Central Banks Quasi-Fiscal Policies and Inflation

Although central banks have recently taken unconventional policy actions to try to shore up macroeconomic and financial stability, little theory is available to assess the consequences of such measures. This paper offers a theoretical model with which such policies can be analyzed. In particular, the paper shows that in the absence of the fiscal authorities’ full backing of the central bank’s balance sheet, strange things can happen. For instance, an exit from quantitative easing could be inflationary and central banks cannot successfully unwind inflated balance sheets. 

Therefore, the fiscal authorities’ full backing of the monetary authorities’ quasi-fiscal operations is a pre-condition for effective monetary policy.

Recently, central banks implemented unconventional operations by accumulating risky assets in an attempt to mitigate the financial turmoil that began in 2008 and the Euro zone fiscal crises. The operations altered the central banks’ balance sheet in both size and substance, and the magnitude of these operations was significant. These operations can be referred to as a

‘quasi-fiscal policy’ of central banks because they do not conform to traditional monetary policy, which is used to stabilize inflation by controlling the policy interest rate. Instead of being innate to central banks, most of these activities could be implemented by fiscal authorities. In this paper, a quasi-fiscal policy is defined as any policy action that affects the central banks’ balance sheets, with the exception of the traditional monetary policy mentioned above. For example, since credit easing operations alter the composition of the central banks’ asset accounts, they are considered quasi-fiscal policies. If losses are incurred from the central bank’s assets and the fiscal authorities decide not to compensate these losses, then the fiscal authorities’ decision is also a quasi-fiscal policy because it decreases the central banks’ capital account.

Some have worried that the quasi-fiscal policies of the central bank may undermine its independence and ability to stabilize inflation (Sims, 2003; and Goodfriend, 2011). In this regard, Goodfriend (2011) proposed accord principles between the central banks and fiscal authorities that will insulate the central banks from quasi-fiscal policy shocks. Also, an empirical study by Klüh and Stella (2008) showed that financially weak central banks were ineffective in stabilizing inflation. However, little economic theory is available to explain how and when the central banks’ quasi-fiscal policy affects inflation and imposes restriction on monetary policy. The issue can be particularly crucial for central banks without sound fiscal support, such as the European Central Bank. This paper proposes a simple dynamic stochastic general equilibrium (DSGE) model in order to address the following questions: (i) Do quasi-fiscal policies and the central banks’ balance sheets affect inflation? and (ii) Do the central banks’ balance sheets have implications for policy interactions between the central banks and fiscal authorities?

The model predicts that the central banks’ balance sheet shocks affect inflation through private agents’ (households’) portfolio adjustment when the fiscal authorities do not financially support central banks. That is, in that particular policy regime, the price level is determined by a ratio between the nominal and real value of the central bank’s net liability. For example, suppose that a central bank with a negative capital suffers additional losses from long-term bond holdings while the central bank tries to increase short-term interest rate in response to inflationary pressure. As the real value of holding the central bank’s net liability falls below the equilibrium with the negative return shock, then the private agent tries to decrease holdings of the central bank’s liability (nominal money balance) and increase consumption. In the end, the general price level increases, and the central bank passively increases nominal money supply in order to satisfy real money balance demand.

Paradoxically, the hike in the policy rate (deflationary monetary policy) induces inflation in this case. In other words, the central bank is confined to a situation where it cannot play an active role in stabilizing inflation. Since fiscal support of the central bank’s balance sheet precludes such type of equilibrium, therefore, the fiscal authority’s back-up is a pre-condition for effective monetary policy when the central bank is engaged in the other policy role such as maintaining financial stability.

Sargent and Wallace (1981), Leeper (1991) and Sims (1994) connected monetary and fiscal policy by showing that one policy may impose restrictions on the other policy, and that the two policies should interact in a coherent way in order to deliver a unique equilibrium. In this conventional approach to policy interaction, the budget constraints of the central banks and fiscal authorities are consolidated into a single equation. In other words, conventional models implicitly assume that the fiscal authorities acknowledge the central banks’ liabilities and assets as their own liabilities and assets, and that the central banks’ losses are automatically compensated by the fiscal authorities. Owing to these assumptions, in conventional models

the budget constraint of the central banks does not impose restrictions on the equilibrium.

However, questions can be raised about this conventional assumption. Stella and Lönnberg (2008) surveyed 135 central banks and discovered that laws did not always guarantee the fiscal authorities’ responsibility for the central banks’ liabilities, and that the fiscal authorities are not always prompt in recapitalizing the central banks. In this regard, this paper relaxes the conventional assumption by elaborating on the institutional details which state that the central banks’ flow budget constraint is separate from the fiscal authorities’ flow budget constraint. In addition, this paper’s public sector model includes the fiscal authorities transfer rule for recapitalizing the central banks, and the transfer rule is the key quasi-fiscal policy in the benchmark model.

