Central Bank Policy What should the Fed do?
The Goals of Monetary Policy • Price Stability • High Employment • Economic Growth • Financial Market Stability • Interest Rate Stability • Exchange Rate Stability
Price Stability • Implies keeping inflation both low and stable • Increasingly viewed as the most important goal of monetary policy • The costs of inflation: • Menu costs • Shoeleather costs • Increased uncertainty • Arbitrary redistributions of wealth • Increasing evidence that high inflation actually slows economic growth. • Need to use a nominal anchor (monetary aggregate or the inflation rate?)
High Employment • High unemployment creates both personal and societal costs • With unemployment, there are idle resources that could be put to work. • What employment rate should the Fed target? • Frictional Unemployment • Structural Unemployment • Natural Rate of Unemployment • Tricky policy target, as the natural rate can change over time. • Better short run target than a long run one.
Economic Growth • Promoting economic growth should lead to lower unemployment and lower inflation in the long run • Supply Side Economics: • Give firms a greater incentive to invest and people a greater incentive to save. • Increased investment rates will expand the capital stock in the future. • Greater production will lead to both lower unemployment and lower prices as returns trickle down throughout the economy • Effective in theory, but may generate significant short-run pain. • How should monetary policy be used to promote growth?
Stability • Financial Market Stability • Bank panics and financial crises can create great strain on the economy • The Fed can help avert these crises by acting as a lender of last resort and providing technical assistance to financial markets. • Interest Rate Stability • Volatile interest rates increase uncertainty and reduce both savings and investment. • Rapidly rising interest rates may create hostility toward the Central Bank, leading to a loss of independence. • Exchange Rate Stability • International trade and investment is damaged by wildly fluctuating exchange rates. • Central bank intervention in foreign exchange markets can temper these movements, increasing stability.
The Time Inconsistency of Monetary Policy • Monetary policy is often crafted to produce a long-run outcome (like price stability) • However, the actions needed to achieve this long run goal may not be the best choices in the short run. • Such policies are time-inconsistent • We do not consistently follow the plan over time. Such a plan will almost always be abandoned. • Suppose the Fed wanted to pursue the long run goal of price stability • In the short run, they will be tempted to inflate the economy to boost economic output. • Doing so jeopardizes the goal of long run price stability as people revise their expectations about the Fed’s policy stance • Expected inflation rises, which causes wages and prices to rise in the long run!
Should Price Stability be the Primary Goal? • In the long run, price stability and the other goals of monetary policy are not mutually exclusive. • The natural rate of unemployment is unaffected by inflation • Economic growth is only affected by real variables in the long run • Price stability will promote interest rate and exchange rate stability in the long run. • However, short-run price stability will frequently conflict with these other goals of monetary policy. • Faced with rapidly rising prices, the Fed would have to cut the money supply and raise interest rates • Doing so increases short-run unemployment and creates volatility in financial markets though!
Hierarchical vs. Dual Mandates • Price stability is an important goal for monetary policy, but should it take precedence over all others? • In a hierarchical mandate, price stability is the first goal and any other policy objective may only be targeted so long as it doesn’t interfere with price stability. • The ECB has a hierarchical mandate – it can pursue high levels of employment and economic growth as long as it doesn’t endanger price stability. • In a dual mandate, the central bank can simultaneously pursue both price stability and other goals (usually low unemployment). These goals may conflict in the short run. • The Fed operates under such a system, with the stated goals of maximum employment, stable prices, and moderate long-term interest rates. • There is no stated order of preference amongst these goals.
Hierarchical vs. Dual Mandates • A hierarchical mandate reinforces the public’s belief in the central bank’s commitment to price stability. • It gets around the time inconsistency problem by limiting the policies that the central bank can do. • However, it can lead to the central bank targeting short-run price stability, leading to large fluctuations in output and employment. • A dual mandate gives central banks the freedom to stabilize employment in the short run while still setting a long run policy target of price stability. • However, the dual mandate is subject to the time inconsistency problem. • If people believe that the central bank is always going to promote employment over price stability in the short run, they will revise their inflation expectations upward.
