Monetary Policy: Strategies and Tactics

•Target monetary aggregates

•Target inflation

•“Just do it”…Whatever worksIn recent years, the United States has achieved excellent macro-economic performance (including low and stable inflation) until the subprime crisis occurred, without using an explicit monetary anchor. Fredric Mishkin, 9th edition, p. 405

Milton Friedman and the Monetarists•Steady money growth an automatic stabilizer

MV = PY

• Discretionary policy Monetary mischief

•Lags Too much too late

The Empirical Effects of an Increase in the Federal Funds Rate LagsThe Empirical Effects of an Increase in the Federal Funds Rate Lags

Monetary Aggregate TargetingUnited States (1975 – 93)• Paul Volker (1979 – 1987) focus on nonborrowed reserves– Monetarist experiment?– Smokescreen for high interest rate target?

Volcker Disinflation: 1980 - 1983

Monetary Aggregate TargetingUnited States (1975 – 93)• Paul Volker (1979) focused on nonborrowed reserves

– Monetarist experiment?– Smokescreen for high interest rate target?

• Alan Greenspan (1993) dropped monetary aggregates as a guide for conducting monetary policy

Germany (1970s - ) • Buba focused on “central bank money” in early 1970s.

• Monetary targeting can restrain inflation in long-run, even when targets are missed.– Clearly stated policy objectives expectations

Japan: (1978—”forecasts” of M2 + CDs)• 1987 M growth bubble

• 1989 Tightening lost decade

Monetary Aggregate TargetingAdvantages• Flexible, transparent, accountable

• Advantages•Almost immediate signals

fix inflation expectations less inflation•Almost immediate accountability

Disadvantages

• Need strong and stable relationship between targeted monetary aggregate & goal variable

• Can you control the targeted aggregate?– Financial innovations: NOW accounts, sweeps– Reserve requirement lags: complicates NBR mgt

Target Monetary Aggregate: M1? M2? M2+CDs?

Inflation Targeting:Favored by Bernanke/Mishkin

• Public announcement of medium-term inflation target

• Price stability the primary, long-run goal of monetary policy: commitment to the inflation goal

• Many variables are used in making decisions

• Transparency of the strategy

• Accountability of the central bank

New Zealand/Canada/UK/Sweden/Finland/Australia/Spain/Israel/Chile/Brazil/Eurozone/Armenia/Colombia/Ghana/Guatamala/Indonesia/Peru/Romania/Serbia/Thailand/Uruguay/Albania/Czech Rep/Hungary/Iceland/Korea/Mexico/Norway/Philippines/Poland/South Africa/Turkey

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.

Inflation Targeting• Advantages

– Does not rely on one variable to achieve target

– Easily understood– Reduce chance of time-inconsistency trap– Stresses transparency and accountability

• Disadvantages– Delayed signaling

• Target is for 2 – 3 years in future

– Too much rigidity? Inflation-nutters?• Potential for increased output fluctuations• Low economic growth during disinflationBUT…• Respond to other things in short-run

Constrained discretionFlexible inflation targeting

Monetary Policy with an Implicit Nominal Anchor

• No explicit nominal anchor of overriding concern for the (Greenspan) Fed.

• Forward looking behavior and periodic “preemptive strikes”– Prevent inflation from getting started.– Oppose deflation!

Monetary Policy with an Implicit Nominal Anchor

• Advantages– Uses many sources of information– Avoids time-inconsistency problem– Demonstrated success

• Disadvantages– Lack of transparency and accountability– Strong dependence on the preferences, skills, and trustworthiness of individuals in charge

– Inconsistent with democratic principles

Monetary Policy Strategies:Advantages and Disadvantages

Tactics: Choosing the Policy Instrument

• Tools– Open market operation– Reserve requirements– Discount rate

• Policy instrument (operating instrument)– Reserve aggregates: NBRs, R, MB– Interest rates: Overnight interbank rate (ffrate)– May be linked to an intermediate target

• Interest-rate and aggregate targets are incompatible

Market for Reserves

Target Nonborrowed Reserves:FFRATE varies as reserve demand shifts

Target Federal Funds Rate:Must vary NBRs to accommodateshifts in reserve demand

Tools, Policy Instruments, Intermediate Targets and Goals of Monetary Policy

Criteria for Choosing the Policy Instrument• Ease of observing and measuring• Ability to control• Predictable effect on Goals

The Taylor Rule, NAIRU, and the Phillips Curve

Federal funds rate target =

inflation rate equilibrium real fed funds rate

1/2 (inflation gap)1/2 (output gap)• Respond to inflation gap and output gap

– Stabilizing real output is an important concern– Phillips Curve Output gap is an indicator of future inflation

• Manage expectations– When Fed raises federal funds rate target, people understand it intends to bring down future inflation

– Expectation of reduced future inflation raises long-term real interest rate slows economy and reduces inflation

• NAIRU– Rate of unemployment at which there is no tendency for inflation to change

Taylor Rule for Federal Funds Rate:1970–2008

Source: Federal Reserve: www.federalreserve.gov/releases and author’s calculations.

McChesneyMartin

Arthur F. Burns

Paul Volcker

Wm.Miller

A l a n G r e e n s p a n

BenBernanke

Central Bank’s and Asset Price Bubbles• Asset-price bubble:

– Pronounced increase in asset prices that depart from fundamental values…and eventually burst.

• Types of asset-price bubbles– Credit-driven bubbles

• Subprime financial crisis• East-Asia financial crisis

– Bubbles driven solely by irrational exuberance• Dot.com bubble• Tulip Mania

• Should central banks respond to asset price bubbles?– Strong argument for not responding to bubbles driven by irrational exuberance

– Bubbles are easier to identify when asset prices and credit are increasing rapidly at the same time.

Lessons From the Subprime Crisis

• Macropudential regulation: regulatory policy to affect what is happening in credit markets in the aggregate.

• Central banks and other regulators should not have a laissez-faire attitude – Should not let credit-driven bubbles proceed without any reaction.

Historical Perspective: Fed Operations• Discount policy and the real bills doctrine, 1913 – early

1920s

• Discovery of open market operations, early 1920s -

• The Great Depression: Contagion of fear

• Reserve requirements as a policy tool: Thomas Amendment, 1933

• War finance and the pegging of interest rates, 1942 – 1951 • Targeting money market conditions, 1950s and 1960s

Procyclical monetary policy:Yi MB M ; π πe i MB M

• Targeting monetary aggregates, weakly 1970s (Burns, Miller)

• New Fed operating procedures, Oct. 1979 – Oct. 1982 (Volcker)– De-emphasis of federal funds rate

• De-emphasis of monetary aggregates , Oct. 1982 – early 1990s– Borrowed reserves target

• Federal funds targeting again: Early 1990s – (Greenspan)– Preemptive strikes against inflation

– Preemptive strikes against economic downturns and financial disruptions

• LTCM/Enron/Subprime meltdown

• International policy coordination…this weekend