flexible operations: policy supports real economic growth insofar as it does not hinder attaining the inflation target over the medium term. - Financial stability: careful attention to monetary policy’s impact on financial stability. - Relation of financial stability to IT: persistent financial imbalances could undermine macro stability; give due attention to financial stability within flexible IT. - Assessment and harmonization: regular assessment and reporting on financial stability; complement monetary policy with macroprudential policies. ### Box 1 — Key challenges for monetary policy after the GFC - Four identified challenges: - Managing inflationary expectations in a more uncertain post-GFC environment. - Decline in the equilibrium real interest rate (ERIR). - Exchange rate volatility. - Tensions between financial stability and inflation objectives. - Managing inflationary expectations: - Larger and more varied shocks led to more persistent deviations of inflation from target, making credibility harder to sustain and increasing the sacrifice ratio. - Remedy: active management of expectations — strengthen communications on how the central bank intends to adjust the policy rate path to return inflation to target over the medium term and implement policy consistent with that communication (communicate the central bank’s reaction function). - Rationale: monetary transmission depends on moving long-term rates; communications that shape expectations help price a policy path into longer-term rates. - Decline in ERIR: - ERIR declined in advanced economies since the GFC; implies a lower policy rate is needed to hit the target and raises scope for error. - Remedies: improved estimation of ERIR and clear communication about uncertainty and management approaches; a lower ERIR increases risk of hitting the ELB in large negative shocks and justifies a more aggressive policy response when close to the ELB. - Heightened exchange rate volatility: - Exchange rate flexibility is important for medium-term effectiveness, but short-run volatility increases policy uncertainty. - Korea experience after the GFC: roughly 30 percent depreciation of the won against the dollar helped reverse a sharp increase in the output gap; the won then rebounded 35 percent to reach a post-crisis high in 2014 as the gap narrowed. - Since 2013, correlation of the won with the output gap weakened as volatility remained relatively high while the output gap stabilized. - Remedies: strengthen communication on the transitory impact of currency volatility on inflation; commit to a flexible exchange rate and clarify the limited role of FX intervention (FXI) — i.e., to address disorderly market conditions — to avoid undermining credibility. - Balancing financial and monetary stability objectives: - Low interest rates needed to return inflation to target can exacerbate financial stability risks, creating incentives to “lean against the wind” and potentially raise rates prematurely. - Use macroprudential policy as a second instrument targeting financial stability risks so monetary policy can focus on the inflation target. - Preconditions: strong macroprudential framework and sufficient central bank influence over macroprudential tools. - Role for monetary policy when risks materialize: monetary easing can help prevent financial distress from worsening downturns; in severe crises monetary policy may need temporary diversion from the inflation objective to stabilize financial or exchange markets. ### Strengthening monetary policy effectiveness: a two-pronged approach - Overall approach: - Clarify (i) how the inflation target will be achieved over the medium-term via a forecasting and policy analysis system (FPAS), and (ii) how macroprudential policy will be used to contain financial stability risks so monetary policy can focus on achieving the inflation target. - A. BOK communication of monetary policy - 2012–16 Monetary Policy Reports (MPRs) highlighted economic weakness but provided limited guidance on how the policy rate would be adjusted. - Lending rates did not respond fully to policy rate cuts; question whether markets adequately priced-in policy easing. - 2016 signaling: expand explanations behind decisions, signal future policy directions, better connect with economic outlooks, and expand disclosure of MPB meeting materials via MPR and press releases. - Current practice: high transparency — MPC members’ views summarized after each meeting; dissenting votes and assessments reported separately — communicating MPC assessment, diversity of views, and macroeconomic developments that could prompt policy rate adjustments. - Opportunity: strengthen communication on how the central bank intends to adjust the policy rate to return inflation to target over the medium term. - B. BOK communication relating to financial stability - Financial Stability Report (FSR) provides high-quality analysis