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The Economics of Money, Banking, and Financial Markets

Fourth Edition

Chapter 19

The Conduct of Monetary Policy: Strategy and Tactics

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This chapter examines the goals of monetary policy and then considers one of the most important strategies for the conduct of monetary policy, inflation targeting

Learning Objectives (1 of 2)

19.1 Define and recognize the importance of a nominal anchor.

19.2 Identify the six potential goals that monetary policymakers may pursue.

19.3 Summarize the distinctions between hierarchical and dual mandates.

19.4 Compare and contrast the advantages and disadvantages of inflation targeting.

19.5 Identify the key changes made over time to the Federal Reserve monetary policy strategy.

Learning Objectives (2 of 2)

19.6 List the four lessons learned from the global financial crisis and discuss what they mean to inflation targeting.

19.7 Summarize the arguments for and against central bank policy response to asset-price bubbles.

19.8 Describe and assess the four criteria for choosing a policy instrument.

19.9 Interpret and assess the performance of the Taylor rule as a hypothetical policy instrument for setting the federal funds rate.

The Price Stability Goal and the Nominal Anchor

Over the past few decades, policy makers throughout the world have become increasingly aware of the social and economic costs of inflation and more concerned with maintaining a stable price level as a goal of economic policy.

The role of a nominal anchor: a nominal variable, such as the inflation rate or the money supply, which ties down the price level to achieve price stability

The time-inconsistency problem

Other Goals of Monetary Policy

Five other goals are continually mentioned by central bank officials when they discuss the objectives of monetary policy:

High employment and output stability

Economic growth

Stability of financial markets

Interest-rate stability

Stability in foreign exchange markets

Should Price Stability Be the Primary Goal of Monetary Policy?

Hierarchical Versus Dual Mandates:

Hierarchical mandates put the goal of price stability first, and then say that as long as it is achieved other goals can be pursued

Dual mandates are aimed to achieve two coequal objectives: price stability and maximum employment (output stability)

Price Stability as the Primary, Long-Run Goal of Monetary Policy

Either type of mandate is acceptable as long as it operates to make price stability the primary goal in the long run but not the short run.

Inflation Targeting (1 of 3)

Public announcement of medium-term numerical target for inflation

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

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

Increased transparency of the strategy

Increased accountability of the central bank

Inflation Targeting (2 of 3)

New Zealand (effective in 1990)

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

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

Canada (1991)

Inflation decreased since 1991; some costs in term of unemployment

United Kingdom (1992)

Inflation has been close to its target.

Growth has been strong and unemployment has been decreasing.

Figure 1 Inflation Rates and Inflation Targets for New Zealand, Canada, and the United Kingdom, 1980–2014

Sources: Ben S. Bernanke, Thomas Laubach, Frederic S. Mishkin, and Adam S. Poson, Inflation Targeting: Lessons from the International Experience (Princeton: Princeton University Press, 1999); and Federal Reserve Bank of St. Louis, FRED database: http:// research.stlouisfed.org/fred2 /.

Inflation Targeting (3 of 3)

Advantages:

Does not rely on one variable to achieve target

Easily understood

Reduces potential of falling in time-inconsistency trap

Stresses transparency and accountability

Disadvantages:

Delayed signaling

Too much rigidity

Potential for increased output fluctuations

Low economic growth during disinflation

The Evolution of the Federal Reserve’s Monetary Policy Strategy (1 of 3)

The United States has achieved excellent macroeconomic performance (including low and stable inflation) until the onset of the global financial crisis without using an explicit nominal anchor such as an inflation target.

History:

Fed began to announce publicly targets for money supply growth in 1975

Paul Volker (1979) focused more in nonborrowed reserves

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

The Evolution of the Federal Reserve’s Monetary Policy Strategy (2 of 3)

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

Forward looking behavior and periodic “preemptive strikes”

The goal is to prevent inflation from getting started.

The Evolution of the Federal Reserve’s Monetary Policy Strategy (3 of 3)

Advantages

Uses many sources of information

Demonstrated success

Disadvantages

Lack of accountability

Inconsistent with democratic principles

The Fed’s “Just Do It” Monetary Policy Strategy

Advantages of the Fed’s “Just Do It” Approach:

forward-looking behavior and stress on price stability also help to discourage overly expansionary monetary policy, thereby ameliorating the time-inconsistency problem

Disadvantages of the Fed’s “Just Do It” Approach:

lack of transparency; strong dependence on the preferences, skills, and trustworthiness of the individuals in charge of the central bank

Lessons for Monetary Policy Strategy from the Global Financial Crisis (1 of 2)

Developments in the financial sector have a far greater impact on economic activity than was earlier realized.

The zero-lower-bound on interest rates can be a serious problem.

The cost of cleaning up after a financial crisis is very high.

Price and output stability do not ensure financial stability.

Lessons for Monetary Policy Strategy from the Global Financial Crisis (2 of 2)

How should Central banks respond to asset price bubbles?

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

Types of asset-price bubbles

Credit-driven bubbles

Subprime financial crisis

Bubbles driven solely by irrational exuberance

Should Central Banks Respond to Bubbles? (1 of 2)

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.

Monetary policy should not be used to prick bubbles.

Should Central Banks Respond to Bubbles? (2 of 2)

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

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

Tactics: Choosing the Policy Instrument

Tools

Open market operation

Reserve requirements

Discount rate

Policy instrument (operating instrument)

Reserve aggregates

Interest rates

May be linked to an intermediate target

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

Figure 2 Linkages Between Central Bank Tools, Policy Instruments, Intermediate Targets, and Goals of Monetary Policy

Figure 3 Result of Targeting on Nonborrowed Reserves

Figure 4 Result of Targeting on the Federal Funds Rate

Criteria for Choosing the Policy Instrument

Observability and Measurability

Controllability

Predictable effect on Goals

Tactics: The Taylor Rule

An inflation gap and an output gap

Stabilizing real output is an important concern

Output gap is an indicator of future inflation as shown by Phillips curve

NAIRU

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

Figure 5 The Taylor Rule for the Federal Funds Rate, 1970–2014

Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

Federal funds rate targetinflation ratee

quilibrium real fed funds rate

(inflation gap) (output gap)