Furthermore, this paper departs from conventional models by assuming that the real values of the central banks’ and fiscal authorities’ liabilities have finite upper bounds, which are the expected present values of their future earnings. Owing to this assumption, the peculiar equilibria, where the fiscal authorities and central banks can run a Ponzi scheme on each other and the real value of the central banks’ capital grows (or shrinks) infinitely, are excluded from this paper. By utilizing this assumption and the institutional details of the flow budget constraints, we show that the intertemporal equilibrium condition from the central banks’ budget constraint (the central banks’ net liability valuation formula) restrict equilibrium inflation in a certain policy regime.

In the abovementioned policy regime, quasi-fiscal policy is ‘active,’ while monetary and fiscal policies are ‘passive.’4 The active quasi-fiscal policy means that the fiscal authorities do not stabilize the central banks’ real capital and do not increase the fund transfer to the central banks when losses are incurred. As described in the previous example, monetary and fiscal policies are passively adjusted in order to satisfy the other equilibrium conditions, thus equilibrium inflation is uniquely determined by the central banks’ net liability valuation formula in this regime. In this regard, this paper is an extension of the Fiscal Theory of Price Level (FTPL) such as Leeper (1991). The model in this paper includes two intertemporal equilibrium conditions (from the public sector’s separated flow budget constraints) and three policy instruments (monetary, fiscal, and quasi-fiscal), whereas one intertemporal equilibrium condition (from the public sector’s consolidated flow budget constraint) and two policy instruments (monetary and fiscal) exist in the conventional FTPL.

A few studies have been completed that shed light on the effects of concerns over the central banks’ balance sheets. Jeanne and Svensson (2007) showed that if the central banks suffer losses when their capital falls under a fixed level, then the central banks’ commitment to escape from the liquidity trap is more credible. Sims (2003) showed that the central banks’ balance sheet concerns might undermine the central banks’ abilities to prevent inflation. Berriel and Bhattarai (2009) showed that the optimal monetary policy is significantly different when the central bank’s budget constraint is separate from the fiscal authorities’ budget constraint. Specifically, as the central banks place higher effective weight on inflation in the loss function, the variation in inflation decreases.

One of the differences between this paper and previous literature on the central banks’ balance sheets is that a new type of equilibrium exists even if the policy interest rate does not depend upon the status of the central banks’ balance sheets. For example, in Jeanne and Svensson (2007) and Berriel and Bhattarai (2009), the central banks’ loss function includes a deviation of the central banks’ real capital. In these cases, the central banks’ monetary policy behavior may be restricted by the balance sheet concerns. However, the monetary policy behavior in this paper follows a simple Taylor rule. In other words, the central bank, in this paper, will not generate seigniorage in response to its balance sheet concerns.

The remainder of this paper is organized as follows. In Section II, we build the model for the rational-expectations general equilibrium in exact nonlinear forms. In Section III, the equilibrium conditions are linearized around the deterministic steady state in order to derive analytic solutions. In addition, we explain the equilibrium in the active quasi-fiscal policy regime in this section. The benchmark model is extended to include the exit strategy in Section IV, and Section V concludes the paper.

World Bank. Author/Editor:Park, Seok Gil

Central Banks Quasi-Fiscal Policies and Inflation x

Clarity of Central Bank Communication About Inflation

This paper examines whether the clarity of central bank communication about inflation has changed with the economic environment. We use readability statistics and content analysis to study the clarity of communication on the inflation outlook by seven central banks between 1997 and 2010. Overall, we find no strong indications that central banks were less clear in explaining their policies when faced with higher uncertainty or a less favorable inflation outlook. The global financial crisis, however, did have a negative impact on clarity of central bank communication.

This paper studies the clarity of communication by central banks, in particular their communication on the inflation outlook. Communication is an integral element of monetary policy in many developed and emerging economies. Indeed, central banks have made great efforts to increase their transparency and accountability to the public (Eijffinger and Geraats, 2006; Dincer and Eichengreen, 2007). Central banks provide a greater volume of information and communicate through a range of channels – including inflation reports, press releases, and press conferences – and this information tends to be available faster, more frequently, and to wider audiences than ever before. Previous research has identified various benefits of the increase in communication such as higher predictability of interest rate decisions (e.g., Woodford, 2005; Blinder and others, 2008).

Little is known, however, about how clear central banks’ communication is, and what factors drive changes in clarity over time. Recent studies suggest that central banks have not always provided a clear message (Bulíř and others, 2008; Bulíř, Čihák, and Šmídková, forthcoming). In these papers, central banks in a sample of developed and emerging market countries were found to be clear on average between 60 percent and 95 percent of the time. But why have some communications been clear while others are not? Can these variations in clarity be explained? So far, this has not been extensively researched.

Communication clarity and changes therein should be relevant for policymakers, as the quality of communication on the inflation outlook affects the degree to which inflation expectations can be managed. Or, as Blinder (2009) puts it:

“Since clearer communications presumably have higher signal-to-noise ratios, they should in principle convey more information. (…) While the clarity issue has received scant attention in the literature, I find it tantalising that (…) different methodologies come to the same conclusion: that greater clarity enhances the quality of central bank communication. I would love to jump to this conclusion, but it so far rests on a slender evidentiary base. More research on this issue would be welcome.”

