Do central banks announce strategically?

4 Do central banks announce strategically?

In order to provide a …rst step for future empirical research about the dependability of in‡ation announcements, this paper makes use of and updates the data set, collected for paper 2, of annual in‡ation targets and outcomes for in‡ation-targeting countries. This section explores whether there is empirical evidence to support the hypothesis that central banks announce annual in‡ation targets strategically and …nds that there is no such evidence.

Previous sections point out that there is a strategic aspect in the decision about the level of the in‡ation announcement, as have been previously remarked by Canzoneri (1985), Stein (1989) and more recently by Walsh (1999). The fact that the policymaker has private information gives her incentives to manipulate in‡ation expectations so as to o¤set the e¤ect of anticipated shocks. For instance, in an economy facing in‡ationary shocks, the central bank would like to make private agents believe in‡ation will be low. In this way, the e¤ect on in‡ation expectations compensates for the potential e¤ect of the shock on in‡ation. In contrast, when the central bank makes truthful in‡ation announcements, the e¤ect of supply shocks is either not incorporated into the announcement, if the announcement is made well in advance, or is truthfully revealed if the announcement is made when information about upcoming shocks is available.

To derive a condition that can be empirically tested, let us analyse more formally the di¤erence between strategic and truthful announcements in the particular case of in‡ation targets. The last part of section 3.2.3 shows that the in‡ation target announce- ment conforms to truth when it is made at a late stage in the previous period. In this case, the announcement follows (34), or (61) in Appendix C, and realised in‡ation is described by (36). In the same section, it was important to distinguish the period in which the in‡ation announcement is made, so we denoted the in‡ation target that ap- plies to period t but is announced late in period t

1 by tjt 1 . Since in this section the relevant period is the one for which the target applies, for simplicity of notation tjt 1 will be denoted simply by t . Taking this into consideration and using (34) and (36) the following condition can be obtained,

(40) where Cov [:] is the covariance between the variables inside the brackets. This condition

Cov [ t

t ; t ]=0

is not particular to the case of late announcements presented in this paper. If we assume that, as in earlier literature, the central bank commits to truthful communication the result is the same. In this case, at the beginning of every period the central bank reveals the implicit target and hence t = t . Then, solving the model implies that realised

in‡ation is p = t + 1+ s t b t +s t +s u

t +d t . Using both expressions we can verify that (40) holds.

A more general condition is obtained when we take into account the possibility that there might be some correlation between the implicit in‡ation target and the demand shock or the supply shock. In the present paper, for the sake of simplicity, it has been assumed that there was no such correlation. Instead, we could assume that in‡ationary shocks might increase the optimal rate of in‡ation for a speci…c period. For instance,

the error term in equation (2) could follow t =z 1 d t +z 2 s t +' t where z 1 and z 2 are nonnegative constants and ' is white noise. Assume for simplicity that d t and s t are completely anticipated by both the central bank and the public. It can then be shown that if the central bank truthfully reveals the implicit target the following condition holds 13

Cov [ t

t ; t ] 0 (41)

13 Cov [ t

t ; t ]=z 2 2 s .

The same condition applies to the model of paper 2. In countries with high in‡ation, the purchasing power of wages is substantially reduced over a year and past in‡ation plays a signi…cant role in wage setting, and therefore in determining current in‡ation. In this case, as empirically con…rmed by Mahadeva and Sterne (2002), in countries with moderate-to-high in‡ation central banks tend to overshoot the target, and (41) holds. 14

Recall that in the …rst paper of the present dissertation, incentives to make truthful announcements arise from the fact that the central bank is exogenously penalised for deviations from its own announcements.

