The Bank of Israel has become the first central bank worldwide to raise interest rates in this downturn. A few weeks ago, I wrote an elongated blog post titled Does unconventional monetary policy and unusual fiscal policy presage an upsurge in inflation?. This was partly motivated by the concerns of the time (this was in mid-June) about the exit strategy of central bankers. I had argued that inflation targeting gave the right framework for all three phases: the sharp drop in the policy rate, the shift to quantitative easing when the short rate fell to zero, and the eventual rise of interest rates. It is not surprising that the first mover on the exit process is an inflation targeting central bank.
A Taylor rule with an inflation coefficient of 1.5 and an output coefficient of 0.5 gives us a rough approximation to the thinking of inflation targeting central banks. The puzzle then lies in forecasting the extent to which inflation will exceed the target and forecasting the extent to which output will be below the target. These two forecasts are hard to make. But as I said in the above article:
As the financial system comes back to life, as the money multiplier comes back to normal values, the intellectual framework of inflation targeting will shape the responses of the central banks. There will obviously be some mistakes in forecasting inflation, given that the parameter estimates in our models are driven by normal times. But one can expect an average error of zero in the sequencing through which unconventional monetary policy is withdrawn. And when mistakes are made, when de jure inflation targeting is in place, the bond market will know that these are mistakes of execution and not a change in strategy.
Originally published at Ajay Shah’s blog and reproduced here with the author’s permission.