of risks and macroprudential policy impact; shows macroprudential policy has been effective and framework being strengthened (e.g., addition of a new Debt Service Ratio instrument). - Opportunity: broaden the FSR to clarify how tensions between inflation and financial stability objectives will be managed. - Recent BOK and MPC statements on this have been relatively general and may contribute to uncertainty about how the trade-off will be managed and commitment to the inflation target. - Remedies: communicate complementary roles of monetary and macroprudential policy, assess macroprudential effectiveness, discuss circumstances under which monetary policy may need to lean against the wind, and address how to strengthen the macroprudential framework and roles of other entities (e.g., Financial Stability Committee). - C. Communicating medium-term policy intentions (Inflation Forecast Targeting, IFT) - BOK could strengthen interest rate expectations management through forward guidance on how it intends to adjust the policy rate to return inflation to target over the medium term. - Risk to avoid: misinterpretation as commitment to a specific policy rate path. - Many central banks use quantitative models to identify a policy path that returns inflation over a medium-term forecast horizon — “inflation forecast targeting” (IFT). - IFT communication ranges from qualitative descriptions to publication of a numerical path; all emphasize conditionality and revision in response to shocks and new data. - Implementing IFT requires addressing model limitations via an FPAS that integrates model-based analysis with a broad set of data and information tailored to the country. - D. Central bank experiences with IFT - IFT can enhance effectiveness and credibility by communicating the central bank’s reaction function while avoiding misinterpretation as a committed policy rate path. - Country experiences suggest IFT provides a more resilient nominal anchor; inflation expectations remain more firmly anchored during significant deviations of inflation from target. - Transparency improvements are associated with IFT central banks (Dincer-Eichengreen index); IFT central banks appear to have more firmly anchored inflationary expectations and smaller deviations of inflation from target. ### Communications Near the ELB - Key indicators and country examples excerpted: - Czech Republic 0.6 1.7 (-0.3) 2.1 (0.1) -0.2 Yes (2002) - New Zealand 0.7 1.7 (0.3) 2.0 (0.0) -0.3 Yes (1997) - Sweden 1.0 1.5 (-0.5) 2.2 (0.2) -0.3 Yes (2007) - United States 1.3 2.3 (0.0) 2.3 (0.0) 0.0 Yes (2012) - Euro Area 0.3 1.3 (-0.7) 1.5 (-0.5) -1.2 No - Japan -0.1 0.6 (-1.4) 0.9 (-1.1) -2.5 No - (Source: CDIC) - Key findings and rationale: - With the policy rate close to a record low and inflation below the 2 percent target, Korea faces material risk of hitting the ELB in a negative shock. - ELB creates an asymmetric risk because conventional policy becomes less effective at the ELB; this justifies more aggressive easing when inflation and the policy rate are low. - Aggressive easing aims to return inflation to target more quickly so the policy rate can be raised to a neutral level. - Policy communication prescription near the ELB: - Adopt a more accommodative near-term stance to ensure faster convergence of inflation to the target. - Allow inflation to overshoot the target in expectation by committing to keep nominal rates at the ELB for longer, generating stimulus via reductions in the real interest rate through higher expected inflation. - When at the ELB, focus on expectations channels: an “active” policy of announcing commitment to keep the policy rate at the ELB for as long as needed raises inflationary expectations, reduces real interest rates, and depreciates the real exchange rate; quantitative easing can reinforce these effects. - Avoid a “passive” ELB stance without an announcement effect, which risks a downward spiral of declining inflation, rising real rates, and falling output. - Label this management of interest rate expectations near the ELB as ad-hoc forward guidance to distinguish it from conventional forward guidance (Obstfeld 2016). ### Implementing a Model-Based FPAS - Purpose and benefits: - Integrates a wide range of information with model-based analysis for policy decisions. - Helps the MPC adopt a more strategic, medium-term policy focus and avoids excessively short-term bias. - Models, suitably qualified, aid communication of policy intentions and clarify the policy reaction function. - FPAS outputs and communication: - Model-based macroeconomic baseline forecast including an endogenous path for the future short-term interest rate that achieves the inflation target. - Quantification of uncertainty via model-consistent confidence intervals reflecting historical shock variability. - Risk assessments presented as alternative scenarios for assumed shocks and policy