Our aim is to fill this gap, that is, to explain variations in the clarity of central bank communication. In particular, does the clarity of central bank communication depend on the context? Is clarity sensitive to the inflation outlook or uncertainty therein, or both?

To motivate why uncertainty in the inflation outlook can influence clarity, imagine writing inflation reports in two different scenarios. The first scenario is straightforward: persistent monetization of debt has resulted in high inflation, and this policy is widely expected to continue. In the second scenario, assume there are many factors, some difficult to measure precisely, and some offsetting each other. On the one hand, there is relatively less to gain from “crafting the message” in the first scenario, because the causes of inflation are obvious and likely to continue; on the other hand, delivering a clear message is relatively easy. In the second economy, the potential gains from a well-crafted message are substantial; however, delivering a clear message is more challenging. In essence, we try to find out whether the communication effort is reflected in additional clarity during complex economic situations.

Our initial hypothesis is that when the inflation outlook is less certain, or less favorable, communication will be more difficult for the central bank, leading to less clarity. More uncertainty is typically associated with more explanatory factors and more challenges when measuring these factors and communicating their impact on the inflation outlook. Admittedly, in situations of greater uncertainty, the clarity of the central bank’s message yields a higher return. The central bank may be well aware that, in some cases, clear explanations are expected. If it then invests more heavily in the drafting process, clarity may well remain unchanged, or it may even increase. We are not aware of research that has sought to investigate this issue empirically.2

It is important to understand the drivers of communication clarity, for two main reasons. First, as argued by Jansen (2011a), clarity is an important pre-condition for transparency. Even if a central bank communicates frequently, but does so opaquely, it can hardly be called transparent. Second, clarity may carry direct benefits. As noted by Blinder (2009), clearer communication has a higher signal-to-noise ratio and carries more information. So far, there has been little work to investigate this hypothesis empirically, but the evidence at hand does suggest that clarity is beneficial. Fracasso, Genberg and Wyplosz (2003) have found that well-written inflation reports are associated with higher predictability of decisions. Jansen (2011b) finds that greater clarity of the Humphrey-Hawkins testimonies by the Fed chairman has gone hand in hand with lower volatility in financial markets.

Our paper makes several contributions to the literature. First, we use a measure for clarity which is standard in many fields, such as linguistics or psychology, but has not often been used by economists. One benefit of this criterion is its objectivity, as it only uses textual characteristics: the number of words, sentences, and syllables. As an alternative measure of clarity, we also use the length of the reports. Second, using this measure, we are able to document how clarity of various types of communications by seven central banks has evolved over the last decade. Third, we analyze if and how clarity has been related to the context in which communications were made. In particular, we study how inflation outlook and the uncertainty around the outlook affected clarity.

To preview our findings, we uncover significant and persistent differences in clarity over time and across countries. Readability appears to be country

While some countries’ inflation reports have become more readable over time (Chile, Sweden, and the United Kingdom), in other countries readability worsened (Thailand).

Regarding our main hypothesis, overall, we find little evidence that central banks were less able to clearly explain their policies when faced with higher uncertainty or a less favorable inflation outlook. Short-term fluctuations in clarity are hard to account for, although the central bank’s assessment of inflation and dissent in voting on interest rates explain some of the variation. Finally, we find that the global financial crisis contributed to making central bank communication less clear. This indicates that—while central bank communication has generally been successful in adapting to new contexts—the financial crisis provided a major communication challenge.

The remainder of the paper is organized as follows. Section II outlines the data and estimation approach. Section III presents results for the clarity of inflation reports, press releases and statements, and report length. Section IV concludes

IMF. Author/Editor:Bulir, Ales; Cihák, Martin; Jansen, David-Jan

Clarity of Central Bank Communication About Inflation

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Inflation Dynamics in Asia: Causes, Changes, and Spillovers from China

The perception that Asia’s inflation dynamics is driven by idiosyncratic supply shocks implies, as a corollary, that there is little scope for a policy reaction to a build-up of inflationary pressures. However, Asia’s fast growth and integration over the last two decades suggest that the drivers of inflation may have changed, and that domestic demand pressures may now play a larger role than in the past.

This paper presents a quantitative analysis of inflation dynamics in Asia using a Global VAR (GVAR) model, which explicitly incorporates the role of regional and global spillovers in driving Asia’s inflation. Our results suggest that over the past two decades the main drivers of inflation in Asia have been monetary and supply shocks, but also that, in recent years, the contribution of these shocks has fallen, whereas demand-side pressures have started to emerge as an important contributor to inflation in Asia.

IMF. Osorio,Carolina;Unsal,D.Filiz.November 01, 2011.Working Paper No. 11/257
Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

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