CENTRAL BANKS AND
MONETARY POLICY
STRATEGY
( Chap. 14; Chap 17, 434-444…454-457)
2
Principles of Monetary Policy Strategy
1.
2.
3.
4.
5.
There is no long-run tradeoff between unemployment and
inflation.
Price stability has important benefits.
Inflation is always and everywhere a monetary phenomenon
- Monetary authorities own inflation since monetary policy
has least legislative and implementation lag.
Expectations are critical to monetary policy outcomes;
A strong nominal anchor is the key to producing good
monetary policy outcomes.
Mishkin, Monetary Policy Strategy After the Crisis
Expectations, Policy Credibility, and Transparency
2
3
Nominal Anchors
• Monetary Targets – Growth in monetary
aggregates
• Exchange Rate Targets
• Inflation Targets
Nominal anchor is a quantitative variable used to pin down
public expectations about the future path of money.
4
What is Inflation Targeting?
• An increasingly popular choice of monetary policy
framework first adopted in New Zealand in 1989.
• Many inflation targeting countries have
successfully lowered inflation and inflation
expectations.
5
INFLATION TARGETING
Q1-1983
Q4-1983
Q3-1984
Q2-1985
Q1-1986
Q4-1986
Q3-1987
Q2-1988
Q1-1989
Q4-1989
Q3-1990
Q2-1991
Q1-1992
Q4-1992
Q3-1993
Q2-1994
Q1-1995
Q4-1995
Q3-1996
Q2-1997
Q1-1998
Q4-1998
Q3-1999
Q2-2000
Q1-2001
Q4-2001
Q3-2002
Q2-2003
Q1-2004
Q4-2004
Q3-2005
Q2-2006
Q1-2007
Q4-2007
Q3-2008
Q2-2009
Q1-2010
Q4-2010
Q3-2011
Q2-2012
Q1-2013
Q4-2013
Korea Adopts Inflation Targeting in 1998
Korea: YoY CPI Inflation
12
10
8
6
4
2
0
8
Characteristics
1.
2.
3.
4.
5.
An explicit central bank mandate to pursue
price stability as the primary objective of
monetary policy,
Explicit quantitative targets for inflation;
Policy actions based on a forward-looking
assessment of inflation pressures, taking into
account a wide array of information;
Increased transparency of monetary policy
strategy and implementation.
Mechanisms of accountability for
performance in achieving the objective;
9
1. Commitment to Price stability as primary goal
• Central Bank has commitment to achieve low and
stable inflation in the short-run and in the long-run
“Like most other central banks, the Bank of Korea
takes price stability as the most important objective of
its monetary policy. The current Bank of Korea Act
clearly sets out price stability as the purpose of the
Bank of Korea's establishment and stipulates that it
should seek to bring about price stability by setting an
inflation target in consultation with the government and
do its utmost to attain this target.”
BACK
10
What measure of Inflation should be used?
Headline Consumer Price Index
Core’ versus ‘headline’ CPI
• Headline CPI ~ Index of All Consumer Goods
• Core Inflation ~ Index of Consumer Goods less volatile
price goods (i.e. food and energy).
Tradeoffs
• ‘core’ more stable and better predictor of future inflation
• Food and Energy large share of emerging market consumer
baskets and hard for public to ignore.
Back
2. Medium term numerical targets for
inflation.
Public announcement of specific inflation rate goal (w/
room for error) over specific term or period.
• Based on Article 6, Clause 1 of
the 「Bank of Korea Act」, the
Numerical goal subject to change
Bank of Korea sets the mid-term
inflation target to be applied for
three years in consultation
with the government. The
inflation target measure during
the period from 2013 to 2015 is
set at 2.5~3.5%, based
on consumer price
inflation (year-on-year).
11
Targeters and
their
Targets
Bank of England Handbook
13
3. Policy actions based on a forward-looking
assessment of inflation pressures
• Forward looking
operating procedure –
monetary instruments
operate only with some
lag. Targeting medium
term inflation means
setting today’s policy
for tomorrow’s
economy.
