Chapter 19

Chapter 19The Conduct of Monetary Policy: Strategy and Tactics Possibly Better: Goals and Strategies

Preview

• Examines the goals of monetary policy and then strategies.

• Look at one of the important strategies for the conduct of monetary policy - inflation targeting

Two Primary Goals of Monetary Policy(1) Price stability (low stable inflation)•Concept - Nominal Anchor

– This is a nominal variable such as the money supply or the inflation rate that policy makers target to achieve price stability.

– The idea is to “anchor” inflationary expectations

•Some countries have explicit inflation targets.– Explicit Nominal Anchor.

•The Fed only recently has stated its target is 2% inflation, but this is not a written policy.

– An Implicit Nominal Anchor.

Two Primary Goals of Monetary Policy

(2)Low Unemployment (high stable growth)

•Monetary policy can not permanently affect the real level of economic activity so the Fed does not have a stated unemployment target.

•However, legislation states Fed must promote full employment along with stable prices

–Dual mandate

Should Price Stability Be the Primary Goal of Monetary Policy?

• Hierarchical Versus Dual Mandates: – Hierarchical mandates put the goal of price stability

first, and then say that as long as it is achieved other goals can be pursued

– Dual mandates are aimed to achieve two coequal objectives: price stability and maximum employment (output stability)

• Price Stability as the Primary, Long-Run Goal of Monetary Policy

Rules Versus Discretion• Should the central bank have policy discretion

regarding goals or be tied to a rule?– Debated for a long time.

• Examples of a Fixed Rule: • A rule that states the FOMC must target a stated

rate of growth in the money supply or target an explicit rate of inflation.

• The Fed has Discretion– Dual mandate gives a lot of discretion

The Concern About Discretionary Policy: Time Inconsistency Problem

• Policy makers can change their goal

• Definition: A scenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement

• Destroys policymakers’ credibility, thereby reducing effectiveness of their policies

The Time-Inconsistency Problem• Example: To reduce expected inflation, the

central bank announces it will tighten monetary policy and increase interest rates

• but faced with high unemployment, they may relent cuts interest rates.

The Time-Inconsistency Problem

• In general, rational agents (you and me) understand the incentive for the policymaker to renege, and this expectation affects their behavior.

• The solution: take away the policymaker's discretion and replace with a credible commitment to a fixed policy rule. –For example, an explicit inflation target which around 27 countries have adopted.

Linking Central Bank Tools to Goals• Central Bank Tools

– Open Market Operations (OMO), Discount Loans, Reserve Req., Interest on Reserves (IOR/IOER)

• Policy Instruments – Federal Funds Rate or Monetary base

• Intermediate targets– ST and LT interest rates; Monetary Aggregates (M1 ,

M2)

• Goals: – Low Inflation, growth and low unemployment,

stable interest rates

Linking Central Bank Tools to Goals

Open Market Operations

Discount Policy

Reserve Requirements

Interest on Reserves

Large-scale Asset Purchases

Forward Guidance

Tools of theCentral Bank

PolicyInstruments

IntermediateTargets

Goals

Monetary Aggregates (M1, M2)

Interest rates (short-term and long-term)

Price Stability

High Employment

Economic Growth

Financial Market Stability

Interest-Rate Stability

Foreign Exchange Market Stability

Reserve Aggregates (reserves, nonborrowed reserves, monetary base, nonborrowed base)

Interest rates (short-term such as federal funds rates)

Linking Central Bank Tools to Goals

Open Market Operations

Discount Policy

Reserve Requirements

Interest on Reserves

Large-scale Asset Purchases

Forward Guidance

Tools of theCentral Bank

PolicyInstruments

IntermediateTargets

Goals

Monetary Aggregates (M1, M2)

Interest rates (short-term and long-term)

Price Stability

High Employment

Economic Growth

Financial Market Stability

Interest-Rate Stability

Foreign Exchange Market Stability

Reserve Aggregates (reserves, nonborrowed reserves, monetary base, nonborrowed base)

Interest rates (short-term such as federal funds rates)

• From the previous chapter we know the Fed can use its tools to control the monetary base and the federal funds rate.

• But, what about “Link 1” and “Link 2” ?• Can the Fed control the money supply, market interest

rates, inflation and growth?

