1. Copyright  2011 Pearson Canada Inc. 18 - 1 Chapter 18 What Should Central Banks Do? Monetary Policy Goals, Strategy and Tactics

2. Copyright  2011 Pearson Canada Inc. 18 - 2 Monetary Targeting Strategy Central bank announces it will achieve a certain value (the target) of the annual growth rate of a monetary aggregate. Central bank then is accountable for hitting the target Monetary targeting was adopted by several countries: Germany, Switzerland, Canada, the U.K., Japan and the U.S.

3. Copyright  2011 Pearson Canada Inc. 18 - 3 Monetary Targeting Flexible, transparent, accountable Advantages –Almost immediate signals help fix inflation expectations and produce less inflation –Almost immediate accountability Disadvantages –Must be a strong and reliable relationship between the goal variable and the targeted monetary aggregate

4. Copyright  2011 Pearson Canada Inc. 18 - 4 Inflation Targeting Public announcement of medium-term numerical target for inflation Institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal Information-inclusive approach in which many variables are used in making decisions Increased transparency of the strategy Increased accountability of the central bank

5. Copyright  2011 Pearson Canada Inc. 18 - 5 Inflation Targeting in New Zealand Reserve Bank of New Zealand Act 1989 Minster of Finance and Governor of Reserve Bank to make Policy Targets Agreement Governor of the Reserve Bank was held accountable for the success of monetary policy. Inflation brought down from above 5% to below 2% by the end of 1992 Since 1992 NZ growth rate has been high and unemployment declined significantly

6. Copyright  2011 Pearson Canada Inc. 18 - 6 Inflation Targeting In Canada In 1991, the Minister of Finance and the Governor of the Bank of Canada established formal inflation targets The target range was 2-4% by the end of 1992, 1.5-3% by June 1994 and 1-3% by December 1996 After a new government took office in 1993, the target was set at 1-3% and has been kept at this level ever since Canadian inflation has fallen dramatically since the adoption of targets, falling from 5% in 1991, to zero in 1995 and between 1-2% in the late 1990’s

7. Copyright  2011 Pearson Canada Inc. 18 - 7 Inflation Targeting in the U.K. Adopted inflation target as nominal anchor in October 1992 Inflation target was initially set at 1-4% May 1997 inflation target set at 2.5% and Bank of England was given power to set interest rates (provided independence) December 2003, target was changed to 2%. Growth in U.K. economy has been strong leading to reduction in the unemployment rate

8. Copyright  2011 Pearson Canada Inc. 18 - 8 Inflation Rates and Inflation Targets Figure 18-1(a)

9. Copyright  2011 Pearson Canada Inc. 18 - 9 Inflation Rates and Inflation Targets Figure 18-1(b)

10. Copyright  2011 Pearson Canada Inc. 18 - 10 Inflation Rates and Inflation Targets Figure 18-1(c)

11. Copyright  2011 Pearson Canada Inc. 18 - 11 Inflation Targeting Advantages –Does not rely on one variable to achieve target –Easily understood –Reduces potential of falling in time-inconsistency trap –Stresses transparency and accountability Disadvantages –Delayed signaling –Too much rigidity –Potential for increased output fluctuations –Low economic growth

12. Copyright  2011 Pearson Canada Inc. 18 - 12 Monetary Implicit Nominal Anchor U.S. does not use explicit nominal anchor. Involves forward looking behaviour, careful monitoring for signs of future inflation coupled with periodic “pre-emptive strikes” by monetary policy against threat of inflation Monetary policy has long lags Cannot wait to respond until inflation has begun. Needs to be forward-looking and pre-emptive

13. Copyright  2011 Pearson Canada Inc. 18 - 13 Advantages and Disadvantages to the U.S Approach Does not rely on a stable money-inflation relationship Discourages overly expansionary monetary policy Lack of transparency Uncertainty leads to unnecessary volatility in financial markets, doubt among producers/general public Strong dependence on the preferences, skills and trustworthiness of the central bank staff

14. Copyright  2011 Pearson Canada Inc. 18 - 14 Summary of Advantages and Disadvantages of Different Monetary Policy Strategies

