Boğaziçi University Department of Economics Money, Banking and Financial Institutions L.Yıldıran

Boğaziçi University Department of Economics Money, Banking and Financial Institutions L.Yıldıran Chapter 13 GOALS, STRATEGIES AND TACTICS Too loose MP à inflation rises, efficiency declines, growth is hampered, bubbles, crisis. Too tight MP à output falls, unemployment rises, recession, deflation, crisis. Goals of Monetary Policy: Price stability, high employment, economic growth, stability of financial system, interest rate stability, stability in FX markets. Price Stability (Low & Stable Inflation) and Nominal Anchor: It is the most important goal. Inflation is undesirable. Because 1. Makes the information conveyed by prices harder to interpret, complicates decisions of consumers/firms/governments, financial system becomes less efficient. 2. Creates uncertainty, it becomes more difficult to plan for future 3. Rising interest rates due to high inflation/risk premiums hamper investments, leading to lower economic growth 4. Affects social fabric, leads to conflicts and inequality in wealth/income Nominal Anchor: Adherence to a nominal variable (e.g., inflation rate, money supply, FX rate), as a commitment device, limits the time inconsistency problem, which leads to poor long-run outcome. Policy makers are tempted to pursue a discretionary MP that is more expansionary than people expect, because economic output is boosted in the short-run. But, Prescott with his famous quote Rules Rather than Discretion criticizes discretionary policies, because decisions about wages and prices incorporate expectations about MP. Discretionary MP à inflation expectations à wages & prices à no higher output. So, CBs can have better inflation performance in the long run if they adhere to a plan and don t try to surprise people. High Employment: Unemployment leads to human misery, idle resources, and loss in output. Frictional unemployment: Beneficial Conjunctural/Cyclical unemployment: MP can be effective Structural unemployment: Mismatch between job requirements and skills/availability of workers, MP can t solve this problem. Natural rate of unemployment that is consistent with full employment (usually 4-6%) Economic Growth: Closely related to high employment. Supply-side economic policies encourage firms to invest and people to save. Stability of Financial System: Disruption in financial markets à contraction in economy; FED was created in response to 1907 bank panic to play the LLR role and to promote financial stability. Interest Rate Stability: Fluctuations in interest rates lead to uncertainty for consumers and firms, affect decisions to borrow/consume/invest. They are also very harmful for banks à interest rate risk (recall S&L crises) Stability in FX Markets: 1

Appreciation in local currency makes local industries less competitive; depreciation stimulates inflation. Stability makes future planning easier. It is especially important for countries that are dependent on foreign trade/funds. à In the short run: Price stability often conflicts with high employment and interest rate stability. E.g., when economy is expanding/overheated/inflationary, to pursue price stability, CB: interest rates à employment à interest rate stability. Negatively sloped Philips Curve (inflation vs. unemployment) in the short run. à In the long run: No conflict between price stability and other goals. Higher inflation can t produce lower unemployment in the long run. No long run trade-off between inflation and employment. High and sustainable growth is not possible without price stability. Price stability reduces uncertainty, improves foreseeability, enables long run planning, reduces interest rates, encourages investment, and fosters growth. In the long run, price stability promotes economic growth as well as financial and interest rate stability. [Philips Curve does not hold in the long run.] Hierarchical vs. Dual Mandates Maastricht Treaty à ESCB: As long as price stability is achieved other goals can be pursued (hierarchical mandate). Federal Reserve à co-equal objectives: price stability and maximum employment (dual mandate) No dispute that price stability should be the primary long run goal of MP. But, attempts to keep inflation at the same level in the short run no matter what would likely to lead to excessive output fluctuations. As long as price stability is a long run goal (not a short run goal), CBs can focus on reducing output fluctuations by allowing inflation to deviate from the long run target for short periods of time. In this sense, both mandates are equivalent. Monetary Policy Strategies: Monetary targeting, inflation targeting, implicit nominal anchor Monetary Targeting: In 1970s several countries, most notably Germany, Switzerland, Canada, UK, Japan, US adopted monetary targeting. Actually, their policy was different from Milton Friedman s suggestion: chosen monetary aggregate should be targeted to grow at a constants rate (e.g., 5% annual growth rate of M1, M2, M3, etc.). In these countries CBs never adhered to strict, ironclad rules. Ø US: In 1970 Arthur Burns started monetary targeting. Fed often missed the targets. In 1979 Paul Volcker focused on non-borrowed reserves. His performance was even worse. Explanation: Volcker never intended to control monetary supply. He was more concerned with interest rate movements. He wanted to free his hand and manipulate interest rates. Thus, he could raise interest rates sharply to dampen inflation, without abandoning (announcing so) the interest rate targets. In 1993 Greenspan testified that no longer monetary aggregates will be used as guides. Bank of England and Canada had similar experiences. Gerald Bouey (Governor of Bank of Canada) said We didn t abandon monetary aggregates; they abandoned us. Ø Japan: Oil shock in 1973 à 20% inflation rate. Attention was placed on monetary aggregates (M2). After the 2 nd oil shock in 1979, quickly reduced M2 growth. Successful performance for the 78-87 period: lower average inflation rate and lower variability in real output than those in the US. Financial innovation and deregulations reduced the usefulness of monetary aggregates. Upon concerns about appreciation of Yen, Bank of Japan significantly increased monetary growth between 87-89. à Bubble economy à land, stock prices. To reduce speculation, in 1989 tighter MP with slower M2 growth. 2

