Money and Banking Chapter 17 Monetary Policy Targets and Goals

Chapter 17 Monetary Policy Targets and Goals CHAPTER OBJECTIVES By the end of this chapter , students should be able to . Explain why the Fed was generally so ineffective before the late 19805 . Explain why volatility declined from the late until 2008 . List the that central banks face and describe how they confront them . Define monetary targeting and explain why it succeeded in some countries and failed in others . Define inflation targeting and explain its importance . Provide and use the Taylor Rule and explain its importance . URL books 352

A Short History of Fed Blunders LEARNING OBJECTIVES . Why was the Fed generally so ineffective before the late 19805 ?

Why has volatility declined since the late ?

The long and salutary reign of the Great ( and the auspicious beginning of the rule of the Bald ( provided the Fed with something it has rarely enjoyed in its nearly existence , the halo of success and widespread approbation . While it would be an exaggeration to call Federal Reserve Board members the Keystone of monetary policy , the Fed history , a taste of which we ve already indulged ourselves with in Chapter 11 The Economics of Financial Regulation , is more sour than sweet . Central banks are , after all , the last bastions of central planning in otherwise free market economies . And central planning , as the Communists and the Austrian economists who critiqued them discovered , is darn This is not a history textbook , but the past can often shed light on the present History warns us to beware of claims of infallibility . In this case , however , it also provides us with a clear reason to be optimistic . Between 1985 or so and 2007 , the , particularly output , was much less volatile than previously . That was a happy development for the Fed because , as noted in Chapter 13 Central Bank Form and Function , central banks are generally charged with stabilizing the , among other things . The Fed in particular owes its genesis to the desire of Americans to be shielded from panics and economic crises . The Fed almost 60 percent ofthe reduction in volatility . Is anyone surprised by this ?

Don we all embrace responsibility for good outcomes , but eschew it when things turn ugly ?

Skeptics point to other causes for the Great Calm , including dumb luck less volatile oil prices ( the were a difficult time in this regard ) less volatile total factor productivity and improvements in management , especially inventory techniques , which has helped to reduce the inventory of yore . Those factors all played roles , but it also appears that the Fed monetary policies actually improved . Before Paul ( the Fed engaged in URL books 353

cyclical monetary policies . Since then , it has tried to engage in policies . And that , as poet Robert Frost wrote in The Road Not Taken , has made all the difference , For reasons that are still not clearly understood , economies have a tendency to cycle through periods of boom and bust , of expansion and contraction . The Fed used to exacerbate this cycle by making the highs ofthe business cycle higher and the lows lower than they would otherwise have been . Yes , that ran directly counter to one of its major missions . Debates rage whether it was simply ineffective or if it purposely made mistakes . It was probably a mixture of both that changed over time . In any event , we go there because a simple narrative will . The Fed was conceived in peace but born in war , As William points out in his book When Washington Shut Down Wall Street , the Federal Reserve was rushed into operation to help the system , which had been terribly shocked , economically as well as politically , by the outbreak of the Great War ( in Europe . At first , the Fed the monetary base ( through its literally discounted again business commercial paper already discounted by commercial banks , A wholesaler would take a bill owed by one of its customers , say , a department store like , to its bank . The bank might give for a bill due in sixty days . If , say , thirty days later the bank needed to boost its reserves , it would take the bill to the Fed , which would rediscount it by giving the bank , say , in cash for it . The Fed would then collect the when it fell due . In the context of World War I , this policy was , leading to price increases in 1919 and 1920 . The Fed responded by raising the discount to , setting sharp recession . The postwar recession hurt the Fed revenues because the volume of shrank precipitously . It responded by investing in securities and , in so doing , accidentally stumbled upon open market operations . The Fed fed the speculative asset bubble of the late , then sat on its hands while the economy crashed and burned in the early . Here another tidbit it also exacerbated the Roosevelt Recession of by playing with fire , by raising the reserve requirement , a new policy placed in its hands by and his New Dealers in the Banking Act of 1935 . URL books 354

