The Evolution to Inflation Targeting: How Did We Get Here and Where Do We Need to Go?

1. The Evolution to Inflation Targeting: How Did We Get Here and Where Do We Need to Go? Daniel L. Thornton Prepared for the 6th Norges Bank Monetary Policy Conference June 11-12, 2009 The views are mine and do not necessarily reflect the views of the Board of Governors of the Federal Reserve or the Federal Reserve Bank of St. Louis

2. Outline • Discuss the monetary-policy-ineffectivenessproposition circa the early 1970s • I argue that most economists accept the tenets of the mpip today, and ask: how did we get from monetary policy is relatively unimportant for inflation or output stabilization to inflation targeting?

3. Outline • I answer the question • I review the experience of 21 inflation-targeting central banks • I suggest that the tension between economic theory and inflation targeting presents problems for inflation targeting going forward • I recommend three things that inflation-targeting central banks should do in order to guard against these problems

4. Recommendations for ITCBs • Drop any consideration of what Meyer (2004) calls a dual mandate, i.e., a commitment to price stability and economic stability, with no priority expressed. • Engage in serious a dialogue with constituents about the optimal rate of inflation and, in particular, whether a little inflation enhances economic growth

5. Recommendations for ITCBs • Carefully and honestly evaluate the extent to which the real economy can be stabilized around potential output. The end product should be a statement about the extent to which the ITCB believes it can stabilize output

6. The Monetary-Policy-Ineffectiveness Proposition • Consumption and investment spending are relatively interest insensitive • The monetary policy actions affect short-term rates • Long-term rates are important for spending decisions • Central banks’ ability to influence long-term real rates is very limited • “monetary aggregates matter little, or even not at all, for monetary policy.” Svensson, 2008

7. The Fed’s Ability to Affect Long-Term Rates • CBs control long-term rates via the EH. • The EH implies a commitment to keep the interest rate target at a level for a period of time • Eggertsson and Woodford (2003) suggest that a central bank should demonstrate its commitment to keep short-term rates low by purchasing long-term Treasuries--the “effect [on long-term yields] follows not from the purchases themselves, but from how they are interpreted,” and that the purchase of long-term Treasuries may help overcome “private sector skepticism about whether the history-dependent interest rate policy will actually be followed.”

8. The Fed’s Behavior: 1982-94 • During the period 1982-1994 the FOMC was coy about the extent to which it was targeting the funds rate (Thornton, 2006). • February 1994 FOMC statement read “the Federal Open Market Committee decided to increase slightly the degree of pressure on reserve positions. The action is expected to be associated with a small increase in short-term money market interest rates.”

9. The Fed’s Behavior: 2003-05 In response to a presentation by Glenn Rudebusch on optimal policy inertia at the March 2003 FOMC meeting, then-Governor Bernanke accepted Rudebusch’s finding that there was no policy inertia, but suggested “there should be more in order to get more effect on long-term rates.”

10. The Fed’s Behavior: 2003-05 The August FOMC statement read, “in these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.” The vote was 11 to 7.

12. The Fed’s Behavior: 2003-05 When the FOMC began increasing the target in June 2004, it again provided forward guidance, indicating that policy accommodation could be removed at “a measured pace.” By February 2005, Greenspan was calling the fact that long-term rates declined in spite of the 150-basis-point increase in the funds rate target a conundrumand Bernanke (2005) suggested it was a consequence of a “a global saving glut.” For an alternative explanation, see Thornton (2007).

14. The Fed’s Behavior: 2009 On March 18, 2009, the FOMC essentially attempted to implement the Eggertsson and Woodford (2003) strategy –announce that the intention to keep the funds rate target low for an extended period of time and reinforce that commitment by purchasing long-term assets.

18. The Evolution to Inflation Targeting • Demonstration that central banks could control inflation • Paul Volcker

19. The Evolution to Inflation Targeting • Demonstration that central banks could control inflation • Paul Volcker • Swiss and German Experience

22. The Evolution to Inflation Targeting • Demonstration that central banks could control inflation • Paul Volcker • Swiss and German Experience • The Lucas Critique • Large and persistent government deficits • The Great Depression

23. Danger#1: Dual Mandate • Dual mandate—“monetary policy is directed at promoting both full employment and price stability, with no priority expressed,” a.k.a., flexible inflation targeting.