• Must inevitably target
the forecast.
14
Over what horizon should inflation be targeted?
• Usually over a range of 1 year at the shortest to 3
years at the outside.
• Keeping inflation near target even in the short-run offers
greater credibility…if it can be accomplished.
Short-term programs often adopted for disinflation.
• Longer term targets allow the economy more flexibility to
adjust to temporary shocks.
15
4. Transparency
• The more unstable are market expectations, the greater
will be the instability in macroeconomic performance
• Learning about policymakers’ plans can cause shifts in
expectations Keeping agents’ expectations aligned with
policymakers’ plans helps avoid big surprises
• Credible central bank communications has calming
impact on agents’ expectations
16
Pillars of Central Bank Communication
Strategy
Goals and Instruments
i.
Fun Fact: Until 1994, U.S. Fed did not reveal policy instrument
was Fed Funds Rate
ii. Policy Decisions and their Basis
•
Policy Statements & Meeting Minutes
iii. Economic Forecasts
iv. Monetary Policy Outlook
•
Specific or suggestive
Monetary Policy Decisions
The Committee forecasts that the global
economy will sustain its modest recovery
going forward…
The Committee forecasts that the domestic
economy will show a trend of recovery
going forward, owing chiefly to the
expansionary macroeconomic policies and to
the ending of the MERS outbreak, but judges
the uncertainties surrounding the growth path
to be high….
Looking ahead, ..the Committee will conduct
monetary policy so as to maintain price
stability over a medium-term horizon and pay
attention to financial stability. In this process it
will closely monitor the trend of increase in
household debt and external risk factors such
as any shift in the US Federal Reserve’s
monetary policy and the financial instabilities
in some emerging economies, as well as the
trends of capital flows.
Link
Meeting Minutes
Link
….. One member expressed his
personal opinion as to the desirability
of maintaining the Base Rate at its
current level for the intermeeting
period and closely checking for
changes in the upside and downside
risks to the growth and price paths on
the basis, for example, of the
information additionally obtained from
economic indicators. He reasoned,
firstly, that although the GDP growth
forecasts for 2015 had been revised
downward, this was attributable to an
extremely lackluster second-quarter
performance due mainly to one-off
factors and that the Board had
expected it and responded
preemptively by cutting the Base Rate
in June. ….
Interest Rate Path
• Norgesbank and
Riksbank publish
forecast of future
interest rates offering
guidance about the
path.
• Many central banks
worry this would be
viewed
Link
20
5. Mechanisms of Accountability
• Under IT, central
bank retains
instrument
independence but
must thereby retain
responsibility for
achieving objectives.
• Many IT regimes
include an
accountability
mechanism.
Open Letter to the President
To ensure accountability in cases where the BSP fails to achieve the inflation target, the BSP
Governor issues an Open Letter to the President outlining the reasons why actual inflation did
not fall within the target, along with the steps that will be taken to bring inflation towards the
target. Open Letters to the President have been issued on 16 January 2004, 18 January
2005, 25 January 2006, 19 January 2007, 14 January 2008 and 26 January 2009.For 2010,
the BSP met the target and no open letter was issued.
How flexible are Inflation Targets
• Central banks may also attempt to achieve other goals
which may sometimes conflict with inflation targeting.
• Output Stability
• Financial Stability
• Exchange Rate Stability
23
Macroeconomics of Supply Shocks
• A shock that increases costs of production will tend to
push up prices/inflation and reduce willingness of firms
to produce output.
Monetary policy transmission primarily affects
demand.
• If monetary policy emphasizes price stability, demand
must be constrained to keep firms from passing along
cost shocks – GDP will fall.
• If monetary policy emphasizes output stability, demand
must be stimulated to keep firms from dropping out of
the market – inflation will rise.
