Lecture 6.1
The Conduct and Strategy of Monetary Policy (part 1)
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Friedman 1968 The role of monetary policy
Mishkin: Chapter 17
Macfarlane 1998, Monetary policy in the last quarter of the 20th century
These next two lectures examine the goals of monetary policy and consider one of the most important strategies that has been chosen for the conduct of monetary policy: inflation targeting.
Learning Objectives
Understand the thinking that prevailed in central banks before the widespread adoption of inflation targets
Define and recognize the importance of a nominal anchor
Identify potential goals that monetary policymakers may pursue
Understand the reasons for adopting inflation targeting
Identify the key changes made over time to the monetary policy strategy in major central banks
Real and nominal variables
Nominal: Any variable whose scale is proportionate to the general price level.
eg the CPI, nominal GDP, the money supply, the dollar price of an individual good or service, the dollar value of incomes or output
Real: Variables whose scale does not depend on the general price level
eg physical quantities of production, relative prices
In practice, real variables are often measured by adjusting a nominal measure for inflation
eg real wage = nominal wage adjusted for CPI movements
In general, it is the real variables that determine economic well-being
Digression: a thought experiment
Suppose we were to double every nominal magnitude in the economy:
the price of every good and service produced and consumed
the wage/salary of every employee
every government benefit payment
the amount of money in circulation and in every bank account
the size of every fixed monetary obligation (debt)
Classical theory says that in this scenario, there is no reason for any real variable to be affected
Something like this happened in Australia in 1966 with the introduction of decimal currency. All the nominal numbers doubled but the real economy was unaffected
Before inflation targeting (1)
Friedman’s summary of the monetarist position:
In the long run, real and nominal magnitudes in the economy are separately determined
The key objectives of macroeconomic policy are real growth, employment and inflation control
The central bank controls the money supply, and this anchors the other nominal magnitudes (particularly the price level and hence inflation)
Before inflation targeting (2)
In the short-run (while the economy is adjusting) changes in M have temporary effects on real variables
An expansionary monetary policy will cause a rise in prices or an acceleration of inflation
This will provide only a temporary boost to output and employment, but permanently higher inflation
The effect on output and employment lasts only as long as the inflation remains less than fully anticipated (but this may be some time)
Friedman: what monetary policy cannot do
Permanently hold down the level of interest rates
Permanently boost output and employment above levels that would otherwise prevail
“A rising rate of inflation may reduce unemployment, a high rate will not.”
Note: the main problem at that time was too much inflation
Friedman: what monetary policy can do
Avoid being a source of instability
Control inflation
Provide the ‘nominal anchor’ for inflation expectations
Meanwhile, real-economy objectives must be assigned to other policies (eg fiscal, structural)
Evolution of monetary thinking after (1968) was a highly influential summary of the views that came to prevail in central banks in the 70s and 80s
His key strategic propositions continue to guide central bank thinking today
However, that thinking has been modified in some important ways:
M is not the instrument, R is the instrument
In extreme conditions, financial stability may become an overriding central bank objective
Quantities become important again when the zero lower bound is reached
What is inflation targeting?
Key elements are:
a measurable numerical target for inflation
a public commitment to achieving it
These things are often accompanied by some formal delegation of authority to the central bank for achieving the target, an accountability mechanism and a set of decision-making procedures (eg RBA Board meetings)
A simplified decision procedure
Assume that the policy rate will evolve on a path consistent with current market expectations
Based on that assumption and other available information, forecast the key macroeconomic variables over the next 2-3 years
If inflation is forecast to be on a higher trajectory than desired, consider raising the cash rate
Repeat the process in a month’s time, taking into account any new information that becomes available in the meantime
Rationale for inflation targeting
Choice of instrument: unstable money demand
Instability of the monetary aggregates means that the interest rate must be the instrument of monetary policy
But the interest rate cannot itself be the objective (see Friedman)
The inflation target therefore links management of the instrument to the achievable long-run objective
A target helps to anchor expectations
It provides accountability
as the pioneer inflation targeter
BNZ Act came into effect Feb 1990
Part of a wider set of market-based reforms
RBNZ Governor to be the independent decision maker
Policy Targets Agreement with Government set inflation target of 0–2 per cent
Governor could be dismissed for missing the target
Subsequent revisions to the regime have made it less rigid by
raising the target (now 1 – 3 per cent)
‘softening’ the edges (to be achieved on average, rather than continuously)
Other early adopters: Canada and UK
Canada adopted an inflation target in Feb 1991
This was by agreement between the Central Bank Governor and the Finance Minister, not by legislation
The target was 1–3 percent, with a transition path
In the UK, the Bank of England unilaterally adopted a target of 1-4% in Oct 1992 to replace a failed exchange-rate peg
May 1997 the BoE was given independence to set the policy rate and an inflation target of 2.5% formally delegated by the government
Inflation Rates and Inflation Targets for , Canada, and the United Kingdom, 1980–2021
Development of the policy framework in Australia (1)
(Source: Macfarlane, 1998)
In Australia there was no sudden regime change, more a gradual evolution
1945–71: fixed exchange rate
1971-83: gradual increase in exchange rate flexibility
1976-85: monetary targeting (the Friedman influence)
Development of the policy framework in Australia (2)
1983 onwards: floating exchange rate
1985: the “checklist”
1988-93: a ‘period of discretion’
1993-96: increased public emphasis on inflation objective of 2-3 per cent
1996: Statement on the Conduct of Monetary Policy (formal adoption of an inflation target of 2-3%
Statement on the Conduct of Monetary Policy 1996
“In pursuing the goal of medium term price stability the Reserve Bank has adopted the objective of keeping underlying inflation between 2 and 3 per cent, on average, over the cycle.
This formulation allows for the natural short run variation in underlying inflation over the cycle while preserving a clearly identifiable benchmark performance over time.”
Inflation in Australia: before and after the target
Evolution of the Federal Reserve’s Monetary Policy Strategy (1)
The United States pursued its objectives (including low and stable inflation) from the early 1980s until the financial crisis of 2007 – 2009 without using an explicit inflation target.
Like in Australia, the shift from monetary targets to inflation targets was a gradual one
Evolution of the Federal Reserve’s Monetary Policy Strategy (2)
Background:
Federal Reserve began to announce targets for money supply growth in 1975 (again, the Friedman influence).
The ‘Volcker disinflation’ 1979-1982
FR Chairman Greenspan announced in July 1993 that the Fed would not use any monetary aggregates as a guide for conducting monetary policy
Evolution of the Federal Reserve’s Monetary Policy Strategy (3)
In the Greenspan era (ending in 2006), there was no explicit nominal anchor in the form of a publicly stated numerical U.S. inflation goal
Forward looking behavior and periodic “preemptive strikes”
The intention was to prevent inflation from getting restarted
The Federal Reserve’s Strategy since January 2012
The FOMC in January 2012 put out a statement of its longer-run goals and policy strategy in which it made its price-stability goal (which was already guiding policy for many years but had not been quantitatively explicit) more precise by specifying it as a longer-term 2 percent inflation rate.
The Federal Reserve’s Goals-and-Strategy Statement
Reviewed each January since its initial release in January 2012.
Excerpt: “The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. 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.”
An inflation target requires:
a numerical objective for inflation
a public commitment to achieving it
An inflation target provides a strategy for pursuing the classical objectives of monetary policy
while recognizing that the policy instrument is the interest rate, not the money supply
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