24. Problems with a Dual Mandate • Obtaining a precise measure of potential output or NAIRU is a prerequisite for successful output stabilization • Cannot get even reasonable good real-time estimates of potential (FRBSL, 2009) • The conventional measure of potential is not the correct one. A more theoretically correct measure is the rate of output the economy would have if there were no nominal rigidities, but all other (real) frictions and shocks were unchanged

25. Problems with a Dual Mandate • The theoretically correct measure of potential would vary over the business cycle and, in particular, it would be affected by aggregate supply shocks, such as oil price shocks and shocks to the financial markets. • Hence, even if one could obtain reasonably good estimates of the conventional measure, policy based on such measures would likely be bad.

26. Problems with a Dual Mandate • Dual mandate is unnecessary when there are demand shocks. “the ultimate source of this long-run tradeoff [between the variance of prices and the variance of output] is the existence of shocks to aggregate supply.” Bernanke, 2004. In the case of demand shocks, inflation stabilization and output stabilization are perfect complements

27. Problems with a Dual Mandate The need to determine a preference for price stability or economic stability comes into play only when there are shocks to aggregate supply! Bernanke (2004) suggests several ways that lower and more stabile inflation could have resulted in the Great Moderation –none of which relate to better counter-cyclical MP. This would suggest that preference should be given to price stability when confronted by supply shocks

28. Problems with a Dual Mandate • The MPIP: there is little evidence that MP is effective in stabilizing output around potential, e.g., Rasche and Williams (2007). Episodic evidence that suggest that several economic recessions (including the Great Depression) were “caused” by a monetary policy contraction provide no evidence that MP can stabilize output around potential.

29. Danger # 2: A Little Inflation Is Good The belief in a permanent Phillips curve tradeoff has been replaced by the belief that “a little inflation is good for economic growth.” These beliefs on which this conclusion is based are either questionable or unsound (Marty and Thornton, 1995).

30. Danger # 2: A Little Inflation Is Good • Extending Rasche and Williams (2007) analysis of 21 inflation targeting countries, I find: • Only Brazil, Canada, Israel, Norway, Sweden, Switzerland, Thailand, and the U.K. have successfully maintained the moving average inflation rate below the upper end of the target range since 2004 • Columbia, Iceland, Mexico, Peru, and South Africa appear to be inflation targeting in name only, and Norway is in danger of moving significantly above its inflation objective • Many inflation targetershave had a two-year moving average inflation in the upper end of their ranges

31. Danger #3: The Hierarchical Mandate • The MPIP • The inability of policymakers to predict what would have happened if they had not attempted to stabilize the economy • The inability of policymakers to predict the longer-run consequences of their actions

32. Danger #3: The Hierarchical Mandate Reifschneider and Tulip (2007) analyze the forecasting accuracy of the Greenbook, the CBO, the Administration, the Blue Chip, and the SPF short-run forecasts of GDP growth, the unemployment rate and CPI inflation over the period 1986 to 2006. The average RMSE relative to the sample SD: 90% for GDP, 50% for UR, and 80% for CPI inflation and differences across forecasters were small.

33. Danger #3: The Hierarchical Mandate December 2003 meeting the data suggested the economy grew at a 3.3 percent rate in the second quarter and at an extremely rapid 8.2 percent rate in the third quarter, yet the FOMC kept the target at 1 %. The FOMC had credibility so they could be aggressive in the pursuit of “output stabilization.”

34. Danger #3: The Hierarchical Mandate Taylor (2009) and others have suggested that this excessively easy MP contributed significantly to the housing price bubble. The bursting of the bubble has lead to a massive increase in the monetary base, a.k.a., quantitative easing in the pursuit of what I (Thornton, 2009) call credit allocation and Taylor (2009) calls “industrial policy.” I believe that we are about to re-learn that monetary aggregates matter.

35. Recommendations for ITCBs • Drop any consideration of what Meyer (2004) calls a dual mandate, i.e., a commitment to price stability and economic stability, with no priority expressed. • Engage in serious a dialogue with constituents about the optimal rate of inflation and, in particular, whether a little inflation enhances economic growth.

36. Recommendations for ITCBs • Carefully and honestly evaluate the extent to which the real economy can be stabilized around potential output. The end product should be a statement about the extent to which the ITCB believes it can stabilize output.

37. Questions?