Chapter 17 The Conduct of Monetary Policy: Strategy and Tactics
Six Goals of Central Banks Price stability High employment Economic growth Stability of financial markets Interest rate stability Stability in foreign exchange markets 16-2
The Price Stability Goal Price stability (i.e. low and stable inflation) is viewed as the most important goal of monetary policy Inflation Creates uncertainty and difficulty in planning for the future When there is uncertainty, investment declines (investors look for a stable environment where they can predict demand) Decision making is more difficult for the consumers as well Less efficient financial system Lowers economic growth I (down)y (down) Strains social fabric Political tension between groups to ensure that their real incomes stay the same 16-3
Nominal anchor In order to achieve price stability, a nominal anchor is chosen Nominal anchor is a nominal target variable such as the inflation rate or the money supply to fix the price level to ensure stability Nominal anchor is particularly important in dealing with the time-inconsistency problem Time-inconsistency problem The conflict that arises between short-run and long-run priorities. Short-run expansionary policies seem more appealing (everybody is happy) but long-run consequences of an expansionary policy is inflation. Nominal anchor sets a rule to be followed in the short-run 16-4
Other Goals of Monetary Policy High employment It is desired to utilize economic capacity Both in terms of workers and other capital resources High employment does not necessarily imply zero unemployment Frictional unemployment Structural unemployment The tricky issue is to determine the natural rate of unemployment The unemployment rate at full employment How could one determine the full employment level? Try to maintain an unemployment level that is not inflationary: currently 4.5-6% in U.S. 16-5
Economic Growth Closely related to high employment Capital investment is more likely to take place if unemployment rate is low and current factories are working at full capacity CB can engage in policies to promote investments or savings The aim is to increase potential GDP 16-6
Stability of Financial Markets Financial stability is necessary for financial markets to work efficiently in channeling funds Example: Recent financial crisis 16-7
Interest Rate Stability Stability allows people to plan for the future e.g. housing market (house credit) is a large part of the economy CB may want to avoid upward movements in interest rates Tight monetary policy creates hostility towards CB 16-8
Stability in Foreign Exchange Markets The importance of this goal increases with the share of foreign trade. Stabilizing the value of foreign exchange enables planning for the exporters and importers An increase in the value of domestic currency will decrease exports 16-9
Should Price Stability be the Primary Goal? In the long run there is no conflict between the goals The usual inflation-unemployment trade-off does not work in the long run High unemployment in the short run does not cause changes in the natural rate of unemployment In the medium run it can conflict with the goals of high employment and interest-rate stability Y (up), unemployment (down), inflation (up) contractionary MP interest rate (up) unemployment (up) 16-10
How can the Central Bank resolve the conflict among different goals? Hierarchical mandate Impose price stability as the primary goal of the central bank by law Other goals can be supported once price stability is achieved Dual mandate Allow the central bank to balance between price stability and sustainable growth Gives more flexibility to the central bank. However, the emphasis should be long-run (not short-run) growth in output 16-11
Which one is better? So long as the price stability goal is interpreted as the long-run goal, both mandates would work If the CB is operating under hierarchical mandate, then it should be careful not to focus on deviations of inflation from its long run goals for short periods of time. If dual mandate leads a CB to pursue short-run expansionary policies without worrying about long run inflation, the time-inconsistency problem would occur. 16-12
If the CB is operating under a dual mandate, then it should be careful to interpret maximum employment as full employment in the long-run. Pushing for high employment in the short-run may cause output to increase such that Y Actual >Y Potential, inflation (up) 16-13
Inflation Targeting I Public announcement of medium-term numerical target for inflation Institutional commitment to price stability as the primary, long-run goal of monetary policy (i.e. hierarchical mandate) and a commitment to achieve the inflation goal Information-inclusive approach in which many variables are used in making decisions CB considers any variable that may be relevant in decision making Increased transparency of the strategy In order to achieve better communication and set inflationary expectations Increased accountability of the central bank CB is accountable for achieving long-run objectives 16-14
FIGURE 1 Inflation Rates and Inflation Targets for New Zealand, Canada, and the United Kingdom, 1980 2008 Source: Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Poson, Inflation Targeting: Lessons from the International Experience (Princeton: Princeton University Press, 1999), updates from the same sources, and www.rbnz.govt.nz/statistics/econind/a3/ha3.xls.
Take a look at the relevant picture for Turkey at the following link (scroll down to the bottom of the page): http://www.tcmb.gov.tr/ Implicit inflation targeting from 2002-2005 Explicit inflation targeting from 2006 onwards 16-16
Inflation Targeting: Advantages Reduces potential of falling in time-inconsistency trap Sets an excuse against expansionary monetary policy Easily understood The relationship between monetary aggregates (say M2) and inflation may be less clear and can change over time Stresses transparency and accountability Better communication with public through speeches, annual inflation reports, etc. The goal is to help the public form expectations for the future Increase investment 16-17
Inflation Targeting: Disadvantages (I) Delayed signaling It takes a while to achieve a target inflation rate (long lags) Too much rigidity It may limit the ability of the CB to respond to unforeseen circumstances Ex: During the financial crisis, oil prices increased, putting an upward pressure on inflation rate Should a CB implement contractionary monetary policy in the middle of a global recession? Solution: Flexible inflation targeting 16-18
Inflation Targeting: Disadvantages (II) Potential for increased output fluctuations The focus on lowering the inflation may cause the CB to ignore output (Ex: ECB tightened its policy rate in the middle of the crisis because they did not think that Euro area inflation rate necessitated easy MP yet) In order to avoid the negative impact of a low inflation rate on output, inflation targeters might want to choose a target above zero Targeting non-zero inflation makes deflation risk less likely Low economic growth The trade-off between low inflation and high employment However, once a lower level of inflation is achieved, output growth returns to its original level (or higher) as lower inflation attracts more investment 16-19
Implicit Nominal Anchor (The Fed example) An explicit nominal anchor refers to an explicit target such as monetary targeting or inflation targeting In the U.S. there is no explicit anchor. Instead there is an implicit anchor which is long-run inflation This has changed in January 2012. http://www.reuters.com/article/2012/01/25/us-usafed-inflation-target-idustre80o25c20120125 16-20
U.S. policy is forward looking and preemptive Policy makers watch for future inflation and take actions today to prevent future inflation Once the inflation is realized and gains momentum, it is built into expectations and is very hard to stop 16-21
Advantages Uses many sources of information Similar to inflation targeting Avoids time-inconsistency problem Emphasis on price stability discourages overly expansionary policy Demonstrated success Inflation rate has been around 3 percent for the last 30 years Growth rate has been around 3 percent as well 16-22
Disadvantages Lack of transparency and accountability Not as transparent as inflation targeting (no announcements of nominal objectives) Nothing is stated explicitly as long-term goals Volatility in financial markets Strong dependence on the preferences, skills, and trustworthiness of individuals in charge What if the future leaders are not as committed to price stability? Inconsistent with democratic principles Because there are no explicit goals, the CB is not accountable to public unlike the case of explicit anchors 16-23