Vitor Constâncio: Comments on "Monetary policy today - sixteen questions
and about twelve answers" by Alan Blinder
Comments by Mr Vitor Constâncio, Governor of the Bank of Portugal, at the conference on "Central
Banks in the 21st Century", hosted by the Bank of Spain, Madrid, 8 June 2006.
* * *
It is indeed a pleasure to comment such a challenging and thought provoking paper. Unfortunately, I
will not have the time to go through all the very pertinent questions raised in the paper and so my
remarks will be selective. The combination of theoretical and practical aspects in the paper reflects the
remarkable progress of the dialogue between the academic and Central Bank worlds in the past 15
years or so. Changes on both sides contributed to that development. The emergence of a new
benchmark macro model that eliminates the LM curve and clearly establishes the interest rate as the
monetary policy instrument, as it had been usually the practice of Central Banks, helped the
connection with the practical side of things. In its dynamic version the new benchmark combines the
methodology of Dynamic Stochastic General Equilibrium models that came from the Real Business
Cycles school with the new Keynesian nominal rigidities and gives sense to the effects of money on
the real economy through a more realistic transmission mechanism. Monetary policy affects prices
indirectly through its effect on optimising consumption, investment and labour market decisions, in the
context of real and nominal rigidities. The output gap, representing the degree of slack in the
economy, plays an important role in the model as an influent channel on inflation and as a policy
target. This avoids the assumption of a direct effect of money through a pure liquidity effect and
corresponds better to the stylized fact that policy influences first the real side of the economy and then
prices. The new approach also assumes the possibility of an optimal behaviour of Central Banks when
policy is determined by a rule that comes from an optimization exercise and responds to inflation and a
theoretically consistent output gap. All this helped the dialogue to which Central Banks contributed by
beginning to take more seriously the need to commit to a more precise policy framework, to focus on
the importance of expectations and the requirement to influence them by becoming more credible and
transparent through appropriate communication. This led to what the author in his latest book calls the
«quiet revolution» in central banking.1
At the same time, we have observed a remarkable convergence of practices of Central Banks in
conducting monetary policy. Even when they profess different strategies, one can identify some
common denominator, a set of general principles that seem to have universal acceptance. I group
those under five headings:
1. First, the main goal of monetary policy has been more clearly defined as being price stability,
meaning a low medium term objective for the inflation rate. Other objectives may be added,
explicitly or implicitly, with different or equal weights in the objective function, but there is
now no ambiguity about the main goal of policy.
2. Second, to form a view about the economic situation and the risks for inflation, a full
information approach is adopted, analysing the complete set of information variables. As
Wim Duisenberg (2000)2 expressed it once: «Monetary policy-making in the euro area has to
reflect the complexities and uncertainties which surround the transmission mechanism of
monetary policy ... These uncertainties imply that no single approach is likely to be entirely
reliable. ...Reliance on a single indicator or forecast, or a single model of the economy or
view of the world, would, in these circumstances, be extremely unwise. The strategy needs
to incorporate the full range of relevant indicators and assess them in the context of a variety
of different models». Even if the assessment is organized around two types of analysis, as it
is the case in the Eurosystem, the aim is «the cross-checking of information in coming to its
unified overall judgement on the risks to price stability»3. This is the way the issue is
expressed in our May 2003 communiqué that clarified our basic policy framework, which also
added that « the monetary analysis mainly serves as a means of cross-checking, from a
medium to long-term perspective, the short to medium-term indications coming from
economic analysis». It was also stated, «Monetary analysis will take into account
developments in a wide range of monetary indicators including M3, its components and
counterparts, notably credit, and various measures of excess liquidity». This reference to
many aggregates, including credit, is important especially in view of the instability since 2003
of traditional money demand functions for M3 that impairs monetary analysis.4
From the point of view of the convergence of policy practices that I mentioned, it is
interesting to confront this with one of the criteria used by the Norges Bank, that epitome of
inflation targeting, in «assessing whether a future interest rate path appears reasonable
compared with the monetary policy objective». In fact, the 5th criterion asserts that «Interest
rate setting must also be assessed in the light of developments in property prices and credit.
