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Lecture 6.1

The Conduct and Strategy of Monetary Policy (part 2)

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Issues in Inflation targeting

This lecture looks at a range of practical issues involved in the design and implementation of inflation targeting strategies

Learning Objectives
Define and recognize the time consistency problem in monetary policy
Understand the institutional arrangements designed to address this problem
Learn the distinction between different types of policy mandate
Examine a range of practical issues encountered by central banks in managing inflation targeting systems

The time consistency problem
The problem: It may be optimal to plan now to do something that will not be optimal when the time comes to do it. That is, the optimal plan may not be ‘time-consistent’
Example: saving for retirement
it is optimal to plan to save regularly for retirement out of weekly income
however, in any given week, a small amount of extra spending has a negligible effect on your eventual retirement
so the optimal behaviour in each particular week is inconsistent with the optimal lifetime plan
Generic solution: a ‘pre-commitment mechanism’
something that makes you stick to the plan
example: regular salary deductions for retirement

Ulysses and the sirens (from Greek mythology)
The sirens are spirits who sing irresistible songs
They inhabit a channel with dangerous rocks, which Ulysses and his crew must pass through
Their music always lures sailors to their deaths
Ex ante, Ulysses wants to hear the music but also wants to survive

Optimal plan: hear the music and don’t follow the sirens
Problem: this is not time-consistent. Once you hear the music you know you are going to change your mind

Solution: a pre-commitment mechanism

Ulysses orders himself tied to the mast
Ears of crew are blocked with beeswax – they are safe
Crew are ordered not to untie him until they are safely through the channel

Result: Ulysses hears the songs and survives

The time-consistency problem and monetary policy
Rational expectations hypothesis asserts that economic agents will expect central banks to do what is optimal at a given point in time, regardless of what they have said beforehand
In theory, at any given time, it is optimal for central banks to be a bit more expansionary than expected, so as to boost output and employment (Friedman)
But markets know this, so the extra inflation is fully anticipated and there is no gain to output or employment
But you still get the higher inflation
This set of incentives is argued to create an inflationary bias in monetary policy

Bernanke speech on monetary policy strategy
Bernanke’s speech, “Central Bank Independence, Transparency and Accountability,” speech, May 2010 (http://www.federalreserve.gov/newsevents/speech/bernanke20100525a.htm) summarizes many of the key considerations that underlie the formulation of monetary policy strategy.
The following quote refers specifically to the time-consistency problem:

Bernanke speech on monetary policy strategy: excerpt
“A central bank subject to short-term political influences would likely not be credible when it promised low inflation
The public would recognize the risk that monetary policymakers could be pressured to pursue short-run expansionary policies
The public will expect high inflation and, accordingly, demand more-rapid increases in nominal wages and in prices.
Thus, lack of independence of the central bank can lead to higher inflation and inflation expectations in the longer run, with no offsetting benefits in terms of greater output or employment.”

Central Bank Independence
Central bank independence is seen as a solution to the time consistency problem
It provides a pre-commitment mechanism
Goal versus instrument independence:
Government sets the goal
Central Bank sets the instrument
Independence calls for a corresponding degree of accountability
CB has a legal obligation to aim for the target

Aspects of independence and central bank governance
Who is the decision maker: Governor, Board or Monetary Policy Committee?
How are those people appointed?
What is the accountability mechanism: reporting requirement, letter of explanation; dismissal of Governor?
Hard- or soft-edged targets
What is the mandate (charter): see next slide

Two types of policy mandate
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 put two objectives on the same footing: price stability and maximum (sustainable) employment (full employment, or output stability).
Price Stability as the Primary, Long-Run Goal of Monetary Policy
Either type of mandate is workable provided it
operates to make price stability the primary goal in the long run but not the overriding short-run goal.
Australia has the second type of mandate

The RBA mandate
The RBA policy mandate comes from two sources:

Legislation
The Reserve Bank Act, 1959

Memorandum of Understanding (between RBA Governor and Treasury minister)
Statement on the Conduct of Monetary Policy, 1996
This is not new law, but sets out the agreed interpretation of the Act

Reserve Bank Act 1959
The Act separated the central banking functions from the commercial banking functions of the existing Commonwealth Bank. It sets out:

powers: banking, market operations, note issue
governance: the Board of the bank, and relationship to government
objectives: how the powers should be used

The Reserve Bank Act: Objectives
It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to:
(a) the stability of the currency of Australia;
(b) the maintenance of full employment in Australia; and
(c) the economic prosperity and welfare of the people of Australia.

