1. CENTRAL BANKS AND MONETARY POLICY STRATEGY ( Chap. 14; Chap 17, 434-444…454-457)

2. 2 Principles of Monetary Policy Strategy Pt. I. Why Price Stability? 1. There is no long-run tradeoff between unemployment and inflation. 2. Price stability has important benefits. 3. Inflation is always and everywhere a monetary phenomenon. 4. A strong nominal anchor is the key to producing good monetary policy outcomes. A strong nominal anchor is the key to producing good monetary policy outcomes. Expectations, Policy Credibility, and Transparency 2 Mishkin, Monetary Policy Strategy After the Crisis

3. 1. No Long Run Tradeoff: The Phillips Curve Overall goal of government economic policy is to increase wealth in the economy High Real Economic Growth High Employment Levels Economic Consensus: Central banks cannot directly impact long-run real growth on the basis of decision to produce more (or fewer) bank notes but they can affect real output & employment in the short-run.

4. 4 World Development Indicators Outline

5. 2. Benefits of Price Stability High inflation leads to Increased transactions costs Tax on Cash Holdings Distortions of economic decisions Uncertainty Over-investment in financial sector 5

6. 3. Inflation is Always a Monetary Phenomena Trite at some level. Inflation is growth rate of prices. Prices are measured in money. QED. Relevant Meaning – Monetary authorities own inflation. Central Banks are monetary authorities in modern economies.

7. Policy Framework Fed Objective Humphrey Hawkins Act (1978): Fed instructed by Congress to be “conducting the nation's monetary policy.. in pursuit of maximum employment, stable prices, and moderate long-term interest rates “ ECB Objective “The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.” Japan Objective: Bank of Japan Act Article 2 Currency and monetary control by the Bank of Japan shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy

8. 8 “Thirty years ago, the public's expectations of inflation were not well anchored. With little confidence that the Fed would keep inflation low and stable, the public at that time reacted to the oil price increases by anticipating that inflation would rise still further. A destabilizing wage-price spiral ensued as firms and workers competed to "keep up" with inflation. … The episode highlights the crucial importance of keeping inflation expectations low and stable, which can be done only if inflation itself is low and stable.” Bernanke, 2006 4. A strong nominal anchor The Wage Price Spiral Expectations, Policy Credibility, and Transparency 8

9. 9 The importance of the nominal anchor. If workers expect high inflation they will demand high wage growth. But if firms experience growth in labor costs, they will price in high inflation. A self-fulfilling prophecy! Only if central bank displays a strong commitment to low and stable inflation, will expectations be anchored toward low and stable inflation. Expectations, Policy Credibility, and Transparency 9

10. Quantitative Anchors Monetary Targets – Growth in monetary aggregates Exchange Rate Targets Inflation Targets 10 Fatas, Mihov, and Rose (2006) find that countries with explicit targets have less inflation. They find that meeting pre-announced numerical targets leads to an improvement in macroeconomic outcomes; this matters more than the nature of the regime

11. 11 What is Inflation Targeting? An increasingly popular choice of monetary policy framework first adopted in New Zealand in 1989. Many inflation targeting countries have successfully lowered inflation and inflation expectations. WEO (2005) presents an optimistic view. Gürkaynak, Levin, and Swanson (2006) show long- term inflation expectations are more stable under inflation targeting indicating better anchoring.

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13. 13 List of Inflation Targeting Countries Rose, 2006 A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed Rose Outline

14. New IT Italics indicate possible non-FFIT. Reference: IMF Working Paper; Bank of England Handbook; Various central banks.Handbook

15. INFLATION TARGETING

16. Characteristics 1. An explicit central bank mandate to pursue price stability as the primary objective of monetary policy, An explicit central bank mandate to pursue price stability as the primary objective of monetary policy 2. Explicit quantitative targets for inflation; Explicit quantitative targets for inflation 3. Policy actions based on a forward-looking assessment of inflation pressures, taking into account a wide array of information; Policy actions based on a forward-looking assessment of inflation pressures, taking into account a wide array of information 4. Increased transparency of monetary policy strategy and implementation.Increased transparency of monetary policy strategy and implementation. 5. Mechanisms of accountability for performance in achieving the objective; Mechanisms of accountability for performance in achieving the objective; 16 Laxton and Freedman, 2009, Why Inflation Targeting

17. 17 1. Commitment to Price stability as primary goal Central Bank has commitment to achieve low and stable inflation in the short-run and in the long-run “Like most other central banks, the Bank of Korea takes price stability as the most important objective of its monetary policy. The current Bank of Korea Act clearly sets out price stability as the purpose of the Bank of Korea's establishment and stipulates that it should seek to bring about price stability by setting an inflation target in consultation with the government and do its utmost to attain this target. ” BACK

