COMMUNICATION SCHEMES UNDER INFLATION TARGETING CASE 1: The Target. Preliminar June, 2005*

Transcription

1 COMMUNICATION SCHEMES UNDER INFLATION TARGETING CASE 1: The Target Javier Luque Pontificia Universidad Católica del Perú and Central Reserve Bank of Peru Rafael A. Vera Tudela Central Reserve Bank of Peru Preliminar June, 2005* A number of Central Banks around the world have adopted Inflation Targeting (IT) as their formal Monetary Policy framework. In the center of this framework is the ability to communicate its goals, the communication channel. The public should anticipate the reactions of the central bank, which will improve overall well being. In this paper we focus on the first sign coming from the IT regime: the target. Do agents believe the central bank target? The approach is based on the behavior of the price setters; our objective is to evaluate price dispersion and short-term pass through from general inflation to individual price decisions for disaggregated zones through time. We employ monthly time series on prices for 49 consumption goods that account for one third of the Lima CPI disaggregated in five zones covering the period During the IT regime, we find that nearly a half of the analyzed goods show a diminishing variance and almost a third show a minor short-term passthrough through time. However, the nature of the available set of information impose constraints to our results. Particularly, more coverage of the CPI and, specially, a greater inclusion of core goods are conditions for the extent of the conclusions. Finally, it must be noticed that Peru showed low inflation rates during the period, context that would has reduced the role played by inflation and inflation expectations in economic decisions. Taking Greenspan seriously, the better inflation could be the one no one cares about. *Preliminary version not to be cited. Usual disclaimer applied

2 I. Introduction Since 2002, as many other countries, Peru has adopted a monetary policy regime based on explicit inflation target following the seminal New Zealand experience. This approach has as one of its cornerstones the ability of Central Banks to communicate their objectives, that will justify their actions, and no there should not exist surprises in the relationship between the public and the central bank. This paper is a part of a broader research agenda that looks to assess how successful have communication schemes been. In this paper we will focus on the inflation target, as a final goal in the scheme, but we are also concerned on predictability of central bank movements in terms of changes in interest rates, or other central bank policies. Success rate has been high, as countries that adopted the scheme to lower their inflation rates have been able to do so. However, the success of the regime in countries that adopted the scheme when they already had low interest rate is more difficult to establish. We should establish how successful the communication scheme is in terms of interiorizing the inflation target.} A first evaluation could be if inflation remains in the target after the scheme was announced. During the two years experiencing the inflation targeting scheme in Peru, the regime has maintained the inflation rate on the announced range. Hence, the answer for the Peruvian case is yes, so Peru passed the first evaluation. An alternative evaluation could be how important is the level of the target to the agents while they make pricing decisions. Do they believe in the target and set prices accordingly? If agents believe in the official target, they will become more forward looking in their pricing decisions and not be affected by past inflation shocks. Therefore, the variability of inflation will diminish, and the pass-through of past inflation on particular goods prices will reduce as well. In this paper we test this two hypothesis using standard econometric techniques based on the recent literature about price flexibility (Konieczny and Shrzypacz, 2001; Bils and Klenow, 2002) We find no major changes in pricing behavior as we move along time. However, it is important to notice that prices have been relatively stable in Peru during the period (making the second

3 evaluation specially important to assess what agent may do in turbulent times). In that context, inflation rate and inflation expectations would not have played a major role in economic decisions. The rest of the paper is organized as follows: the next section presents a resumed review of the recent literature on price flexibility, in section three the database and the methodology employed are shown, the fourth part presents the main results and the final section summarizes and discusses directions for further research. II. Review of theoretical and empirical literature The analysis of price behavior is an important topic in macroeconomics given the implications of price flexibility in terms of inflation dynamics and real impact of monetary policy. Supported on the Calvo (1983) and Taylor (1999) theoretical works of price stickiness, nowadays, sticky-price models are still the core of the study of business cycle fluctuations and monetary policy. Recent work built on the nominal rigidity assumption are Goodfriend and King (1997); Rotemberg and Woodford (1997); Clarida, Gali y Gertler (1999); Erceg, Henderson and Levin (2000); Chari, Kehoe and McGrattan (2000); and Christiano, Eichenbaum and Evans (2001). These studies, as Calvo (1983) and Taylor (1999), include time-dependent pricing implying more persistent and less volatile inflation rates if prices remain stable. Given the assumptions, these settings generate a transitory impact of monetary policy on real activity. However, it must be noticed that studies supported on the nominal rigidity assumption generally provide no evidence about the empirical validity of the price stickiness. In this regard, a microeconomic approach could be employed in order to answer macroeconomic questions relatives to price dynamics. The disaggregated analysis of the price evolution corresponding to a representative basket of goods can provide evidence about the extension of sticky prices and, give some light about the price setting policies followed by the agents.