Substantial decline in land and stock prices, collapse of bubble economy, severe banking crisis, deflation, stagnation for a decade. Many criticisms: Japan pursued overly tight MP, needs to substantially increase money growth to lift the economy out of its stagnation. Ø Germany: Starting mid 70s, successful MP for two decades; not Friedman type targeting; Central Bank Money (MB=C+R) taken as target; allowed growth outside of its target range for 2-3 years, and then reversed subsequently; 50% of time missed the targets because of other objectives including output and exchange rates; flexibility by allowing its inflation goal to vary over time and to converge gradually to the long run target; tremendous effort in publications/speeches to communicate policy. Lessons: o Monetary targeting regime can restrain inflation in the long run despite substantial misses. Adherence to a rigid policy rule is not necessary to obtain good inflation outcome. o Success despite frequent misses, thanks to effective communication and clearly stated objectives. Inflation Targeting: Given the breakdown of the relationship between monetary aggregates and inflation, many countries, starting with New Zealand in 90, Canada in 91, UK in 92, Sweden and Finland in 93, adopted inflation targeting, involving: 1. Public announcement of medium term numerical targets for inflation 2. Institutional commitment to price stability as the primary long run goal 3. Information inclusive approach in which many variables (not just monetary aggregates) are used in decision making 4. Increased transparency of MP through communications about plans, objectives 5. Increased accountability of CB for attaining inflation objectives Ø New Zealand: New Banking Law in 1990 à the most independent CB with the sole objective of price stability. Targets (3-5%) are set with the Minister of Finance. Governor, who will be evaluated by his performance, is subject to dismissal in case of failure. In the short run à deep recession and rise in unemployment. Since 1992, inflation is in check, growth is high, and unemployment is low. Figure 1 Inflation Rates and Inflation Targets for New Zealand, Canada, and the United Kingdom, 1980 2011 17-8 2013 Pearson Education, Inc. All rights reserved. 3

Implicit Nominal Anchor (or Implicit Inflation Targeting): Excellent macroeconomic performance in the US (during Greenspan): The Fed didn t articulate an explicit strategy, but pursued a coherent strategy involving an implicit (not explicit) nominal anchor, in the form of overriding concern to control inflation in the long run, with forward-looking behavior, coupled with preemptive strikes against threats of inflation. Preemptive strikes: MP effects have long lags ( 1 year to affect output, 2 years to affect inflation) (Milton Friedman) à MP can t wait overt signals of inflation; it will already be too late to maintain stable prices, at least not without severe MP tightening; inflation expectations embedded/ingrained in various long-term wage/price setting contracts can create inflation momentum that will be hard to halt. Examples of such strikes: 1. 94-95 Fed rates rose from 3 to 6 % even though inflation was not increasing during this period (recall 94 crisis in Turkey?) à inflation didn t rise, fell slightly, longest expansion from 91 to 2001, brought unemployment down to 4%. 2. In Jan 2001, shortly before the start of the recession in March 2001: Fed rates from 6.5% to 1%. 3. In June 2004 Fed again preemptively began raising Fed rate 25bp at each FOMC meeting. Advantages Disadvantages Monetary Targeting Inflation Targeting Implicit Nominal Anchor Immediate signal on Simplicity & clarity of target. Doesn t rely on stable achievement of target. Doesn t rely on stable money-inflation money-inflation relation. Prevent falling in timeinconsistency relationship. Demonstrated success in US. trap. Reduced effects of inflation shocks. Uses many sources. Uses many sources of information Relies on stable money-inflation relationship, which proved to be nonexistent. Delayed signal about achievement. Could impose a rigid rule, though not in practice. Larger output fluctuations if sole focus is inflation. Lack of transparency. Success depends on individuals in charge. Low accountability. Tactics: Choosing the Policy Instrument Tools Policy/Operating Instruments Intermediate Target Goal OMOs Reserves, MB, NonBor Reserves Monetary Aggregates Stability & Growth DLs E.g., 5% growth and Reserve Req. Fed Rate, Other Sh.Term Rates Interest Rates 5% inflation. Can CB choose both intermediate targets simultaneously? NO! i ib R s i ib R s NBR R D Q NBR R D Q If monetary aggregate is chosen, interest rate will be left to fluctuate depending on demand. If interest rate is chosen, monetary aggregate will be adjusted. 4

