Chapter Eighteen Chapter 18 Monetary Policy: Stabilizing the Domestic Economy Part 3 Linking Tools to Objectives Tools OMO Discount Rate Reserve Req. Deposit rate Linking Tools to Objectives Monetary goals are given to policy makers by their elected officials. Fed, dual mandate ECB, price stability BoE, inflation target But day-to-day policy is left to the technicians. 1
Linking Tools to Objectives: Making Choices 1. The reserve requirement is not useful as a policy tool too powerful, 2. Central bank lending (discount loans) as a tool is necessary to ensure financial stability, and 3. OMO - Short-term interest rates are the instrument of choice used to stabilize shortterm fluctuations in prices and output. Desirable Features of a Policy Instrument It is easily observable by everyone Ensure transparency in policymaking, which enhances accountability. It is controllable and quickly changed It is tightly linked to goals and objectives - the more predictable the impact of an instrument, the easier it will be for policymakers to meet their objectives. Which Instrument? Interest rate or monetary aggregate? choice between controlling quantity (monetary base) or controlling price (federal funds rate)? 2
Desirable Features of a Policy Instrument Central banks in the world today choose to target an interest rate rather than reserves. Targeting reserves creates interest rate volatility. With reserve supply fixed, shifts in reserve demand changes the federal funds rate. Result of Targeting Reserves Federal Funds Rate i d i ff * i ff i ff R s A rightward or leftward shift in the demand curve for reserves R d leads to fluctuations in the federal funds rate i or R d R d* NBR * Quantity of Reserves, R Federal Funds Rate Result of Targeting the Federal Funds Rate i d s R Step 1. A rightward or leftward shift in the demand curve for reserves * i ff Federal Funds Rates Target, i * ff d R Step 2. lead the central bank to shift the supply curve of reserves so that the federal rate does not change i er d R NBR NBR* NBR d * R Quantity of Reserves, R Step 3. with the result that non-borrowed reserves fluctuate between NBR ff and NBR ff. 3
Side Note - From 1979 to 1982, under Paul Volker, the Fed targeted reserves rather than interest rates. We saw interest rates that would not have been politically acceptable if they had been announced as targets. Since they said they were targeting reserves, the Fed escaped responsibility for the high interest rates. When inflation had fallen and interest rates came back down, the FOMC reverted to targeting the federal funds rate. Desirable Features of a Policy Instrument Interest rates are the primary linkage between the financial system and the real economy. Stabilizing growth means stabilizing interest rates The best way to do this is to target interest rates. Intermediate Targets Central bankers sometimes use the terms operating instrument and intermediate target. The FFR is the Fed s operating instrument, we ll just use instrument The term intermediate targets refers to instruments that are not directly under the policy maker s control, but lie somewhere between their policy tools and their objectives. 4
Intermediate Targets Monetary aggregate (money supply) is a prime example of intermediate target. The idea being that changes in the monetary base affect the monetary aggregates which in turn affect output and inflation. Central bankers have largely abandoned the idea of intermediate targets and focus directly on policy objectives TOOLS OMO Discount Rate Reserve Req. Deposit rate Link 1 is weak and Link 2 is weak. Focus on Link No. 3. Inflation Targeting One approach for linking instrument to goal is inflation targeting. Bypasses intermediate targets and focuses on the final objective of low stable prices. Components: Public announcement of numerical target, Commitment to price stability as primary objective, and Frequent public communication. Benefit - Inflation targeting increases policymakers accountability and helps to establish their credibility. 5
A Guide to Central Bank Interest Rates: The Taylor Rule How does or should the FOMC sets the target federal funds rate. The Taylor Rule: Relates the target federal funds rate to the real interest rate, inflation, and output. Target Fed Funds rate = 2% + Current Inflation + ½ (Inflation gap) + ½ (Output gap) These are all percentages. Published in 1993 based on data covering 1987 1992. A Guide to Central Bank Interest Rates: The Taylor Rule This equation assumes the long-term real interest rate consistent with full employment is 2 percent. Called the neutral real rate The inflation gap is current inflation minus an inflation target. The output gap is (current GDP - potential GDP)/ potential GDP The percentage deviation of current output from potential output. The Taylor Rule: How it Works Suppose target inflation is 2% and actual inflation is on target at 2%, and there is no output gap. The target nominal federal funds rate should be set at its neutral target real rate of 2% plus 2% inflation. FFR = 2% + 2% + 0.5(0) + 0.5(0) FFR = 4% 6
