Some Remarks on the Theory of Optimal Monetary Policy Marc Giannoni Columbia Business School CEPR, CIRANO, NBER HEC Montréal October 20, 2007

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!

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

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

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

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

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

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

Inflation or Price-Level Targeting? Path of log price level with no shock Quarters  log(P) = 2%

Inflation or Price-Level Targeting? Effect of a cost-push shock (date 0) Quarters Optimal path under IT  log(P) = 2%

Inflation or Price-Level Targeting? Effect of a cost-push shock (date 0) Quarters Optimal path under IT Optimal path under PLT Commitment to bringing P to trend stabilizes prices

Inflation or Price-Level Targeting? Effect of a cost-push shock (date 0) PLT close to optimal Quarters Optimal path under PLT Optimal path under IT Optimal policy

Inflation or Price-Level Targeting? Effect of a demand or productivity shock (date 0) PLT: close to optimal (?) Quarters Optimal path under IT Optimal policy Optimal path under PLT

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

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?....

Inflation: Which series? US quarterly inflation (demeaned)

Assessing state of the economy 1.Intuitive approach –Greenspan: large set of detailed statistics.... (sales of men’s underwear…) 2.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

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

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