11

The Conduct of Monetary Policy: Strategy and Tactics

Chapter 16

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Monetary Targeting IMonetary Targeting I

United StatesUnited StatesFed began to announce publicly targets for Fed began to announce publicly targets for

money supply growth in 1975.money supply growth in 1975.Paul Volcker (1979) focused more on Paul Volcker (1979) focused more on

nonborrowed reservesnonborrowed reserves

Greenspan announced in July 1993 that the Greenspan announced in July 1993 that the Fed would not use any monetary aggregates Fed would not use any monetary aggregates as a guide for conducting monetary policyas a guide for conducting monetary policy

33

Monetary Targeting IIMonetary Targeting II

JapanJapan In 1978 the Bank of Japan began to In 1978 the Bank of Japan began to

announce “forecasts” for M2 + CDsannounce “forecasts” for M2 + CDsBank of Japan’s monetary performance was Bank of Japan’s monetary performance was

much better than the Fed’s during 1978-1987.much better than the Fed’s during 1978-1987. In 1989 the Bank of Japan switched to a In 1989 the Bank of Japan switched to a

tighter monetary policy and was partially tighter monetary policy and was partially blamed for the “lost decade”blamed for the “lost decade”

44

Monetary Targeting IIIMonetary Targeting IIIGermanyGermany

The Bundesbank focused on “central bank The Bundesbank focused on “central bank money” in the early 1970s.money” in the early 1970s.

A monetary targeting regime can restrain A monetary targeting regime can restrain inflation in the longer run, even when targets inflation in the longer run, even when targets are missed.are missed.

The reason of the relative success despite The reason of the relative success despite missing targets relies on clearly stated missing targets relies on clearly stated monetary policy objectives and central bank monetary policy objectives and central bank engagement in communication with the public. engagement in communication with the public.

55

Monetary TargetingMonetary Targeting

Flexible, transparent, accountableFlexible, transparent, accountable

AdvantagesAdvantagesAlmost immediate signals help fix inflation Almost immediate signals help fix inflation

expectations and produce less inflationexpectations and produce less inflationAlmost immediate accountabilityAlmost immediate accountability

DisadvantagesDisadvantagesMust be a strong and reliable relationship Must be a strong and reliable relationship

between the goal variable and the targeted between the goal variable and the targeted monetary aggregatemonetary aggregate

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Inflation Targeting IInflation Targeting I Public announcement of medium-term numerical Public announcement of medium-term numerical

target for inflationtarget for inflation

Institutional commitment to price stability as the Institutional commitment to price stability as the primary, long-run goal of monetary policy and a primary, long-run goal of monetary policy and a commitment to achieve the inflation goalcommitment to achieve the inflation goal

Information-inclusive approach in which many Information-inclusive approach in which many variables are used in making decisionsvariables are used in making decisions

Increased transparency of the strategyIncreased transparency of the strategy

Increased accountability of the central bankIncreased accountability of the central bank

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Inflation Targeting IIInflation Targeting II New Zealand (effective in 1990)New Zealand (effective in 1990)

Inflation was brought down and remained within the target Inflation was brought down and remained within the target most of the time. most of the time.

Growth has generally been high and unemployment has Growth has generally been high and unemployment has come down significantlycome down significantly

Canada (1991)Canada (1991) Inflation decreased since then, some costs in term of Inflation decreased since then, some costs in term of

unemploymentunemployment United Kingdom (1992)United Kingdom (1992)

Inflation has been close to its target.Inflation has been close to its target. Growth has been strong and unemployment has been Growth has been strong and unemployment has been

decreasing.decreasing.

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Inflation Targeting IIIInflation Targeting III AdvantagesAdvantages

Does not rely on one variable to achieve targetDoes not rely on one variable to achieve targetEasily understoodEasily understoodReduces potential of falling in time-inconsistency Reduces potential of falling in time-inconsistency

traptrapStresses transparency and accountabilityStresses transparency and accountability

DisadvantagesDisadvantagesDelayed signalingDelayed signalingToo much rigidityToo much rigidityPotential for increased output fluctuationsPotential for increased output fluctuationsLow economic growth during disinflationLow economic growth during disinflation

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Inflation TargetsInflation Targets

Source:Source: Ben S. Bernanke, Ben S. Bernanke, Thomas Laubach, Frederic S. Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen, Mishkin, and Adam S. Posen, Inflation Targeting: Lessons Inflation Targeting: Lessons from the International from the International ExperienceExperience (Princeton: (Princeton: Princeton University Press, Princeton University Press, 1999), updates from the same 1999), updates from the same sources, and sources, and www.rbnz.govt.nz/statistics/econind/a3/ha3.xls

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Monetary Policy with an Monetary Policy with an Implicit Nominal AnchorImplicit Nominal Anchor

There is no explicit nominal anchor in the There is no explicit nominal anchor in the form of an overriding concern for the Fed.form of an overriding concern for the Fed.

Forward looking behavior and periodic Forward looking behavior and periodic “preemptive strikes”“preemptive strikes”

The goal is to prevent inflation from getting The goal is to prevent inflation from getting started. started.

