The Conduct of Monetary

Policy: Strategy and Tactics

Financial Markets
Week 14

Copyright © 2019 Pearson Education, Ltd.

Preview

• This chapter examines the goals of monetary

policy and then considers one of the most
important strategies for the conduct of monetary
policy, inflation targeting
Learning Objectives [1 of 2]

• Define and recognize the importance of a nominal anchor.

• Identify the six potential goals that monetary policy
makers may pursue.
• Summarize the distinctions between hierarchical and dual
mandates.
• Compare and contrast the advantages and disadvantages
of inflation targeting.
• Identify the key changes made over time to the Federal
Reserve monetary policy strategy.
Learning Objectives [2 of 2]

• List the four lessons learned from the global financial

crisis and discuss what they mean to inflation targeting.
• Summarize the arguments for and against central bank
policy response to asset-price bubbles.
• Describe and assess the four criteria for choosing a policy
instrument.
• Interpret and assess the performance of the Taylor rule as
a hypothetical policy instrument for setting the federal
funds rate.
The Price Stability Goal and the Nominal
Anchor

• Over the past few decades, policy makers throughout the

world have become increasingly aware of the social and
economic costs of inflation and more concerned with
maintaining a stable price level as a goal of economic
policy.

• The role of a nominal anchor: a nominal variable, such as

the inflation rate or the money supply, which ties down
the price level to achieve price stability

• The time-inconsistency problem

Other Goals of Monetary Policy

• Five other goals are continually mentioned by central

bank officials when they discuss the objectives of
monetary policy:

1. High employment and output stability

2. Economic growth
3. Stability of financial markets
4. Interest-rate stability
5. Stability in foreign exchange markets
Should Price Stability Be the Primary Goal of
Monetary Policy?

• 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 are aimed to achieve two coequal
objectives: price stability and maximum employment
(output stability)

• Price Stability as the Primary, Long-Run Goal of Monetary

Policy
– Either type of mandate is acceptable as long as it
operates to make price stability the primary goal in the
long run but not the short run.
Inflation Targeting (1 of 3)

• 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
Inflation Targeting (2 of 3)

• New Zealand (effective in 1990)

– Inflation was brought down and remained within the target
most of the time.
– Growth has generally been high, and unemployment has come
down significantly.
• Canada (1991)
– Inflation decreased since 1991; some costs in term of
unemployment
• United Kingdom (1992)
– Inflation has been close to its target.
– Growth has been strong, and unemployment has been
decreasing.
Figure 1 Inflation Rates and Inflation Targets for New
Zealand, Canada, and the United Kingdom, 1980–2017
Inflation Targeting (3 of 3)

• 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 during disinflation
The Evolution of the Federal Reserve’s
Monetary Policy Strategy (1 of 2)

• The United States has achieved excellent macroeconomic

performance (including low and stable inflation) until the
onset of the global financial crisis without using an
explicit nominal anchor such as an inflation target.

• History:
– Fed began to announce publicly targets for money supply
growth in 1975
– Paul Volker (1979) focused more in nonborrowed reserves
– Greenspan announced in July 1993 that the Fed would not use
any monetary aggregates as a guide for conducting monetary
policy
The Evolution of the Federal Reserve’s
Monetary Policy Strategy (2 of 2)

• There is no explicit nominal anchor in the form of an

overriding concern for the Fed.
• Forward looking behavior and periodic “preemptive
strikes”
• The goal is to prevent inflation from getting started.
• Advantages
– Uses many sources of information
– Demonstrated success
• Disadvantages
– Lack of accountability
– Inconsistent with democratic principles
The Fed’s “Just Do It” Monetary Policy
Strategy

• Advantages of the Fed’s “Just Do It” Approach:

– forward-looking behavior and stress on price stability also help
to discourage overly expansionary monetary policy, thereby
ameliorating the time-inconsistency problem

• Disadvantages of the Fed’s “Just Do It” Approach:

– lack of transparency; strong dependence on the preferences,
skills, and trustworthiness of the individuals in charge of the
central bank
The Evolution of the Federal Reserve’s
Monetary Policy Strategy

• Advantages
– Uses many sources of information
– Demonstrated success

• Disadvantages
– Lack of accountability
– Inconsistent with democratic principles
Inside the Fed: Ben Bernanke’s Advocacy
of Inflation Targeting

• While a professor at Princeton, Bernanke, in several

articles and in a book cowritten with the author of this
book, argued that inflation targeting would be a major
step forward for the Federal Reserve and would produce
better economic outcomes, for many of the reasons
outlined earlier. When Bernanke took his position as a
governor of the Federal Reserve from 2002 to 2005, he
continued to advocate the adoption of an inflation target.
Lessons for Monetary Policy Strategy from
the Global Financial Crisis

1. Developments in the financial sector have a far greater

impact on economic activity than was earlier realized.

2. The zero-lower-bound on interest rates can be a serious

problem.

3. The cost of cleaning up after a financial crisis is very

high.

4. Price and output stability do not ensure financial stability.

Implications for Inflation Targeting

• Level of the Inflation Target

• Flexibility of Inflation Targeting

Should Central Banks Respond to Bubbles?
(1 of 2)

• How should Central banks respond to asset price bubbles?

– Asset-price bubble: pronounced increase in asset prices
that depart from fundamental values, which eventually burst.

• Types of asset-price bubbles

– Credit-driven bubbles
• Subprime financial crisis
• Bubbles driven by irrational exuberance
Should Central Banks Respond to Bubbles?
(2 of 2)

• Strong argument for not responding to bubbles driven by

irrational exuberance.

• Bubbles are easier to identify when asset prices and

credit are increasing rapidly at the same time.

• Monetary policy should not be used to prick bubbles.

Should Central Banks Respond to Bubbles?

• Macropudential policy: regulatory policy to affect what

is happening in credit markets in the aggregate.

• Monetary policy: Central banks and other regulators

should not have a laissez-faire attitude and let credit-
driven bubbles proceed without any reaction.
Tactics: Choosing the Policy Instrument

• Tools
– Open market operation
– Reserve requirements
– Discount rate

• Policy instrument (operating instrument)

– Reserve aggregates
– Interest rates
– May be linked to an intermediate target

• Interest rate and aggregate targets are incompatible

(must choose one or the other).
Figure 2 Linkages Between Central Bank Tools, Policy
Instruments, Intermediate Targets, and Goals of
Monetary Policy
Figure 3 Result of Targeting on Nonborrowed
Reserves
Figure 4 Result of Targeting on the Federal Funds
Rate
Criteria for Choosing the Policy Instrument

• Observability and Measurability

• Controllability

• Predictable effect on Goals

Tactics: The Taylor Rule

Federal funds rate target =

inflation rate + equilibrium real fed funds rate
+1/2 (inflation gap) +1/2 (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
Figure 5 The Taylor Rule for the Federal Funds
Rate, 1960–2017
Inside the Fed: Fed Watchers

• Interest rates have a major impact on investors’ and

financial institutions’ profits. As a result, these parties are
particularly interested in scrutinizing the Fed’s behavior.
To assist in this task, financial institutions hire Fed
watchers, experts on Federal Reserve behavior who may
have worked in the Federal Reserve System and so have
an insider’s view of Federal Reserve operations.
Thank You