reaction function options. - Publication of baseline, risk assessments, and alternative scenarios can clarify current stance and conditional policy responses. - Publishing the endogenous future path for the short-term interest rate is feasible with caveats to avoid misinterpretation; it effectively communicates the MPC’s “reaction function.” ### Model Design, Simulations, and Scenarios - Model structure — key components: - Four behavioral equations: output gap (aggregate demand), expectations-augmented Phillips curve, policy reaction function, and open interest rate parity. - Additional identities: headline inflation; trade and financial linkages; longer-term interest rates. - Forward-looking, model-consistent expectations. - Nonlinearities: Phillips curve flattening with larger negative output gap; ELB constraint; quadratic policy reaction function. - Two reaction functions: - IFB: linear, inflation-forecast-based Taylor rule responding to output gap and one-year ahead forecast inflation relative to target; includes lagged policy rate smoothing. - OPT: non-linear, loss-minimization rule with quadratic loss on squared inflation gap and squared output gap and squared change in policy rate for smoothing; induces stronger responses to larger shocks and a risk-management stance near the ELB. - Historical simulation (starting 2013Q1) — initial conditions: - Negative output gap of 1.5 percent of GDP. - Inflation rate of 1.5 percent (below mid-point 3 percent target then). - Simulated policy responses vs actual: - IFB: interest rate cut 100 basis points within a year vs actual 25 basis points; by end-2015 output gap closed and inflation returned to target in simulation. - OPT: 200-basis-point cut, more rapid gap closure and temporary inflation overshoot. - Interpretation: actual policy reductions appear too gradual to close the negative output gap and return inflation to target over the 4-year period, though unmodeled negative shocks after 2013Q1 weakened outcomes. - Incorporating historical shocks: - When post-2013 negative shocks are added, OPT still implies much larger early rate cuts that are later reversed; easing resumes with subsequent shocks, yielding simulated paths more similar to actual rates. - Conclusion: early aggressive cuts in simulation were sufficient to push output gap and inflation back to target, suggesting actual easing may have been too cautious. - Baseline projections (initial conditions in 2017): - Initial conditions: modest negative output gap; headline inflation at 2 percent; core inflation at 1.5 percent. - Both IFB and OPT generate large, up-front policy rate cuts; OPT is more aggressive with faster output recovery; IFB produces smoother interest rate path. - Difference between OPT and IFB is modest for small shock (starting output gap 0.5 percent); differences grow for larger shocks. - Downside scenario under two reaction functions: - Hypothetical large negative shock: output gap widens to 2 percent (instead of 0.5 percent) with inflation slowing by more than one percentage point. - Both OPT and IFB cut policy rates to the ELB; under OPT the policy rate is cut faster and held at the ELB for one additional quarter. - Under OPT: stronger forward-looking expectations channel leads to output gap positive by mid-2018 and inflation close to baseline by 2019. - Under IFB: much slower recovery. - Downside scenario with fiscal backstop: - When policy rate hits the ELB, fiscal multiplier is larger (no crowding out); combining fiscal and monetary stimulus is more effective. - Adding fiscal expansion equivalent to about one percent of GDP reduces the number of quarters at the ELB under both reaction functions. - Outcome is much better under OPT, where longer monetary accommodation plus fiscal stimulus produces inflation path similar to milder baseline. - Under IFB, recovery remains more sluggish and inflation below baseline for several years, but complementary fiscal expansion improves medium-term outcomes relative to monetary policy alone constrained by the ELB. ### Conclusion — Key policy implications - Achievements and challenges: - BOK achieved stabilization of inflation at a low level after decades of high and volatile inflation. - Post-GFC challenges: inflation persistently below the 2 percent target (target revised in 2016 from range 2.5–3.5 percent to new target of 2 percent), posing credibility risks; potential conflict between financial stability mandate and inflation targeting. - Recommended two-pronged approach: - Strengthen communications on (i) how the inflation target will be achieved over the medium-term, and (ii) how macroprudential policy will be used to contain financial stability risks, including assessment of macroprudential effectiveness and potential need to strengthen the framework. - Adopt a greater medium-term focus using an FPAS with a model calibrated to recent Korean performance and MPC views to generate