Link #1 Link #2

How to choose a Policy Instrument

• Observability and Measurability• Controllability• Predictable effect on Goals

• Short-term interest rates are the preferred instrument of monetary policy used to stabilize short-term fluctuations in prices and output

A rightward or leftward shift in the demand curve for reserves …

Quantity ofReserves, R

ffi

*ffi

FederalFunds Rate

di

ori

ffi

Rs

NBR*

leads to fluctuations in thefederal funds rate between

and .ff ffi i

Rd*

Rd′′

Rd′

Instrument Conflict: Result of Targeting Non-borrowed Reserves.

The Federal Funds Rate must be allowed to fluctuate

*ffi Federal Funds

Rates Target, *ffi

d *R

sRid

ier

Federal Funds Rate

Quantity of Reserves, R

NBR*NBR NBR

Step 1. A rightward or leftward shift in the demand curve for reserves…

Step 2. lead the central bank to shift the supply curve of reserves so that the federal rate does not change…

Step 3. with the result that non-borrowed reserves fluctuate between NBR′ff and NBR′′ff.

dR

dR

Instrument Conflict – Result of Targeting the Federal Funds Rate.

Reserves and the money supply must be allowed to fluctuate

Policy Strategies: Monetary Targeting

• Used in the 1970’s by a number of central banks – US, UK, Germany, Canada…

• Methodology: Central bank announces that it will target a certain rate of growth in a monetary aggregate such as the MB or the money supply– For example, 5 percent annual growth in

M1

Policy Strategies: Monetary Targeting

• The Fed began to announce targets for money supply growth in 1975.

• Not very successful

• The Fed found that it lost control of the money supply because of financial innovation

• Substitutes for M1 such as MMMF

1+(C/D)• Also: M1= MB rD + (ER/D) + (C/D)

Monetary Targeting• Advantages

– Money supply is easily observed

• Disadvantages– Requires a strong Link No. 1– Requires a stable relationship between the money supply

and the goal variable (inflation or nominal income) – Strong Link No. 2.

– This relationship has been shown to be weak.• Velocity of money is not stable

• Greenspan announced in July 1993 that the Fed would not use monetary aggregates as a guide for conducting monetary policy. Change to target the Federal Fund rate.

Policy Strategies: Inflation Targeting• Given the breakdown in the relationship between

monetary aggregates and goal variables, a number of countries adopted inflation targeting as their policy strategy.

• New Zealand, Canada and the UK have explicit inflation targets - around 27 countries in total.– Bank of Canada Governor Gerry Bouey, who reputedly remarked that "we

didn't abandon monetary aggregates, they abandoned us".

• With inflation targeting, the central bank bypasses intermediate targets and focuses on the final objective. Link #3 in the next slide.

Policy Strategies: Inflation Targeting

Link #1 Link #2

Link #3

• The Policy Instrument is linked to a single goal.

Inflation Targeting• New Zealand (1990)

– Part of central bank reform in 1990– Sole objective is price stability with an explicit

target–range.– Inflation was brought down and remained

within the target range most of the time. – Governor of the central bank is accountable

and can be dismissed.• Canada (1991)

– Explicit target range.– Inflation brought down, some costs in term of

unemployment• United Kingdom (1992)

– Part of central bank reform in 1992– Explicit Target

Central Bank Web Pages

• http://www.rbnz.govt.nz/– Click on Monetary Policy

• http://bankofcanada.ca/en/index.html– Click on Monetary Policy

• http://www.bankofengland.co.uk/– Click on Monetary Policy Framework

Inflation Targeting – How does it work?

• Commitment to price stability as the primary long-run goal of monetary policy and a commitment to achieve the inflation goal

• Communication with public to increase transparency of the strategy

– Public announcement of a numerical inflation target

• Increased accountability of the central bank

Inflation Targeting - Intent

• Keep inflation low • Anchor inflation expectations • This will anchor long-term interest rates to

promote growth. i = r + πe

• Follows a hierarchical mandate: inflation first, everything else second.

Remember: Fed has a dual mandate. Has shied away from adopting inflation targeting.

– A “policy framework”, not a rule• A policy rule is inflexible – requires an

automatic policy response regardless of the current economic situation.

• Pure discretionary (or, unconstrained) policy reacts only to current developments and has no regard for long-run goals.

• Inflation targeting is meant to be constrained discretion

“By imposing a conceptual structure and its inherent discipline on the central bank, but without eliminating all flexibility, inflation targeting combines some of the advantages traditionally ascribed to rules with those ascribed to discretion.” Bernanke, et. al. (1999).

