1. Chapter 19 The Conduct of Monetary Policy: Strategy and Tactics Better Title: The Conduct of Monetary Policy: Goals and Strategies

2. Preview Examine the goals of monetary policy and then strategies. Look at one of the important strategies for the conduct of monetary policy - inflation targeting

3. Two Primary Goals of Monetary Policy (1) Price stability (low stable inflation) Concept - Nominal Anchor –This is a nominal variable such as the money supply or the inflation rate that policy makers target to achieve price stability. –The idea is to “anchor” inflationary expectations Some countries have explicit inflation targets. –Explicit Nominal Anchor. The Fed only recently has stated its target is 2% inflation, but this is not a written policy. –An Implicit Nominal Anchor.

4. Two Primary Goals of Monetary Policy (2)Low Unemployment (high stable growth) Monetary policy can not permanently affect the real level of economic activity so the Fed does not have a stated unemployment target. However, legislation states Fed must promote full employment along with stable prices –Dual mandate

5. Should Price Stability Be the Primary Goal of Monetary Policy? Hierarchical Versus Dual Mandates: –Hierarchical mandates put the goal of price stability first, and then say that as long as it is achieved other goals can be pursued –Dual mandates are aimed to achieve two coequal objectives: price stability and maximum employment (output stability)

6. Rules Versus Discretion Should the central bank have policy discretion regarding goals or be tied to a rule? –Debated for a long time. Examples of a Fixed Rule: A rule that states the FOMC must target a stated rate of growth in the money supply or target an explicit rate of inflation. The Fed has Discretion –Dual mandate gives a lot of discretion

7. The Concern About Discretionary Policy: Time Inconsistency Problem Policy makers can change their goal Definition: A scenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement Destroys policymakers’ credibility, thereby reducing effectiveness of their policies

8. The Time-Inconsistency Problem Example: To reduce expected inflation, the central bank announces it will tighten monetary policy and increase interest rates but faced with high unemployment, they may relent cuts interest rates.

9. The Time-Inconsistency Problem In general, rational agents (you and me) understand the incentive for the policymaker to renege, and this expectation affects their behavior. The solution: –take away the policymaker's discretion –replace with a credible commitment to a fixed policy rule. For example, an explicit inflation target which around 27 countries have adopted.

10. Linking Central Bank Tools to Goals Central Bank Tools –Open Market Operations (OMO), Discount Loans, Reserve Req., Interest on Reserves (IOR/IOER) Policy Instruments –Federal Funds Rate or Monetary base Intermediate targets –ST and LT interest rates; Monetary Aggregates (M1, M2) Goals: –Low Inflation, growth and low unemployment, stable interest rates

11. Linking Central Bank Tools to Goals Open Market Operations Discount Policy Reserve Requirements Interest on Reserves Large-scale Asset Purchases Forward Guidance Tools of the Central Bank Policy Instruments Intermediate Targets Goals Monetary Aggregates (M1, M2) Interest rates (short-term and long-term) Price Stability High Employment Economic Growth Financial Market Stability Interest-Rate Stability Foreign Exchange Market Stability Reserve Aggregates (reserves, nonborrowed reserves, monetary base, nonborrowed base) Interest rates (short-term such as federal funds rates)

12. Linking Central Bank Tools to Goals Open Market Operations Discount Policy Reserve Requirements Interest on Reserves Large-scale Asset Purchases Forward Guidance Tools of the Central Bank Policy Instruments Intermediate Targets Goals Monetary Aggregates (M1, M2) Interest rates (short-term and long-term) Price Stability High Employment Economic Growth Financial Market Stability Interest-Rate Stability Foreign Exchange Market Stability Reserve Aggregates (reserves, nonborrowed reserves, monetary base, nonborrowed base) Interest rates (short-term such as federal funds rates) From the previous chapter we know the Fed can use its tools to control the monetary base and the federal funds rate. But, what about “Link 1” and “Link 2” ? Can the Fed control the money supply, market interest rates, inflation and growth? Link #1Link #2

13. How to choose a Policy Instrument Observability and Measurability Controllability Predictable effect on Goals Over time, central bankers have adopted short-term interest rates as the preferred instrument of monetary policy used to stabilize short-term fluctuations in prices and output

14. A rightward or leftward shift in the demand curve for reserves … Quantity of Reserves, R Federal Funds Rate RsRs NBR * leads to fluctuations in the federal funds rate between Rd*Rd* R d′′ R d′ Instrument Conflict: Result of Targeting Non- borrowed Reserves. The Federal Funds Rate must be allowed to fluctuate