01-Jan-06
01-Apr-06
01-Jul-06
01-Oct-06
01-Jan-07
01-Apr-07
01-Jul-07
01-Oct-07
01-Jan-08
01-Apr-08
01-Jul-08
01-Oct-08
01-Jan-09
01-Apr-09
01-Jul-09
01-Oct-09
01-Jan-10
01-Apr-10
01-Jul-10
01-Oct-10
01-Jan-11
01-Apr-11
01-Jul-11
01-Oct-11
01-Jan-12
01-Apr-12
01-Jul-12
01-Oct-12
01-Jan-13
01-Apr-13
01-Jul-13
01-Oct-13
01-Jan-14
01-Apr-14
01-Jul-14
01-Oct-14
01-Jan-15
01-Apr-15
01-Jul-15
YoY Inflation
Korean Inflation
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
CPI: Core (Excl Agricultural Products & Oils)
Consumer Price Index
25
Response to Temporary Supply Shocks
• What to do if temporary supply shocks cause inflation?
Communication!
• Focus public attention on “core” CPI which is less impacted by
supply shocks and greater indicator of long-term inflation path.
• Carefully monitor economic indicators to watch for signs that
commodity price increases may be threatening to pass into core
inflation.
• More persistent supply side effects may require temporary
adjustment of inflation target.
• Look and listen for any indicators that market participants might
be beginning to doubt the credibility of monetary policy.
Dual Mandate
• The US Federal Reserve is explicitly tasked with achieving
more than one target. In 1977, Congress tasked central bank
with ensuring.
- maximum employment;
- stable prices
- moderate long-term interest rates
• Fed interprets maximum employment as keeping the labor
market in equilibrium (closing the output gap).
• Fed interprets stable prices “The FOMC noted in its statement
that the Committee judges that inflation at the rate of 2 percent
(as measured by the annual change in the price index for
personal consumption expenditures, or PCE) is most
consistent over the longer run with the Federal Reserve's
statutory mandate. Link”
Taylor Rule
•
Economist named John Taylor argues that US target
interest rate is well represented by a function of
1.
2.
3.
current inflation
Inflation GAP: current inflation vs. target inflation
%Output Gap: % deviation of GDP from long run path
Function: Inflation Target π* = .02
•
TGT
t
i
 .02   t 
1
2
 ( t  
TGT
Yt  Yt
) 2
P
Yt
1
P
Should Fed Raise Rates
• Bernanke-Taylor Rule
itTGT  .02   tCORE  1 2  ( tCORE
P
Y

Y
  TGT )  1 t P t
Yt
Problems with Dual Mandate
• Not always possible to achieve both goals. If the output
gap and inflation are moving in opposite directions, is it
possible to anchor inflation expectations.
• Ambiguity about definitions of goals relative to inflation
targeting framework may cause uncertainty. OTOH, one
person’s ambiguity is another’s flexibility.
Financial Stability in the Era of Bubbles
• Speculative Bubbles –
Housing Price Index
160
150
130
120
110
100
Ireland
United States
Spain
1-May-10
1-Dec-09
1-Jul-09
1-Feb-09
1-Apr-08
1-Sep-08
1-Nov-07
1-Jun-07
1-Jan-07
1-Aug-06
1-Mar-06
1-Oct-05
1-May-05
1-Jul-04
1-Dec-04
1-Feb-04
90
1-Sep-03
2003=100
140
A speculative bubble
occurs when the prices of
assets are above their
fundamental value
because investors believe
prices will be even
farther above
fundamental values when
they sell assets in the
future.
31
Two Views of the role of monetary policy in
ensuring financial stability.
A. Conventional View Asset Price Indicators should
only influence monetary policy as they impact aggregate
demand and inflation over the medium term.
B. Leaning Against the Wind/Extra Action ECB
2005 “The central bank would adopt a somewhat tighter
policy stance in the face of an inflating asset market than
it would otherwise allow if confronted with a similar
macroeconomic outlook under more normal market
conditions.”
• Trade certainty of worse near-term economic performance for possibility of
better future performance
31
32
How should monetary policy response to asset
price developments?