Statement on the Conduct of Monetary Policy
Objectives of Monetary Policy
The framework for the operation of monetary policy is set out in the Reserve Bank Act 1959 which requires the Board to conduct monetary policy in a way that, in the Board’s opinion, will best contribute to the objectives of:

the stability of the currency of Australia;
the maintenance of full employment in Australia; and
the economic prosperity and welfare of the people of Australia.

The first two objectives lead to the third, and ultimate, objective of monetary policy and indeed economic policy as a whole. These objectives allow the Reserve Bank to focus on price (currency) stability while taking account of the implications of monetary policy for activity and, therefore, employment in the short term. Price stability is a crucial precondition for sustained growth in economic activity and employment.

Other Central Bank Charters
RBA has a dual (or multiple) mandate
The Fed has a dual mandate
Other Central Banks have ‘hierarchical’ mandates that put inflation control first
(eg RBNZ (formerly), Bank of Canada, Bank of England and ECB)

Dual Mandate and Inflation Targeting
How different are they in practice?
Although the Federal Reserve’s dual mandate is often contrasted with inflation targeting, in practice it amounts to the same thing
2 percent inflation goal seen as consistent with achieving maximum sustainable employment.
Above-normal unemployment will tend to push inflation below 2 percent.
Inflation-targeting central banks also stress this point.
When full employment and inflation goals are in conflict, this consideration will slow the speed at which policymakers seek to return to the target inflation rate when it is too high.

The level of the target
The exact targets differ slightly from country to country
Why aim higher than zero?
cost/benefit considerations in inflation reduction
downward nominal rigidities
the zero lower bound for interest rates
measurement bias in inflation

Summary: Key elements of flexible inflation targeting
Goal-setting by some combination of government and central bank
Instrument setting (R) by the independent central bank
Publicly stated numerical target for inflation
Accountability mechanism
Flexibility for decision-makers to respond to unforseen events
Arrangements for these things have tended to become more similar across countries over time since the early 1990s

A controversial question: should central banks respond to asset bubbles?
Asset bubble: a sustained rise in the price of an asset class, fuelled by expectations that the price will rise further
Examples: real estate prices, tech-stock bubble
Destabilising impact when the bubble bursts
May be associated with rising leverage (borrowing to buy assets) which increases the risk

The ‘lean vs clean’ debate
Asset bubbles and associated leverage may be encouraged by easy monetary policy (low interest rates)
This is a possible argument for monetary policy to ‘lean against’ a perceived bubble
Bubbles are hard to identify when they are happening
Due to uncertainty of impact, a rise in R might just amplify the downside
Hence it may be more effective to take no action during bubble expansion but use MP to ‘clean up’ the damage after it collapses
This was the Greenspan view during tech bubble (1990s), and tends to be consensus CB view today, though a matter of debate
Other instruments may be available to deal with assets bubbles and leverage (macroprudential policies)

A possible tactical approach: The Taylor Rule
Policy rate = inflation rate + R* + 0.5(inflation gap) + 0.5(output gap)

R* = ‘neutral’ real policy rate
Inflation gap = inflation minus the target rate
Output gap = percentage difference between real output and its full-employment value

Output gap stabilization is a policy goal (the full-employment goal); in addition the output gap matters for future inflation.

The Taylor Rule baseline for the Federal Funds Rate compared with the actual rate, 1970–2020

Evidence suggests that the Tayor rule is a rough approximation of actual policy decisions
Source: Federal Reserve Bank of St. Louis, FRED database: http://research.stlouisfed.org/fred2/.

Some further points on the Taylor rule
It is a stylised description of how central bank decision makers might summarise and respond to information
Not used anywhere as an actual procedural tool
Conceptually, it should be forward looking due to impact lags from monetary policy actions

Decision-making in practice: a simplified decision procedure
Assume that the policy rate will evolve on a path consistent with current market expectations
Based on that assumption, and on 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

Sources of uncertainty facing central banks
Tracking error (forecasting vs ‘nowcasting’)
Recognition lags
Statistical and measurement error
Impact lags
Inherent unpredictability of the economy
Inherent unpredictability of policy impact

RBA forecasts and the range of uncertainty
Feb 2021 SMP

20212019201720152023 85 90 95 100 105 index 85 90 95 100 105 index GDP Forecastscenarios,December2019=100 Baseline Actual Forecasts Upside/ Downside Sources:ABS;RBA

20212019201720152023 4 5 6 7 % 4 5 6 7 % UnemploymentRate Forecastscenarios Forecasts Actual Baseline Upside/ Downside (monthly) Sources:ABS;RBA

20192015201120072023 0 1 2 3 4 % 0 1 2 3 4 % TrimmedMeanInflation Forecastscenarios,year-ended Upside/ Downside Actual Baseline Forecasts Sources:ABS;RBA

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