Inflation Targeting in Practice

Inflation Targeting - Advantages• Stable relationship between money supply

and inflation is not needed.

• Easily understood.

• Focus is long term inflation goal.

• Reduces potential of over expansion in money supply to pursue political goals.

• Stresses transparency and accountability

Inflation Targeting - Disadvantages• “Delayed signaling”

– Effects of change in policy on inflation only revealed after long lags (12 to 24 months)

• Some economist argue too much rigidity– However, in practice there is policy discretion,

target is within a range.

• Potential for increased output fluctuations.– For example, with a sole focus on inflation,

monetary policy may be too tight if π > target, leading to greater fluctuations in output.

Inflation Rates and Inflation Targets for New Zealand, Canada, and the United Kingdom, 1980–2008

US. Inflation - Without Explicit Inflation Target

Consumer Price Inflation

0

2

4

6

8

10

12

14

1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 200 200

US - Monetary Policy with an Implicit Nominal Anchor • The previous chart shows the US has achieved

good results without an explicit nominal anchor.

• Fed strategy has been to follow and implicit nominal anchor.

• Fed policy must be forward looking and preemptive – The goal is to prevent inflation from getting started.– Lag between implementation and impact on real output is

about 1 year and about 2 years to affect inflation

US Monetary Policy with an Implicit Nominal Anchor • Advantages

– Uses many sources of information– Demonstrated success

• Disadvantages– Lack of transparency and accountability

– Strong dependence on the preferences, skills, and trustworthiness of individuals in charge

– Inconsistent with democratic principles <= Pooh!

Important Summary Table Advantages and Disadvantages of Different Monetary Policy Strategies

Price-Level Targeting• Price-level Targeting

The central bank targets the rate of increase of the price level.

• Many economists consider a 2% annual increase in the price level to be appropriate in the long run.

A key question is where to start. 2007?, 2008, 2014?

Inflation Targeting• Inflation targeting

also aims to move the economy along a pre-set path

• If inflation targeting were fully successful, the economy would follow exactly the same path as under price-level targeting

Inflation target path

Inflation and Price-Level Targeting - Compared• The two policies differ

when the economy strays from its intended path, for example, at point A.

• Under inflation targeting, the aim is to put the economy on a new path parallel to, but below the original one (dashed red line). “Trend drift”

• Price-level targeting, instead, aims to return to the original path (dashed green line)

2% inflation

The Claimed Advantage of Price-Level Targeting• Along the segment A-B,

PLT would require a more expansionary policy to produce a rate of inflation higher than 2%

• Low inflation at A is likely to be accompanied by high unemployment (as in the US in 2010), price-level targeting would bring unemployment back to normal faster than inflation targeting. Faster rate of growth in the money supply.

> 2% inflation

Criticisms of Price-Level Targeting• Critics of PLT fear that rapid

inflation along the segment A-B would destabilize inflation expectations (become “unanchored”) and raise risk premiums in financial markets

• They also worry that PLT would undermine the central bank’s credibility

• The fear is that if the central bank promotes high inflation, if only for a brief period, people would come to doubt its inflation-fighting intentions in the future

Concerns about PLT when Inflation is High• Critics also say that PLT

would work poorly when an external supply shock (say, a world oil price rise) causes inflation to drift above its 2% target path

• PLT would then require a strong contractionary policy in order to decrease the price level until the average price level returned to its original path

• In this case, it might be better to let bygones be bygones, and start a new target path at A

Concerns about PLT when Inflation is High

• Supporters of Price Level Targeting tend to agree that PLT would not work well against high inflation caused by an external supply shock

• The important thing, they say, is that the Fed should be clear about the kinds of circumstances in which PLT would be used, and those in which it would not be used

Posted Jan. 3, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

Reply to Critics of PLT• Backers of price-level targeting say worries about

expectations and credibility can be overcome if the central bank is clear about its intentions

• Make it clear that the Fed will apply PLT only when inflation has been very low for a considerable period

• Make it clear that the Fed will moderate its strongly expansionary policy as soon as the economy returns to its original price-level path (point B in the earlier figure)

Guide to Central Bank Interest Rates The Taylor Rule• Taylor Rule:

iff = rff + π + a(π –πt) + b((Y –Y*)/Y*)

– Where

iff = target nominal federal funds rate

rff = “equilibrium” real federal funds rate

πT = target rate of inflation

Output gap = (Y –Y*)/Y* = percent by which real GDP(Y) deviates from full employment potential (Y*)

π = the actual rate of inflation.

