Transcript Chapter 19

Chapter 19
Chapter 19
The Conduct of Monetary Policy:
Strategy and Tactics
Two Primary Goals of Monetary Policy
(1) Price stability (low stable inflation)
• Concept - Nominal Anchor
– This is a nominal variable such as the money supply
or the inflation rate that policy makers target to
achieve price stability.
– The idea is to “anchor” inflationary expectations
• Some countries have explicit inflation targets.
– Explicit Nominal Anchor.
• The Fed only recently has stated its target is
2% inflation, but this is not a written policy.
– An Implicit Nominal Anchor.
Two Primary Goals of Monetary Policy
(2)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.
• However, legislation states Fed must promote
full employment along with stable prices
–Dual mandate
Rules Versus Discretion
• Should the central bank have policy discretion
regarding goals or be tied to a rule?
– Debated for a long time.
• Examples of a Fixed Rule:
• A rule that states the FOMC must target a stated
rate of growth in the money supply or target an
explicit rate of inflation.
• The Fed has Discretion
– Dual mandate
The Concern About Discretionary Policy:
Time Inconsistency Problem
• Policy makers can change their goal
• 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
The Time-Inconsistency Problem
• 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 cuts interest rates.
• 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 in order to raise more tax revenue.
The Time-Inconsistency Problem
• In general, rational agents (you and me)
understand the incentive for the policymaker
to renege, and this expectation affects their
behavior.
• The solution: take away the policymaker's
discretion and replace with a credible
commitment to a fixed policy rule.
– For example, an explicit inflation target which
around 27 countries have adopted.
Linking Central Bank Tools to Goals
• 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:
– Low Inflation, growth and low
unemployment, stable interest rates
Linking Central Bank Tools to Objectives
Interest on Reserves
Linking Central Bank Tools to Objectives
Interest on Reserves
Link #1
Link #2
• From the previous chapter we know the Fed can use its
tools to control the monetary base and the federal
funds rate.
• But, what about “Link 1” and “Link 2” ?
• Can the Fed control the money supply, market interest
rates, inflation and growth?
How to choose a Policy Instrument
• Easily observable
• 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
Policy Strategies: Monetary Targeting
• Used in the 1970’s by a number of central
banks – US, UK, Germany, Canada…
• The central bank announces that it will
target a certain rate of growth in a monetary
aggregate such as the MB or the money
supply
– For example, 5 percent annual growth in
M1
Policy Strategies: Monetary Targeting
• The Fed began to announce targets for
money supply growth in 1975.
• Not very successful
• The Fed found that it lost control of
the money supply because of financial
innovation
• Substitutes for M1 such as MMMF
1+(C/D)
M1 =
 MB
rD + (ER/D) + (C/D)
Monetary Targeting
• Advantages
– Money supply is easily observed
• Disadvantages
– Requires a strong Link No. 1
– Requires a stable relationship between the money
supply and the goal variable (inflation or nominal
income) – Strong 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.
Change to target the Federal Fund rate.
Policy Strategies: Inflation Targeting
• Given the breakdown in the relationship
between monetary aggregates and goal
variables, 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.
• 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
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?
• Commitment to price stability as the primary longrun goal of monetary policy and a commitment to
achieve the inflation goal
• Communication with public to increase
transparency of the strategy
– Public announcement of a numerical inflation target
• Increased accountability of the central bank
Inflation Targeting - Intent
• Keep inflation low
• Anchor inflation expectations
• This will 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.
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).
Inflation Targeting in Practice
– A “policy 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
“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).
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
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 a 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
US. Inflation - Without Explicit Inflation Target
Policy Strategies: 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!
Important Summary Table Advantages and
Disadvantages of Different Monetary Policy
Strategies
Price-Level Targeting
• Price-level Targeting
The central bank sets
the objective of
holding the rate of
increase of the price
level to a preannounced path
• 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
Inflation Targeting
• Inflation targeting
also aims to move the
economy along a preset path
Inflation target path
• If inflation targeting
were fully successful,
the economy would
follow exactly the
same path as under
price-level targeting
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”
• Price-level targeting,
instead, aims to return to
the original path (dashed
green line)
2% inflation
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), pricelevel targeting would
bring unemployment
back to normal faster
than inflation targeting.
Faster rate of growth in
the money supply.
> 2% inflation
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
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
• 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 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
Reply to Critics of PLT
• Backers of price-level targeting 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
Instrument Conflict – Result of Targeting Non-borrowed
Reserves.
The interest rate must be allowed to fluctuate
Instrument Conflict – Result of Targeting the
Federal Funds Rate.
Reserves and the money supply must be allowed to fluctuate
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*)
Output Gap – From PS No. 1 2014
The Taylor Rule
•States 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:
iff = 2.0 + π + 0.5( π – 2.0) + 0.5 ((Y – Y*)/Y*)
Target Fed Funds rate = 2 % + Current Inflation Rate
+ ½ (Inflation gap)+ ½(Output gap)
Published in 1993 based on data from 1987 - 1992
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.
• 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%
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
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
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 Data for 2011/12: π= 2%, gap = -6%:
• Rule 1: iff = 1 + 1.5(2) + .5(-6) ; iff = 1 percent
• What if the output gap coefficient is 1.0.
• Rule 2: iff = 1 + 1.5(2) + 1.0(-6); iff = -2 percent
Comparison of Rule 1 and Rule 2
March 2013
FOMC Sept. 2014
The Taylor Rule for the Federal Funds
Rate, 1970–2011
Source: Federal Reserve; www.federalreserve.gov/releases and author’s
calculations.
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.
Criticisms of the Taylor Rule
• Several alternatives measure inflation and the output
gap:
– The Taylor Rule differs considerably, depending on
the price index and output gap measure used.
• The impact lag of monetary policy means that the ideal
active policy rule should not use current observations
for inflation, real GDP and potential real GDP, but
rather should use expected rates 9-12 months in the
future.
• The weights or response coefficients used in the Taylor
Rule have no theoretical basis.
• The Taylor Rule is too simple.
The Taylor Rule – Rearrange Terms
iff = rff + π + .5(π –πt) + .5((Y –Y*)/Y*)
iff = rff + π + .5π –.5πt + .5((Y –Y*)/Y*)
iff = rff + 1.5π –.5πt + .5((Y –Y*)/Y*)
iff = rff + πt + 1.5π –1.5πt + .5((Y –Y*)/Y*)
iff = rff + πt + 1.5(π – πt) + .5((Y –Y*)/Y*)
In General:
iff = rff + πt + a(π – πt) + b ((Y –Y*)/Y*)
Empirical studies (information only)
iff = rff + πt + a(π – πt) + b ((Y –Y*)/Y*)
Use of data to estimate a and b –
Clarida, Gali, and Gertler (1999)
How well the Fed has done in shooting at its
target.