This year we invited extraordinary Professor Peet Strydom to write a series of guest posts about economic theory. In this second post he considers monetary policy after the financial crisis, specifically the use of policy guidance:
Monetary policy, as presently being conducted by the major central banks, is broadly described as flexible inflation targeting. Although the US Federal Reserve does not explicitly apply this policy framework its conduct of monetary policy does not contradict the principles of inflation targeting.
The basic tenets of inflation targeting are that the central bank aims at achieving a particular inflation target, usually set by government. The prime instrument to achieve this target is the short-term interest rate. In South Africa this is referred to as the repo rate (repurchase rate). Monetary policy is conducted according to the principle of one policy target and one policy instrument. Flexible inflation targeting means that the central bank, in conducting its interest rate policy, should take cognisance of the state of GDP growth. As a general rule the central bank adheres to an interest rate rule according to a formula associated with John Taylor. This rule links interest rate policy to the rate of inflation and the so-called output gap i.e. the difference between potential and actual GDP growth. The major central banks conduct monetary policy in terms of this approach. In the US the Federal Reserve has a so-called dual policy mandate namely, to control inflation and to preserve employment.
This policy framework has served us well in controlling inflation successfully while being sensitive to macroeconomic growth prospects. Moreover, the policy framework and central bank behaviour was fairly successfully communicated to market participants. Furthermore, it delivered stability externalities in the sense that a low inflation economy generated stability benefits in terms of economic growth, the labour market and foreign exchange rates. Within this framework, often referred to as the great moderation, the monetary or financial system was disrupted from time to time with asset price bubbles and exchange rate volatility but the consensus was not to intervene in asset price bubbles and to clean up the destructive results afterwards. During the great moderation several countries experienced exchange rate volatility but the consensus was to subscribe to a system of flexible exchange rates with limited intervention by central banks.
This monetary policy framework was severely challenged during the financial crisis and the great recession of 2008-2009. As the financial crisis started in August 2007 central banks, with the ECB in the lead, started supporting the global banking system with liquidity as banks experienced difficulties in trading US mortgaged backed securities. Monetary policy was applied to its full limit and short-term interest rates reached the zero lower bound. Conventional monetary policy came to a halt and central banks in the US, the UK, and the ECB embarked on unconventional monetary policy measures such as central bank balance sheet expansion and policy guidance.
The latter topic is the subject of this paper. We first introduce the methodology of policy guidance followed by a discussion of the prominence of real sector variables in this approach. We then assess the role of expectations in policy guidance and finally present our conclusions.
1. The new monetary policy framework
There are different forms of monetary policy guidance as has been described by the Bank of England (2013) and Carney (2013) but they have one element in common i.e. they are directly associated with zero lower bound interest rates.
Open-ended policy guidance
This type of policy guidance was first applied by the Bank of Japan in 1999 and is aimed at communicating qualitative information about the future direction of monetary policy, given the conditions that could force the Bank to change its policy. Similarly, the Federal Reserve gave open-ended guidance in 2003 when the Bank announced that its accommodation policy would be maintained for a considerable period. On 4 July 2013 the ECB applied this procedure when it stated that the key ECB interest rates were expected to remain at their present or lower levels for an extended period of time. As indicated by Praet (2013) this policy guidance was aimed at clarifying the ECB’s assessment of the economic conditions and a confirmation of its policy strategy. It was made within the context of rising money market interest rates and tightening credit conditions that contradicted the policy stance, as explained by Praet (2013). As is evident from our exposition these communications do not refer to any time constraints. Moreover, terms such as “considerable” and “extended” are referred to as code words by Woodford (2012) as they require special interpretation, particularly by so-called central bank watchers.
