Lecture 16: Monetary policy conduct

Taylor principle

1% increase in inflation rate -> > 1% increase in FFR target

Clean debate

Cleaning up: CB should just clean up after the bubble burst - Hard to identify bubbles - Localized bubbles vs efficacy of aggregate MP (Blunt instrument) to pop - Usually not so costly to clean up if policymakers respond in timely fashion

The nominal anchor

- A nominal variable (e.g inflation rate or money supply) that ties down the price level to achieve price stability. - Promotes low and stable inflation expectations -> promotes price stability Also limits time-inconsistency problem (the urge to pursue a discretionary, more expansionary policy with short-term gains but possible poor long-term outcomes)

Inflation targeting

- Public announcement of medium-term numerical inflation target - Institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation - Information-inclusive approach in which many variables are used in making decisions about MP - Increased transparency of the strategy - Increased acountability of the central bank for attaining inflation objectives.

Cons of inflation targeting

- delayed signaling, long lags in monetary policy effects - too much rigidity (esp short run) - potential for increased output fluctuations - low econ growth in the disinflation stage ( if adopted during high-inflation period)

Lessons for monetary policy strategy from the GFC

- never underestimate financial sector's impacts on econ activity - Zero lower bound (ZLB) can be a serious problem - Costly cleaning up of a fin crisis - Price and output stability don't ensure financial stability. ZLB problem: level of the target? iS 2% TOO LOW? at ZLB, the real interest rate is -2% But higher inflation is costly and difficult to stabilize. Financial instability -> flexibility of the target - Flexible target -> short run deviation allowed -> price stability + short-run output stability (Fed's choice since 2020) - But doesn't ensure financial stability, may need to rethink monetary policy

Pros of inflation targeting

- reduction of time-inconsistency trap - easily understood and more transparent - stresses accountability along with transparency and communication - countries with inflation targeting have had low rates of inflation and inflation expectations

Strong argument for: bubbles driven by irrational exuberance? credit-driven bubbles

1) let them be 2) prick (Easier to identify credit booms, more dangerous and difficult to clean up) - key: In general, design regulation and supervision + monetary policy to prevent credit booms

ex: given inflation = 3, long run eqm FFR = 2, inflation gap =1, real output gap = 0, FFR target?

5.5%

Tatics: choosing the policy instrument

Conventional: open market ops, reserve, requirement, discount rate, interest on reserves, etc. Nonconventional: forward guidance, asset purchases, term funding facilities, etc.

Inflation targeting countries

Early adopters: - New zealand (effective in 1990) -- inflation: down and mostly remained within the target -- growth: generally high -- Unemployment: a sharp rise at first, has gone down significant since Canada (1991): - Inflation: down; also had cost of unemployment in first few years United Kingdom (1992): - Inflation: close to its target (note: inflation had already been falling when targeting started) - Growth: strong growth and reduced unemployment

Stance of MP

Easy (interest rate increases, expansionary) vs tight (interest rate decreases, contractionary) Knowing the tools does NOT tell us about the policy stance -> observable policy instruments show the stance

Taylor rule - to choose target short term interest rate such as the FFR

FFR target = inflation rate + long run eqm real FFR + 0.5 (inflation gap) + 0.5(real output gap) inflation gap = inflation rate - inflation target real output gap (in %) ~ log(real GDP) - log(real potential GDP) - serves as a guideline do not mechanically follow policy rules

Other goals of monetary policy

Five other goals are continually mentioned by central bank officials when they discuss the objectives of monetary policy: -High employment and output stability -Economic growth -Stability of financial markets -Interest-rate stability -Stability in foreign exchange markets Problem: short run conflicts between these and price stability

Should central banks try to stop asset-price bubbles? Lean vs Clean debate

Lean against: central banks should try to pop or slow the growth of bubbles Dangerous crises that can be hard to clean up

How might central banks try to stop bubbles

Monetary policy: - "Risk-taking channel of monetary policy" or "search for higher yields" - Idea: low interest rates -> more risk-taking - Lesson from GFC: central banks and other regulators should not have a laissez-faire attitude and let credit-driven bubbles proceed. --- shouldn't stand back and let everything happen, take actions

Price stability goal

PS: low and stable inflation - All central banks share this monetary policy goal - Increasingly viewed as the most important goal

Should price stability be the primary goal of monetary policy?

Price stability should be the primary, long-run goal of monetary policy -> should not be the only primary short-run goal -> either type of mandate is acceptable Hierachical vs dual mandates - Hierachical mandate - goal of price stability first, if achieved other goals can be pursued - ecb, boe, bank of can, PBC, reserve bank of new zealand, etc.) - Dual mandate: 2 or more objs: price stability and other goals (e.g. maximum employment) - For the Fed "promoting maximum employment, stable prices, and moderate long-term interest rates"

Macroprudential regulation

Regulatory policy on credit markets and financial system overall (as opposed to microprudential regulation) - Ex: disclosure and capital requirements, monitoring of institutions' risk management - Lobbying against macroprudential policy and financial institutions looking for loopholes -> macroprudential supervision along may not be enough, may need monetary policy as well.

Why are large and rapid changes in prices a problem?

Symptomatic of deeper woes (eg. umemployment) - Impacts purchasing power and icnreases uncertainty about saving and investment decisions - Create need to frequently rewrite contracts/ menus/ catalogues etc.

Should central banks try to stop asset-price bubbles?

asset price bubbles: pronounced growth in asset prices >> fundamental values will eventually burst - Credit-driven bubbles: form during credit boom, very dangerous - subprime fin crisis - Bubbles by irrational exurberance (overly optimistic expectations) less harmful - tech stock bubbles in late 1990s

Stronger advocate for inflation targeting and Fed transaprency

during Ben Bernanke in 2006 - Still, only had a weak, implicit form of inflation targeting until FOMC finally moved to inflation targeting in 2012. - Since 2012, the target was set and remained at 2% -> FYI: the Fed updated its interpretation of the 2% target in 2020. - Notably, acknowledged inflation maybe allowed to rise above 2% after periods when inflation was frequently below 2%

Workflow of monetary policy

goals: dual mandates (max employment, low and stable inflation), monetary policy (target for the fed fund rate, communications), transmission channels (overal financial condition: i, asset prices, exchange rates, exp of households and busi), effect (spur or restrain growth in overall demand for goods and services)

Historical examples of nominal achors

gold standard, fixed exchange rate, money supply targeting - US from mid-1980s to early 2000s: no explicit nominal anchor (like inflation target) -- excellent macroeconomic performance (including low and stable inflation) until GFC or GR - "Just do it" policy strategy: had some key elements of inflation targeting but less transparency and accountability - Greenspan opposed adoption of inflation target: 07/1993 announcement that Fed would not use any Monetary Aggregates (M1 or M2) as a guide for conducting monetary policy

central banks now generally use what policy?

observability and measurability, controllability, predictable effect on goals - not entirely clear, most central banks concludes that interst rates link strongly to goals -> short term interst rate as policy instrumnet

Policy instruments

operating instrument: variable that directly responds to central bank's tools and indicate stance of MP - Reserve aggregates (R, BR, NBR, MB) or interest rates (eg. FFR) - maybe linked to an immediate target (M1, M2,or a long-term interest rate) - Interest rate and aggregate targets are usually incompatible (must choose one or the other) - bc of market for reserves