"What Should Inflation Targeting Countries Do When Oil Prices Rise and Drop Fast?"

33 Pages Posted: 2 Jun 2009

See all articles by Nicoletta Batini

Nicoletta Batini

International Monetary Fund (IMF)

Eugen Tereanu

World Bank

Date Written: May 2009

Abstract

After a long period of global price stability, in 2008 inflation increased sharply following unprecedented increases in the price of oil and other commodities, notably food. Although inflation remained lower and growth higher in inflation targeting countries than elsewhere, almost everywhere price stability seemed in jeopardy as consumer prices kept surging and central banks struggled to maintain expectations anchored. The rapid drop in energy and food prices that later accompanied the world slowdown helped avert the worse, but inflation stayed high in many inflation targeting countries. This paper uses a small open-economy DSGE model to design the correct monetary policy response to a protracted supply shock of the kind observed today, and explains how to choose optimal policy horizons under such shock. Using a version of the model with Kalman learning, the paper also evaluates the implications of a loss of target credibility, showing how rules must be adjusted when the authorities' commitment to low inflation has been eroded. The appropriate response to future evolutions of the price of oil, including to a large downward correction as recently observed, is also evaluated.

Keywords: Agricultural commodities, Agricultural prices, Central banks, Commodity price fluctuations, Consumer prices, Demand, Economic models, External shocks, Inflation, Inflation targeting, Monetary policy, Oil prices, Price stabilization

Suggested Citation

Batini, Nicoletta and Tereanu, Eugen, "What Should Inflation Targeting Countries Do When Oil Prices Rise and Drop Fast?" (May 2009). IMF Working Papers, Vol. , pp. 1-32, 2009. Available at SSRN: https://ssrn.com/abstract=1413000

Nicoletta Batini

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States

Eugen Tereanu

World Bank ( email )

1818 H Street, NW
Washington, DC 20433
United States

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