4 The literature relative to the microeconomic approach of price stickiness is substantial, especially for the United States. Since Mills (1927), studies as Parks (1978); Fischer (1981); Cecchetti (1986); Domberger (1987); Lach and Tsiddon (1992); Kashyap (1995); Konieczny and Shrzypacz (2001); Kackmeister (2001) and Bils and Klenow, (2002) have focused the analysis on: i) Frequency, magnitude and variance of the price change of particular goods to asses the extension of price stickiness. ii) Differences in price stickiness across consumption categories. iii) Relation between market structure and price flexibility. iv) State-dependent vs. Time-dependent rules of price setting. v) Forward looking behavior of price setters. vi) Inflation impact on price variability and inflation of a particular good. Unlike the prior five points of analysis which results are strongly dependent to the employed sample, the positive relation between inflation and different measures of price variability is a common place in the literature. As Konieczny and Shrzypacz (2001) mentioned, there are two main explanations of this general conclusion: the incomplete information (Lucas, 1973) and the menu cost (Sheshinki and Weiss, 1997, 1984) approaches. In one hand, the incomplete information model concludes that the inability of firms to distinguish between specific and aggregate shocks generate price variability increases with inflation in case the persistence differ across markets. In the other hand, the menu cost models suggests that, given costly price adjustments, the inflation rate affect positively the price variability if prices changes are imperfectly synchronized. The differences between these two approaches have significant implications in terms of inflation expectations. Unlike the incomplete information models, Lach and Tsiddon (1992) stand out that the menu cost model implies that price variability is affected by expected inflation. Hence, in theory, the role played by inflation and inflation expectations in the process of price formation is significant. Following this line, Konieczny and Shrzypacz (2001) implement an interesting approach for the target of this paper. They analyses the behavior of price setters in Poland during transition from a planned to a market economy focusing on the role played by the expected inflation in the making-

5 decision process of price formation. The main results, according to menu cost model, are: price variability increases with inflation and price setters are forward-looking as long as expected inflation has a significant effect in price variability. In term of the Peruvian experience, the theoretical considerations and the empirical evidence mentioned above, suggest that the examination of the making-decision process of price formation could have a particularly importance during an economic transition of the monetary policy regime. In this sense, the successful implementation of an inflation targeting scheme, which is supposed to involve a natural change on expectations, would derive in agents who are forward-looking given the credibility of the monetary authority. Putting simple, if price setters trust in the announced target, they will become more forward looking in their pricing decisions and not be affected by past inflation shocks. Therefore, the price variability will diminish, and the pass-through of past inflation on particular goods prices will reduce as well. Adapting the techniques developed by Konieczny and Shrzypacz (2001) and Bils and Klenow (2002) to our requirements and available information, we are able to test these two hypotheses. III. Database and methodology 1. Database The data were collected by the Instituto Nacional de Estadística e Informática (INEI) in order to calculate the Consumer Price Index of Lima, Peru. The dataset consists of monthly time series on prices of 49 consumption goods, corresponding to the Food and Beverages group which accounts for the 33 per cent of the Consumer Price Index, disaggregated in five geographical zones. We point out that the dataset comprise the period , so it includes the initial period of implementation of the inflation targeting regime in Peru 1. 1 The authors are working on new results with more data, unfortunately we were not able to include those results in this version of the paper.

6 2. Methodology This paper focuses on the making-decision process of price formation. As we mentioned before, the objective is evaluating the implications of the inflation targeting scheme in terms of the behavior of price setters as an alternative assessment of the monetary policy regimen. In this line, the analysis is based on two separated approaches: evolution of the variability of the price of a particular good, and the evolution of the pass-through from inflation to particular prices. Analysis of price variability The dataset allows us to construct the variance of the price of a particular good for a particular period of time. We will analyze if these variances (one per particular good, per month) have been diminishing through time. The basic relationship to be estimated is: Equation 1 v it = α1 + α2t + α3π t Where v it = variance of the price of good i during period t t = number of months that the inflation targeting regime has been working on period t π t = inflation in period t This equation is similar to the one presented by Konieczny and Shrzypacz (2001). The expected sign of the coefficients is negative for α 2 and positive forα 3.

