Monetary Policy Rules and Transmission Mechanisms under Inflation Targeting in Israel

In this paper we analyze Israel’s recent inflation targeting policies and their role in the disinflation process in the 1990s. Special features of Israel’s economic background underlying inflation targeting are: a high-inflation history which produced various institutions and mechanisms—such as wage and financial indexation--that may produce strong inflation persistence; lack of consensus about the benefits from reducing inflation and thereby lack of full credibility of monetary policy under inflation targeting; the existence of monetary policy overburdening in its attempts to meet the inflation targets, especially when fiscal policy was not compatible with achieving the targets; the coexistence of an exchange rate band together with the inflation targets. Since some of these conditions are not unique to Israel, the analysis is of interest because they may apply to other countries as well. A key finding of the econometric analysis in the paper is that there is a time-varying passthrough from exchange rates to prices, which depends on the state of the business cycle and the size of exchange rate fluctuations. In particular, a higher degree of passthrough was found in booms vs. recessions, and a stronger contemporaneous passthrough emerged under relatively large vs. small exchange rate movements. In the present empirical specifications, monetary conditions are shown to have played a key role in accounting for the various turning points along the disinflation process. Estimates of an analogue of a ‘Taylor rule’ for the central bank interest rate indicate that in contrast with the monetary accommodation that prevailed in the past, monetary policy in the more recent years has acted as an inflation stabilizer. Moreover, in recent years there has been a growing importance in the role of market-based inflation expectations and a larger degree of interest rate smoothing in the estimated monetary policy rule. Monetary Policy Rules and Transmission Mechanisms under Inflation Targeting in Israel ABSTRACT In this paper we analyze Israel’s recent inflation targeting policies and their role in the disinflation process in the 1990s. Special features of Israel’s economic background underlying inflation targeting are: a high-inflation history which produced various institutions and mechanisms—such as wage and financial indexation--that may produce strong inflation persistence; lack of consensus about the benefits from reducing inflation and thereby lack of full credibility of monetary policy under inflation targeting; the existence of monetary policy overburdening in its attempts to meet the inflation targets, especially when fiscal policy was not compatible with achieving the targets; the coexistence of an exchange rate band together with the inflation targets. Since some of these conditions are not unique to Israel, the analysis is of interest because they may apply to other countries as well. A key finding of the econometric analysis in the paper is that there is a time-varying passthrough from exchange rates to prices, which depends on the state of the business cycle and the size of exchange rate fluctuations. In particular, a higher degree of passthrough was found in booms vs. recessions, and a stronger contemporaneous passthrough emerged under relatively large vs. small exchange rate movements. In the present empirical specifications, monetary conditions are shown to have played a key role in accounting for the various turning points along the disinflation process. Estimates of an analogue of a ‘Taylor rule’ for the central bank interest rate indicate that in contrast with the monetary accommodation that prevailed in the past, monetary policy in the more recent years has acted as an inflation stabilizer. Moreover, in recent years there has been a growing importance in the role of market-based inflation expectations and a larger degree of interest rate smoothing in the estimated monetary policy rule.