During World War II , the Fed became the Treasury lapdog . Okay , that is an exaggeration , but not much of one . The Treasury said thou our bonds to keep the prices up ( and yields down ) and the Fed did , basically monetizing the national debt . In short , the Fed wasn very independent in this period . Increases in demand , coupled with quantity rationing , kept the lid on during the titanic against Fascism , but after the war the of opened . Over the course of just three years , 1946 , 1947 , and 1948 , the price level jumped some 30 percent . There was no net change in prices in 1949 and 1950 , but the start of the Korean War sent prices up another almost percent in 1951 , and the Fed got some backbone and stopped pegging interest rates . As our analysis of central bank independence in Chapter 13 Central Bank Form and Function suggests , dropped big time , to percent in 1952 , and to less than percent in 1953 and 1954 . In 1955 , prices actually dropped slightly , on average . This is not to say , however , that the Fed was a fully competent central bank because it continued to exacerbate the business cycle instead of , wealth would increase ( decrease ) driving interest rates ( as we learned in Chapter The Economics of Fluctuations ) up ( down ) inducing the Fed to buy ( sell ) bonds , thereby increasing ( decreasing ) and thus the money supply ( So when the economy was naturally expanding , the Fed stoked its and when it was contracting , the Fed put its foot on its head . Worse , if interest rates rose ( bond prices declined ) due to an increase in ( think Fisher Equation ) the Fed would also buy bonds to support their prices , thereby increasing the and causing yet further . This , as much as oil price hikes , caused the Great of the . Throughout the crises of the and , the Fed toyed around with various targets ( rate ) but none ofit mattered much because its cyclical bias remained . Stop and Think Box Another blunder made by the Fed was Reg , which capped the interest rates that banks could pay on deposits . When the Great began in the late , nominal interest rates rose ( think Fisher Equation ) above those set by the Fed . What horror directly resulted ?

What Fed goal was thereby impeded ?

URL books 355 Shortages known as credit crunches resulted . Whenever , shortages result because the quantity demanded exceeds the quantity supplied by the market . Banks couldn make loans because they couldn attract the deposits they needed to fund them . That created much the same effect as high interest entrepreneurs couldn obtain for good business ideas , so they wallowed , decreasing economic activity . In response , banks engaged in the loophole mining discussed in Chapter Financial Structure , Transaction Costs , and Asymmetric Information . By the late , the Fed , began to engage in , to lean into the wind by raising rate before became and by lowering the federal funds rate at the sign of recession . Since the implementation of this crucial insight , the natural swings of the have been much more docile than hitherto , until the crisis of , that is . The United States experienced two ( July 1991 and March 2001 ) they were soft landings , that is , short and shallow . have been longer than usual and not so intense . Again , some of this might be due to dumb luck ( no major wars , low real oil prices until summer 2008 that is ) and better technology , but there is little doubt the Fed played an important role in the stabilization . Of course , past performance is no guarantee of future performance . Just look at the New York Knicks . As the crisis of approached , the Fed resembled a fawn trapped in the headlights of an oncoming , too afraid to continue on its path of raising interest rates and equally frightened of reversing course . The result was an economy that looked like road kill . Being a central banker is a bit like being Goldilocks . It important to get monetary policy just right , lest we wake up staring down the of three hungry bears . I don mean Stephen bears here , but rather bear markets . KEY TAKEAWAYS The Fed was generally ineffective before the late because it engaged in monetary policies , expanding the and lowering interest rates during and constricting the and raising interest rates during , the exact opposite of what it should have done . URL books 356

The Fed was also ineffective because it did not know about open market operations ( at first , because it did not realize the damage its toying with could cause after New Dealers gave it control of reserve requirements , and because it gave up its independence to the Treasury during World War II . Also , in the , it targeted monetary , although its main policy tool was an interest rate . The Fed switch from to monetary policy , where it leans into the wind rather than running with it , played an important role in decreased volatility , although it perhaps can not take all of the credit because changes in technology , particularly inventory control , and other lucky events conspired to help improve macro stability over the same period . Future events will reveal if central banking has truly and permanently improved . factor productivity ( business ) 119 In the interest of full disclosure , is a colleague , but also the coauthor of a competing , and storied , money and banking textbooks . 10 ?

