José De Gregorio: The Great Moderation and the risk of inflation - a view
from developing countries
Keynote speech by Mr José De Gregorio, Governor of the Central Bank of Chile, at the
10th Geneva Conference on the World Economy "Low inflation? Testing times for Central
Banks", organized by the ICMB (International Center for Monetary and Banking Studies),
Geneva, 6 May 2008.
I am very grateful to Christopher Neilson and Andrea Tokman for their great contributions and suggestions.
* * *
It is an honor to be a keynote speaker at this important gathering. Personally, this is a special
meeting as I contributed, together with Barry Eichengreen, Takatoshi Ito, and Charles
Wyplosz, to the writing of the first report for this series of conferences back in 1999. It was
lots of fun and an intellectual pleasure to work with such a great team of colleagues, and in
such an important issue. In that first Geneva Report we wrote about the need to reform the
IMF giving it independence, such as what we praise for central banks, and accountability, an
essential element to make independence effective. In the future I would like to develop
further on those issues; however, today I will focus on an even more pressing debate in the
recent macro juncture: monetary policy, stability and the current risks of an outburst of
inflation around the world, which is precisely the subject of this conference.
I will first refer to the Great Moderation, an expression in use to describe the decline in output
and inflation volatility of industrial countries in the last twenty years. There has been
significant research on the factors behind this phenomenon, better monetary policy being
one of them. I will argue that in developing countries the Great Moderation was achieved
about ten years ago and coincidentally with the conquest of low inflation. The timing of
events supports the hypothesis of a causal relationship from inflation control to decreased
output and inflation volatility. Thus, improvements in monetary policy contribute to obtaining
not only price stability but also output stability, or smoothed business cycles. I will argue that
the long time that passed between the great moderation in industrial countries and
developing ones, cast doubts on the validity and generality of hypotheses based on common
positive shocks ("good luck"), such as the decline in oil prices and technological improvement
(e.g., better inventory management).
The second issue I will address is the prospect for maintaining stability in a context of severe
inflationary risks. Indeed, in the last quarters we have witnessed one of the largest
inflationary shock in the post-World War II period. This is the biggest threat we have
encountered to the impressive achievement of stable business cycles and low/stable
inflation. Up to now, the shock has had enormous effects on the poor, as the prices of basic
foodstuff have increased sharply. In addition, if inflation persists, the cost along the business
cycle may become excruciating. I will close with some thoughts on the challenges ahead for
monetary policy.
The Great Moderation
The substantial decline in macroeconomic volatility we have witnessed in the US and the
world during the last decades has been widely documented by a substantial body of
empirical research. Kim and Nelson (1999) and Blanchard and Simon (2001) were among
the first to point at this phenomena which later became known as the Great Moderation.
These latter authors found, for the US, that the variability of quarterly growth in real output
had declined by half since the mid-1980s, while the variability of inflation had declined by
about two thirds. Similar declines in the volatility of output and inflation occurred in most other
G-7 countries roughly around the mid-eighties (Stock and Watson, 2003).
While we know that the control of inflation was achieved by the actions of monetary policy in
the US, there is still an ongoing discussion regarding what caused the persistent decline in
both output and inflation volatility. In general, the different reasons can be separated into
three groups:
•
The first argument is that the Great Moderation is the result of smaller and less
frequent shocks hitting the economy. This would imply that the observed reduction
in macroeconomic volatility would be the result of good fortune and would thus only
last until bad luck or larger shocks were to re-appear. Several studies have provided
support for the "good-luck hypothesis" (Ahmed, et al., 2002).
•
A second related explanation is focused on structural and technological changes
which are permanent in nature, but were not directly caused or controlled by
macroeconomic policies. For example, a special type of technological progress
frequently mentioned in the discussion of output volatility refers to the improved
management of inventories. If a significant part of the business cycle dynamics
occurs through inventory fluctuations, "just in time" technologies and better
management of inventories in general would reduce volatility along the business
cycle (McConnell and Perez-Quiroz, 2000; Cecchetti et al., 2005). Another important
structural change is related to worldwide economic integration and globalization, as
reviewed in the Geneva Report prepared for this conference (Gerlach et al., 2008).
Cavallo (2007), for example, emphasizes that trade openness has reduced output
volatility, and hence, more open economies are also more stable. This evidence
refutes the old view that more open economies are more exposed to volatility. On
the contrary, Cavallo (2007) argues that more open economies have more
opportunities to adjust to international shocks. Following this argument, the notable
increase in openness all around the world would make all countries more stable.1
•
A third and final factor which I would like to emphasize is related to improved
monetary policy. These reforms have resulted in the reduction of not only inflation
levels, but also its volatility. Figure 1 shows average growth and inflation over an
ample set of developing countries,2 while figure 2 shows the volatility of output and
inflation. It can be seen that volatility declined in developing economies towards the
mid-nineties. This is almost a decade after the developed economies experienced
their "Great Moderation". Thus, we can say that this evidence suggests there is a
timing mismatch between the great moderation of developed and developing
economies.