Having established (41), we are interested in knowing if the same condition applies to an economy in which the central bank misrepresents private information and is able to deceive private agents. Assume that agents trust the central bank and so they set

e E p [ t jI t ]= t . Therefore, in‡ation expectations are t = t +s t . The central bank announces strategically and minimises (25), which implies that p t = t (1 + ) s t

s b t . In this case, the central bank is able to o¤set the e¤ect of anticipated shocks by manipulating expectations and then realised in‡ation deviates from the implicit target

only as a result of unanticipated shocks, 15 t = t +s t +d t . It can be veri…ed that

(42) This result is not particular to the case in which full credibility is given to the in‡ation

Cov [ t

t ; t ]<0

target announcement. It is also satis…ed when private agents make use of the available information in many alternative ways. For instance, (42) holds when private sector in‡ation expectations follow a more general form to allow for any value of the coe¢cient

on the supply shock s p t and also include a weighted average between the in‡ation target announced and the private agents’ estimator of the implicit target, e t =a 0 +a t + (1 p a ) b t(0) +a s s t with a

1. Notice that this form even admits negative values for

a , which allows for the possibility that private agents consider the fact that the central bank is pretending to have a very low (high) in‡ation target just to o¤set the e¤ect of an in‡ationary (de‡ationary) shock.

Appendix D.2 analyses the general case, in which in‡ation expectations are described by (26), for given parameters a i i 2 f0; ; s;

g. Notice that the two cases mentioned above are special cases of the general one for which a 0 =a = 0, a = 1 and a s = , in the …rst case (i.e. full credibility) or a =1 a , in the second case. It is shown in the appendix that a su¢cient (but not necessary) condition to satisfy (42) is that a

0. This condition allows for a great variety of cases and plausible values of coe¢cients. Condition (42) is also satis…ed when we allow for correlation between the implicit target and the demand shock or the supply shock (i.e. t =z 1 d t +z 2 s t +' t as above).

and (1 a a ) (1 a )

14 As mentioned in footnote 5, in the model of the …rst paper the announcement follows t = 0 + 1 t1 + (1

3 t 1 . Using both equations it can be seen that Cov [ t

1 ) 0 and realised in‡ation, t = 2 + 3 t1 + (1

1 V ar [ t ]. Numerical solutions in the …rst paper show that 0< 1 < 3 <

t ; t ]=

3 1 and hence 1

15 Cov 2 [ t t ; 2 t ]= (1 + )

If private agents trust the in‡ation announcement and the central bank announces strategically, (42) holds as long as z 2 < 1+. 16 It is reasonable to expect that an increase in the supply shock will not a¤ect the optimal rate of in‡ation more than proportionally (and hence z 2 1). Therefore, we should expect (42) holds for strategic in‡ation target announcements. The analysis above suggests a simple way in which we can empirically analyse de- pendability of in‡ation target announcements. When the central bank makes truthful announcements, such announcements are either uncorrelated or positively correlated with the di¤erence between in‡ation and the in‡ation target announced for the same period. If, in contrast, in‡ation target announcements are strategic, the correlation is negative. Since information about both variables realised in‡ation and in‡ation target announcements is available, empirical evidence for (41) versus (42) can be examined.

The data set is the one used in the second paper of this dissertation updated to take into account new in‡ation targeters (Indonesia, Romania, Slovakia and Turkey) and information for years 2007 and 2008. It includes 134 observations of annual in‡ation

targets and outcomes for the disin‡ation periods of 19 in‡ation targeting countries. 17 Periods in which the annual target is constant and equal to the long-run target are not

included in the sample. A constant target is likely to happen when the economy has attained low in‡ation. However, it must be remarked that constant in‡ation targets are completely consistent with truthful announcements. By covariance properties (40) is equivalent to state that Cov [ t ; t ] = V ar [ t ]. This condition is satis…ed when t is constant over time because in this case Cov [ t ; t ] = V ar [ t ] = 0. Intuitively, strategic announcements in this paper refer to those in‡ation announcements that misrepresent central bank’s private information to o¤set the e¤ect of the supply shock on in‡ation. Since the supply shock varies over time, strategic announcements should vary over time as well.

