Central Bank Policy

1
Central Bank Policy

• What should the Fed do?

2
The Goals of Monetary Policy

• Price Stability
• High Employment
• Economic Growth
• Financial Market Stability
• Interest Rate Stability
• Exchange Rate Stability

3
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?)

4
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.

5
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?

6
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.

7
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 Feds policy stance
• Expected inflation rises, which causes wages and
  prices to rise in the long run!

8
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!

9
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 doesnt interfere
  with price stability.
• The ECB has a hierarchical mandate it can
  pursue high levels of employment and economic
  growth as long as it doesnt 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.

10
Hierarchical vs. Dual Mandates

• A hierarchical mandate reinforces the publics
  belief in the central banks 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.

11
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 Banks
  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.

12
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.

13
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
  banks 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?

14
Inflation Targeting in Canada and New Zealand
15
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.

16
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?

17
Reviewing Monetary Policy Strategies
18
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.

19
Using NBR as a Policy Instrument cedes Control
over the Federal Funds Rate
20
Using the Federal Funds Rate as a Policy
Instrument cedes control over NBR
21
Choosing a Policy Instrument

• The Policy Instrument should be Observable and
  Measurable
• Quick observation and measurement are necessary
  to signal the central banks 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?

22
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 p rff a(p-p) ß(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).

23
The Taylor Rule in Practicerff 2, p 2, a
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