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We would like to thank Enrique Flores, Vikram Haksar, Martin Kaufman, David J Robinson, staff at the Banco de México, and participants of IMF WHD seminar for their very useful and constructive comments. All remaining errors are ours. Part of this paper was written when Yu was an IMF intern—he gratefully acknowledges the kind hospitality and stimulating work environment at the Fund.
Central banks of course also influence the economy through tools other than short-term interest rates and money supply (e.g., qualitative and quantitative easing, FX intervention).
For instance, in the U.S., Alan Greenspan was well-known in the past for his preference for ambiguity. In a much-cited remark from his Senate testimonial in 1987, Greenspan said, “Since becoming a central banker, I have learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.”
For instance, through communicating their policy intentions regarding the future short-term interest rates, central banks can affect also the current longer-term rates.
Some often-cited potential drawbacks of central bank transparency include: central bank communications may be misinterpreted; it is difficult to accurately communicate the wide spectrum of views held by the different policy committee members; and more information made available by the central bank might crowd out the private sector’s incentives to generate information.
A prominent example is the recent series of strong signals sent by the U.S. Federal Reserve about keeping interest rates low for an extended period of time has firmly anchored the market’s interest rate expectations for the near term.
It is worth emphasizing that uncertainty about the central bank’s response function does not necessarily imply a lack of central bank credibility to maintain price stability (or keep inflation at the target) or unanchored medium-term inflation expectations.
In addition, unlike e.g., Erceg and Levin (2003), the exercise does not show that greater communications can help substantially reduce inflation persistence—this (lack of) result is also in line with the finding of Minegishi and Cournede’s (2009) empirical study.
The model could be extended to the open economy by including the exchange rate pass-through to prices and imposing a real uncovered interest rate parity (UIP) condition. However, as the empirical evidence from the Mexican data shows below, this extension is not quantitatively important. The data also confirm that autocorrelations in the shocks can be assumed away.
The forward-looking rules may be susceptible to indeterminacy of rational expectations equilibria as shown by Bernanke and Woodford (1997), but it is not a problem under our calibration.
As we propose no micro-founded theory about how the central bank and the private sector form their economic outlook (which is beyond the scope of this paper), for simplicity we avoid imposing a richer structure on v.
See Sims (2002) for a general set of restrictions for the existence and uniqueness of the solution. The simulation exercise in a later section—based on parameters similar to those estimated with the Mexican data— the existence of a non-explosive solution and its uniqueness is guaranteed.
This assumption enables us to withdraw from dealing with time-varying volatilities in observation noises. See Milani (2007b) and references therein for learning with time-varying volatility.
Some central banks even opt to publish numerical projections of the interest rate path (e.g., Czech Republic, New Zealand, Norway). However, there is not yet a consensus on the benefits of such a practice (see, e.g., Mishkin, 2004; Andersson and Hofmann, 2009).
Note that inflation is not converted into annual rate.
This series from the original data is represented in annual rate, and is transformed into quarterly rate.
For estimation of (1) and (2), the instruments include 3 lags of inflation, interest rate, and the output deviation from trend, and 2 lags of real marginal cost. For estimation of (6), the instrument set is the same but without lags of real marginal cost.
Including the exchange rate in the estimations does not meaningfully improve the fit of the Phillips and IS curves, although the exchange rate effect may have been more prominent in the post-global crisis period. Our estimate of q is similar to OECD (2011) and Moura and Carvalho (2010), which include lagged interest rate in their estimations of the policy reaction function for Mexico.
In particular, the weight on the backward-looking component of the New Keynesian Phillips curve in our estimation seems low compared to other studies on Mexico and other countries. For example, see Gali, et al. (2001), Benigno and Lopez-Salido (2002) and Gagnon and Khan (2004), Cespeds, et al. (2005), and Ramos-Francia and Torres (2006).
The one quarter-ahead inflation expectations are computed from Banxico’s survey data on 12 month-ahead inflation expectations, under the simplifying assumption that the latter is geometrically accumulated from the former at a constant rate.
A caveat to using the survey data is such information is conditional upon the individual analysts’ own interest rate expectations, which are not necessarily the same as the “model-consistent” interest rates.
In our simple analytical framework with unchanged policy reaction function, repeated learning over a long period of time implies that the distribution of the private sector’s prior belief about q would converge around the “true” value with decreasing variance. In practice, however, the policy reaction function may change from time to time (e.g., depending on the policy board’s composition) and hence even repeated learning cannot guarantee a convergence of belief in the long run.
The demand and supply shocks here are calibrated so as to generate a 0.275 percentage point deviation in inflation from the steady state in the first period.
For example, there may be a diverse view on the strength and timing of passthrough from a previous exchange rate adjustment, or on whether an asset price boom would lead to greater domestic demand, etc.
Note that if there are no mistakes by either the central bank or the private sector in assessing the outlook, transparency creates no value in our case (the blue line would coincide with the benchmark case), as we assume that the initial perceived q is the same as the true q.
Many central bank officials have expressed a preference for a slow policy adjustment to avoid surprising and roiling the markets. For a different reason why inertial interest rate path is optimal, see Woodford (2002).
For instance, some suggested that concerns about spillovers to wages and core inflation called for a tightening in monetary policy, while others who thought the commodity price shocks were transient and weighed on demand and activity argued against that.
A spillover to the core inflation could be broadly interpreted as a supply shock of a very long duration. In other words, uncertainty about the likelihood of commodity prices contemplating the core inflation can be viewed as an uncertainty about the duration of the supply shock in our current setting.
In our setting, it means a supply shock is applied to each of the first three periods.