a policy rate path showing how the inflation target can be achieved. - Communicate the conditional policy path (the MPC’s reaction function) qualitatively or as a numerical forecast to reduce the risk of hitting the ELB by prompting more aggressive responses when that risk is higher. ### Key factual points and metrics cited - Inflation target: 2 percent rate of consumer price inflation (year-on-year). - Policy rate example: cut to a low of 1.25 percent during the post-GFC period. - June 2016 policy change: replaced 2½–3½ percent target range with point target of 2 percent. - Exchange rate movements after the GFC in Korea: roughly 30 percent depreciation of the won against the dollar; the won then rebounded 35 percent to reach a post-crisis high in 2014. - Institutional change: addition of a new Debt Service Ratio instrument to the macroprudential framework. - Simulation specifics: - Historical simulation start 2013Q1: output gap -1.5 percent of GDP; inflation 1.5 percent. - IFB simulated cut: 100 basis points within a year vs actual 25 basis points. - OPT simulated cut: 200-basis-point cut with faster recovery in simulation. - Downside fiscal backstop: fiscal expansion equivalent to about one percent of GDP improves outcomes and reduces time at ELB. *Source: 1. Central Bank Experiences with Inflation Forecast Targeting (IFT), wpiea2019103.* ### 1. Central Bank Experiences with Inflation Forecast Targeting (IFT) ....................................16 ### 1. Central Bank Experiences with Inflation Forecast Targeting (IFT) ### Introduction - Paper assesses challenges facing monetary policy under inflation targeting (IT) since the Global Financial Crisis (GFC). - Argues effectiveness of policy could be enhanced by further strengthening communications and the policy framework. - Sections outlined: - Review of Korea’s experience with IT after the GFC as inflation fell below its target range. - Key challenges: risk of de-anchoring inflationary expectations; declining equilibrium real interest rate; exchange rate volatility; tensions between inflation and financial stability objectives. - A two-pronged approach to enhance communications with a greater medium-term policy focus. - Simulations of a model calibrated to Korea to illustrate benefits of a forecasting and policy analysis system. ### Inflation Targeting Performance (Korea) - Korea adopted inflation targeting as foundation for monetary policy in 1998. - Post-1997–98 Asian crisis reforms included a new IT framework agreed by the government and the Bank of Korea (BOK). - Pre-GFC performance: inflation remained relatively stable around its target (Figure 1), aided by the “great moderation” and steady appreciation of the won after its sharp fall in the Asian crisis. - After the GFC: - Growth was relatively weak and remained below potential. - Output gap and a global deflationary shock from a fall in commodity prices pushed inflation below its target range in 2012. - In 2014, inflation expectations also fell below the target range, pointing to a weakening of the nominal anchor provided by monetary policy. - The BOK’s mandate evolved with the addition of a financial stability objective in 2011 (Box 1), increasing the need to balance inflation and financial stability objectives. - Policy tradeoff example: - When policy interest rates needed to narrow the output gap are low enough to exacerbate financial stability risks, conflict between objectives can arise. - This may have been the case when inflation fell below target and the policy rate was cut to a low of 1.25 percent. - Concern that the central bank will deviate from its inflation target to target financial stability weakens the credibility of the nominal anchor. ### Policy Framework Change and Credibility - In June 2016, the BOK replaced the 2½–3½ percent target range with a point target of 2 percent — a percentage point cut relative to the midpoint of the range. - Rationale: part of the BOK’s regular triennial review, based on an assessment that the optimal inflation target had declined owing to structural changes (for example, rapid population aging). - Also aligned the target with what had become the standard in most advanced economies. - Timing risk to credibility: - With inflation below target, the change in June 2016 contributed to a perception that the target was cut to match the lower inflation rate rather than that policy would aggressively push inflation back to the old target. ### Effectiveness of Monetary Policy after the GFC - Effectiveness can be gauged by assessing transmission of policy rate changes into long-term interest rates. - Indicator: how well the future path of the policy rate is reflected in forward interest rate curves at different points in time (Figure 2). - Closer alignment of the 2-year forward with the policy rate path over the subsequent two years would indicate markets are correctly anticipating, and pricing-in, future policy rate decisions. - Differences between forward rates and policy rate paths can arise from a risk premium in forward rates and unanticipated shocks. - Closer alignment also depends on effective communication of policy intentions and the credibility of IT. *Source: 1. Central Bank Experiences with Inflation Forecast Targeting (IFT), wpiea2019103.