Wide fluctuations in these variables may constitute a source of instability in demand and
output in the somewhat longer run.»5
3. Third, it is well established that the short-term monetary interest rate is the instrument of
monetary policy and not any quantitative monetary variable. In addition, the strategy of using
intermediate targets for monetary policy has been abandoned and the instrument is related
with the final targets as Benjamin Friedman (1990)6 recommended many years ago as a
more efficient use of information. Here, we should note that the notion of an inflation-forecast
as an intermediate target put forward by Svensson does not contradict this because the
forecast variable is directly related with the final target of policy.
4. Fourth, according to the new benchmark model, the transmission mechanism goes first
through the real economic decisions of households and firms and only with a longer lag on
prices. Also, the model gives great importance to expectations of future values of the
relevant variables. With forward-looking rational agents, expectations of future policy
influence present decisions and so problems of credibility become relevant for monetary
policy. This implies that policy must adopt a forward-looking approach and that a focus on
expectations is required. However, it should be clear that this does not imply that policy
should follow market expectations, since this could entail serious dynamic instability and
indeterminacy problems. Quite on the contrary, in order to influence expectations, monetary
authorities must embark into effective communication with other economic agents and
become more transparent about their own decision making process in order to establish
credibility.
5. Fifth, in spite of granting more importance to a rules-based orientation of policy no central
banker will deny the need for some discretion in conducting policy in face of real life
uncertainties. As Alan Blinder put it in his previous book on central banking: «Rarely does
society solve a time-inconsistency problem by rigid precommitement or by creating
incentivecompatible compensation schemes for decision makers. Enlightened discretion is the rule»7.
When mention is made of rule-based policy, we should not forget that there is a lot of confusion
surrounding the word «rule». Theory talks about commitment to rules but that notion seemingly
includes mere respect for a precise procedure in conducting monetary policy. Ben Bernanke and
Frederic Mishkin (1997)8 say, for instance, about inflation targeting that it «...does not represent an
ironclad policy rule...Instead, inflation targeting is better understood as a policy framework». Even
when Lars Svensson defines, for instance, «general or specific target rules» we see that he does not
mean any sort of mechanical rule, but commitment to a framework that has been made more precise
in some aspects but still allows room for exercising judgment9. In some circumstances, the «specific
target rules» alluded to by Svensson may be nevertheless too rigid. The expression «constrained
discretion» was coined to designate the current practice and at least for monetary authorities of big
countries or big economic areas that is the name of the game.
The five points I just described are not sufficient to characterize a policy framework and the missing
details are the ones that are important to differentiate the various regimes in existence. I find that the
questions raised by Alan Blinder in his paper concerning the «institutional design » and the «operating
principles» as particularly apt to help us complete that task. As I will not comment on all those
questions, I hope that my answers plus the five points I just mentioned help to convey my overall view
on the way to conduct monetary policy.
Let me start then with the question about the specification of the for monetary policy
objective function
(Question 1). The general formula presented in the paper is quite accepted and widely used and I
have no qualms with it. Going further to a full specification of all the parameters is of course another
mater. Fully specifying the objective function has been one of the insisting recommendations of Lars
Svensson in the context of the inflation target regime10. The only pragmatic version of that regime is
the so-called «flexible inflation targeting» that takes into consideration the stabilization of the output
gap and, consequently, the demand for a full specification is a way of defending the inflation targeting
framework from the accusations of being misleading as, in spite of its name, it includes other targets
after all. That is alluded by Alan Blinder in the paper when he suggests the regime could as well be
called «unemployment targeting» (see page 18) but has been used to justify a harsher criticism of
inflation targeting by Jon Faust, Dale Henderson and Benjamin Friedman11. It is true that Svensson
formally demonstrated quite a while ago (Lars Svensson, 1997)12 that, when you have a model that
makes the output gap a major determinant of future inflation, to define a longer period to achieve a
pure inflation target in a gradual way is the same as putting the output gap in the objective function. In
addition, many inflation targeters have made explicit that they have a «flexible» framework, meaning
that they do consider an objective of stabilization of the output gap. One can even go as far as
recognizing that any monetary policy strategy that accepts that an indicator of the slack in the
economy, like the output gap, has a major role in the transmission channels of monetary policy,
implicitly includes the stabilization of that gap as part of its intermediate goals. In effect, from a long
term perspective, stabilizing the output gap is a way of assuring the elimination of both inflationary and
deflationary forces. Nevertheless, in the short term a trade-off may exist between the two gaps,
inflation from its target and output from its potential. That trade-off may be related with the desired
speed at which the economy converges to its long term equilibrium or may result from considering that
it is welfare enhancing to avoid too much volatility of output (see Laurence Meyer, 2001)13. If the
possibility of a short-term trade-off is accepted then a specification of λ would be useful.
