Appendix to chapter 16 Monetary Targeting In pursuing a strategy of monetary targeting, the central bank announces that it will achieve a certain value (the target) of the annual growth rate of a monetary aggregate, such as a 5% growth rate of M1 or a 6% growth rate of M2. The central bank then is accountable for hitting the target. Monetary Targeting in the United States, Japan, and Germany In the 1970s, monetary targeting was adopted by several countries most notably, Germany, Switzerland, Canada, the United Kingdom, Japan, and the United States. Monetary targeting in practice was quite different from Milton Friedman s suggestion that the chosen monetary aggregate be targeted to grow at a constant rate. Indeed, in all of these countries, the central banks never adhered to strict, ironclad rules for monetary growth. In some of these countries, monetary targeting was not pursued very seriously. United States In 1970, Arthur Burns was appointed chairman of the Board of Governors of the Federal Reserve, and soon thereafter the Fed stated that it was committing itself to the use of monetary targets to guide monetary policy. In 1975, in response to a congressional resolution, the Fed began to announce publicly its targets for money supply growth, though it often missed them. In October 1979, two months after Paul Volcker became chairman of the Board of Governors, the Fed switched to an operating procedure that focused more on nonborrowed reserves and control of the monetary aggregates and less on the federal funds rate. Despite the change in focus, the performance in hitting monetary targets was even worse: In all three years of the 1979 1982 period, the Fed missed its M1 growth target ranges. What went wrong? Several answers to this question are possible. The first is that the U.S. economy was exposed to several shocks during this period that made monetary control more difficult: the acceleration of financial innovation and deregulation, which added new categories of deposits such as NOW accounts to the measures of monetary aggregates; the imposition by the Fed of credit controls from March to July 1980, which restricted the growth of consumer and business loans; and the back-to-back recessions of 1980 and 1981 1982. 1 1 Another explanation focuses on the technical difficulties of monetary control when using a nonborrowed reserves operating target under a system of lagged reserve requirements, in which required reserves for a given week are calculated on the basis of the level of deposits two weeks earlier. See David Lindsey, Nonborrowed Reserve Targeting and Monetary Control, in Improving Money Stock Control, ed. Laurence Meyer (Boston: Kluwer-Nijhoff, 1983), pp. 3 41. 1
2 a p p e n d i x t o c h a p t e r 1 6 Monetary Targeting A more persuasive explanation for poor monetary control, however, is that controlling the money supply was never really the intent of Volcker s policy shift. Despite Volcker s statements about the need to target monetary aggregates, he was not committed to these targets. Rather, he was far more concerned with using interest-rate movements to wring inflation out of the economy. Volcker s primary reason for changing the Fed s operating procedure was to free his hand to manipulate interest rates and thereby fight inflation. It was necessary to abandon interest-rate targets if Volcker were to be able to raise interest rates sharply when a slowdown in the economy was required to dampen inflation. This view of Volcker s strategy suggests that the Fed s announced attachment to monetary aggregate targets may have been a smokescreen to keep the Fed from being blamed for the high interest rates that would result from the new interest-rate policy. In 1982, with inflation in check, the Fed decreased its emphasis on monetary targets. In July 1993, Board of Governors chairman Alan Greenspan testified in Congress that the Fed would no longer use any monetary aggregates as a guide for conducting monetary policy. The Bank of Canada and the Bank of England also made commitments to monetary targets around the same time as the Federal Reserve and had similar experiences to that in the United States. By the 1980s, they found that monetary aggregates were not a reliable guide to monetary policy and, like the Federal Reserve, abandoned monetary targeting. Gerald Bouey, the governor of the Bank of Canada, described his bank s experience colorfully by saying, We didn t abandon monetary aggregates; they abandoned us. Japan The increase in oil prices in late 1973 was a major shock for Japan, which experienced a huge jump in the inflation rate, to greater than 20% in 1974 a surge facilitated by money growth in 1973 in excess of 20%. The Bank of Japan, like the other central banks discussed here, began to pay more attention to money supply growth rates. In 1978, the Bank of Japan began to announce forecasts at the beginning of each quarter for M2 + CDs. Although the Bank of Japan was not officially committed to monetary targeting, monetary policy appeared to be more money-focused after 1978. For