7 Analysis of inflation pass-through We will analyze the short term pass-through from general inflation to a particular good inflation. The equation to be estimated is: Equation 2: P it = β IPC + β ( γ P γ IPC ) t 2 1 it 1 2 t Where P it = price of good i during period t IPC t = consumer price index in period t As we mentioned above, this equation is similar to the ones employed in the inflation passthrough literature. Our specification has the advantage that the coefficient β 1 can be interpreted as the short term inflation pass-through. We evaluate the short term pass through along time, in order to do so; we segment the sample in two parts: one which includes the first fifteen months of the sample and one which includes the last fifteen months of the sample. The expected evolution of the coefficient β 1 is a diminishing behavior through time. IV. Results The main results are reported in Table 1 and 2. The conclusions about the first hypothesis are derived from Table 1. In this matter, we account 24 goods which show the expected result as we move along time. In other words, almost the 50 percent of the sample presents a negative relation between price variability and the number of months that the inflation targeting scheme has been working. By other side, 26 goods present a positive relation between price variability and inflation showing a behavior accorded to the theory.

8 The conclusions relative to the second hypothesis are reported in Table 2. In this regard, 27 percent of the sample shows the theoretical evolution: a diminishing behavior of the short term inflation pass through along the inflation targeting scheme works. By contrary, 22 percent of the sample presents an unexpected dynamic through time. The rest of the sample shows no correct signs, so we do not report those results. We find no representative changes in pricing behavior through time. However, it must be noticed that the available set of information impose restrictions to the extent of our results. Since the data does not provide conclusive evidence about the influence of the implementation of the inflation targeting regime in the price setting decisions, we present our main observations about the results in order to delineate directions for future research: i) The analyzed period is relatively short generating a potential bias to reject the theoretical statements. Our data counts comprise the period implying that the agents count with only two-year experience with the inflation targeting regime. We remind that credibility is an asset positively related with the duration of successful events. ii) The available sample of goods represents nearly a third of the Lima CPI and includes core and non-core goods. In one hand, the limited size of the available sample makes necessary the inclusion of core and non-core goods; however, in the other hand, the inclusion of non-core goods (with prices that are subject to supply shocks) generates an additional potential bias to reject the hypothesis. iii) In addition, we point out that prices have been relatively stable in Peru during the period of analysis. In this context, it is rational to consider that inflation rate and inflation expectations would not have played a major role in the making-decision process of price formation.

9 V. Concluding remarks The focus of the paper is the formation of price setting decision in order to evaluate the implications of the inflation targeting scheme in terms of the behavior of price setters. As was mentioned above, the purpose of the study is to propose an alternative assesment of the monetary policy regimen. This paper tries to approach the behavior of price setters in Peru during the initial implementation of an inflation targeting scheme. Our objective is to evaluate price dispersion and short-term pass through from general inflation to individual price decisions for disaggregated zones through time. We employ monthly time series on prices for 49 consumption goods that account for one third of the Lima CPI disaggregated in five zones covering the period During the IT regime, we find that nearly a half of the analyzed goods show a diminishing variance and almost a third show a minor short-term passthrough through time. In other words, the evidence suggests no representative changes in pricing behavior through time. However, it must be pointed out that the evidence is not conclusive due to the nature of the available set of information that impose constraints to our results. In addition to the short duration of the analyzed period that generate a bias to reject the theoretical statements, the available sample of prices limits us to a list of core and non-core goods that represents nearly a third of the Lima CPI. Particularly, more coverage of the CPI and, specially, a greater inclusion of core goods and services are crucial to the extent of the conclusions. Finally, we have to remark that Peru showed low inflation rates during the period, context that could reduce the role played by inflation and inflation expectations in economic decisions. Taking Greenspan seriously: better inflation could be the one no one cares about.

10 Bibliography Bils, Mark and Klenow, Peter (2002), Some Evidence on the Importance of Sticky Prices. NBER Working Paper No. W9069. Calvo, Guillermo A. (1983), Staggered Pricing in Utility Maximizing Framework, Journal of Monetary Economics 12, Cecchetti, Stephen G. (1986), The frequency of price Adjustment: A Study of The Newsstand Prices of Magazines, Journal of Econometrics, Christiano Lawrence J., Martin Eichenbaum, and Charles L. Evans (1999), Monetary Policy Shocks: What Have We learned and to What End? Chapter 2 in Handbook of Macroeconomics, John and Michael Woodford, eds., Elsevier, New York. Clarida, Richard, Jordi Gali, and Mark Gertler (1999), The Science of Monetary Policy, Journal of Economic Literature 37, Domberger, Simon (1987), Relative Price Variability and Inflation: A Disaggregates AnaLysis, Journal of Political Economy, Erceg, Christopher J., Dale w. Henderson, and Andrew R. Levin (2000), Optimal Monetary Policy with Staggered Wage and Price Contracts, Journal of Monetary Economics 46, Fischer, Stanley (1977), Long-Term Contracts, Rational Expectations and the Optimal Money Sopply Rule, Journal of Political Economy, Goodfriend, Marvin and Robert G. King (1997), The Keynesian Neoclassical Synthesis and the Role of Monetary Policy, NBER Macroeconomics Annual 12, Kackmeister, Alan (2001), Has Retail Price Behavior Changed since 1889? Evidence from Microdata, manuscript, University of California, Berkeley.

