Monetary Policy: Strategies and Tactics
•Target monetary aggregates
•Target inflation
•“Just do it”…Whatever works
In recent years, the United States has achieved excellent macroeconomic performance (including low and stable inflation) until
the subprime crisis occurred, without using an explicit monetary
anchor.
Fredric Mishkin, 9th edition, p. 405
Milton Friedman and the Monetarists
•Steady money growth  an automatic stabilizer
MV = PY
• Discretionary policy  Monetary mischief
•Lags  Too much too late
The Empirical Effects of an Increase in the Federal Funds Rate  Lags
Monetary Aggregate Targeting
United States (1975 – 93)
• Paul Volker (1979 – 1987) focus on nonborrowed
reserves
– Monetarist experiment?
– Smokescreen for high interest rate target?
Volcker Disinflation: 1980 - 1983
Monetary Aggregate Targeting
United States (1975 – 93)
• Paul Volker (1979) focused on nonborrowed reserves
– Monetarist experiment?
– Smokescreen for high interest rate target?
• Alan Greenspan (1993) dropped monetary aggregates
as a guide for conducting monetary policy
Germany (1970s - )
• Buba focused on “central bank money” in early 1970s.
• Monetary targeting can restrain inflation in long-run,
even when targets are missed.
– Clearly stated policy objectives  expectations
Japan: (1978—”forecasts” of M2 + CDs)
• 1987 M growth  bubble
• 1989 Tightening  lost decade
Monetary Aggregate Targeting
Advantages
• Flexible, transparent, accountable
• Advantages
• Almost immediate signals
 fix inflation expectations  less inflation
• Almost immediate accountability
Disadvantages
• Need strong and stable relationship between
targeted monetary aggregate & goal variable
• Can you control the targeted aggregate?
– Financial innovations: NOW accounts, sweeps
– Reserve requirement lags: complicates NBR mgt
Target Monetary Aggregate: M1? M2? M2+CDs?
Inflation Targeting:
Favored by Bernanke/Mishkin
New Zealand/Canada/UK/Sweden/Finland/Australia/Spain/Israel/Chile/Brazil/
Eurozone/Armenia/Colombia/Ghana/Guatamala/Indonesia/Peru/Romania/Serbia/
Thailand/Uruguay/Albania/Czech Rep/Hungary/Iceland/Korea/Mexico/Norway/
Philippines/Poland/South Africa/Turkey
• Public announcement of medium-term inflation target
• Price stability the primary, long-run goal of monetary
policy: commitment to the inflation goal
• Many variables are used in making decisions
• Transparency of the strategy
• Accountability of the central bank
Inflation Rates and Inflation Targets for New Zealand,
Canada, and the United Kingdom, 1980–2008
Source: Ben S. Bernanke,
Thomas Laubach, Frederic S.
Mishkin, and Adam S. Poson,
Inflation Targeting: Lessons
from the International
Experience (Princeton: Princeton
University Press, 1999), updates
from the same sources, and
www.rbnz.govt
.nz/statistics/econind/a3/ha3.xls
.
Inflation Targeting
• Advantages
–
–
–
–
Does not rely on one variable to achieve target
Easily understood
Reduce chance of time-inconsistency trap
Stresses transparency and accountability
• Disadvantages
– Delayed signaling
• Target is for 2 – 3 years in future
– Too much rigidity? Inflation-nutters?
• Potential for increased output fluctuations
• Low economic growth during disinflation
BUT…
• Respond to other things in short-run
Constrained discretion
Flexible inflation targeting
Monetary Policy with an
Implicit Nominal Anchor
• No explicit nominal anchor of overriding
concern for the (Greenspan) Fed.
• Forward looking behavior and periodic
“preemptive strikes”
– Prevent inflation from getting started.
– Oppose deflation!
Monetary Policy with an
Implicit Nominal Anchor
• Advantages
– Uses many sources of information
– Avoids time-inconsistency problem
– Demonstrated success
• Disadvantages
– Lack of transparency and accountability
– Strong dependence on the preferences, skills, and
trustworthiness of individuals in charge
– Inconsistent with democratic principles
Monetary Policy Strategies:
Advantages and Disadvantages
Tactics: Choosing the Policy Instrument
• Tools
– Open market operation
– Reserve requirements
– Discount rate
• Policy instrument (operating instrument)
– Reserve aggregates: NBRs, R, MB
– Interest rates: Overnight interbank rate (ffrate)
– May be linked to an intermediate target
• Interest-rate and aggregate targets are incompatible
Market for Reserves
Target Nonborrowed Reserves:
Target Federal Funds Rate:
FFRATE varies as reserve demand shifts
Must vary NBRs to accommodate
shifts in reserve demand
Tools, Policy Instruments, Intermediate Targets and
Goals of Monetary Policy
Criteria for Choosing the Policy Instrument
• Ease of observing and measuring
• Ability to control
• Predictable effect on Goals
The Taylor Rule, NAIRU, and the Phillips Curve
Federal funds rate target =
inflation rate  equilibrium real fed funds rate
1/2 (inflation gap) 1/2 (output gap)
• Respond to inflation gap and output gap
– Stabilizing real output is an important concern
– Phillips Curve Output gap is an indicator of future inflation
• Manage expectations
– When Fed raises federal funds rate target, people understand it
intends to bring down future inflation
– Expectation of reduced future inflation raises long-term
real interest rate  slows economy and reduces inflation
• NAIRU
– Rate of unemployment at which there is no tendency for
inflation to change
Taylor Rule for Federal Funds Rate:1970–2008
Paul Volcker
A l a n G r e e n s p a n
McChesney
Martin
Ben
Bernanke
Wm.
Miller
Arthur F. Burns
Source: Federal Reserve: www.federalreserve.gov/releases and author’s calculations.
Central Bank’s and Asset Price Bubbles
• Asset-price bubble:
– Pronounced increase in asset prices that depart from
fundamental values…and eventually burst.
• Types of asset-price bubbles
– Credit-driven bubbles
• Subprime financial crisis
• East-Asia financial crisis
– Bubbles driven solely by irrational exuberance
• Dot.com bubble
• Tulip Mania
• Should central banks respond to asset price bubbles?
– 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.
Lessons From the Subprime Crisis
• Macropudential regulation: regulatory policy to
affect what is happening in credit markets in
the aggregate.
• Central banks and other regulators should not
have a laissez-faire attitude
– Should not let credit-driven bubbles proceed without
any reaction.
Historical Perspective: Fed Operations
• Discount policy and the real bills doctrine, 1913 – early 1920s
• Discovery of open market operations, early 1920s • The Great Depression: Contagion of fear
• Reserve requirements as a policy tool: Thomas Amendment, 1933
• War finance and the pegging of interest rates, 1942 – 1951
• Targeting money market conditions, 1950s and 1960s
Procyclical monetary policy:Yi MB  M ; π  πe  i MB  M
• Targeting monetary aggregates, weakly 1970s (Burns, Miller)
• New Fed operating procedures, Oct. 1979 – Oct. 1982 (Volcker)
– De-emphasis of federal funds rate
• De-emphasis of monetary aggregates , Oct. 1982 – early 1990s
– Borrowed reserves target
• Federal funds targeting again: Early 1990s – (Greenspan)
– Preemptive strikes against inflation
– Preemptive strikes against economic downturns and financial disruptions
• LTCM/Enron/Subprime meltdown
• International policy coordination…this weekend