URL books 357 Central Bank Goal LEARNING OBJECTIVE . What do central banks face and how do they confront them ?

Central banks worldwide often find themselves between a rock and a hard place . The rock is price stability ( control ) and the hard place is economic growth and employment . Although in the long run the two goals are perfectly compatible , in the short run , they sometimes are not . In those instances , the central bank has a decision to make . Should it raise interest rates or slow or even stop growth to stave , or should it decrease interest rates or speed up growth to induce companies and consumers to borrow , thereby stoking employment and growth ?

In some places , like the European Union , the central bank is instructed by its charter to stop . The primary objective of the European System of Central Banks , the Treaty clearly states , shall be to maintain price stability . Without prejudice to the objective of price stability , the shall support the general economic policies in the Community including high employment and economic growth . The Fed charter , by contrast , gives the Fed a dual mandate to ensure price stability and maximum employment . Little wonder that the Fed has not held the line on as well as the European Central Bank ( but unemployment rates in the United States are generally well below those of most European nations . There are additional reasons for that difference that are not germane to the discussion here . Stop and Think Box When central banks act as a lender of last resort ( to restore stability to the financial system , they create a time inconsistency problem . Can you identify what it is ?

Hint It involves moral hazard . It is believed that if a central bank or other lender of last resort , like the International Monetary Fund , steps in too often , it creates a moral hazard problem because businesses , including banks , take on extra risks safe in the knowledge that if the system gets in trouble , prompt and effective aid will be forthcoming . This is time inconsistent because , by stopping one panic or crisis , the central bank plants the seeds for the next . URL books 358

Do note that almost nobody wants 100 percent employment , when everyone who wants a job has one . A little unemployment , called frictional unemployment , is a good thing because it allows the labor market to function more smoothly . structural unemployment , when workers skills do not match job requirements , is not such a good thing , but is probably inevitable in a dynamic economy saddled with a weak educational system . As structural unemployment increased in the United States , education improved somewhat , but not enough to ensure that all new jobs the economy created could be with domestic laborers . So the Fed shoots for what is called the natural rate . Nobody is quite sure what that rate is , but it is thought to be around percent , give or take . KEY TAKEAWAYS The main that central banks face is a one between inflation , which calls for tighter policy ( higher interest rates , slower money growth ) and employment and output , which call for looser policy ( lower interest rates , faster money growth ) Some central banks confront by explicitly stating that one goal , usually price stability ( controlling inflation ) is of paramount concern . Others , including the Fed , confront the on an ad hoc , basis . URL books 359

Central Bank Targets LEARNING OBJECTIVES . What is monetary targeting and why did it succeed in some countries and fail in others ?

What is inflation targeting and why is it important ?

Once a central bank has decided whether it wants to hold the line ( no change A ) tighten ( increase i , decrease or slow the growth ) or ease ( lower i , increase ) it has out how best to do so . Quite a gulf exists between the central bank goals ( low , high employment ) and its tools or instruments ( discount loans , changing ) So it sometimes creates a target between the two , some intermediate goal that it shoots for with its tools , with the expectation that hitting the target bull would lead to goal satisfaction GOAL In the past , many central banks targeted monetary like or . Some , like Germany and Switzerland central bank , did so successfully . Others , like the Fed , the Bank of Japan , and the Bank of England , failed miserably . Their failure is partly explained by what economists call the time inconsistency problem , the inability over time to follow a good . diets suffer from the time inconsistency problem , too , and every form of procrastination is essentially time inconsistent . Basically , like a wayward dieter or a lazy student ( rare animals to be sure ) they overshot their targets time and time again , preferring pleasure now at the cost of pain later . Another was that monetary targets did not always equate to the central banks goals in any clear way . Long lags between policy implementation and made it to know to what degree a policy was not . Worse , the importance as a determinant rates and the price level waxed and waned over time in ways to predict . Finally , many central banks experienced a disjoint between their tools or operating instruments , which were often interest rates like the federal funds , and their monetary targets . It turns out that one can control both an interest rate and a monetary aggregate at the same time . To see why , study Figure . Note that if the central bank leaves the supply of money , URL books 360

changes in the demand for money will make the interest rate jiggle up and down . It can only keep i by changing the money supply . Because open market operations are the easiest way to conduct monetary policy , most central banks , as we ve seen , eventually changed reserves to maintain an interest rate target . With the monetary supply moving round and round , up and down , it became to hit monetary targets . Figure URL books 361