This guidance goes further than the first form of guidance by providing explicit conditional commitment about the date at which the policy stance will be reversed or reconsidered. The explicit calendar dates serve as a substitute for code words. This communication was first applied by the Bank of Canada in April 2009 when it announced to hold short-term interest rates at the lower bound for effectively one year (i.e. the second quarter of 2010), conditional on the outlook for inflation. This message to market participants was carried by the Bank’s credibility as a successful inflation targeting institution. Moreover, the central bank’s projections on short-term interest rates are likely to carry substantial weight with market participants considering the Bank’s monopoly position in determining short-term interest rates.
The Federal Reserve applied this guidance for the first time in August 2011. The Bank then issued a statement confirming that economic conditions at the time warrant the low federal funds rate “at least through mid-2013”. In subsequent statements this guidance was updated by extending the explicit date further into the future. Such statements made by the prime mover of short-term interest rates are likely to carry meaningful weight in shaping the views of market participants.
In December 2012 the Federal Reserve pioneered the state-contingent guidance as formulated in its press release of 12 December 2012 (Federal Reserve, 2012). The Federal Open Market Committee (FOMC) then emphasised that the accommodative monetary policy will remain appropriate into the next economic recovery. This policy commitment into the recovery is in accordance with the proposed strategy as outlined by Eggertsson and Woodford (2003). In its state-contingent guidance the FOMC indicated that the federal funds rate was to be maintained at the 0 to 0.25 per cent level and this was considered to be the appropriate level as long as the employment rate remains above 6.5 per cent while inflation does not exceed the 2 per cent inflation target of the FOMC by more than a half percentage point between one and two years ahead. Moreover, long-term inflation expectations should remain well anchored. Since December 2012 the FOMC continued its state-contingent guidance while adhering to the same criteria.
On 7 August 2013 the BoE announced its decision to apply state-contingent guidance. As indicated in its research report, Bank of England (2013), price stability was to remain the prime objective of monetary policy with a target rate of 2 per cent. The Bank communicated its intention of keeping Bank Rate at its current level of 0.5 per cent; at least until the unemployment rate had fallen to 7 per cent. The unemployment rate is considered as a threshold. Reaching the threshold does not automatically result in a rise in Bank Rate. Thus the employment threshold is not a trigger for monetary policy. This policy framework linking Bank Rate and asset sales to the unemployment threshold will no longer apply if any of the following conditions, referred to as “knockouts”, were breached.
(a) If the inflation rate 18 to 24 months ahead will be 0.5 percentage points or more above the 2 per cent target.
(b) Medium-term inflation expectations appear to be no longer well anchored.
(c) If the monetary policy framework poses a significant threat to financial stability as determined by the Financial Policy Committee.
From the exposition above, it is evident that the availability and reliability of data are of crucial importance in securing an effective state-contingent policy framework. Considering the importance of the 7 per cent employment threshold it would appear that the BoE now subscribes to a dual monetary policy mandate.
2. Real sector variables and monetary policy
The important feature of state-contingent guidance is the prominence of real sector variables. The linking of such variables with monetary policy is not new. Approximately 30 years ago Vines et al (1983) proposed a nominal GDP target for monetary policy. Recently there has been a revived interest in this topic, as for instance, by Carney (2012) and Woodford (2012). The disadvantages of this proposal have been extensively analysed by Bean (1983 and 2013) and we will not repeat this debate at this juncture.
After careful consideration, the BoE decided in favour of unemployment as the real sector threshold for its state-contingent policy framework. Similarly, in the US, the FOMC settled for the unemployment rate.
The fundamental problem of linking monetary policy actions to real sector variables is that the central bank introduces variables into the policy framework that are beyond its control. Carney (2012) claims that private companies can provide estimates about their future performance but they are unable to guarantee the final outcome. As opposed to this it is claimed that central banks can communicate about a future policy path and they can deliver. Carney is correct in his assessment of private companies because the final business results are dependent on many variables and some are beyond the control of management. The claim that central banks can deliver refers to policy outcomes that are dependent on variables under control of the central bank. Real sector variables hardly meet this requirement. The central bank has little control over real sector variables such as supply-side constraints on production or employment. Furthermore, inflexible labour market constraints or government regulatory disruptions are beyond the control of the central bank and yet they can have significant effects on real sector variables. Monetary policy outlook could be severely disrupted by real sector variables that are part of the monetary policy framework but beyond the control of the central bank.