I do not believe that it is possible or desirable to announce a full specification of the objective function.
First, I think that it would be impossible or misleading to get a value for λ from a collective
decisionmaking body. More fundamental though, I think it would not be advisable for the reasons that stem
from the relationship established by Michael Woodford in his book14 between consumer welfare and
the form of the loss function to be adopted for monetary policy purposes. A major conclusion of his
analysis is that the form of the loss function depends on the structure the economy considered in the
model and defining the transmission mechanism. Specifically, regarding the loss function of Blinder's
9
Svensson, Lars (2003) "What's wrong with Taylor rules? Using judgment in monetary policy through targeting rules" in
Journal of Economic Literature 41: 426-77.
10
See the previous note and Svensson, Lars (2003) "The Inflation Forecast and the Loss Function," in Paul Mizen, ed. (2003),
Edward Elgar, 135-152.
Central Banking, Monetary Theory and Practice: Essays in Honour of Charles Goodhart, Volume I,
Also available in http://www.princeton.edu/svensson/.
11
Faust, Jon and Dale Henderson (2004) " Is inflation-targeting best-practice monetary policy? And Friedman, Benjamin
(2004) Comment on Faust and Henderson in Federal Reserve Bank of St. Louis Review, Volume 86, Number 4,
,July/August 2004, pages 117-149.
12
Svensson, Lars (1997) "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets",
European Economic
41 (1997) 1111-1146. Also available in http://www.princeton.edu/svensson/.
Review
13
Meyer, Laurence H. (2001) "Inflation Targets and Inflation Targeting" Speech made at the University of California at San
Diego Economics Roundtable, in http://www.federalreserve.gov/.
14
Woodford, Michael (2003) "Inflation stabilization and welfare" chapter 6 of Princeton University Press.
"Interest and Prices",
BIS Review 53/2006 3
paper, Michael Woodford shows that it is a reasonable approximation to the indirect consumer utility
function if the following conditions are met:
a) There are no «welfare consequences of transaction frictions that account for the demand for
the monetary base», which means the results apply to a «cashless limit» economy.
Otherwise a term with an interest rate differential would have to be added to the objective
function.
b) The only nominal distortion stems from sticky prices.
c) There are cost-push shocks.
d) Only monetary policy is considered. There is no consideration of cyclical fiscal policy.
Changes in this set-up may alter the form of the objective function. For instance, if there were no
costpush shocks, then there would be no trade off between the inflation and the output gap and the
objective of the central bank would be just to eliminate the inflation deviation from its target. In the
considered set-up wages are considered flexible and prices follow the Calvo model of sticky prices,
which implies that inflation variation results in distortions of relative prices and the welfare losses are
proportional to the expected discounted sum of squared deviations of the inflation rate from zero.
Nevertheless, as Woodford (2006) remarks, if different price adjustment schemes are assumed the
form of the function varies: «For example, if the probability of adjustment of an individual price is
increasing in the time since that price was last reviewed - a specification that is both intuitively
plausible and more consistent than the simple Calvo specification with empirical models of inflation
dynamics- then welfare losses are proportional to a discounted sum of squared deviations of the
current inflation rate from a moving average of recent past inflation rates, rather than deviations from
zero. The goal of policy hen should be to keep inflation from differing too greatly from the current
"inertial" rate of inflation, which implies that inflation should not be reduced too abruptly if it has been
allowed to exceed its optimal long-run level»15.