example, after the second oil price shock in 1979, the Bank of Japan quickly reduced M2 + CDs growth, rather than allowing it to shoot up as occurred after the first oil shock. The Bank of Japan now conducts monetary policy with operating procedures that are similar in many ways to those of the Federal Reserve. It uses the interest rate in the Japanese interbank market (similar to the federal funds market) as its daily operating target, just as the Fed does. The Bank of Japan s monetary policy performance during the 1978 1987 period was much better than the Fed s. Money growth in Japan slowed gradually, beginning in the mid-1970s, and was much less variable than in the United States. The outcome was a more rapid braking of inflation and a lower average inflation rate. In addition, these excellent results on inflation were achieved with lower variability in real output than in the United States. In parallel with the United States, financial innovation and deregulation in Japan began to reduce the usefulness of the M2 + CDs monetary aggregate as an indicator of monetary policy. Because of concerns about the appreciation of the yen, the Bank of Japan significantly increased the rate of money growth from 1987 to 1989. Many observers blame speculation in Japanese land and stock prices (the bubble economy) on the increase in money growth. To reduce this speculation, in 1989 the Bank of Japan switched to a tighter monetary policy aimed at slower money growth. The aftermath was a substantial decline in land and stock prices and the collapse of the bubble economy.
A p p e n d i x t o c h a p t e r 1 6 Monetary Targeting 3 As a result, the Japanese economy was in a slump for ten years, often referred to as the lost decade. The collapse of land and stock prices helped provoke a severe banking crisis, discussed in Chapter 11, that was a serious drag on the economy. The resulting weakness of the economy even led to deflation, promoting further financial instability. The outcome has been an economy that has stagnated for over a decade. Many critics believe that the Bank of Japan has pursued overly tight monetary policy and needs to substantially increase money growth in order to lift the economy out of its stagnation. Germany Starting in the mid-1970s and continuing through the next two decades, both Germany and Switzerland engaged in monetary targeting. The success of monetary targeting in controlling inflation in these two countries explains why monetary targeting still has strong advocates and is an element of the official policy regime for the European Central Bank (see the Global box). Because the success of the German monetary-targeting regime in producing low inflation has received the most attention, we ll concentrate on Germany s experience. Germany s central bank, the Bundesbank, chose to focus on a narrow monetary aggregate called central bank money, the sum of currency in circulation and bank deposits weighted by the 1974 required reserve ratios. In 1988, the Bundesbank switched targets from central bank money to M3. The key fact about the monetary-targeting regime in Germany is that it was not a Friedman-type monetary-targeting rule in which a monetary aggregate is kept on a constant-growth-rate path and is the primary focus of monetary policy. The Bundesbank allowed growth outside of its target ranges for periods of two to three years, and overshoots of its targets were subsequently reversed. Monetary targeting in Germany was instead primarily a method of communicating the strategy of monetary policy focused on long-run considerations and the control of inflation. Global The European Central Bank s Monetary Policy Strategy The European Central Bank (ECB) pursues a hybrid monetary policy strategy that has elements in common with the monetary-targeting strategy previously used by the Bundesbank but also includes some elements of inflation targeting.* Like inflation targeting, the ECB has an announced goal for inflation over the medium term of below, but close to, 2%. The ECB s strategy has two key pillars. First, monetary and credit aggregates are assessed for their implications for future inflation and economic growth. Second, many other economic variables are used to assess the future economic outlook. (Until 2003, the ECB employed something closer to a monetary target, setting a reference value for the growth rate of the M3 monetary aggregate.) The ECB s strategy is somewhat unclear and has been subject to criticism for this reason. Although the below, but close to, 2% goal for inflation sounds like an inflation target, the ECB has repeatedly stated that it does not have an inflation target. This central bank seems to have decided to try to have its cake and eat it, too by not committing too strongly to either a monetary-targeting strategy or an inflationtargeting strategy. The resulting difficulty of assessing the ECB s strategy has the potential to reduce the accountability of the institution. *For a description of the ECB s monetary policy strategy, go to the ECB s website at www.ecb.int.