Expectations feature prominently in the exposition on policy guidance, particularly with reference to the zero lower bound. Eggertsson and Woodford (2003) have, in this context, argued a case in favour of the “skilful management of expectations” by the central bank regarding the future conduct of policy. The emphasis on expectations at the zero lower bound can be illustrated by the fact that interest rates cannot fall further. Fixing expectations regarding interest rates at a prolonged lower bound could discourage spending since prolonged low interest rates could be associated with sustained recession. As indicated by Carney (2013), interest rate risk at the zero lower bound is asymmetric since short-term rates can rise but they cannot fall. If expectations about prolonged short-term interest rates could be entrenched, arbitrage transactions are likely to secure lower long-term rates.
These are interesting examples of converging expectations and the macroeconomic analysis regarding expectations management by Eggertsson and Woodford (2003) is based on such expectations. They are typical of the micro foundations associated with rational expectations and representative agents where expectations converge to the behaviour of the representative agent or the model of the economy that is uniformly known to economic agents. Put differently, converging expectations are well-known phenomena in a general equilibrium Walrasian analytical framework.
As opposed to this, the real world features diverging expectations. In the final analysis financial sector transactions or real sector deals are concluded because of diverging expectations by market participants.
The association of monetary policy with real sector variables is likely to speed up diverging expectations. In the event of state-contingent guidance, market participants will have expectations about conditions in the labour market, the outlook for inflation and the likely effect of these developments on policy thresholds as well as the future policy stance. It appears that the management of diverging expectations is very much different from the job description inspired by an analytical framework based on converging expectations.
Since the crisis we have witnessed important developments in the thinking about monetary policy with short-term interest rates at the zero lower bound. Unconventional policy measures associated with the expansion of central banks’ balance sheets were innovative and significant. Lately the management of expectations through policy guidance is attracting the attention of policy makers as well as academic researchers. We have argued that the present analytical framework supporting expectations management is flawed. Moreover, the role of real sector variables in the monetary policy framework could disrupt the policy outlook without the central bank having control of these variables.
BANK OF ENGLAND (2013) Monetary Policy Trade-offs and Forward Guidance, August, www.bankofengland.co.uk.
BEAN, C.R. (1983) Targeting Nominal Income: An Appraisal, Economic Journal, 93:806-819.
BEAN, C. (2013) Nominal Income Target – An Old Wine in a New Bottle, Speech by Mr Charles Bean, Deputy Governor for Monetary Policy of the Bank of England, at the Institute for Economic Affairs Conference on the State of the Economy, 22 February.
CARNEY, M. (2012) Guidance, Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board, to the CFA Society Toronto, Ontario, 11 December.
CARNEY, M. (2013) Monetary Policy After the Fall, Remarks Former Governor of the Bank of Canada Presented to Eric J. Hanson Memorial Lecture University of Alberta Edmonton, Alberta, www.bankofcanada.ca.
EGGERTSSON, G. AND WOODFORD, M. (2003) The Zero Bound on Interest Rates and Optimal Monetary Policy, Brookings Papers on Economic Activity 1:139-233.
FEDERAL RESERVE (2012) Press Release, 12 December.
PRAET, P. (2013) Forward Guidance and the ECB, www.voxeu.org.
VINES, D., MACIEJOWSKI, J.M. AND MEADE, J.E. (1938) Demand Management, London: Allen & Unwin.
WOODFORD, M. (2008) Forward Guidance for Monetary Policy: Is it Still Possible? www.voxeu.org.
WOODFORD, M. (2012) Methods of Policy Accommodation at the Interest-rate Lower Bound, Federal Reserve Bank of Kansas City, Jackson Hole Symposium.