In addition, if it recognized, as it results from many empirical analysis, that wage stickiness is very
important to the inflation process then again the trade-off between the two gaps will be different. As
Olivier Blanchard and Jordi Gali (2005)16 showed recently when real wage rigidities are introduced
what they call «the divine coincidence» of stabilizing together the two gaps disappears. In that case
and « in contrast with the baseline NKPC model, the divine coincidence no longer holds, since
stabilizing the output gap (y - y2) is no longer desirable. This is because what matters for welfare is the
distance of output not from its second-best level, but from its first-best level. In contrast to the baseline
model, the distance between the first- and the second-best levels of output is no longer constant»
As Woodford (2006) points out «If [prices and] wages are staggered in accordance with the Calvo
specification, then the welfare-theoretic loss function includes a term proportional to the squared rate
of goods price inflation and another term proportional to the squared rate of wage inflation each
period. In this case, optimal policy involves a trade-off between inflation stabilization, nominal wage
growth stabilization, and output-gap stabilization».17
Finally, there are two important issues related to the measurement and interpretation of the output
gap. First, it is well known that any output gap variable is very imprecisely estimated, particularly in
real-time. Second, the theoretically consistent output gap that plays a central role in the
NewKeynesian literature bears little resemblance to the three empirical measures presented in the paper.
The theoretical output gap is defined as the deviation of output from its equilibrium level in the
absence of nominal rigidities. Given that the theoretically consistent output gap is model-dependant,
this adds to the difficulty of defining a reliable and applicable objective function.
All this indicates that, as no Central Bank should be committed to a pure instrument-rule, in the same
way it should not commit to and make public a precise objective function. In effect, if the information
changed about the transmission mechanism the Central Bank should have then the opportunity of
changing the parameters without facing a very difficult communication task of explaining that change.
Regarding the price index to use in the definition of the target for inflation I tend to sympathize with the
author's position. To the arguments mentioned in the paper one could add that the same analysis by
Woodford about the relationship between welfare and the loss function for monetary policy,
demonstrates that «If prices are adjusted more frequently in some sectors of the economy than in
others, then the welfare-theoretic loss function puts more weight on variations in prices in the sectors
where prices are stickier... This provides a theoretical basis for seeking to stabilize an appropriately
defined measure of "core" inflation rather than an equally weighted price index»18.
There are nevertheless important practical obstacles to the use of a sort of core inflation index. First,
the communication difficulties would be very significant and the principle of accountability to public
opinion would be compromised as the general population is used to headline inflation which is the
general index that appears as relevant for daily life expenditures. Second, it would be difficult to
assess the relative degree of price rigidity of all the goods composing the HICP, in order to compute
the "core" inflation aggregate. Actually, this core aggregate would only be theoretically adequate in
case price stickiness was the main nominal rigidity in the economy. Finally, I agree that a practical
important implication of the choice of index is the degree of policy reaction to supply shocks that may
affect the more volatile components that are normally excluded from a core index. In the Eurosystem
we have dealt with the problem by allowing headline inflation going temporarily above our definition of
price stability without a monetary policy reaction when the increase in prices resulted from a
recognized supply shock and second-round effects were not present. I think this is the appropriate way
to deal with the question which puts me in the camp of those that Faust and Henderson (2004)19
designate as LETers (Limited exploitable trade-off) instead of a NETer (Non exploitable trade-off) or, in
the more colourful expression of Mervyn King, an «inflation nutter» aiming at reaching its target in
every period. A strategy that is forward-looking and has a medium term horizon for the achievement of
its objective should be able to deal with this problem of supply shocks.
A final point about the objective function regards the consideration of other possible objectives of
policy in the field of financial stability. The author's solution is to adopt a quasi-lexicographic approach:
«The central bank minimizes (the objective function) unless serious financial instability arises, in which
case it turns its attention to the latter» (page 11). This is coherent with the idea, defended in the paper
in relation to asset price bubbles, that monetary policy should adopt a pure «mop up after» strategy
when dealing with financial stability issues. I have doubts that this strategy is sufficient and I think that
monetary policy should not forget completely about those issues in its regular functioning or in special
turning points.
There is some ambiguity about the definition of financial stability but two main meanings stand out.
