Some Remarks on the Theory of Optimal Monetary Policy

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Some Remarks on the Theory of Optimal Monetary
Policy

• Marc Giannoni
• Columbia Business School
• CEPR, CIRANO, NBER
• HEC Montréal
• October 20, 2007

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Background Fascinating developments over last
15 years

• Practice
• Early 1990s introduction of inflation targeting
  (IT) in several countries (NZ, Canada, Sweden,
  UK)
• Wonderful results Inflation at low, stable
  levels inflation expectations well anchored,
  economic activity fairly stable
• Macroeconomic Theory
• Early 1990s little role for monetary policy
• Principles for conduct monetary policy based on
  IT (Bernanke, Laubach, Mishkin, Posen, 1999)
• Mid-1990s
• DSGE models usable for monetary policy analysis
  (Goodfriend-King, Rotemberg-Woodford,
  Clarida-Gali-Gertler, Svensson)
• Optimal monetary policy expressed as flexible
  inflation target
• Progress on analysis of model uncertainty
• Practice and Theory meet again!

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IT in practice

• Set instrument (interest rate) so as to achieve
  long-term constant inflation target (e.g. 2)
• Flexibility in short-term (flexible-IT)
• Extensive explanation to public (monetary policy
  reports)
• Transparency of decision process, objectives
• But typically, forecasts of monetary policy
  instrument not announced

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Optimal IT in theory(Svensson, Giannoni-Woodford)

• Macroeconomic model (DSGE, estimated)
• Used to compute optimal path of all variables of
  interest (inflation, output gap, interest
  rates...)
• Implementation inflation forecast targeting
  (IFT)
• Fixed long-run inflation target
• But in short term, CB commits to adjust
  instrument (interest rate) as required for a
  projection of future path of economy (inflation,
  output gap) to satisfy a target criterion
• Target criterion specifies optimal short-term
  deviations form long-run inflation target
• Can be robust to model misspecifications
• e.g. Norges Bank

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Optimal IT in theory (2)(Svensson,
Giannoni-Woodford)

• CB commits to publish projections and explain
  policy decisions
• May include interest-rate projections entire
  path of expected short-term interest rates
  matters
• Helps manage expectations
• E.g. RBNZ, Norges Bank, Riksbank
• Possible that limits on transparency are desirable

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Advantages of IFT

• Transparency (of monetary policy goals,
  decisions)
• Anchor medium-term inflation expectations
• Optimal short-run responses to shocks
• Can be robust to nature of disturbances

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Features of optimal IT criterion

• Target for adjusted inflation projection
  (flexible IT)
• output gap also matter (includes all of CB's
  stabilization goals)
• Optimal target value should vary over time
  (history-dependent)
• even though long-term inflation pinned down at a
  constant level
• helps for expectations management
• Use all available information about current state
  of the economy to make projections (may include
  judgment)
• Not a mechanical reaction function

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Features of optimal IT criterion (2)

• Projections under forecasted future policy
• not constant interest rate or market
  expectations
• Forecasts at relatively short horizons
• horizons at which CB actions begin to affect
  target variables

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Inflation or Price-Level Targeting?

• Path of log price level with no shock

Dlog(P) 2
Quarters
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Inflation or Price-Level Targeting?

• Effect of a cost-push shock (date 0)

Dlog(P) 2
Optimal path under IT
Dlog(P) 2
Quarters
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Inflation or Price-Level Targeting?

• Effect of a cost-push shock (date 0)

Optimal path under IT
Optimal path under PLT Commitment to bringing P
to trend stabilizes prices
Quarters
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Inflation or Price-Level Targeting?

• Effect of a cost-push shock (date 0)
• PLT close to optimal

Optimal path under IT
Optimal policy
Optimal path under PLT
Quarters
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Inflation or Price-Level Targeting?

• Effect of a demand or productivity shock (date 0)
• PLT close to optimal (?)

Optimal path under IT
Optimal path under PLT
Optimal policy
Quarters
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Inflation or Price-Level Targeting?

• IT bygones are bygones
• PLT
• Commitment to bringing prices to target limits
  incentive to raise prices too much
• Error correction ? desirable given model
  misspecification
• Optimal policy desirability of history
  dependence
• Effective management of expectations
• Not exactly PLT, but close

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Forecasts Key for implementation of IFT

• Need to be reliable
• But Assessing the economy's true state remains a
  formidable challenge(Bernanke, 10/19/07)
• productivity?
• potential output?
• inflation?....

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Inflation Which series?
US quarterly inflation (demeaned)
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Assessing state of the economy

• Intuitive approach
• Greenspan large set of detailed statistics....
  (sales of mens underwear)
• Complement Formal statistical analysis
• Exploiting systematically information from in
  data-rich environments (Stock-Watson,
  Bernanke-Boivin-Eliasz, Reichlin et al.,
  Boivin-Giannoni)
• Can be combined in fully consistent way with
  theoretical models
• Successful for forecasting, estimating state of
  the economy

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Estimated Inflation in US Close to core PCE
US quarterly inflation (demeaned)
Data GDP deflator
Inflation estimated using large data set
Source Boivin-Giannoni (2006)
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Conclusion

• Great progress has been achieved in
• Conduct of monetary policy
• Monetary theory
• Estimation of models
• It is now possible to
• Estimate accurately state of economy using large
  information sets
• Use estimated models as effective guides for
  conduct of monetary policy
• Some lessons from the theory
• Optimal policy can be implemented by flexible IT
• History dependence desirable ? PLT may be good
  approximation to optimal policy / robust
• Progress on analysis of model uncertainty, but
  more work to be done