* ### Box 1. General Principles of Monetary Policy Operation ### Box 1. General Principles of Monetary Policy Operation ### General principles and objectives - Goal of monetary policy in the Bank of Korea Act: “contribute to the sound development of the national economy through ensuring price stability, while giving due consideration to financial stability in carrying out its monetary policy.” - Core principles the Bank of Korea (BOK) sets to enhance transparency, predictability and effectiveness: - Inflation targeting: The BOK maintains a flexible inflation targeting system; the inflation target is currently set at a 2 percent rate of consumer price inflation (year-on-year). - Medium-term horizon: The inflation target is meant to be achieved over a medium-term horizon, reflecting transitory/irregular factors and lags in monetary policy transmission. - Forward-looking operation: The BOK conducts policy in a forward-looking manner and considers symmetrically the risks of inflation remaining persistently above or below the target. - Flexible operations: Policy supports real economic growth to the extent this does not hinder attaining the inflation target over the medium term. - Financial stability: The Bank pays careful attention to the impact of monetary policy on financial stability. - Relation of financial stability to inflation targeting: Persistent financial imbalances could undermine macroeconomic stability; the Bank gives due attention to financial stability within flexible inflation targeting. - Assessment of financial stability: The Bank examines, assesses and reports on financial stability conditions on a regular basis to help prevent excessive buildup of financial imbalances. - Harmonization with macroprudential policy: Monetary policy needs to be complemented by macroprudential policies because there are limits to maintaining financial stability solely by monetary policy. ### Key challenges for monetary policy after the GFC - Four key challenges identified: - Managing inflationary expectations in a more uncertain post-GFC environment. - The decline in the equilibrium real interest rate (ERIR). - Exchange rate volatility. - Tensions between financial stability and inflation objectives. - Managing inflationary expectations: - Larger and more varied shocks after the GFC led to more persistent deviations of inflation from target, making credibility harder to sustain. - Weakening credibility increases the cost of achieving the target (raising the sacrifice ratio). - Remedy: more active management of expectations—strengthen communications on how the central bank intends to adjust the policy rate path to return inflation to target over the medium term and implement policy consistent with that communication (communicate the central bank’s reaction function). - Monetary policy transmission depends on moving long-term rates; communication that shapes expectations helps price a policy path into longer-term rates. - Decline in the equilibrium real interest rate (ERIR): - ERIR has declined in advanced economies since the GFC; the decline implies a lower policy rate is needed to hit the target. - The decline makes assessment of monetary stance more difficult and raises the scope for error in setting policy. - Improved estimation of ERIR and clear communication about uncertainty and how the central bank will manage it can limit adverse effects on credibility. - A lower ERIR increases the risk that the policy rate could hit the ELB in a large negative shock, justifying a more aggressive policy response when close to ELB. - Heightened exchange rate volatility: - Exchange rate flexibility is important for medium-term monetary effectiveness, but short-run volatility increases policy uncertainty. - Korea experience after the GFC: a roughly 30 percent depreciation of the won against the dollar helped reverse a sharp increase in the output gap; the won then rebounded 35 percent to reach a post-crisis high in 2014 as the gap narrowed. - Since 2013, correlation of the won with the output gap weakened as volatility remained relatively high while the output gap stabilized. - Currency volatility complicates communication by adding to inflation variability and making the inflation target harder to hit. - Remedy: strengthen communication on (i) the transitory impact of currency volatility on inflation, and (ii) a commitment to a flexible exchange rate and to allow it to play its role in monetary transmission. - Clarify limited role of FX intervention (FXI) — i.e., to address disorderly market