Inflation targeting in an open economy: Nonlinearity, asset prices and interest rates

Abstract

Inflation targeting has been the central focus of monetary policy since early 1990s as more than 60 central banks across the countries target it explicitly, others target it implicitly. However, how precisely does the central bank target inflation in practice? Does monetary policy always only respond to inflation or does it also react to asset prices and open economy variables? This thesis models these aspects of monetary policy primarily focusing to the UK inflation targeting regime. The empirical results are significant. First, monetary policy in UK is forward looking. It responds to deviations of inflation from the target, to the output gap and to asset prices misalignments. The policy reaction to inflation is strongest followed by the reaction to the output gap, the foreign interest rate, the exchange rate, house prices and share prices. Second, monetary policy is nonlinear because (a) it has deflationary bias, (b) it responds to asset prices only when asset prices misalignments are high, and (c) it responds to the output gap only when it does not respond to inflation and asset price misalignments. Third, policy response to exchange rates does not depend on inflation regime while the reaction to inflation does depend on the exchange rate regime. Fourth, policy response to inflation is asymmetric and it aims to keep inflation within a range rather than pursuing a point target of 2.5%. Fifth, neither the exchange rate misalignment nor the foreign interest rate alone can capture the open economy effects; policy responds to both variables.