In Search of Monetary Stability: The Evolution of Monetary Policy

The mid-1980s began a period that might, in retrospect, be seen as the golden age of monetary policy. Worldwide inflation rates, which had come down from the high levels reached in the 1970s, were at the lowest level seen in a long time. In the real economy, low and stable inflation went along with growth - at first, reasonable, and later, remarkable - and with reduced volatility. The term Goldilocks is sometimes used to describe this solid, sustainable situation - meaning that, like the porridge in the fairy tale, it was neither too hot nor too cold but just right. A number of fortunate circumstances contributed to the Goldilocks economy. Deregulation and globalisation, with their impact on competition and pricing power in goods and labour markets, are sometimes seen as major factors supporting the achievement and maintenance of low inflation (Rogoff (2003)). With the weakening of deregulation and globalisation, will we see the end of the golden age, which then will turn out to have been only a short episode? On the one hand, an end to the golden age would be no surprise for those who have stressed from the outset that its highly positive macroeconomic outcomes were the result, if not of luck, then of benign circumstances whose combination could not be expected to last forever (Sims and Zha (2006)). And do not recent developments already confirm this sceptical assessment of the role of central banks and monetary policy during this period? Isn't inflation rising? Doesn't the ongoing turbulence in financial markets indicate that central banks did not - or, rather, could not - prevent such developments? On the other hand, have we not seen the emergence of a policy regime that should be robust enough to continue the period of monetary stability? And would not a regime of monetary stability contribute to the stability of the real economy? We might only ex post be able to give a definite answer to these questions. For the time being, we can just study the emergence of the current policy regime and its elements via the practice of central banking and the results of research. I would like to start with a personal note. It would be, to say the least, overambitious to survey in just a few pages roughly three decades of research on monetary policy. The same is true for the analysis of monetary policymaking during this period. What I have tried to do is simply provide the reflections of someone who, coming from academia, played a special role in two central banks - the Bundesbank (from 1990 to 1998) and the European Central Bank (from 1998 to 2006) - under extremely difficult circumstances, namely the aftermath of German reunification in 1990 and the launch of the European Union two years later. It was a challenge and a privilege to build the bridge between monetary policy research and monetary policymaking in those two central banks. What were the most relevant aspects of theory to be considered when deciding on monetary policy? How did it work in practice? I will start with some results of monetary policy and the advances in research that, to a large degree, were triggered by those results. The later sections analyse the principles guiding the conduct of monetary policy by the Bundesbank and the ECB and some specific aspects of monetary policy. One of the main lessons I got during my 16 years of central banking practice is that it is critical to raise questions and not ignore important insights - even if the dominant approaches in research seem to suggest otherwise. It should therefore not come as a surprise that the paper ends with open questions. This is part of a series of BIS Working Papers (273 to 278) collecting papers presented at the BIS's Seventh Annual Conference on "Whither monetary policy? Monetary policy challenges in the decade ahead" in Luzern, Switzerland, on 26-27 June 2008. The event brought together senior representatives of central banks and academic institutions to exchange views on this topic. BIS Paper 45 contains the opening address of William R White (BIS), the contributions of the policy panel on "Beyond price stability - the challenges ahead" and speeches by Edmund Phelps (Columbia University) and Martin Wolf (Financial Times). The participants in the policy panel discussion chaired by Malcolm D Knight (BIS) were Martin Feldstein (Harvard University), Stanley Fischer (Bank of Israel), Mark Carney (Bank of Canada) and Jean-Pierre Landau (Banque de France). This Working Paper includes comments by Allan H Meltzer.