11 Kashyap, Anil K. (1995), Sticky Prices: New Evidence from Retail Calalogs, Quartely Journal of Economics, Konieczny, Jerzy and Skrzypacz, Andrzej (2001), Inflation and Price Setting in a natural experiment, Research Paper Series No. 1695, Graduate School of Business, Stanford University. Lach, Saul and Daniel Tsiddon (1992), The Behavior of Prices and Inflation: An Empirical Analysis of Disaggregated Price Data, Journal of Political Economy, Mills, Frederic (1927), The Behaviour of Prices, New York. Parks, Richard W. (1978), Inflation and Relative Price Variability, Journal of Political Economy, Sheshinski, Eytan and Yoram Weiss (1977), Inflation and Costs of Price Adjustment, Review of Economics Studies, Sheshinski, Eytan and Yoran Weiss (1983), Optimun Pricing Pollicy and Stochastic Inflation, Review of Economics Studies, Rotemberg, Julio J. And Michael Woodford (1997), An Optimization-based Econometric Framework for the Evaluation of Monetary Policy, NBER Macroeconomica Annual 12, Taylor, John B. (1999), Staggered Price and Wage Setting in Macroeconomics, chapter 15 in Handbook of Macroeconomics, John B. Taylor and Michael Woodford, eds., Elservier, New York.

12 TABLE 1 ANALYSIS OF VARIANCE PER PRODUCT 1/ GOOD GOOD RELATIONSHIP RELATIONSHIP SCHEME DESCRIPTION WITH TIME WITH INFLATION WORKS 2/ 1 RICE YES 2 RICE (HIGH QUALITY) NO 3 AVENA ENVASADA NO 4 WHEAT NO 5 WHEAT NO 6 FLOUR (WHEAT) NO 7 SPAGETHI YES 8 MEAT NO 9 MEAT (PORK) NO 10 MEAT (BEEF) NO 11 CHICKEN YES 12 DUCK NO 13 CHICKEN (NO MEAT) NO 14 MONDONGO DE RES NO 15 CHARQUI NO 16 JAM NO 17 COJINOVA NO 18 JUREL FRESCO NO 19 CHOROS YES 20 TUNA NO 21 EGGS NO 22 MILK NO 23 CHEESE YES 24 OIL NO 25 MARGARINE YES 26 CHILE NO 27 AJO ENTERO NO 28 APIO YES 29 ONION YES 30 CORN YES 31 ARVERJA VERDE AMERICAN YES 32 TOMATOE YES 33 CARROT YES 34 ZAPALLO MACRE YES 35 LIMON NO 36 ORANGE JUICE NO 37 DURAZNO BLANQUILLO YES 38 APPLE YES 39 AVOCADO FUERTE YES 40 PAPAYA NO 41 BANANA YES 42 GRAPE YES 43 FREJOL CANARIO YES 44 HAR. DE ARVEJA YES 45 SWEET POTATOE YES 46 OLLUCO YES 47 POTATOE YES 48 YUCA YES 49 SUGAR NO 1/ Analysis based on equation 1. 2/ If coeficient on time is negative, we consider that IT works.a25

13 TABLE 2 ANALYSIS OF SHORT TERM PASS THROUGH 1/ GOOD GOOD SHORT TERM SHORT TERM SCHEME DESCRIPTION A B WORKS 2/ 1 RICE RICE (HIGH QUALITY) AVENA ENVASADA WHEAT WHEAT FLOUR (WHEAT) NO 7 SPAGETHI NO 8 MEAT MEAT (PORK) SI 10 MEAT (BEEF) CHICKEN SI 12 DUCK NO 13 CHICKEN (NO MEAT) NO 14 MONDONGO DE RES CHARQUI SI 16 JAM COJINOVA JUREL FRESCO SI 19 CHOROS TUNA EGGS SI 22 MILK NO 23 CHEESE OIL NO 25 MARGARINE SI 26 CHILE AJO ENTERO APIO SI 29 ONION CORN ARVERJA VERDE AMERICANA SI 32 TOMATOE SI 33 CARROT SI 34 ZAPALLO MACRE LIMON SI 36 ORANGE JUICE NO 37 DURAZNO BLANQUILLO APPLE SI 39 AVOCADO FUERTE NO 40 PAPAYA BANANA GRAPE SI 43 FREJOL CANARIO HAR. DE ARVEJA SWEET POTATOE NO 46 OLLUCO POTATOE NO 48 YUCA NO 49 SUGAR / Analysis based on equation 2. 2/ If 2 nd coefficient is smaller than 1 st we consider that IT works

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