Interest Rate , i I . Interest Rate , I Quantity of Money , URL books 362 Central banks can control , but not both . In response to all this , several leading central banks , beginning with New Zealand in 1990 , have adopted explicit targets . The result everywhere has been more or less the same lower employment and output in the short run as expectations are wrung out of the economy , followed by an extended period of prosperity and high employment . As long as it remains somewhat , targeting frees central bankers to do whatever it takes to keep prices in check , to use all available information and not just monetary statistics . targeting makes them more accountable because the public can easily monitor their success or failure . New Zealand took this concept a step further , enacting legislation that tied the central banker job to keeping within the target range . Stop and Think Box What do you think of New Zealand law that allows the legislature to oust a central banker who allows too much ?

Well , it makes the central bank less independent . Of course , independence is valuable to the public only as a means of keeping in check . The policy is only as good as the legislature . If it uses the punishment only to oust incompetent or corrupt central bankers , it should be salutary . If it good central bankers caught in a tough situation ( for example , an oil supply shock or war ) the law may serve only to keep good people from taking the job . If the central banker salary is very high , the law might also induce him or her to try to distort the official figures on which his or her job depends . The Fed has not yet adopted explicit targeting , though a debate currently rages about whether it should . And under Ben , it moved to what some have called , with a new policy of communicating with the public more frequently about its forecasts , which now run to three years instead of the traditional two . As noted above , the Fed is not very transparent , and that has the effect of roiling the markets when expectations about its monetary policy turn out to be incorrect . It also induces people to waste a lot of time engaging in Fed watching , looking for clues about monetary policy . Reporters actually used to comment on the thickness of briefcase when he went into Federal Open Market Committee ( meetings . No joke ! URL books 363

Why doesn the Fed , which is charged with maintaining financial market and price stability , adopt explicit targets ?

It may be that it does not want to be held accountable for its performance . It probably wants to protect its independence , but for its private interest ( power ) rather than for the public interest ( low ) It may also be that the Fed has found the holy grail of monetary policy , a rule that helps it to determine the target . KEY TAKEAWAYS Monetary targeting entails setting and attempting to meet growth rates of monetary such as or . It succeeded in countries like Germany and Switzerland , where the central bank was committed to keeping inflation in check . In other countries , like the United States and the United Kingdom , where price stability was not the paramount goal of the central bank , the time inconsistency problem eroded the effectiveness of the targets . In short , like a dieter who ca resist that extra helping at dinner and two desserts , the central banks could not stick to a good plan day to day . Also , the connection between increases in particular and the price level broke down , but it took along time for central bankers to realize it because the lag between policy implementation and world outcome was often many months and sometimes years . Inflation targeting entails keeping increases in the price level within a predetermined range , and percent per year . Countries whose central banks embraced inflation targeting often suffered a recession and high unemployment at first , but in the long run were able to achieve both price level stability and economic expansion and high employment . Inflation targeting makes use of all available information , not just monetary , and increases the accountability of central banks and bankers . That reduces their independence but not at the expense of higher inflation because inflation targeting , in a sense , is a substitute for independence . The Federal Reserve Letting Light In , The Economist ( 17 November 2007 ) URL books 364

ies URL books ( 365 The Taylor Rule LEARNING OBJECTIVE . What is the Taylor Rule and why is it important ?

