The Evolution of ECB's Inflation Approach: From Small Country to Large Country, Monografías, Ensayos de Macroeconomía

¡Descarga The Evolution of ECB's Inflation Approach: From Small Country to Large Country y más Monografías, Ensayos en PDF de Macroeconomía solo en Docsity! Phillips vs. Pass-through, or the changing ECB understanding of inflation This blog post looks at how the approach of the ECB to inflation has changed over the years. It shows the ECB has moved, over the years, from a small towards a large country approach, giving more weight to the improving employment conditions than to the appreciating exchange rate in deciding its monetary policy moves. By: Francesco Papadia and Alessandra Marcelletti Date: October 25, 2017 Two basic approaches to inflation There are basically two schematic approaches to assess and forecast inflation developments: the “small country” and the “large country” approach. Pushing them to the extreme, we get, on one hand, to the “atomistic open economy” model and, on the other hand, to the “closed economy” model. In the small country approach, basically all prices, and hence inflation, are determined in the global economy and the exchange rate of the small country, translating global prices into domestic ones and inflation, is the only differentiating factor between domestic and global variables. The “pass-through” from the exchange rate to domestic prices is high, tendentially unitary, and stable. In the large country approach, instead, the basic determinants of inflation are to be found in the domestic labour market, according to some version of the Phillips curve: the tighter are the conditions in the labour market the higher are wages and inflation. Of course, in reality the two approaches are complementary rather than rival. Still their relative weight is very different depending on the size and the openness of the country: if you want to interpret inflation developments in a tiny, very open economy like, say, Luxembourg pre-euro, the exchange rate will be the dominant variable; to understand inflationary phenomena in the United States, instead, you are likely to start with the labour market. The interpretative approach of the ECB An interesting development, somewhat akin to an experiment, took place in 1999, when the euro was adopted, increasing at the strike of a pen the size of the 11 participating economies, which were, from a monetary point of view, melted into a larger, less open economy. This post aim at documenting whether, when and in what way the ECB has incorporated into its interpretative model of inflation the increased size and lower openness of the countries which adopted the euro, which, as is well known, grew from 11 in 1999 to 19 now. The authors of this post think that the change of approach by the ECB is justified, but this is not the point of this post, which merely aims at documenting it, without passing a judgment. The question of a possible change of approach is particularly important in current circumstances for two reasons: 1. The ECB is struggling with too low inflation and the way it interprets the inflationary phenomenon is critically important to understand what its policy will be, 2. The exchange rate and the unemployment rate send opposing signals, with the former A semantic analysis of the speeches of the ECB President and Vice President To get a handle on this issue we proceeded to a semantic analysis of the speeches of the President and the Vice President of the ECB. In particular we have counted, year after year, the frequency of the terms that are consistent with the “large” and the “small’ country approaches respectively[1]. Figure 3 shows the results. Figure 3. Ratio of frequency of terms consistent with the small and the large country approach. ECB 1999-2016. Source: Authors’ elaboration. Moving average (over 2 periods). To give a clear sense of the relative frequency of the terms consistent with the two approaches, figure 3 gives the ratio of the two frequencies: when the ratio is higher than one more terms consistent with the small country approach are to be found in the speeches of the President and the vice President, when the ratio is lower than one, the opposite prevails. One clearly sees that, up until 2006 the terms consistent with the small country approach were more frequently used than those consistent with the large country approach. Since 2007 the opposite result prevails. Still, while remaining lower than one, starting from 2013 the ratio started to increase, implying a more intensive use of small country terms approach. The main variables leading this upward movement are the “exchange rate” and “oil (food) price”. This likely reflects the falling price of oil observed in the last 4 years and the emphasis on the exchange rate as a channel of transmission of Quantitative Easing. Based on the evidence in Figure 3, one should conclude that, about a decade after the adoption of the euro, the ECB moved from the paradigm of a small open economy towards that of a large economy. This change of perspective would have happened during Trichet’s tenure. Thus, since more than 10 years, the ECB clearly gives less weight than previously to the exchange rate and other variables consistent with the small country approach in assessing inflation prospects.[2] Do changes in underlying variables influence the frequency with which small or large country terms are used? One issue in drawing conclusions from the results reported in Figure 3 is that the frequency with which a term appears in the speeches of the President and the Vice President could depend on whether variables consistent with one or the other approach deviate from some historical norm. In simpler terms, are they going to mention the exchange rate or unemployment rate more often when they are further away from some historical norm? To check on this, the frequency of terms relating to the two approaches was regressed on deviations from the mean of the most salient variable pertaining to the two approaches: the exchange rate for the small country and the unemployment rate for the large country approach respectively. In Appendix 2 a more precise specification is given of the regressions that were run. A first regression shows that the deviation, either upwards or downwards, of the unemployment rate from the historical average does not seem to push the President and the Vice President of the ECB to mention large country terms more often. Thus, there does not seem to be the need to correct the frequency in their use reported in Figure 3. Instead, deviations of the exchange rate from the average, either in the appreciation or the depreciation direction, do lead the two ECB representatives to mention more often terms consistent with the small country approach. Unfortunately, the regression results are not precise enough to allow using the regression residuals as “frequency corrected for the deviation of the exchange rate from the mean”. However, the residuals clearly indicate a break in 2007, when they become consistently negative. This indicates that the actual frequency of small economy terms was lower than that estimated on the basis of the deviations of the exchange rate from its mean. This is consistent with a decreased importance of the small country approach in the inflationary assessment of the ECB. Comparison with the Fed. The same analysis conducted for the ECB was carried out for the Fed, with quite striking results, as shown in Figure 4.