Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Why Do Central Banks Monitor So Many Inflation Indicators?

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

Why Do Central Banks Monitor So Many Inflation Indicators?

Article excerpt

Monetary policy is typically undertaken with an eye to achieving a select few objectives in the long run. In the United States, the Federal Reserve conducts monetary policy to promote two long-run goals: price stability and sustainable economic growth. In many other countries, central banks have a single long-run goal defined in terms of an inflation target. Yet while central banks have narrowly defined long-run goals, most monitor a wide range of economic indicators.

Why do central banks collect and analyze so many indicators? To understand the answer, it is first important to recognize that monetary policy affects economic activity and inflation with long and variable lags. One consequence of the lagged response is that central banks cannot undertake policy actions to immediately realize their inflation or output goals. A second consequence is that the magnitudes of economic responses to policy actions cannot be estimated with precision. Thus, policymakers face the difficult task of taking forward-looking policy actions when they cannot be certain about the magnitudes of the economic implications of their actions. To cope with this uncertainty, central banks search for economic indicators that may be closely related to policy's long-term goals.

This article presents multicountry empirical evidence to assess whether any single indicator reliably predicts inflation. If such an indicator exists, it would need to perform adequately under a wide variety of economic conditions and changing economic structures, because no country faces an unchanging economic environment. One way to test for such robust performance is to examine the value of indicators across a variety of countries experiencing different economic conditions, financial structures, policy shifts, and so forth.

The first section discusses why several widely used indicators might predict inflation. The second section explains how the predictive performance of these indicators can be compared. The third section reports empirical results for 11 developed economies, including the United States. The article concludes that while monitoring the change in GDP growth is useful on average across countries, no single economic indicator is always reliable. This evidence supports an approach to policymaking that involves monitoring a wide range of economic indicators.

I. POTENTIAL INDICATORS

OF INFLATIONARY PRESSURES

Many economic indicators may help predict inflation. For instance, a recent study on forecasting U.S. inflation examined 168 variables (Stock and Watson 1999). Rather than cast such a wide net, this article limits the list of indicators to those that are more closely linked to inflation by economic theory or that have been regularly used in previous empirical studies. In addition, because the analysis is done for a collection of industrialized countries, data availability imposes further limitations on the variables that may be analyzed.1 Consequently, the indicators discussed in this section are likely only a subset of the economic variables monitored by policymakers. Nevertheless, the chosen indicators have broad coverage.

This section reviews reasons why these indicator variables might be expected to predict inflation. The indicators fall into two basic groups. One group includes financial variables that might predict inflation because they reflect current or expected monetary policy actions. This group includes variables such as interest rates, money growth, and exchange rates. The second group includes measures of real economic activity which might predict inflation because they provide information on excess demand conditions in the economy. This group includes variables such as the unemployment rate and real GDP growth.

Interest rates

Most central banks conduct monetary policy by setting or targeting an overnight interest rate or another short-term rate. Increases in these interest rates are generally regarded as tightenings of monetary conditions and are expected to slow economic activity and decrease inflationary pressures. …

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