“What Should Inflation Targeting Countries Do When Oil Prices Rise and Drop Fast?”
IMF Working Papers, May 1, 2009
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Bibliographic details
- Authors: Nicoletta Batini, Eugen Tereanu
- Published: May 1, 2009
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451872484.001
Overview
- Context: After a long period of global price stability, in 2008 inflation increased sharply following unprecedented increases in the price of oil and other commodities, notably food.
- Problem statement: Inflation targeting countries faced surging consumer prices and challenged inflation expectations; a rapid drop in energy and food prices later helped avert worse outcomes but inflation remained high in many inflation targeting countries.
- Objective: Use a small open-economy DSGE model to design the correct monetary policy response to a protracted supply shock of the kind observed in 2008 and to explain how to choose optimal policy horizons under such shocks.
Model and methods
- Model type: Small open-economy DSGE model.
- Additional method: Version of the model with Kalman learning to evaluate implications of a loss of target credibility and the resulting need to adjust rules when authorities’ commitment to low inflation has been eroded.
- Policy evaluation: The model is used to evaluate appropriate responses to future evolutions of the price of oil, including to a large downward correction as recently observed.
Key findings
- Inflation dynamics: Sharp rises in the price of oil and food in 2008 led to large increases in inflation that put price stability at risk and tested central banks’ ability to maintain anchored expectations.
- Relative performance: Inflation targeting countries experienced lower inflation and higher growth than elsewhere, yet still faced persistent inflationary pressures after the subsequent drop in energy and food prices.
- Policy horizon importance: The correct monetary policy response to a protracted supply shock depends critically on the choice of optimal policy horizons under such shocks.
- Credibility effects: Loss of target credibility alters the optimal design of monetary policy rules; commitment erosion requires rule adjustments as shown in the Kalman-learning variant of the model.
Policy recommendations and implications
- Design policy to account for protracted supply shocks: Monetary policy rules should be calibrated with explicit consideration of prolonged supply-driven movements in oil and food prices.
- Choose policy horizons deliberately: Authorities should choose optimal policy horizons that reflect the persistence and expected duration of the supply shock.
- Adjust rules when credibility is eroded: If the public’s belief in the authorities’ commitment to low inflation weakens, policy rules must be adjusted to restore credibility and manage inflation expectations.
- Prepare for large downward corrections: The model evaluates and informs the appropriate monetary response to significant downward corrections in oil prices.
Subjects and keywords (as listed)
- Subject: Banking, Inflation, Inflation targeting, Oil, Oil prices
- Keywords: central bank, interest rate, monetary policy, output gap, Phillips curve, WP
Nicoletta Batini and Eugen Tereanu, IMF Working Paper No. 2009/101 (May 1, 2009).