conditions — to avoid undermining credibility. - Balancing financial and monetary stability objectives: - Low interest rates needed to return inflation to target can exacerbate financial stability risks, creating incentives to “lean against the wind” and potentially raise rates prematurely. - Use of macroprudential policy as a second instrument targeting financial stability risks can allow monetary policy to focus on the inflation target. - Preconditions for this approach: a strong macroprudential policy framework and sufficient influence of the central bank over macroprudential policy to implement pre-emptive measures. - Monetary policy may have a role when financial stability risks materialize: monetary easing can help prevent financial distress from worsening downturns; in severe crises monetary policy may need to be temporarily diverted from the inflation objective to stabilize financial or exchange markets. ### Strengthening monetary policy effectiveness: a two-pronged approach - Overall approach: clarify (i) how the inflation target will be achieved over the medium-term, building on a forecasting and policy analysis system (FPAS), and (ii) how macroprudential policy will be used to contain financial stability risks so monetary policy can focus on achieving the inflation target. - A. BOK communication of monetary policy - Monetary Policy Reports (MPRs) during 2012–16 highlighted weakness in the economy but provided limited guidance on how the policy rate would be adjusted. - Reports note that lending rates did not respond fully to policy rate cuts and question whether markets are adequately pricing-in policy easing. - In 2016 the BOK signaled intention to strengthen communication: expand explanation of backgrounds behind decisions, signal future policy directions, enhance connections with economic outlooks, and expand disclosure of materials from MPB meetings via the Monetary Policy Report and press releases. - Current BOK practice: high transparency—MPC members’ views summarized after each meeting; dissenting votes and assessments reported separately—this communicates MPC assessment, diversity of views, and macroeconomic developments that could prompt policy rate adjustments. - Opportunity: strengthen communication on how the central bank intends to adjust the policy rate to return inflation to target over the medium term. - B. BOK communication relating to financial stability - Financial Stability Report (FSR) provides high quality analysis of risks and the impact of macroprudential policies; shows macroprudential policy has been effective and the framework is being strengthened (e.g., by the addition of a new Debt Service Ratio instrument). - Opportunity: broaden the FSR to clarify how tensions between inflation and financial stability objectives will be managed. - Recent BOK and MPC statements on this have been relatively general and may contribute to uncertainty about how the trade-off will be managed and the commitment to the inflation target. - Remedy: communicate complementary roles of monetary and macroprudential policy, assess macroprudential effectiveness, discuss circumstances under which monetary policy may need to lean against the wind, and address how to strengthen the macroprudential framework and the roles of other entities (e.g., Financial Stability Committee). - C. Communicating medium-term policy intentions - The BOK could strengthen interest rate expectations management through forward guidance on how it intends to adjust the policy rate to return inflation to target over the medium term. - Risk to avoid: being misinterpreted as commitment to a specific policy rate path. - Many central banks use quantitative models to identify a policy path that returns inflation over a medium-term forecast horizon—“inflation forecast targeting” (IFT). - Results of IFT can be communicated in ways ranging from qualitative descriptions to publication of a numerical path; all make clear the path is conditional and can be revised in response to shocks and new data. - Implementing IFT requires addressing communication challenges related to model limitations via a forecasting and policy analysis system (FPAS) that integrates model-based analysis with a broad set of data and information tailored to the country. - D. Central bank experiences with IFT - IFT can enhance effectiveness and credibility by communicating the central bank’s reaction function, while avoiding misinterpretation as a commitment to a policy rate path. - Country experiences suggest IFT provides a more resilient nominal anchor; inflation expectations remain more firmly anchored during significant deviations of inflation from target. - Transparency improvements are associated with IFT central banks (Dincer-Eichengreen index); IFT central banks appear to have more firmly anchored inflationary expectations and smaller deviations of inflation from target. ### Specific factual points and metrics cited - Inflation target: 2 percent rate of consumer price inflation (year-on-year). - Timeline/announcements: BOK provided a statement of General Principles in 2016. - Exchange rate movements after the GFC in Korea: roughly 30 percent depreciation of the won against the dollar; the won then rebounded 35 percent to reach a post-crisis high in 2014. - Institutional change: addition of a new Debt Service Ratio instrument to the macroprudential framework. *Source: Box 1. General Principles of Monetary Policy Operation, wpiea2019103.