The "good luck" hypothesis and the explanations based on structural factors cannot properly
account for this phenomenon. If volatility had fallen only due to good luck, then luck itself
should have only been good for developed countries in the mid 1980s, which then took more
than 10 years to arrive to help developing ones! Similarly, the argument of increased
productivity, such as better inventory management, has similar problems. It is difficult to think
that businesses in developing countries adopted these better techniques more than 10 years
later.3
However, reforms regarding monetary policy have lagged noticeably in their adoption among
developing economies. Central bank independence, inflation targeting and other related
policy reforms have only materialized in developing economies beginning in the mid-90s
which coincides with the fall in volatility in this group of countries. While structural changes,
such as the increased openness, may have indeed helped economies become more stable,
these changes must also include those related to monetary policy because the Great
Moderation coincides with inflation control, suggesting that improved monetary policy has
indeed played a major role.
So, the relevant question is exactly how does monetary policy reduce the volatility of both
output and inflation. We know that there is a tradeoff between output volatility and inflation
variability, and monetary policy attempts to manage this tradeoff optimally. Policymakers
have to decide how to reduce inflation to reach their goal. If they react forcefully to any
inflation deviation, the outcome will be low inflation volatility, but large output volatility. Thus,
in the long run, there is a tradeoff between inflation volatility and output volatility, although
inflation has no effects on the full employment level of output.
It is also possible to practice inefficient monetary policy, one which lags behind the
output/inflation volatility frontier, making both of these inefficiently large. Bernanke (2004)
argues that in such a scenario of inefficient monetary policy, the volatility of both output and
prices can be reduced by moving to better policies. In other words, in the presence of an
inadequate monetary policy, the outcome could be excessive volatility of output and inflation,
and, hence, moving to an efficient policy can "shift the tradeoff to the origin" between output
and inflation volatility, reducing both of them. In other words, improvements in monetary
management can allow reaching an efficient frontier.
For example, a monetary policy that reacts insufficiently to changes in inflation, without
fulfilling the Taylor principle, or a policy too optimistic on the full employment level of output,
could end up generating unnecessary volatility and inflation. These are reasonable
explanations for the conduct of monetary policy in the US before the 1980s' disinflation. This
policy inefficiencies could be even aggravated by a belief on a permanent
unemployment/inflation tradeoff, leading potentially to Friedman's accelerationist hypothesis.
However, I want to emphasize the credibility bonus that comes with commitment to inflation
stabilization. In a standard Phillips curve framework, inflation depends on the output gap (the
reason for the output/inflation volatility tradeoff), inflation expectations, and a set of other
variables including inflationary shocks. Let's consider the case of low credibility in a low
inflation objective. In such a case, an inflationary shock may feedback into price and wage
formation, requiring a more aggressive monetary policy response, and hence, making it
costlier to reduce inflation. This could happen when expectations are not only forward
looking, but have a high degree of inertia, due to, for example, high levels of indexation or
lack of credibility. In contrast, when expectations are well-anchored to an inflation target,
becoming also more forward looking, the monetary policy adjustment required to achieve
stable and low inflation is milder and the sacrifice ratio declines, reducing the volatility of both
inflation and output.4
Of course, achieving credibility is not an easy task and can be done through different
avenues. Certainly the conquest of low inflation, as occurred in developing countries,
increases the belief in policymakers' competence and commitment to controlled inflation.
This allows stable inflationary expectations and reduces inflation persistence. An inflation
target, with the necessary institutional support such as an independent central bank with a
clear mandate to price stability, helps in this regard. It establishes an explicit commitment to
keep inflation low and stable through time, and a strategy to adjust to deviations, including
the time horizon in which this will be achieved. Indeed, among developing countries, those
that adopted inflation targeting regimes have had lower inflation and output volatility than the
rest (figure 3). Of course, this evidence is only suggestive and the direction of the causality
could be the reverse, with more stable economies being more prone to implementing an
inflation targeting regime. The empirical evidence on this subject is mixed, but generally it
has been found that inflation targeting does lower inflation and reduce its volatility.5 There is
some evidence for emerging economies that inflation targeting also reduces growth volatility
(Gonçalves and Salles, 2008).