18. Numerical goal subject to change 2. Medium term numerical targets for inflation. Based on Article 6, Clause 1 of the 「 Bank of Korea Act 」, the Bank of Korea sets the mid-term inflation target to be applied for three years in consultation with the government. The inflation target measure during the period from 2013 to 2015 is set at 2.5~3.5%, based on consumer price inflation (year-on-year). 18 Public announcement of specific inflation rate goal (w/ room for error) over specific term or period. BACK

19. 19 3. Policy actions based on a forward-looking assessment of inflation pressures Forward looking operating procedure – monetary instruments operate only with some lag. Targeting medium term inflation means setting today’s policy for tomorrow’s economy. Must inevitably target the forecast. The Bank reduced the Base Rate that had been held at 2.75% a year since November 2012 by 0.25 of a percentage point in May this year against the background in which not only there were large downside risks to growth owing to the slow pace of the world economic recovery,…, but also inflation pressures were expected to stay at a moderate level for some time to come due to the unexpected stability of oil and agricultural product prices. LINK LINK

20. 20 Garcia-Herrero and Remolena, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1457506 http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1457506 Back

21. Inflation Reports Central bank publishes its inflation forecast with probability distributions to indicated degree of uncertainty. 21 BACK

22. 22 4. Transparency 1. Learning about policymakers’ plans can cause shifts in expectations 2. The more unstable are market expectations, the greater will be the instability in macroeconomic performance 3. Keeping agents’ expectations aligned with policymakers’ plans helps avoid big surprises 4. Credible central bank communications has calming impact on agents’ expectations This approach stands in sharp contrast to previous central banking practice.

23. 4 Things for the Central Bank to Communicate About i. Goals and Instruments Fun Fact: Until 1994, U.S. Fed did not reveal policy instrument was Fed Funds Rate ii. Policy Decisions and their Basis Policy Decisions and their Basis Policy Statements & Meeting Minutes iii. Economic Forecasts Economic Forecasts iv. Monetary Policy Outlook Monetary Policy Outlook Specific or suggestive 23

24. 5. Mechanisms of Accountability Under IT, central bank retains instrument independence but must thereby retain responsibility for achieving objectives. Many IT regimes include an accountability mechanism. 24

25. Mechanisms Open Letter to the President To ensure accountability in cases where the BSP fails to achieve the inflation target, the BSP Governor issues an Open Letter to the President outlining the reasons why actual inflation did not fall within the target, along with the steps that will be taken to bring inflation towards the target. Open Letters to the President have been issued on 16 January 2004, 18 January 2005, 25 January 2006, 19 January 2007, 14 January 2008 and 26 January 2009.For 2010, the BSP met the target and no open letter was issued.16 January 2004, 18 January 200525 January 200619 January 200714 January 200826 January 2009 Bank of England HandbookHandbook

26. 26 What measure of Inflation should be used? Headline Consumer Price Index ‘ Core’ versus ‘headline’ CPI Headline CPI ~ Index of All Consumer Goods Core Inflation ~ Index of Consumer Goods less volatile price goods (i.e. food and energy). Tradeoffs ‘core’ more stable and better predictor of future inflation Food and Energy large share of emerging market consumer baskets and hard for public to ignore. Back

27. Targeters and their Targets Bank of England HandbookHandbook

28. 28 Over what horizon should inflation be measured? Usually over a range of 1 year at the shortest to 3 years at the outside. Keeping inflation near target even in the short-run offers greater credibility…if it can be accomplished. Short-term programs often adopted for disinflation. Longer term targets allow the economy more flexibility to adjust to temporary shocks.

29. HorizonCountries Yearly Brazil, Guatemala (End of Year), One-Two Years Canada (6-8 Quarters), Czech Republic (12-18 Months), Ghana (18-24 Months), Two Years Chile (around two years), Israel (within two years), Sweden (normally two years), Thailand (8 quarters) Medium Term Armenia, Australia, Colombia, Hungary, Indonesia, Mexico, New Zealand, Norway, Philippines (2012-2014), Poland, Romania, Serbia, Iceland (on average), Peru (at all times), UK (at all times), South Africa (on a continuous basis). Three Years South Korea, Turkey (Multi year) 29 Bank of England HandbookHandbook

30. Korea Adopts Inflation Targeting in 1998

31. IT Lite Some central banks will use inflation as a nominal anchor, even announcing numerical goal for inflation without adopting full-fledged inflation targeting (FFIT defining targets, ranges, horizons, accountability mechanisms). Ex. U.S. Federal Reserve Monetary Policy Strategy The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. FOMC Monetary Policy Strategy & Longer Run Goals How much credibility will this build.