For disin‡ation periods we test the signi…cance of the coe¢cient of correlation be- tween t

t and t for each country. Results are reported in Table 1. At the 5% signi…cance level only in one of the 19 countries (the Czech Republic) there is evidence that the correlation coe¢cient may be negative. Notice that Mexico, the country of the sample which starts with the highest level of in‡ation (52% in 1995), presents the strongest evidence of having a positive correlation coe¢cient. As explained before, a positive correlation coe¢cient is consistent with truthful in‡ation announcements in countries with high in‡ation or when the implicit target is correlated with the demand shock or the supply shock.

Unfortunately, the sample size is too small for some countries. This reduces the statistical power of the test i.e. increases the probability of failing to reject the null hypothesis when it is false. On the other hand, for most of the countries the conclusion is the same at much higher levels of signi…cance. This fact enhances the power of the test. To increase con…dence in the conclusion we test the joint hypothesis of whether

16 Cov [ t t ; t ]= (1 +

z 2 ) (1 + ) 2 s .

17 There are, on average, 7 observations per country, ranging from 3 (e.g. Romania) to 17 observations (Colombia).

Table 1: Test of correlation coe¢cients

b p-value

Czech Rep.

New Zealand

* Signi…cant at 5% Source: Table A.1, updated by the author.

the annual in‡ation target plays no role in explaining the di¤erence between in‡ation and the in‡ation target itself in those countries for which the estimated correlation coe¢cient is negative (12 countries, from Table 1). We include individual e¤ects to account for di¤erences in the level of in‡ation among countries. The following equation is estimated, it

it = i0 + 1 it + it , where the subscript i refers to the country and is the error term. Poolability of 1 ( i1 = 1 , 8i) is con…rmed by conducting an F-test (p-value: 0.53). The following results are obtained

it d it 2 =b i0 0:298 it R = 0:322

Individual e¤ects i0 are reported in Appendix D.1. The value reported in parenthesis corresponds to the estimated White period standard error which is robust to serial correlation and time-varying variances in the disturbances. From the estimates, it can

be concluded that 1 is not signi…cantly di¤erent from zero (p-value: 0.14). These results and the ones in Table 1 suggest that there is no evidence that central banks make strategic in‡ation announcements.

In concluding this section, we discuss another important implication from the analy- sis herein that can be empirically tested, namely, that the in‡ation target announce- In concluding this section, we discuss another important implication from the analy- sis herein that can be empirically tested, namely, that the in‡ation target announce-

estimate of the implicit target for t, given the information available to the central bank h i in the second stage of period t

1, i.e. t =E t jI cb t 1(2) . Furthermore, using (34),

(36) and the fact that E cb t jI t 1(2) for " 2 fs; dg, k 2 fp; b; ug, it is easy to see that

cb

(43) In the second stage, the in‡ation target announced is equal to the central bank’s in-

t =E t jI t 1(2)

‡ation forecast as we wanted to show. 18 This would not the case if the central bank announced when it has information about economic shocks, independent of whether it

announces the implicit target truthfully or strategically. In the case of commitment to truthful communication, the reason is that unlike the in‡ation forecast the in‡a- tion target does not incorporate some available information, speci…cally, the e¤ect of anticipated shocks on in‡ation. In the case of strategic behaviour, all of the available information is incorporated into the announcement but in such a way that the e¤ect of shocks on in‡ation is not truthfully revealed.

Diron and Mojon (2008) …nd evidence to support that in‡ation targets announced by 7 industrialised in‡ation-targeting countries and by the ECB outperform standard forecasting models and the mean of in‡ation forecasts constructed by professional fore- casters (surveyed by Consensus Economics Inc.). Since it is implausible that the cen- tral bank’s informational advantage can be large enough to allow the in‡ation target announcement to be such a good forecast while some private information is misrepre- sented, Diron and Mojon’s (2008) results add to the evidence of truthful communication of in‡ation targets.