4 a p p e n d i x t o c h a p t e r 1 6 Monetary Targeting The calculation of monetary target ranges put great stress on making policy transparent (clear, simple, and understandable) and on regular communication with the public. First and foremost, a numerical inflation goal was prominently featured in the setting of target ranges. Second, monetary targeting, far from being a rigid policy rule, was flexible in practice. The target ranges for money growth were missed about 50% of the time in Germany, often because of the Bundesbank s concern about other objectives, including output and exchange rates. Furthermore, the Bundesbank demonstrated its flexibility by allowing its inflation goal to vary over time and to converge gradually to the long-run inflation goal. The monetary-targeting regime in Germany demonstrated a strong commitment to clear communication of the strategy to the general public. The money growth targets were continually used as a framework to explain the monetary policy strategy, and the Bundesbank expended tremendous effort in its publications and in frequent speeches by central bank officials to communicate to the public what the central bank was trying to achieve. Given that the Bundesbank frequently missed its money growth targets by significant amounts, its monetary-targeting framework is best viewed as a mechanism for transparently communicating how monetary policy is being directed to achieve inflation goals and as a means for increasing the accountability of the central bank. There are two key lessons to be learned from our discussion of German monetary targeting. First, a monetary-targeting regime can restrain inflation in the longer run, even when the regime permits substantial target misses. Thus adherence to a rigid policy rule is not necessary to obtain good inflation outcomes. Second, the key reason why monetary targeting was reasonably successful, despite frequent target misses, is that the objectives of monetary policy were clearly stated and the central bank actively engaged in communicating the strategy of monetary policy to the public, thereby enhancing the transparency of monetary policy and the accountability of the central bank. These key elements of a successful monetary-targeting regime flexibility, transparency, and accountability are also important elements in inflation-targeting regimes. German monetary policy was actually closer in practice to inflation targeting than it was to Friedman-like monetary targeting, and thus might best be thought of as hybrid inflation targeting. Advantages of Monetary Targeting One advantage of monetary targeting is that information on whether the central bank is achieving its target is known almost immediately figures for monetary aggregates are typically reported within a couple of weeks. Thus monetary targets can send almost immediate signals to the public and markets about the stance of monetary policy and the intentions of the policymakers to keep inflation in check. In turn, these signals help fix inflation expectations and produce less inflation. Monetary targets also allow almost immediate accountability for monetary policy to keep inflation low, thus helping to constrain the monetary policymaker from falling into the time-inconsistency trap. Disadvantages of Monetary Targeting All of the above advantages of monetary aggregate targeting depend on a big if: There must be a strong and reliable relationship between the goal variable (inflation or nominal income) and the targeted monetary aggregate. If the relationship between the monetary aggregate and the goal variable is weak, monetary aggregate targeting will not work; this seems to have been a serious problem in the United States and other countries
A p p e n d i x t o c h a p t e r 1 6 Monetary Targeting 5 that pursued monetary targets. The weak relationship implies that hitting the target will not produce the desired outcome on the goal variable and thus the monetary aggregate will no longer provide an adequate signal about the stance of monetary policy. As a result, monetary targeting will not help fix inflation expectations and will not be a good guide for assessing central bank accountability. In addition, an unreliable relationship between monetary aggregates and goal variables makes it difficult for monetary targeting to serve as a communications device that increases the transparency of monetary policy and makes the central bank accountable to the public.