Criteria for Choosing Policy Instrument: 1. Observability and Measurability: Reserve aggregates like NB reserves can be observed/measured with some lag (2 weeks). Fed rates (interbank interest rates) are observable/measurable immediately. But, what is more important is the real interest rate (i r = i n - Π e ). Difficult to observe Π e, so it is not clear which is superior. 2. Controllability: Because of shifts in and out of currency in circulation, reserve aggregates are not easily controllable, while the Fed rate is, though not the real rate. Thus, no clearcut superiority. 3. Predictable Effect on Goals: Tightness of the link between policy instrument and goal? Recently, most CBs have concluded that the link between interest rates and inflation is tighter. The Taylor Rule: Fed rate target = inflation rate target+ equilibrium real Fed rate (consistent with full employment in the long run) +! (inflation gap) +! (output gap)!! Figure 5 The Taylor Rule for the Federal Funds Rate, 1970 2011 Source: Federal Reserve; www.federalreserve.gov/releases and author s calculations. 17-23 2013 Pearson Education, Inc. All rights reserved. APPENDIX: FED POLICY PROCEDURES: AN HISTORICAL PERSPECTIVE The well-known adage: The road to hell is paved with good intentions. When Fed was created (1907 crisis à 1913), discount rate was the primary tool. OMO was not discovered and Act made no provision for changes in reserve requirements. Real Bills Doctrine: As long as loans are made for productive purposes (to support production) providing reserves to banking system would not be inflationary. Thoroughly discredited by now. 5

Fed would give loans to member banks when they showed up at the discount window with eligible paper (i.e., with loans to facilitate productions). Initially this was called rediscounting (reeskont): original bank loans were made by discounting the face value of the loan; Fed was discounting them again at the discount rate. During WW1, rediscounting and keeping interest rates low to help the Treasury finance the war à inflation soared to 14% in 1919-20. Fed assumed an active role to influence economy. No longer Real Bills Doctrine, discount rate 4%, 6%, 7%, in 1920. Sharp decline in M, severe recession in 1920-1, inflation 0%. Early 20s, Fed discovered OMOs. Originally, income was from discounting. After the 1920-21 recession, discount rate 0%. To earn income, Fed purchased income-earning securities, and then noticed that reserves grew à multiple expansion of bank loans and deposits (a new MP tool was born.) à prosperous roaring in 20s. 1928-9 stock market boom. Fed was late to temper the boom. When Fed i d in August 1929, it actually hastened the stock market crash and pushed the economy into recession. Weakness in agriculture triggered a contagion of fear à full-fledged panic in Nov & Dec 30. Next two years, Fed sat idly. Final panic culminated in March 33. New President F.D. Roosevelt declared bank holiday: The only thing we have to fear is fear itself. Severity of recession: 1/3 of commercial banks (about 9000) failed, money supply declined 25%. Fed was totally passive, didn t perform its LLR role. Why? i. Officials didn t understand the negative impact of bank failure on money supply and economy; regarded failures as regrettable consequences of bad bank management. ii. In the early stages, bank failures concentrated among smaller banks. Since most influential figures were big city bankers, who deplored the existence of small banks, their disappearance may have been viewed with complacency. Banking Act of 1935 allowed Fed to alter reserve requirements. After Great Depression, banks increased their excess reserves as Fed failed its LLR role. à Control of MP became more difficult. Fed worried that ERs would be lent out, leading to an uncontrollable rise in M. To improve monetary control, Fed increased reserve requirements in 36-7. à Slow down and decline in money growth in 1937 à severe recession of 37-8. Faulty of Great Depression, Fed also aborted the subsequent recovery. Disastrous experience with varying reserve requirements à far more cautious with reserve requirements in the future. War financing and interest rate pegging in 1942-51 lead to procyclical MP. With entrance in WW2 in 41, government spending skyrocketed. Treasury issued bonds, Fed helped by keeping interest rates low (about 3% for TBs and 2.5% for LT bonds) through OM purchases whenever bond prices fell, i.e., relinquished its control of MP to meet financing needs of government. After war, Fed continued interest rate peg, because no inflationary pressures then. But, when Korean War broke out in 1950, interest rates à Fed was forced to expand MB and M à inflation began to heat up 8% à Fed decided to reassert its control over MP by abandoning interest rate peg, but promised not to allow interest rates to rise precipitously [Eisenhower in 52 gave complete freedom to Fed to pursue its monetary objectives (??), but Fed continued its interest rate peg (??)]. 1950s-60s: Targeting Money Market Conditions. Fed chairman William Mac Chesney Martin (28 years till 70 à Burns à Volcker) à Fed targeted money market conditions, esp. interest rates à procyclical MP: Y à i à MB à M. By the late 60s, rising criticisms from Friedman and Meltzer à Fed abandoned its focus on market conditions. 1970s: Targeting Monetary Aggregates. Burns (1970-79), Volcker (79-87). Arthur Burns was appointed in 1970, committed to use monetary aggregates as intermediate target, but was actually using Fed funds rate as operating instrument. However, monetary aggregates and interest rate targets can t be hit simultaneously à MP was as procyclical in 70s as it 6

