Some Remarks on the Theory

of Optimal Monetary Policy

Marc GiannoniColumbia Business School

CEPR, CIRANO, NBER

HEC Montréal

October 20, 2007

Background: Fascinating developments over last 15 years

• Practice: – Early 1990s: introduction of inflation targeting (IT) in several countries

(NZ, Canada, Sweden, UK…)– Wonderful results: Inflation at low, stable levels; inflation expectations

well anchored, economic activity fairly stable

• Macroeconomic Theory:– Early 1990s: little role for monetary policy– Principles for conduct monetary policy based on IT

(Bernanke, Laubach, Mishkin, Posen, 1999) – Mid-1990s:

• DSGE models usable for monetary policy analysis (Goodfriend-King, Rotemberg-Woodford, Clarida-Gali-Gertler, Svensson)

• Optimal monetary policy expressed as flexible inflation target• Progress on analysis of model uncertainty

• Practice and Theory meet again!

IT in practice

• Set instrument (interest rate) so as to achieve long-term constant inflation target (e.g. 2%)

• Flexibility in short-term (flexible-IT)

• Extensive explanation to public (monetary policy reports…)

• Transparency of decision process, objectives– But typically, forecasts of monetary policy instrument

not announced

Optimal IT in theory(Svensson, Giannoni-Woodford)

• Macroeconomic model (DSGE, estimated)

– Used to compute optimal path of all variables of interest (inflation, output gap, interest rates...)

• Implementation: inflation forecast targeting (IFT)– Fixed long-run inflation target– But in short term, CB commits to adjust instrument (interest rate)

as required for a projection of future path of economy (inflation, output gap…) to satisfy a target criterion

• Target criterion specifies optimal short-term deviations form long-run inflation target– Can be robust to model misspecifications– e.g. Norges Bank

Optimal IT in theory (2)(Svensson, Giannoni-Woodford)

• CB commits to publish projections and explain policy decisions

– May include interest-rate projections: entire path of expected short-term interest rates matters

– Helps manage expectations

– E.g. RBNZ, Norges Bank, Riksbank…

– Possible that limits on transparency are desirable

Advantages of IFT

• Transparency (of monetary policy goals, decisions…)

• Anchor medium-term inflation expectations

• Optimal short-run responses to shocks

• Can be robust to nature of disturbances

Features of optimal IT criterion

• Target for adjusted inflation projection (flexible IT)– output gap… also matter (includes all of CB's stabilization goals)

• Optimal target value should vary over time (history-dependent)– even though long-term inflation pinned down at a constant level– helps for expectations management

• Use all available information about current state of the economy to make projections (may include judgment)– Not a mechanical reaction function

Features of optimal IT criterion (2)

• Projections under forecasted future policy– not constant interest rate or market

expectations

• Forecasts at relatively short horizons– horizons at which CB actions begin to affect

target variables

Inflation or Price-Level Targeting?

Path of log price level with no shock

Quarters

log(P) = 2%

Inflation or Price-Level Targeting?

• Effect of a cost-push shock (date 0)

Quarters

Optimal path under IT log(P) = 2%

log(P) = 2%

Inflation or Price-Level Targeting?

• Effect of a cost-push shock (date 0)

Quarters

Optimal path under IT

Optimal path under PLT

Commitment to bringing P to trend stabilizes prices

Inflation or Price-Level Targeting?

• Effect of a cost-push shock (date 0)

• PLT close to optimal

Quarters

Optimal path under PLT

Optimal path under IT

Optimal policy

Inflation or Price-Level Targeting?

• Effect of a demand or productivity shock (date 0)• PLT: close to optimal (?)

Quarters

Optimal path under IT

Optimal policy

Optimal path under PLT

Inflation or Price-Level Targeting?

• IT: “bygones are bygones”

• PLT:– Commitment to bringing prices to target limits incentive

to raise prices too much– Error correction desirable given model

misspecification

• Optimal policy: desirability of “history dependence”– Effective management of expectations– Not exactly PLT, but close

Forecasts: Key for implementation of IFT

– Need to be reliable– But “Assessing the economy's true state

remains a formidable challenge”(Bernanke, 10/19/07)

– productivity? – potential output? – inflation?....

Inflation: Which series?

1965 1970 1975 1980 1985 1990 1995 2000-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

GDP defl.

PCE defl.CPI all

US quarterly inflation (demeaned)

Assessing state of the economy

1. Intuitive approach– Greenspan: large set of detailed statistics.... (sales of

men’s underwear…)

2. Complement: Formal statistical analysis– Exploiting systematically information from in data-rich

environments (Stock-Watson, Bernanke-Boivin-Eliasz, Reichlin et al., Boivin-Giannoni…)

– Can be combined in fully consistent way with theoretical models

– Successful for forecasting, estimating state of the economy

Estimated Inflation in US: Close to core PCE

US quarterly inflation (demeaned)

Inflation estimated using large data set

Data: GDP deflator

Source: Boivin-Giannoni (2006)

Conclusion• Great progress has been achieved in:

– Conduct of monetary policy– Monetary theory– Estimation of models

• It is now possible to:– Estimate accurately state of economy using large information sets– Use estimated models as effective guides for conduct of monetary policy

• Some lessons from the theory:– Optimal policy can be implemented by flexible IT– History dependence desirable

PLT may be good approximation to optimal policy / robust

• Progress on analysis of model uncertainty, but more work to be done