1111

Monetary Policy with an Monetary Policy with an Implicit Nominal Anchor IIImplicit Nominal Anchor II

AdvantagesAdvantages Uses many sources of informationUses many sources of information Avoids time-inconsistency problemAvoids time-inconsistency problem Demonstrated successDemonstrated success

DisadvantagesDisadvantages Lack of transparency and accountabilityLack of transparency and accountability Strong dependence on the preferences, skills, and Strong dependence on the preferences, skills, and

trustworthiness of individuals in chargetrustworthiness of individuals in charge Inconsistent with democratic principlesInconsistent with democratic principles

1212

Advantages and Disadvantages of Advantages and Disadvantages of Different Monetary Policy StrategiesDifferent Monetary Policy Strategies

1313

Tactics: Choosing the Policy Tactics: Choosing the Policy InstrumentInstrument

ToolsTools Open market operationOpen market operation Reserve requirementsReserve requirements Discount rateDiscount rate

Policy instrument (operating instrument)Policy instrument (operating instrument) Reserve aggregatesReserve aggregates Interest ratesInterest rates May be linked to an intermediate targetMay be linked to an intermediate target

Interest-rate and aggregate targets are Interest-rate and aggregate targets are incompatible (must chose one or the other). incompatible (must chose one or the other).

1414

Linkages Between Tools, Policy Linkages Between Tools, Policy Instruments, Intermediate Targets, Instruments, Intermediate Targets,

and Goalsand Goals

1515

Result of Targeting on Result of Targeting on Nonborrowed ReservesNonborrowed Reserves

1616

Criteria for Choosing the Criteria for Choosing the Policy InstrumentPolicy Instrument

Observability and MeasurabilityObservability and MeasurabilityControllabilityControllabilityPredictable effect on GoalsPredictable effect on Goals

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The Taylor Rule, NAIRU, and The Taylor Rule, NAIRU, and the Phillips Curvethe Phillips Curve

Federal funds rate target =

inflation rate equilibrium real fed funds rate

1/2 (inflation gap)1/2 (output gap)

An inflation gap and an output gapAn inflation gap and an output gap Stabilizing real output is an important concernStabilizing real output is an important concern Output gap is an indicator of future inflation as shown by Output gap is an indicator of future inflation as shown by

Phillips curvePhillips curve NAIRUNAIRU

Rate of unemployment at which there is no tendency for Rate of unemployment at which there is no tendency for inflation to changeinflation to change

1818

Result of Targeting on the Result of Targeting on the Federal Funds RateFederal Funds Rate

1919

Central Bank’s Response to Asset Central Bank’s Response to Asset Price BubblesPrice Bubbles

Asset-price bubble: pronounced increase Asset-price bubble: pronounced increase in asset prices that depart from in asset prices that depart from fundamental values, which eventually fundamental values, which eventually burst.burst.

Types of asset-price bubblesTypes of asset-price bubblesCredit-driven bubblesCredit-driven bubbles

Subprime financial crisisSubprime financial crisis

Bubbles driven solely by irrational exuberanceBubbles driven solely by irrational exuberance

2020

Lessons From the Subprime Crisis Lessons From the Subprime Crisis

Should central banks respond to bubbles?Should central banks respond to bubbles?Strong argument for not responding to Strong argument for not responding to

bubbles driven by irrational exuberancebubbles driven by irrational exuberanceBubbles are easier to identify when asset Bubbles are easier to identify when asset

prices and credit are increasing rapidly at the prices and credit are increasing rapidly at the same time. same time.

Monetary policy should not be used to prick Monetary policy should not be used to prick bubbles. bubbles.

2121

Lessons From the Subprime CrisisLessons From the Subprime Crisis

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

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

2222

Historical Perspective IHistorical Perspective I

Discount policy and the real bills doctrineDiscount policy and the real bills doctrine

Discovery of open market operationsDiscovery of open market operations

The Great DepressionThe Great Depression

Reserve requirements as a policy toolReserve requirements as a policy tool Thomas Amendment to the Agricultural Adjustment Act Thomas Amendment to the Agricultural Adjustment Act

of 1933of 1933

War finance and the pegging of interest ratesWar finance and the pegging of interest rates

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Historical Perspective IIHistorical Perspective II

Targeting money market conditionsTargeting money market conditionsProcyclical monetary policyProcyclical monetary policy

Targeting monetary aggregatesTargeting monetary aggregates New Fed operating proceduresNew Fed operating procedures

De-emphasis of federal funds rateDe-emphasis of federal funds rate

De-emphasis of monetary aggregatesDe-emphasis of monetary aggregatesBorrowed reserves targetBorrowed reserves target

Federal funds targeting againFederal funds targeting againGreater transparencyGreater transparency

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Historical Perspective IIIHistorical Perspective III

Preemptive strikes against inflationPreemptive strikes against inflation

Preemptive strikes against economic Preemptive strikes against economic downturns and financial disruptionsdownturns and financial disruptionsLTCMLTCM

EnronEnron

Subprime meltdownSubprime meltdown

International policy coordinationInternational policy coordination

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The Taylor Rule for the The Taylor Rule for the Federal Funds RateFederal Funds Rate

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

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