15. Federal Funds Rates Target, idid i er Federal Funds Rate Quantity of Reserves, R Step 1. A rightward or leftward shift in the demand curve for reserves… Step 2. lead the central bank to shift the supply curve of reserves so that the federal rate does not change… Step 3. with the result that non-borrowed reserves fluctuate between NBR′ ff and NBR′′ ff. Instrument Conflict – Result of Targeting the Federal Funds Rate. Reserves and the money supply must be allowed to fluctuate

16. A little “instrument” history: Monetary Targeting Used in the 1970’s and the 80’s by a number of central banks – US, UK, Germany, Canada… Methodology: Central bank announces that it will target a certain rate of growth in a monetary aggregate such as the MB or the money supply For example, 5 percent annual growth in M1

17. Monetary Targeting The Fed began to announce targets for money supply growth in 1975. Not very successful The Fed found that it lost control of the money supply because of financial innovation Substitutes for M1 such as MMMF 1+(C/D) Also: M1=  MB r D + (ER/D) + (C/D)

18. Monetary Targeting Advantages –Money supply is easily observed Disadvantages –Requires a strong Link No. 1 –Requires a strong Link No. 2. stable relationship between the money supply and the goal variable (inflation or nominal income) –This relationship has been shown to be weak. Velocity of money is not stable Greenspan announced in July 1993 that the Fed would not use monetary aggregates as a guide for conducting monetary policy. Change to target the Federal Fund rate.

19. Policy Strategies: Inflation Targeting Given the breakdown in the relationship between monetary aggregates and goal variables, a number of countries adopted inflation targeting as their policy strategy. New Zealand, Canada and the UK have explicit inflation targets - around 27 countries in total. –Bank of Canada Governor Gerry Bouey, who reputedly remarked that "we didn't abandon monetary aggregates, they abandoned us". With inflation targeting, the central bank bypasses intermediate targets and focuses on the final objective. Link #3 in the next slide.

20. Policy Strategies: Inflation Targeting Link #1Link #2 Link #3 The Policy Instrument is linked to a single goal.

21. Inflation Targeting New Zealand (1990) –Part of central bank reform in 1990 –Sole objective is price stability with an explicit target–range. –Inflation was brought down and remained within the target range most of the time. –Governor of the central bank is accountable and can be dismissed. Canada (1991) –Explicit target range. –Inflation brought down, some costs in term of unemployment United Kingdom (1992) –Part of central bank reform in 1992 –Explicit Target

22. Central Bank Web Pages http://www.rbnz.govt.nz/ –Click on Monetary Policy http://bankofcanada.ca/en/index.html –Click on Monetary Policy http://www.bankofengland.co.uk/ –Click on Monetary Policy Framework

23. Inflation Targeting – How does it work? Commitment to price stability as the primary long- run goal of monetary policy and a commitment to achieve the inflation goal Communication with public to increase transparency of the strategy –Public announcement of a numerical inflation target –Can not renege. Increased accountability of the central bank

24. Inflation Targeting - Intent Keep inflation low Anchor inflation expectations - π e This will anchor long-term interest rates to promote growth. i = r + π e Follows a hierarchical mandate: inflation first, everything else second. Remember: Fed has a dual mandate. Has shied away from adopting inflation targeting.

25. –A “policy framework”, not a rule A policy rule is inflexible – requires an automatic policy response regardless of the current economic situation. Pure discretionary (or, unconstrained) policy reacts only to current developments and has no regard for long-run goals. Inflation targeting is meant to be constrained discretion “By imposing a conceptual structure and its inherent discipline on the central bank, but without eliminating all flexibility, inflation targeting combines some of the advantages traditionally ascribed to rules with those ascribed to discretion.” Bernanke, et. al. (1999). Inflation Targeting in Practice

26. Inflation Targeting - Advantages Stable relationship between money supply and inflation is not needed. Easily understood. Focus is long term inflation goal. Reduces potential of over expansion in money supply to pursue political goals. Stresses transparency and accountability

27. Inflation Targeting - Disadvantages “Delayed signaling” –Effects of change in policy on inflation only revealed after long lags (12 to 24 months) Some economist argue too much rigidity –However, in practice there is policy discretion, target is within a range. Potential for increased output fluctuations. –For example, with a sole focus on inflation, monetary policy may be too tight if π > target, leading to greater fluctuations in output.

28. Inflation Rates and Inflation Targets for New Zealand, Canada, and the United Kingdom, 1980–2008

29. US. Inflation - Without Explicit Inflation Target