The Taylor Rule: How it Works When inflation rises above its target level, Response is to raise interest rates. When output falls below the target level, Response is to lower interest rates. Taylor Rule - Examples Economy at full employment, but inflation above target at 3%: Target i ff = 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: Target i ff = 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: Target i ff = 2.0 + 1.0 + 0.5( 1.0 2.0) + 0.5 (-3.0) = 1.0 percent Question: If inflation rises 1% above target, why is the FFR increased by 1.5%? i ff = 2.0 + 2.0 + 0.5( 2.0 2.0) + 0.5 (0) = 4.0 percent i ff = 2.0 + 3.0 + 0.5( 3.0 2.0) + 0.5 (0) = 5.5 percent 7
The Taylor Rule: How it Works A 1 percentage point increase in the inflation rate raises the target federal funds rate 1½ percentage points. Which means the FFR in real terms increases which is needed to slow the economy. The Taylor rule also states that for each percentage point output is above potential: Target FFR should increase by half a percentage point. The Taylor Rule: How it Works The weights are not fixed and do not have to sum to one. The weights in the equation depend on both preferences of central bankers. The more bankers care about inflation: The bigger the weight for the inflation gap, and the lower the weight for the output gap. Implementation of the The Taylor Rule The Taylor rule requires four inputs: The constant term, set at 2 (this is the real interest rate consistent with full employment) a lot of economist think this is currently much lower that 2%; A measure of inflation; A measure of the inflation gap; and A measure of the output gap. 8
Implementation of the Taylor Rule The Fed uses the personal consumption expenditure (PCE) index to measure of inflation. The PCE comes from the national income accounts. The output gap is the percentage by which GDP deviates from a measure of its trend or potential GDP. A Guide to Central Bank Interest Rates: The Taylor Rule Figure in the book plots the FOMC s actual target federal funds rate, together with the rate predicted by the Taylor rule. The two lines are reasonably close to each other and the FOMC usually changed the target federal funds rate when the Taylor rule predicted it should. A Guide to Central Bank Interest Rates: The Taylor Rule https://www.frbatlanta.org/cqer/research/taylorrule.aspx?panel=1 9
Re-arrange terms i ff = 2.0 + π + 0.5( π 2.0) + 0.5 ((Y Y*)/Y*) i ff = 2.0 + 1.5π 1.0 + 0.5 ((Y Y*)/Y*) i ff = 1+ 1.5π + 0.5 ((Y Y*)/Y*) Y* = Potential GDP Using Data for 2011/12: π= 2%, gap = -6%: Rule 1: i ff = 1 + 1.5(2) +.5(-6) ; i ff = 1 percent What if the output gap coefficient is 1.0. Rule 2: i ff = 1 + 1.5(2) + 1.0(-6); i ff = -2 percent Comparison of Rule 1 and Rule 2 March 2013 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. https://www.bloomberg.com/gra phics/fomc-dot-plot/ 10
Policy Strategies: Inflation Targeting 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 11
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? Stated commitment to price stability as the primary long-run goal of monetary policy - commitment to achieve the inflation goal Communication with public to increase transparency of the strategy Public announcement of a numerical inflation target Can not renege. Increased accountability of the central bank Inflation Targeting - Intent Keep inflation low and anchor inflation expectations (π e ) - nominal anchor This, in turn, will anchor long-term interest rates to promote growth. i = r + π e Follows a hierarchical mandate: inflation first, everything else second or explicit mandate. Remember: Fed has a dual mandate. Has shied away from adopting inflation targeting. 12
Inflation Targeting - Advantages Stable relationship between money supply and inflation (link #2)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 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 13
US. Inflation - Without Explicit Inflation Target 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! 14
Important Summary Table Advantages and Disadvantages of Different Monetary Policy Strategies Price-level Targeting The central bank targets the rate of increase of the price level. Price-Level Targeting (CPI or PCE) 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 also aims to move the economy along a pre-set path Inflation Targeting (CPI or PCE) If fully successful, the economy would follow exactly the same path as under price-level targeting Inflation target path 15
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 2% inflation Price-level targeting, instead, aims to return to the original path (dashed green line) 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 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 Criticisms of Price-Level Targeting 16
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 Fed should be clear about the kinds of circumstances in which PLT would be used, and those in which it would not be used 17