Many observers suspect that the Fed under and has followed the Taylor Rule , named after the Stanford University economist , John Taylor , who developed it . The rule states that gap ) gap ) where federal funds target 11 the real equilibrium fed funds rate gap gap ( target ) gap output gap ( actual output . output potential ) So if the target was percent , actual was percent , output was at its potential , and the real federal funds rate was percent , the Taylor Rule suggests that the fed funds target should be TI ( gap ) gap ) A ( If the economy began running a percentage point below its potential , the Taylor Rule would suggest easing monetary policy by lowering the fed funds target to percent ( If started to heat up to percent , the Fed should respond by raising the fed funds target to ( A ( Practice calculating the fed funds target on your own in Exercise URL books 637 366

EXERCISE . Use the Taylor ( gap ) gap ) determine what the federal funds target should be if Real Fell I ( Rule ' Ir 14 Notice that as actual exceeds the target , the Taylor Rule suggests raising the fed funds rate ( tightening monetary policy ) Notice too that as output falls relative to its potential , the rule suggests decreasing the fed funds rate ( easier monetary policy ) As output exceeds its potential , however , the rule suggests putting on the brakes by raising rates . Finally , if and output are both screaming , the rule requires that the fed funds target soar quite high indeed , as it did in the early . In short , the Taylor Rule is and two Reserve goals price stability and . The Taylor Rule nicely explains history since 1960 . In the early , the two were matched was low , and growth was strong . In the latter part of the , the , and the early , actual was generally well below what the Taylor Rule said it should be . In that period , was so high we refer to the period as the Great . In the latter part of the , was higher than what the Taylor Rule suggested . That was a period of weak growth but decreasing . Finally , since 1990 or so , the Taylor Rule and have again been very closely matched . Like the early , that period has been one of low and high growth . Stop and Think Box URL books 367

Examine Figure The Feds feds fund target , carefully . Assuming the Fed uses the Taylor Rule , what happened to and output from until . Then what happened ?

Figure ' Fed target , 00 ) SUMO 10000 Hill ! JIM ! NINE . A , 09 ' lie all Assuming that the Fed target , the real equilibrium federal funds rate , and the economy output potential were unchanged in this period ( not bad assumptions ) increases in actual and increases in actual output would induce the Fed , via the Taylor Rule , to increase its feds fund target . Both were at play but were moderating by the end of 2006 , freezing the funds target at percent , as shown in Figure and per capita gross domestic product ( Figure and per capita gross product ( URL books 368

None of this means , however , that the Fed will continue to use the Taylor Rule , if indeed it does so . Nor does it mean that the Taylor Rule will provide the right policy prescriptions in the future . Richard Fisher and Michael Cox , the president and chief economist of the Dallas Fed , respectively , believe that globalization makes it increasingly important for the Fed and other central banks to look at world and output levels in order to get domestic monetary policy right . Stop and Think Box Foreign exchange rates can also central bankers and their policies . increasing ( decreasing ) interest rates will , cause a currency to appreciate ( depreciate ) in world currency markets . Why is that important ?

The value of a currency directly affects foreign trade . When a currency is strong relative to other currencies ( when each unit of it can purchase many units of foreign currencies ) imports will be stimulated because foreign goods will be cheap . Exports will be hurt , however , because domestic goods will look expensive to foreigners , who will have to give up many units of their local currency . Countries with economies heavily dependent on foreign trade must be extremely careful about the value of their currencies almost every country is becoming more dependent on foreign trade , making exchange rate policy an increasingly important one for central banks worldwide to consider . KEY TAKEAWAYS books 359

The Taylor Rule is a simple ( 11 gap ) gap ) allows central bankers to determine what their overnight interbank lending rate target ought to be given actual inflation , an inflation target , actual output , the economy potential output , and an estimate of the equilibrium real fed funds rate . When the Fed has maintained the fed funds rate near that prescribed by the Taylor Rule , the economy has thrived when it has not , the economy has been plagued by inflation ( when the fed funds rate was set below the Taylor rate ) or low output ( when the fed funds rate was set above the Taylor rate ) See Richard Fisher and Michael Cox , The New Inflation Equation , Wall , April , 2007 , URL books 370

Suggested Reading Blinder , Alan . Central Banking in Theory and Practice . Cambridge , MA MIT Press , 1999 . William When Washington Shut Down Wall Street The Great Financial Crisis of 1914 and the Origins ofAmerica Monetary Supremacy . Princeton , Princeton University Press , 2007 . Taylor , John . Monetary Policy Rules . Chicago , IL University of Chicago Press , 2001 . URL books 371