Interest Rates
Aggregate
Demand
Inflation
Forecast
Asset Prices
‘lean
against the
wind’
Outline
32
Post GFC View
• Price and Output Stability do not necessarily lead to
financial stability.
• Costs of cleaning up after financial crisis is very high.
• Developments in the Financial sector have a far greater
impact on economic activity than was earlier realized.
Two Types of Asset Bubbles
1. Irrational Exuberance – Bubbles may be ignited by
cycle of optimism by investors (often driven by new
technologies or business opportunities).
2. Credit-Driven – Bubbles may be ignited by availability of
credit to speculators.
Former are less dangerous then the latter if they do not
spillover in damage toward the banking system.
Financial Stability and Korea
• Looking ahead, ..the
Household Credit to GDP - Korea
0.74
0.72
0.7
0.68
0.66
0.64
01-Mar-15
01-Jul-14
01-Nov-14
01-Mar-14
01-Jul-13
01-Nov-13
01-Mar-13
01-Jul-12
01-Nov-12
01-Mar-12
01-Jul-11
01-Nov-11
01-Nov-10
01-Mar-11
01-Jul-10
01-Nov-09
01-Mar-10
01-Jul-09
01-Mar-09
0.62
Committee will conduct
monetary policy so as
to maintain price
stability over a
medium-term horizon
and pay attention to
financial stability. In
this process it will
closely monitor the
trend of increase in
household debt
Sweden “Leaning Against the Wind”
4
3.5
3
2.5
2
1.5
1
0.5
01-May-15
01-Jan-15
01-Sep-14
01-May-14
01-Jan-14
01-Sep-13
01-May-13
01-Jan-13
01-Sep-12
01-May-12
01-Jan-12
01-Sep-11
01-May-11
01-Jan-11
01-Sep-10
-1
01-May-10
-0.5
01-Jan-10
0
Consumer Price Index: YoY
Policy Rate: Month End: Repo Rate
Inflation Expectation: TNS: Avg: Money Market Players: Year 1:
Monthly
Inflation Target
37
Unconventional Monetary Policy
• Taylor Principle suggests that when inflation
expectations fall, the policy rate should be
brought down on a more than 1-for-1 basis.
• But interest rates cannot be brought down
below zero: no one will lend money with a
negative interest rate since money always pays
a 0% interest rate (in theory).
38
Strategies for Dealing w/ Zero Lower Bound
(i)
(ii)
(iii)
(iv)
(v)
(vi)
Negative Interest Rates
Increase inflation target
Forward Guidance
Quantitative easing
Operation Twist
Credit easing
Challenges to Monetary Policy Effectiveness
39
i. Negative Interest Rates Euro
• Deposit facility puts tax on deposits.
2.5
2
1.5
Policy Rate: Month End: Main
Refinancing Operations
Key Interest Rate: Month End: Deposit
Facility
1
Key Interest Rate: Month End: Marginal
Lending Facility
Euro Index Average (EONIA): Overnight
0.5
-0.5
01-Jul-15
01-Apr-15
01-Jan-15
01-Oct-14
01-Jul-14
01-Apr-14
01-Jan-14
01-Oct-13
01-Jul-13
01-Apr-13
01-Jan-13
01-Oct-12
01-Jul-12
01-Apr-12
01-Jan-12
01-Oct-11
01-Jul-11
01-Apr-11
01-Jan-11
01-Oct-10
01-Jul-10
01-Apr-10
01-Jan-10
0
40
ii. Raise Inflation Target
• Cost of borrowing (in terms of purchasing power) is the interest
rate adjusted by the inflation rate between the time a loan is
made and the time is repaid.
rt  it  Et t 1
With zero interest rates, real borrowing rates
will fall when inflation rises.
41
Inflation Target
The newly-introduced "price stability target" is the inflation rate that the Bank judges to
be consistent with price stability on a sustainable basis. … Based on this recognition, the
Bank sets the "price stability target" at 2 percent in terms of the year-on-year rate of
change in the consumer price index (CPI) -- a main price index.