One, more fundamental, follows Mishkin (1991)20 and defines financial stability as a situation where
the financial system is able to ensure in a lasting way, and without major disruptions, an efficient
allocation of savings to investment opportunities. In another sense, financial stability refers to absence
of a major misalignment of asset prices that can threaten future disruption of markets and the real
economy. Both meanings are of course connected as they point to the same notion of smooth function
of financial institutions and markets. Consequently, I also deal with Question 14 in this point.
Traditionally, the dominant view was that asset prices booms were associated with a general
inflationary climate that fostered speculation in a background of expansionary policies. However, since
the late eighties we have witnessed various episodes that contradict that old notion. Two types of
analysis of structural developments in the financial system provide some understanding of recent
events and question the conduct of monetary policy21.
The first approach has been developed in the BIS research, in particular by Claudio Borio and Philip
Lowe (2002) and William White (2006).22 The main idea is that under present circumstances monetary
stability is not enough by itself to ensure financial stability and may even contribute to unstable prices
of financial assets. This contradiction would stem from the very success of monetary authorities in
guaranteeing price stability in a credible way. The coexistence of an environment of low interest rates
with future inflation expectations well anchored in the low levels defined by central banks objectives,
would allow credit expansion that would fuel asset prices increases. If valid, this view would be very
disquieting to central bankers because the traditional view has been exactly the opposite, i.e., that
stability of prices of goods and services would stimulate market participants to concentrate on the real
factors that affect the fundamentals of valuation of financial assets thus contributing to low volatility in
their respective markets. This view, which is certainly basically valid from a long term perspective, is
nevertheless not incompatible with the possibility that a short term trade-off may exist between
monetary and financial stability. That may be the case in particular in periods of transition after a long
period of disinflation or when monetary policy starts to change the interest rate cycle after a long
period of low rates.
The second view providing a broad explanation for the recent instability of asset price has been put
forward by Raghuram Rajan (2005),23 in a recent noted paper. What came to be known as the "Rajan
risk" is linked with the structure of incentives of managers and institutions in the new financial
environment. The gain of importance of market-based non-regulated institutions and the reduced
weight of traditional banking, gives prominence to compensation schemes more linked to returns
which induces managers to incur into riskier transactions. Second, performances in these growing
sector of "investment institutions" tends to be measured essentially against peers which fosters the
herd behaviour already present in financial markets.
Both types of behaviour increase the probability of episodes of asset prices misalignments. The
system tends to assume more risks, including the so-called tail risk where probabilities are low but
losses can be high. Who would have thought some years ago that pensions funds and insurance
companies would become participants in the market for risk of default of other firms? On the other
hand, hedge funds manage nowadays much more assets than in 1998 and are involved in less liquid
markets. Additionally, their returns have become more correlated across supposed different types of
funds which seems to indicate that they could be subject to the same type of risks in a period of tighter
credit and stressful equity markets.
This points, precisely, to accrued risks in periods of monetary policy transition. Central Banks should
not ignore this possibility and in fact they usually take into consideration financial stability issues for
which they are mandated and that is one of the reasons that explains why they embark into
gradualism, interest rate smoothing and manage turning points of policy at a measured pace. More
generally, financial stability concerns should not be ignored in the decision making process even in
more normal periods. As I mentioned a few years ago « ...even without defining precise targets,
interest rate policy, in certain circumstances, should "lean against the wind" when it blows too strongly
in asset markets» (Constancio, 2002)24. I do not recommend an aggressive approach to start bursting
bubbles or to include a term with asset - associated with asset prices booms. prices in the objective
function, but we should not ignore the problem altogether when is starts to emerge, without having the
illusion that monetary policy could provide the whole solution. The problem will have to be addressed
by other instruments, like regulation and supervision. In what concerns monetary policy, the
fullinformation approach that I described as one of the five main principles in the conduct of monetary
policy may be particularly useful here. In particular, looking to developments in credit aggregates may
be informative, namely because, as suggested by research done in the BIS, buoyant credit expansion
is normally - albeit not always25 - associated with asset prices booms.