The Taylor Rule

•States the target nominal federal funds rate should be set equal to the current rate of inflation: (1) plus a target real interest rate; and (2) plus adjustment factors.

•Taylor’s parameters:

Target Fed Funds rate = 2 % + Current Inflation Rate + ½ (Inflation gap)+ ½(Output gap)

iff = 2.0 + π + 0.5( π – 2.0) + 0.5 ((Y – Y*)/Y*)

Published in 1993 based on data from 1987 - 1992

The Taylor Rule - Examples• When inflation rises above its target level,

respond by raising the interest rate.

• When output falls below the target level, respond by lowering the interest rate.

• If the economy is at full employment and inflation on target:

iff = 2.0 + 2.0 + 0.5( 2.0 – 2.0) + 0.5 (0) = 4.0 percent

The nominal FFR at full employment and target inflation is 4.0%

Output Gap –

Taylor Rule - Examples

Economy at full employment, but inflation above target at 3%:

iff = 2.0 + 3.0 + 0.5( 3.0 – 2.0) + 0.5 (0) = 5.5 percent

Inflation on target, but economy 3% less than full employment:

iff = 2.0 + 2.0 + 0.5( 2.0 – 2.0) + 0.5 (-3.0) = 2.5 percent

Inflation below target (1%) and economy 3% below full employment:

iff = 2.0 + 1.0 + 0.5( 1.0 – 2.0) + 0.5 (-3.0) = 1.0 percent

If inflation rises 1% above target, the FFR increases by 1.5%. WHY?

iff = 2.0 + 3.0 + 0.5( 3.0 – 2.0) + 0.5 (0) = 5.5 percent

iff = 2.0 + 2.0 + 0.5( 2.0 – 2.0) + 0.5 (0) = 4.0 percent

Re-arrange terms

• iff = 2.0 + π + 0.5( π – 2.0) + 0.5 ((Y – Y*)/Y*)

• iff = 2.0 + 1.5π – 1.0 + 0.5 ((Y – Y*)/Y*)

• iff = 1+ 1.5π + 0.5 ((Y – Y*)/Y*)

• Using Data for 2011/12: π= 2%, gap = -6%:

• Rule 1: iff = 1 + 1.5(2) + .5(-6) ; iff = 1 percent

• What if the output gap coefficient is 1.0.

• Rule 2: iff = 1 + 1.5(2) + 1.0(-6); iff = -2 percent

Comparison of Rule 1 and Rule 2

March 2013

FOMC Sept. 2014

FOMC Sept. 2015

The Taylor Rule for the Federal Funds Rate, 1970–2011

Source: Federal Reserve; www.federalreserve.gov/releases and author’s calculations.

Did Greenspan follow the Taylor Rule?

“ … rules that relate the setting of the federal funds rate to the deviations of output and inflation from their respective targets, in some configurations, do seem to capture the broad contours of what we did over the past decade and a half.”[1]

[1] Greenspan, Alan, “Risk and Uncertainty in Monetary Policy,” American Economic Review, May 2004, pp. 33-40. The quoted passage appears on pages 38-39.

Criticisms of the Taylor Rule

• Several alternatives measure inflation and the output gap: – The Taylor Rule differs considerably, depending on

the price index and output gap measure used.

• The impact lag of monetary policy means that the ideal active policy rule should not use current observations for inflation, real GDP and potential real GDP, but rather should use expected rates 9-12 months in the future.

• The weights or response coefficients used in the Taylor Rule have no theoretical basis.

• The Taylor Rule is too simple.

The Taylor Rule – Rearrange Terms

iff = rff + π + .5(π –πt) + .5((Y –Y*)/Y*)

iff = rff + π + .5π –.5πt + .5((Y –Y*)/Y*)

iff = rff + 1.5π –.5πt + .5((Y –Y*)/Y*)

iff = rff + πt + 1.5π –1.5πt + .5((Y –Y*)/Y*)

iff = rff + πt + 1.5(π – πt) + .5((Y –Y*)/Y*)

In General:

iff = rff + πt + a(π – πt) + b ((Y –Y*)/Y*)

Empirical studies (information only)

iff = rff + πt + a(π – πt) + b ((Y –Y*)/Y*)

Use of data to estimate a and b – Clarida, Gali, and Gertler (1999)

How well the Fed has done in shooting at itstarget.