Link
42
iii. Forward Guidance
• Central banks can offer an explicit path of future interest
rates to guide asset prices and long term rates
• In 2009 financial crisis, Bank of Canada was explicit…
US Federal Reserve has policymakers
predict the likely path of interest rates.
Preferred Habitat Theory
• Yields of bonds of period n are represented as the
in 
i1  i
e
1, 1
i
e
1, 2
 ...  i
e
1,  n 1
n
Forward guidance operates on yield
curve.
 hn
45
iv. Quantitative Easing
• In 2001, Bank of Japan implemented a sharp
increase of OM purchases to expand bank
reserves referred to as Quantitative Easing.
• Banks mostly held extra reserves on their
balance sheets and did not increase lending or
deposit creation.
• In 2013, Japan begins asset purchases again.
BoJ Assets
M2/10
2013-10-01
2013-04-01
2012-10-01
2012-04-01
2011-10-01
2011-04-01
2010-10-01
2010-04-01
2009-10-01
2009-04-01
2008-10-01
2008-04-01
2007-10-01
2007-04-01
2006-10-01
2006-04-01
2005-10-01
2005-04-01
2004-10-01
2004-04-01
2003-10-01
2003-04-01
2002-10-01
2002-04-01
2001-10-01
2001-04-01
2000-10-01
2000-04-01
1999-10-01
1999-04-01
1998-10-01
1998-04-01
46
Japan: Quantitative Easing…2 rounds
Ueda (2005) argues that Japan QE was part of a strategy to indicate a
BoJ commitment to pushing down long-term interest rates.
Two Rounds of Quantitative Easing
$2,500,000
Did reversal of first QE reduce credibility?
$2,000,000
$1,500,000
$1,000,000
$500,000
$0
2014-01-01
2013-07-01
2013-01-01
2012-07-01
2012-01-01
2011-07-01
2011-01-01
2010-07-01
2010-01-01
2009-07-01
2009-01-01
2008-07-01
2008-01-01
2007-07-01
2007-01-01
2006-07-01
2006-01-01
2005-07-01
2005-01-01
2004-07-01
2004-01-01
2003-07-01
2003-01-01
2002-07-01
2002-01-01
2001-07-01
2001-01-01
2000-07-01
2000-01-01
Challenges to Monetary Policy Effectiveness
47
USA: Quantitative Easing
4500
4000
3500
3000
2500
2000
BASE
1500
M2/10
1000
500
0
48
v. Targeted Asset Purchases
B o J, "Quantitative and Qualitative Monetary
Easing "
Bank of Japan announcement April 4, 2013 -“An increase in JGB purchases and their maturity extension by a
unanimous vote -- With a view to encouraging a further decline in
interest rates across the yield curve, the Bank will purchase JGBs so
that their amount outstanding will increase at an annual pace of
about 50 trillion yen.”
“In addition, JGBs with all maturities including 40-year bonds will
be made eligible for purchase, and the average remaining maturity
of the Bank's JGB purchases will be
extended from slightly less than three years at present to about seven
years…” Link
49
QE Large-Scale Asset Purchase Program
Meaning & Zhu, BIS
Preferred Habitat Theory
• Yields of bonds of period n are represented as the
in 
i1  i
e
1, 1
i
e
1, 2
n
 ...  i
e
1,  n 1
 hn
Qualitative easing
operates on the
liquidity premium
51
LT interest rates fell
Link
52
vi. Credit Easing
• Extending direct credit or financial flows to targeted sectors to
bring down the risk premia.
Link
• Loan Support Program provide loans made against pooled
collateral, with the aim of supporting private financial
institutions' efforts in strengthening the foundations .
• An increase in ETF and J-REIT purchases With a view to
lowering risk premia of asset prices, the Bank will purchase
ETFs and Japan real estate investment trusts
Challenges to Monetary Policy Effectiveness
53
March 2015, ECB implements QE
Challenges to Monetary Policy Effectiveness