The existence of the sort of short-term trade-off that we are considering may create significant
problems to the inflation targeting monetary policy regime. Being by definition very much attached to
targets and forecasts for inflation as an almost exclusive basis for decisions, that framework has
difficulty in incorporating other considerations into the decision-making process without losing some
credibility. The notion that this can be overcome by extending the horizon of the inflation forecast by a
number of years does not look realistic and has not been attempted. It is however very interesting the
addition made by the Central Bank of Norway to the list of criteria to assess future interest rate policy
that I mentioned earlier and refers to asset prices increases and aggregate credit growth. Of course,
this criterion, although subordinate, only adds to the difficult of the framework to fend off the
accusation of having multiple objectives hidden behind a single denomination of «inflation targeting»
without the transparency of disclosing the exact criteria that may justify a temporary deviation from the
main target. A disclosure, let me add, that I would consider virtually impossible or unwise to do.
An important argument that Alan Blinder uses to defend his view on asset price bubbles is that the
«mop up after» strategy has «worked extraordinarily well» in the context of the stock market bubble of
the late 90's. It could be reminded though that it worked well for the economy because of the very
expansionary fiscal policy and the wealth effects on other asset markets (bonds and real estate)
induced by the very aggressive monetary policy. The final result is that the so-called global imbalances
are still with us and no one knows how their winding down will play out.
This discussion highlights the importance I attach to financial stability as one of the core mandates of
any central bank. In this context, I agree with Blinder's conclusion that important supervisory
should remain with central banks (Question 5) . This conclusion stems directly from the
responsibilities
strong complementarities that exist between the macroeconomic prudential surveillance framework
and the microeconomic supervisory responsibilities. About the counterarguments based on the idea of
a conflict of interest with monetary policy let me add just two comments. The first, that it is illusory to
think that this possible conflict would disappear just by separating and giving the two functions of
supervision and monetary policy to different institutions. The second, to underline the fact that the
possibility of that conflict does not exist in the euro area in the case of National Central Banks that are
responsible for supervision but do not decide, only by themselves, the single monetary policy and are
not in full control of money creation.
On transparency (Question 2), I agree that the trend is irreversible in the direction of wider disclosure
by Central Banks of their procedures. Transparency about goals and about methods can be beneficial
to monetary policy because expectations are such an important channel of transmission. Expectations
about future policy and future inflation affect today's decisions on wages and prices and those
expectations depend on the economic agents' view on future monetary policy. So, I agree with the
author in most of the points he makes about these issues. Regarding the methods of published
inflation forecasts and the treatment to be given to the future path of interest rates I think that taking
into account the path indicated by the financial markets is an adequate solution. It is logically
consistent, it is transparent and in the case of the Eurosystem cannot lead to any sort of dynamic
inconsistency as in our framework the staff forecast are just one element, albeit an important one, of
the whole information set that we consider in our deliberations. Contrary to the inflation-targeting
regime, there is no commitment to a direct link between the projections and our decisions on interest
rates.
On transparency regarding the decisions and the decision-making process, I share the arguments that
justify in our case the non-publication of minutes with the indication of individual votes. The young age
of our project and its supra-national nature would create risks of great pressure of national public
opinions on the vote of national Governors. With time and the consolidation of our institutions, I am
open to reconsider my opinion on this issue.
I already expressed a number of opinions on the inflation targeting regime that should be enough to
reach the conclusion that I do not favour the adoption of a full-fledged version of that framework in big
economic areas (Question 3). In relation to small countries and in particular emergent ones, I accept
that the regime may be useful because it provides a level of commitment that fosters the required
credibility for central banks. In the case of big developed areas without significant credibility problems I
think that the regime, the way I see it, has some costs and unnecessary rigidity. This opinion is very
much dependent on my definition of an Inflation Targeting Framework (ITF). Alan Blinder in the paper
states that the «essence of inflation targeting is announcing a numerical value for π* and being
transparent about it». There are some definitions of a ITF that add very little to this requirement to
characterize the regime, appending only aspects of transparency and communication regarding
methods and decisions. If that would be enough for a definition then the Eurosystem could be included
as an inflation targeter, which would come as a surprise to many insiders. In fact, that definition is too
broad to be useful. Lars Svensson, the author that better theorized the regime, distinguishes between
«general targeting rules