* ### 0.1 Yes (1994) ### wpiea2019103 - 0.1 Yes (1994) ### E. Communications Near the ELB - Country/indicator excerpts from source: - 0.1 Yes (1994) - Czech Republic 0.6 1.7 (-0.3) 2.1 (0.1) -0.2 Yes (2002) - New Zealand 0.7 1.7 (0.3) 2.0 (0.0) -0.3 Yes (1997) - Sweden 1.0 1.5 (-0.5) 2.2 (0.2) -0.3 Yes (2007) - United States 1.3 2.3 (0.0) 2.3 (0.0) 0.0 Yes (2012) - Euro Area 0.3 1.3 (-0.7) 1.5 (-0.5) -1.2 No - Japan -0.1 0.6 (-1.4) 0.9 (-1.1) -2.5 No - Source: CDIC - Key findings and rationale: - With the policy rate close to a record low and inflation below the 2 percent target, Korea faces material risk of hitting the ELB in the event of a negative shock. - The ELB creates an asymmetric risk to monetary policy because conventional policy becomes less effective at the ELB; this justifies more aggressive easing when inflation and the policy rate are low. - Aggressive easing aims to return inflation to target more quickly so the policy rate can be raised to a neutral level. - Policy communication prescription near the ELB: - Adopt a more accommodative near-term stance to ensure faster convergence of inflation to the target. - Allow inflation to overshoot the target in expectation by committing to keep nominal rates at the ELB for longer, generating monetary stimulus via reductions in the real interest rate through higher expected inflation. - When at the ELB, focus on expectations channels: an “active” policy of announcing commitment to keep the policy rate at the ELB for as long as needed raises inflationary expectations, reduces real interest rates, and depreciates the real exchange rate; quantitative easing can reinforce these effects. - Avoid a “passive” ELB stance without an announcement effect, which risks a downward spiral of declining inflation, rising real rates, and falling output. - Label this management of interest rate expectations near the ELB as ad-hoc forward guidance to distinguish it from conventional forward guidance (Obstfeld 2016). ### F. Implementing a Model-Based Forecasting and Policy Analysis System (FPAS) - Purpose and benefits of FPAS: - Integrates wide range of information with model-based analysis for policy decisions. - Helps the MPC adopt a more strategic, medium-term policy focus and avoids excessively short-term bias. - Models, with appropriate qualifications, aid communication of policy intentions and clarify policy reaction functions. - The FPAS organizes inputs for MPC decisions and should provide: - A model-based, macroeconomic baseline forecast, including an endogenous path for the future short-term interest rate that achieves the inflation target. - Quantification of uncertainty via model-consistent confidence intervals for key variables reflecting historical shock variability. - Risk assessments presented as alternative scenarios for assumed shocks and options for the policy reaction function. - Communication role: - Publication of the model baseline, risk assessments, and alternative scenarios can clarify the central bank’s current stance and conditional policy responses. - Publishing the endogenous future path for the short-term interest rate is feasible with caveats to avoid misinterpretation as a concrete commitment; it effectively communicates the MPC’s “reaction function.” ### V. Using a Model to Enhance the Medium-Term Focus to Monetary Policy - A. Model Structure and Design — key components: - Four key behavioral equations: - Output gap equation (aggregate demand) depending on foreign activity, real longer-term interest rate minus equilibrium real interest rate, and real exchange rate minus equilibrium real exchange rate. - Expectations-augmented Phillips curve (core inflation driven by output gap). - Policy reaction function ensuring long-run inflation returns to target, output gap goes to zero, and actual and expected inflation converge. - Open interest rate parity condition to ensure long-run exchange rate convergence. - Additional identities: headline inflation; trade and financial linkages; longer-term interest rates. - Forward-looking, model-consistent expectations. - Key nonlinearities: Phillips curve flattening with larger negative output gap; ELB constraint; quadratic monetary policy reaction function. - Two alternative reaction functions: - IFB: linear, inflation-forecast-based Taylor rule responding to output gap and one-year ahead