Chapter 19

1. Chapter 19 Chapter 19 The Conduct of Monetary Policy: Strategy and Tactics

2. Two Primary Goals of Monetary Policy • Price stability (low stable inflation) • Nominal Anchor: A nominal variable that policy makers use to achieve price stability such as the money supply or the inflation rate. The idea is to “anchor” inflationary expectations • Some countries have explicit inflation targets. The Fed only recently has stated its target is 2% inflation, but this is not a written policy.

3. Two Primary Goals of Monetary Policy • 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. • Legislation states Fed must promote full employment • Dual mandate

4. Two Primary Goals of Monetary Policy • Should the central bank have policy discretion regarding goals or be tied to a rule? • Rules Versus Discretion debate

5. The Problem with Discretionary Policy: Time Inconsistency Problem • 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 • Example: To reduce expected inflation, the central bank announces it will tighten monetary policy and increase interest rates … but faced with high unemployment, the central bank may be tempted to cut interest rates.

6. The Time-Inconsistency Problem • To encourage investment, the government announces that it will not tax income from capital. …but after factories have been built, the government is tempted to renege on its promise to raise more tax revenue from them.

7. The Time-Inconsistency Problem • In general, rational agents understand the incentive for the policymaker to renege, and this expectation affects their behavior. • The solution is to take away the policymaker's discretion with a credible commitment to a fixed policy rule.

8. Linking Central Bank Tools to Objectives • 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 (Objectives): • Low Inflation, growth, stable interest rates

9. Linking Central Bank Tools to Objectives Link #1 Link #2 From the previous chapter we know the Fed can control the monetary base and the federal funds rate. But, what about “Link 1” and “Link 2” ?

10. Desirable Features of a Policy Instrument • Easily observable by everyone • Controllable and quickly changed • Tightly linked to the policymakers’ objectives • Short-term interest rates are the preferred instrument of monetary policy used to stabilize short-term fluctuations in prices and output

11. Policy Strategy 1: Monetary Targeting • The central bank announces that it will target a certain rate of growth in a monetary aggregate such as the money supply • For example, 5 percent annual growth in M1 • Used in the 1970’s adopted by a number of central banks – US, UK, Germany, Canada,

12. Monetary Targeting The Fed began to announce targets for money supply growth in 1975. Not very successful because of financial innovation Substitutes for M1 such as MMMF

13. Monetary Targeting Advantages Flexible, transparent, accountable Disadvantages Requires a strong and reliable relationship between the goal variable (inflation or nominal income) and the targeted monetary aggregate (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

14. Policy Strategy 2: Inflation Targeting • Given the breakdown in the relationship between monetary aggregates and goal variables such as inflation and nominal income, 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.

15. Inflation Targeting • With inflation targeting, the central bank bypasses intermediate targets and focuses on final objective. Link #3 in the next slide. • Policy Instrument is linked to a single goal.

16. Inflation Targeting Link #3 Link #1 Link #2

17. Inflation Targeting Put in Place as Part of Central Bank Reform - New Zealand (1990) Part of central bank reform in 1990 Sole objective is price stability 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) Explicit Target

18. 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

19. 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 Public announcement of a numerical inflation target Communication to increase transparency of the strategy Increased accountability of the central bank

20. Inflation Targeting - Intent • Keep inflation low • Anchors inflation expectations • 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.

21. Inflation Targeting in Practice “Inflation targeting is a framework for monetary policy characterized by the public announcement of official quantitative targets (or target ranges) for the inflation rate over one or more time horizons, and by explicit acknowledgement that low, stable inflation is monetary policy’s main long run goal.” Bernanke, et. al. (1999).

22. A “framework”, not a rule A policy rule is inflexible – requires an automatic policy response regardless of the current economic situation. Purely 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 Inflation Targeting in Practice “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).

23. Inflation Targeting Advantages Stable relationship between money supply and inflation is not needed. Does not rely on one variable to achieve target. Easily understood Focus is long term inflation goal. Reduces potential of over expansion in money supply to pursue political goals. Stresses transparency and accountability

24. Inflation Targeting Disadvantages • “Delayed signaling” • Effects 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. • Economy experiences low economic growth during disinflation period to hit target • But experience shows that once lower inflation target is reached, growth is promoted

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

26. US. Inflation w/o Explicit Inflation Target

27. Policy Strategy 3: The 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 The inflation process seems to have tremendous inertia

28. 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

29. 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!!!!!

30. Important Summary Table Advantages and Disadvantages of Different Monetary Policy Strategies

31. Price-Level Targeting • Price-level targeting is a policy under which a central bank sets the objective of holding the rate of increase of the price level to a pre-announced path • Many economists consider a 2% annual increase in the price level to be appropriate in the long run. Price-level target path A key question is where to start

32. 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

33. 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 (dashedred line). “Trend drift” • Price-level targeting, instead, aims to return to the original path (dashed green line) 2% inflation

34. 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 > 2% inflation

35. 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

36. 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 prices in non-oil sectors until the average price level returned to its original path • It might be better to let bygones be bygones, and start a new target path at A

37. 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

38. Reply to the Critics • Backers of price-level targeting, like Charles Evans, President of the Chicago Fed, 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) Posted Jan. 3, 2011 on Ed Dolan’s Econ Blog http://dolanecon.blogspot.com

39. A shift in reserve demand would move the market federal funds rate Reserve or MB target make interest rates volatile The interest rate is the link from the financial sector to the real economy Targeting reserves could destabilize the real economy Instrument Conflict - Targeting Non-borrowed Reserves (The interest rate must be allowed to fluctuate)

40. The Fed has to choose a reserve target or on an interest rate target. If the Fed follows a reserve target it will lose control over interest rates. If the Fed follows an interest rate target it will lose control over reserves. Instrument Conflict - the Federal Funds Rate. (Reserves must be allowed to fluctuate)

41. 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 π = the actual rate of inflation. Output gap = (Y –Y*)/Y* = percent by which real GDP(Y) deviates from full employment potential (Y*)

42. The Taylor Rule • The Taylor Rule says that 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

43. 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. iff = 2.0 + π + 0.5( π – 2.0) + 0.5 ((Y – Y*)/Y*) iff = 1.0 + 1.5 π + 0.5 ((Y – Y*)/Y*) Rearrange terms 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%

44. More 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

45. Question: 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

46. 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 Current Data: • iff = 1 + 1.5(2) + .5(-6) [Rule 1] • iff = 1 percent • What if the output gap coefficient is 1.0. • iff = 1 + 1.5(2) + 1.0(-6) [Rule 2] • iff = -2

47. Comparison of Rules March 2013

49. The Taylor Rule for the Federal Funds Rate, 1970–2011 Source: Federal Reserve; www.federalreserve.gov/releases and author’s calculations.