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Central Bank Policy What should the Fed do?. The Goals of Monetary Policy Price Stability High Employment Economic Growth Financial Market Stability Interest.

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Presentation on theme: "Central Bank Policy What should the Fed do?. The Goals of Monetary Policy Price Stability High Employment Economic Growth Financial Market Stability Interest."— Presentation transcript:

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 i ff, which is available immediately (though r ff 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: –i ff * = π + r ff * + 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).

23 The Taylor Rule in Practice r ff * = 2%, π * = 2%, α = β = 0.5


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