was in 1950s-60s. In 72-73 economy boomed, M1 growth rate 8%, Fed rate 8 1 2 %. Oil shock in 73, economic contraction in 74, Fed rate from 12% to 5% à worst contraction in the post-war era. Interpretation: Fed was actually still concerned with achieving interest rate stability and was reluctant to relinquish its control over interest rate movements (Vietnam War??) 1979-82: New Fed Operating Procedure. Volcker became chairman in 79, de-emphasized Fed rate as operating instrument by widening its target range more than fivefold. Primary operating instrument became non-borrowed reserves, which the Fed would set after estimating discount loans to be borrowed by banks. Fed rate underwent great fluctuations. Fluctuations in money supply growth also increased. Fed missed M1 growth rates in all 3 years btw 79-82. Likely reason: Volcker was not serious about controlling monetary aggregates, wanted to avoid blames for high interest rates that would be necessary to curb inflation (countercyclical MP). Fed rate increased by 5% and reached 15% in March 1980. Due to rapid decline in GDP, Fed eased up on its policy, Fed rate fell to 10%. But, inflation was persistent, thus Fed tightened the screws again, Fed rate climbed to 15% again à 1981-82 recession, large decline in output and employment (beginning of S&L crises)à inflation psychology broken à interest rates were allowed to fall. 1982-90: De-emphasis of Monetary Aggregates. Oct 82, with inflation in check, Fed returned to a policy of smooth interest rates à Procyclical MP again with Borrowed Reserves (DLs) as operating target. Y à i (to prevent the rise in interest rates)à DL à MB à M. Much smaller fluctuations in Fed rate after 1982, but large fluctuations in M growth. In Feb 87 (Greenspan), Fed announced that no longer M1 targets would be set. Two reasons: i. Innovations and deregulations made it difficult to measure money. ii. Stable relation between M1 and economic activity was broken. Fed switched to a broader monetary aggregate M2. But, in early 90s this relationship also broke down. In 93, Greenspan testified in the Congress that no longer any monetary aggregate would be used as a guide. Early 90s and beyond: Fed Rate Targeting Again. From 92 to 94, Fed rate target was 3% (a low level last seen in 1960), due to fear on the part of Fed of credit crunch (1990-91) and recession. Starting Feb 94, after economy returned to rapid growth, Fed began preemptive strike to head off future inflationary pressures by raising the Fed rate in steps to 6% by early 95 (94 April crisis in Turkey??). In early 96 to deal with possible slowing down, and in 98 when the LTCM collapsed Fed reduced the target rate considerably. With strong growth of economy in 99 and heightened concerns about inflation, Fed reversed its course and began to raise Fed rate again (2000-01 crisis in Turkey??). With weakening economy in Jan 2001 (just before the start of the recession in March 2001) Fed again reversed the course, began to reduce sharply from 6.5% to near 1% eventually à Global Liquidity. In 94, Fed started to announce its target instead of keeping it secret: Balance of risks, whether toward higher inflation or toward weaker economy. International Considerations: By 85, strength of dollar had contributed to deterioration in American competitiveness with foreign business. Volcker engineered an expansionary MP, accelerated M growth rates in 85-6, value of $ fell. By 87, Fed agreed that $ had fallen sufficiently and money growth slowed. These MP actions were encouraged by international policy coordination (85 Plaza Agreement, 87 Louvre Accord). International coordination also played a role in Fall 98 to lower Fed rate by 3 4 %. Concerns about the potential worldwide financial crisis in the wake of the collapse of the Russian System, and weakness in economies abroad, particularly in Asia, stimulated Fed to take a dramatic step to calm down markets. International coordination is likely to be a major factor in the conduct of US MP in the future. 7