Bad luck is back: the risks of inflation
Recently, the world has faced one of the worst inflationary shocks in the last 60 years. First,
it happened with oil prices, which started rising sharply at the beginning of the decade, and
has climbed to record-high levels (figure 4). However, even with this shock, inflation and
output have been much less volatile than in previous oil price cycles. Lower oil-dependence
and countercyclical fiscal policy explain part of the milder effects. Better monetary policy has
also contributed to substantially reduce the impact of oil shocks on output and activity.6
However, the price of oil has kept increasing, and although its effects are smaller than in the
past, the shock is becoming so large and persistent that it may have noticeable effects on
inflation and output over the coming quarters. On the bright side, however, the better
monetary policy frameworks that are used today limit these effects.
On the other hand, more recently, we have seen an impressive increase in food prices
(figure 5), with serious inflationary effects in many countries. Food prices have reached in
some cases their highest levels in history. This is mainly due to increased demand from
emerging markets (especially China, India and oil-exporting countries), the use of grains as
biofuels, and some financial factors as investors have increased their long positions in
commodities. Since mid-2006 grain prices, measured by the CRB index, have climbed at an
annual rate of 56%, contrasting with the trend observed between 1990 and mid-2006, when
prices increased around 0.5% per year. This is a common trend for other commodity prices.
Wheat prices registered a reduction of around 1% between 1990 and mid-2006, and a rise of
121% since then, despite a partial reversion in the price during the last month. Similarly, rice
prices, whose levels remained practically unchanged during 1990 and mid-2006, jumped to
its peaks by increasing at annual rates of 71% since mid-2006. Finally, milk price, after falling
at 0.3% per year during 1990-mid 2006, has increased at a 70% annual rate since then.
The first-round price effects of the shock have been felt in sharp increases in foodstuff and
energy while the rest of prices remain well behaved (figure 6). For example, in Chile inflation
hovers at about 8%, four points above the ceiling of our comfort zone (2 to 4%), mainly due
to the rise in foodstuff and energy prices. Indeed, non-food non-energy inflation is still close
to 3%. Foodstuff prices have increased further due to weather problems (frosts in 2007 and
drought in 2008).
The nature of these price hikes is purely international, or related to weather, making them
unavoidable from the point of view of monetary authorities. However, their potential
propagation to other prices and wages through what we normally call second-round effects
gives monetary policy an important role even in the presence of these specific external price
shocks. Given the nature of the shock, driven to a large extent by biofuel production and food
demand in fast-growing Asian countries, the shock is likely to persist for a long time. Some
second-round effects are bound to happen, since price and wage formation always have
some degree of inertia. The role of monetary policy is to ensure that the adjustment of
relative prices occurs without a persistent increase in inflation, that is, beyond normal
dynamics. Put differently, monetary policy must guarantee that the dynamic of prices is
consistent with convergence of inflation to its objective, within the time horizon envisioned in
the inflation target regime. That is, monetary policy must worry about, and act upon, unstable
dynamics that can lead to increases in inflation that may later be too costly to contain. These
are the undesired second-round effects that may require strong monetary policy actions.
In a flexible inflation targeting regime, once there are deviations from the target, monetary
policy is implemented on the basis of bringing back inflation projection towards the targeted
level within a given time horizon. In Chile, this would mean bringing down projected inflation
to 3% in the two year horizon. This length of the horizon takes into account the lags in the
effects of monetary policy, as well as the fact that bringing back inflation to target has an
output cost. It also allows for transitory shocks to undo their effects without shifting the path
of monetary policy. Therefore, in the current context of sharp inflationary pressures,
monetary policy must avoid undesired second-round effects, which are those that generate
an adjustment longer than the one envisioned in the policy horizon.
In order to monitor these potentially undesired second-round effects, we scrutinize price
dynamics that appear to be out of the normal. For example, we follow the evolution of wages
compared to an estimated evolution of wages based on the historical patterns of indexation.
If wages are growing faster than these estimates, we could be facing worrisome wage
dynamics that may require a policy reaction.
In this scenario, it could be argued that one could relax the policy horizon or the target level
to accommodate these inflationary shocks with small output costs. However, based on my
previous discussion, this could be very detrimental for the future. Giving up on inflation will
lead to losing the inflation anchor on expectations, more backward- than forward-looking
behavior of wage and price setters, and an increase in output volatility. In other words, we
would be achieving an inefficient outcome for monetary policy and losing the benefits of the
Great Moderation.
Hence, central banks must carefully monitor inflation expectations. However, in the current
juncture of extreme uncertainty and inflation volatility, the breakeven measures that compare
nominal and inflation protected securities appear to be excessively high world-wide, thus
apparently showing an important increase in inflation expectations, which could even reflect
the loss of the nominal anchor. This has also been the case in Chile, especially since the
deepness of the market of inflation protected instruments tends to make them the natural
safe haven. Therefore, in uncertain times like the ones we are enduring today, breakeven
measures may increase without necessarily implying un-anchoring expectations, making
their timely recognition more intricate.