forecast inflation relative to target; includes lagged policy rate smoothing. - OPT: non-linear, loss-minimization rule with quadratic loss on squared inflation gap and squared output gap and squared change in policy rate for smoothing; induces stronger responses to larger shocks and a risk-management stance near the ELB. - B. Simulation of Historical Scenarios (starting 2013Q1): - Simulation start conditions in 2013Q1: negative output gap of 1.5 percent of GDP; inflation rate of 1.5 percent (below mid-point 3 percent target then). - Simulated policy responses vs actual: - IFB: interest rate cut 100 basis points within a year vs actual 25 basis points; by end-2015 output gap closed and inflation returned to target. - OPT: 200-basis-point cut, more rapid gap closure and temporary inflation overshoot. - Interpretation: - Actual policy reductions appear too gradual to close the negative output gap and return inflation to target over the 4-year period, although unmodeled negative shocks after 2013Q1 weakened outcomes. - C. Comparison Incorporating Historical Shocks: - When post-2013 negative shocks are added to simulations, OPT still implies much larger early rate cuts that are later reversed; easing resumes with subsequent shocks yielding simulated paths more similar to actual rates. - Conclusion: early aggressive cuts in simulation were sufficient to push output gap and inflation back to target, suggesting actual easing may have been too cautious. - D. Baseline Projections (initial conditions in 2017): - Initial conditions: modest negative output gap; headline inflation at 2 percent; core inflation at 1.5 percent. - Both IFB and OPT generate large, up-front policy rate cuts; OPT is more aggressive with faster output recovery; IFB produces smoother interest rate path. - Overall difference between OPT and IFB is modest for small shock (starting output gap 0.5 percent); differences grow for larger shocks. - E. Downside Scenario under Two Reaction Functions: - Hypothetical large negative shock: output gap widens to 2 percent (instead of 0.5 percent) with inflation slowing by more than one percentage point. - Both OPT and IFB cut policy rates to the ELB; under OPT the policy rate is cut faster and held at the ELB for one additional quarter. - Under OPT: stronger forward-looking expectations channel leads to output gap positive by mid-2018 and inflation close to baseline by 2019. - Under IFB: much slower recovery. - F. Downside Scenario with Fiscal Backstop: - When policy rate hits the ELB, fiscal multiplier is larger (no crowding out), so combining fiscal and monetary stimulus is more effective. - Adding fiscal expansion equivalent to about one percent of GDP reduces the number of quarters at the ELB under both reaction functions. - Outcome is much better under OPT, where longer monetary accommodation plus fiscal stimulus produces inflation path similar to milder baseline. - Under IFB, recovery remains more sluggish and inflation below baseline for several years, but complementary fiscal expansion improves medium-term outcomes relative to monetary policy alone constrained by the ELB. ### VI. Conclusion — summary of key policy implications - BOK achieved stabilization of inflation at a low level after decades of high and volatile inflation. - Post-GFC challenges: - Inflation has run persistently below the 2 percent target (target revised in 2016 from range 2.5–3.5 percent to new target of 2 percent), posing credibility risks. - Potential conflict between financial stability mandate and inflation targeting: concerns about macroprudential policy effectiveness and potential for monetary policy to “lean against the wind.” - Recommended two-pronged approach: - Strengthen communications on (i) how the inflation target will be achieved over the medium-term; and (ii) how macroprudential policy will be used to contain financial stability risks, including assessment of macroprudential effectiveness and potential need to strengthen the framework. - Adopt a greater medium-term focus using a forecasting and policy analysis system (FPAS) with a model calibrated to recent Korean performance and MPC views to generate a policy rate path showing how the inflation target can be achieved. - Communicate the conditional policy path (the MPC’s reaction function) qualitatively or as a numerical forecast to reduce the risk of hitting the ELB by prompting more aggressive responses when that risk is higher. *Source: wpiea2019103 - 0.1 Yes (1994), as provided in the excerpt.* ### REFERENCES ### REFERENCES ### Monetary policy, inflation targeting, and policy frameworks - Adrian, T., and others, 2018, Advancing the Frontiers of Monetary Policy, edited by T. 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November. *Reference list as provided in the source PDF "wpiea2019103 - REFERENCES".* --- _Source: https://www.imf.org/-/media/files/publications/wp/2019/wpiea2019103.pdf_