Monetary Targeting • To achieve price stability, you need to have some benchmark that tells you how stable prices are. • Two such targets are widely used: monetary aggregates and the inflation rate. • In monetary targeting, the central bank announces that it will target an annual growth rate in a particular monetary aggregate (like M1 or M2). • Once the rate is set, the Central Bank is responsible for hitting this target • This policy is transparent, flexible and accountable. • It sends a strong signal of the Central Bank’s policy objective and inflation expectations should adjust. • However, it does require that the target (M1 for example) and the goal variable (inflation) have a strong relationship.
Inflation Targeting • The biggest weakness of monetary targeting is that there may not be a strong relationship between the monetary target and inflation. • So why not directly target inflation? • With inflation target, the central bank makes a public announcement of the inflation target. • This is an attempt to revise inflation expectations • Then the central bank makes an institutional commitment to price stability (and the inflation target) as a long-run goal. • Policy decisions (to hit the inflation target) are made using as much information as is available • The process by which the central bank reached a policy is made transparent through open communication with the public • If the central bank fails to hit its objective, it is held accountable.
Inflation Targeting • Inflation targeting has been successfully used to achieve long-run price stability in Canada, New Zealand, and the UK. • However, the process by which long-run stability was achieve involved significant short-term pain. • Advantages • Does not rely on one variable to achieve the target • Transparent and policymakers are accountable for their actions. • Better insulated from time-inconsistency problem. • Disadvantages • Delayed signaling inflation rates are known ex-post, oftentimes with long lags. Need to know current rate to know the stance of the central bank’s target. • Too inflexible, potentially leading to disruptive output fluctuations • During the transition period, there is low economic growth how long until we reach the long run?
Forward Looking Monetary Policy • For countries with a long history of stable prices, there is significant inertia in prices. • The effects of monetary policy may not be felt for up to one year on output and two years on prices. • These lag times are shorter for countries with a history of more volatile inflation (prices are necessarily more flexible) • Because monetary policy takes so long to have an impact, it cannot be reactive. • Rather, the central bank needs to take pre-emptive actions. • If the Fed thinks inflation is going to rise in two years, it needs to raise interest rates today • If the Fed thinks unemployment is going to rise next year, it needs to increase the money supply today. • Because of these lag times, perhaps the best monetary policy target is an “implicit nominal anchor” that is adaptable to the needs of the economy.
Implicit Nominal Anchors • Advantages • Forward looking and pre-emptive • Uses multiple sources of information to make decisions • Forward-looking policy helps to overcome time-inconsistency problem • Has a proven track record of success in the U.S. • Disadvantages • Lack of transparency and accountability • Depends on the abilities and trustworthiness of the people making monetary policy policymakers change! • Undemocratic?
Choosing a Policy Instrument • In conducting monetary policy, the central bank has several policy instruments through which it hopes to achieve its policy goal • In many cases, it uses to policy instrument to achieve an intermediate target which is related to the policy goal. • Ex: The Fed wants to achieve an inflation rate of 3% (policy goal), so it targets the growth rate in M1 (intermediate target) to be 2%. To get this M1 growth rate, the Fed changes Non-Borrowed Reserves (the policy instrument) through Open Market Operations. • The two most commonly used policy instruments are monetary aggregates like NBR and interest rates like the federal funds rate. • The central bank can directly control one of these instruments, but not both simultaneously.
Using NBR as a Policy Instrument cedes Control over the Federal Funds Rate
Using the Federal Funds Rate as a Policy Instrument cedes control over NBR
Choosing a Policy Instrument • The Policy Instrument should be Observable and Measurable • Quick observation and measurement are necessary to signal the central bank’s policy stance • NBR take up to two weeks to report compared to iff, which is available immediately (though rff is subject to expected inflation) • It should be Controllable • The ability of the central bank to conduct policy rests on its ability to change the policy instrument • It should produce Predictable Outcomes • If the policy instrument is changed, how accurately can we predict its effect on the policy goal?
The Taylor Rule • So how should the Fed behave? • Most economists argue that the Fed should have a policy goal of long run price stability • If credible, a dual mandate allows the Fed to moderate short run output fluctuations • The policy instrument should be the Federal Funds rate • The economist John Taylor devised a “rule” for the Fed to follow that tracks the above recommendation: • iff* = π + rff* + α*(π-π*) + β*(y-y*) • The Fed should set the federal funds rate based on the current rate of inflation, the equilibrium real federal funds rate (that which would exist at full employment), and a weighted average of the inflation gap (the difference between current and desired inflation) and the output gap (the percentage difference between actual and full employment output).