Some could incorrectly argue that a way to avoid the monetary policy reaction to some
specific inflationary shocks is to focus inflation control on core rather than headline measures
of inflation. This is a much debated issue, but in the context of the current discussion I would
like to add that above the problem of doing the change in target in an opportunistic way and
the impact it may have on credibility, there is a more profound reason why focusing on core
versus headline inflation is not an issue in the current environment, where commodity prices
have already increased substantially. In the present scenario, second-round effects appear in
all prices. For example, a rapid increase in wages, due to backward looking indexation or
other type of inertia, will affect all prices through the cost channel, and hence, a pernicious
dynamic of inflation will be noticeable in both headline and core inflation. Indeed, a
reasonable adjustment should have foodstuff and energy price inflation falling sharply after
the relative price adjustment has taken place, and core inflation adjusting from a higher level
to the target. Once food and energy prices level out, the propagation of inflation could be a
more serious problem for countries that focus its target on core inflation.
Challenges to monetary policy
Current inflationary shocks pose a serious threat to monetary policy. The recent adjustment
has been uneven across countries. Many have been trying to avoid the increase in prices via
subsidies, taxes or plain price controls. However, it is by now clear that relative prices must
adjust, given the persistency of the shock and the need for appropriate signals for efficient
resource reallocation. On the other hand, there are countries, such as Chile, where changes
in costs are regularly passed on to consumer prices, because markets for foodstuff are
globally integrated and competitive. Hence, a large part of the inflationary shock has been
already absorbed. However, we have continuously witnessed a flow of bad news on
commodity prices, and inflationary shocks keep hitting us, but the benefits that the flexible
inflation targeting regime brings in terms of price stability and credibility must be maintained.
There is no doubt from the developing countries' perspective that this is an important
conquest and cannot be abandoned, least of all in these difficult times.
The world economy is in a very complex situation. It is far from the disastrous 1970s, but we
are in the presence of a slowdown with high risks of inflation. We are at a moment in which
monetary policy is put under a serious stress test that will be crucial in identifying future
refinements in the policy frameworks. Particularly important in the US and industrial countries
is the interaction between price and financial stability. From a policymaker's point of view, we
must ensure that all the benefits achieved during the great moderation phase are preserved.
It would be irresponsible to return to times of instability while searching for short-lived gains.
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Figure 1: Growth and inflation in developing economies
25 6
5
20
4
15
Growth
3
Inflation
10
Output
2
5
1
0 0
1974 1982 1990 1998 2006
Inflation Growth
Note: Inflation was calculated using YoY \% change in consumer prices, given by IFS line 64. Growth was
calculated as the YoY \% change in GDP volume as given by IFS line 99b. Averages are taken over all countries
that have data available from 1975. Industrial and developing status of countries has been taken directly from IFS.
Source: IFS.
Figure 2: Inflation and output growth volatility in developing economies
10 10
5 5
(s.d.) (s.d.)
8 8
4 4
6 6
Volatility Volatility
3 3
4 4
Growth
Inflation
2 2
2 2
1974 1982 1990 1998 2006
1974 1982 1990 1998 2006
Note: Inflation and growth have been calculated as in figure 1 over the same country groups. Volatility is
measured as the standard deviation, over a rolling window of five years.
Source: IFS.
Figure 3: Inflation volatility in developing economies: IT versus non IT
6 6
4 4
2 2
0 0
1998 2000 2002 2004 2006
Non-IT IT
Note: Inflation has been calculated as in figure 1. Volatility is measured as the standard deviation, over a rolling
window of five years. Countries were considered part of one group when more than 50% of the window
corresponded to that group.
Source: IFS.
Figure 4: Real WTI oil price (US$ of February 2008 per barrel)
120 120
100 100
80 80
60 60
40 40
20 20
0 0
1947 1962 1977 1992 2007
Note: Price deflated by US Producer Price Index.
Source: Bloomberg.
Figure 5: Food prices (index, January 2006 = 100)
600 600
500 500
400
400
300 300
200 200
100 100
0 0
48 54 60 66 72 78 84 90 96 02 08
CRB Spot Index CRB Fats & Oils Sub-index
CRB Foodstuffs Sub-index Reuters-CRB Grains and Oilseeds Sub-index
Sources: Commodity Research Bureau, Reuters and Bloomberg.
Figure 6: Inflation: Food, energy and rest (annual change, percent)
Food and energy Non food and energy
25 25 25 25
20 20 20 20
15 15 15 15
10 10 10 10
5 5
5 5
0 0 0 0
-5 -5 -5 -5
-10 -10 -10 -10
00 01 02 03 04 05 06 07 08 00 01 02 03 04 05 06 07 08
U.S. Euro Zone Japan Mexico Chile
U.S. Euro Zone Japan Mexico Chile
Source: Central Banks and Bloomberg