15. Copyright  2011 Pearson Canada Inc. 18 - 15 Tactics: Choosing the Policy Instrument Tools –Open market operation –Government deposit shifting –Last resort lending –Overnight interest rate Policy instrument (operating instrument) –Reserve aggregates –Interest rates –May be linked to an intermediate target Interest-rate and aggregate targets are incompatible

16. Copyright  2011 Pearson Canada Inc. 18 - 16 Linkages Between Central Bank Tools, Policy Instruments, Intermediate Targets and Goals

17. Copyright  2011 Pearson Canada Inc. 18 - 17 The Price Stability Goal Low and stable inflation Inflation –Creates uncertainty and difficulty in planning for future –Lowers economic growth –Strains social fabric Nominal anchor Time-inconsistency problem

18. Copyright  2011 Pearson Canada Inc. 18 - 18 Result of Targeting Non-borrowed Reserves

19. Copyright  2011 Pearson Canada Inc. 18 - 19 Result of Targeting Overnight Funds

20. Copyright  2011 Pearson Canada Inc. 18 - 20 Criteria for Choosing the Policy Instrument Observability and Measurability Controllability Predictable effect on Goals

21. Copyright  2011 Pearson Canada Inc. 18 - 21 The Taylor Rule, NAIRU, and the Phillips Curve Overnight interest rate = inflation rate + equilibrium overnight rate + ½ (inflation gap) + ½ (output gap) An inflation gap and an output gap –Stabilizing real output is an important concern –Output gap is an indicator of future inflation as shown by Phillips curve NAIRU –Rate of unemployment at which there is no tendency for inflation to change

22. Copyright  2011 Pearson Canada Inc. 18 - 22 Taylor Rule and the Overnight Interest Rate

23. Copyright  2011 Pearson Canada Inc. 18 - 23 Central Bank’s Response to Asset-Price Bubbles Two Types of Asset-Price Bubbles –Credit-Driven Bubbles –Bubbles Driven by Irrational Exuberance Central Banks Response to Bubbles Monetary Policy and Asset-Price Bubbles Other Appropriate Policy Responses –Macroprudential regulation

24. Copyright  2011 Pearson Canada Inc. 18 - 24 Bank of Canada Historical Perspective: The Early Years Bretton Wood (1945-1970s) 1971 flexible exchange rate with the U.S Expansionary MP in 1970s lead to high inflation Rise of monetarism CB adopted key monetary aggregates as intermediate targets of monetary policy

25. Copyright  2011 Pearson Canada Inc. 18 - 25 Interest Rates - Canada and U.S., 1941-2009

26. Copyright  2011 Pearson Canada Inc. 18 - 26 Monetary Targeting, 1975-1981 Rising inflation lead Bank of Canada to control M1 growth Announce 1 year in advance the target a path for growth of M1 Attempted to influence expectations to reduce inflation more quickly Nominal exchange rate depreciated Nov. 1982 – monetary policy was abandoned

27. Copyright  2011 Pearson Canada Inc. 18 - 27 Inflation Targeting, 1989 – Present, II In 1991, the Minister of Finance and the Governor jointly announce series of declining inflation targets Bank uses the rate of change in the CPI as its inflation target Core inflation (excludes volatile components) useful in determining trend inflation is on track for medium term Move to targeting directly rather than intermediate variable represent a shift in policy Uses overnight interest rate as the operating target

28. Copyright  2011 Pearson Canada Inc. 18 - 28 Inflation Targeting, 1989 – Present, III During 1960s and 1970s the Bank’s operation characterized by instrument and goal opaqueness Explicit inflation-control target, fixed action dates have moved Bank towards openness and accountability

29. Copyright  2011 Pearson Canada Inc. 18 - 29 Pre-emptive Strikes by the Bank of Canada Financial crisis in August 2007 Bank of Canada easy policy stance Cut overnight interest rate by 25 basis points in December of 2007 Continued easing of monetary policy resulted in overnight funds rate of 0.25% in April 2009 Large injections in liquidity into credit markets

30. Copyright  2011 Pearson Canada Inc. 18 - 30 International Considerations Growing interdependence of national economies –Globalization Requires international cooperation (policy coordination)