Hermann Remsperger: Macroeconomic risk and policy responses
Welcome address by Professor Hermann Remsperger, Member of the Executive Board of the
Deutsche Bundesbank, at the 7th Bundesbank Spring Conference "Macroeconomic Risk and Policy
Responses", Berlin, 27 May 2005.
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I have the pleasure of welcoming you to the 7th Bundesbank Spring Conference which is organised
jointly by the Humboldt University Berlin, the London-based Centre for Economic Policy Research and
the Deutsche Bundesbank. The focus of this year's conference is on "Macroeconomic Risk and Policy
Responses".
Risk and uncertainty are key elements of many decisions, above all those extending into the future.
Hence, the optimal response to risk has always been a topic of great interest to political, military and
economic decision-makers. Concern with this crucial issue is also reflected in the works of our great
philosophers and writers.
Among those men of letters, a rather positive attitude towards taking risks seems to prevail. For
example, the Roman poet Ovid claimed that "Both fortune and love befriend the bold". And Friedrich
von Schiller wrote "He that is overcautious will accomplish little".1
Now, in general, central bankers are not known for their boldness or love of risk, and I would claim that
there are some good reasons for this. So - as a cautious central banker - I was very happy to find that
at least the Greek dramatist Sophocles displayed a more balanced attitude towards risk when he
warned that "Quick decisions are unsafe decisions".
There is no need to explain to this audience that central banks face many forms of risk when taking
monetary policy decisions. This was particularly true for the ECB when it started monetary policy in
January 1999, but it is also true for central banks who act under more normal circumstances. Alan
Greenspan has repeatedly made the point that: „...uncertainty is not just a pervasive feature of the
monetary policy landscape; it is the defining characteristic of that landscape".2
Against this background, it comes as no surprise that the forms and consequences of risk and
uncertainty for the optimal conduct of monetary policy have been a very active field of research in
recent years. Let me use this opportunity to render a very brief summary of what we have learned -
and what we have not learned - from this research so far.
Today it is generally recognised that maintaining price stability is the best contribution which monetary
policy can make to long-run macroeconomic welfare. Therefore, most central banks - like the ECB
and the Bundesbank before it - are committed to the primary objective of achieving and maintaining
price stability.
In order to be able to assess the risks to price stability, monetary policy makers need models which
represent the relevant structural relationships between the price level, the monetary policy instruments
and other factors affecting price movements like changes in oil prices or exchange rates.
However, the exact nature of these relationships is surrounded by a high degree of uncertainty. As a
consequence, the question of which relationships are the "relevant" ones and which simplifications are
"adequate" is - and will probably always be - a contentious one.
One of the lessons that we have learned from recent research is that focusing on specification errors
or parameter uncertainty in the neighbourhood of a particular reference model may dramatically
understate the true degree of model uncertainty.
It is therefore advisable for central banks to base their decisions on a broad range of models which
reflect various assumptions regarding the transmission process. In fact, this is the approach which
most central banks - and certainly the ECB - are already practising.
Now, the question is which weights should policy makers attach to each of these competing models
when assessing the risks to price stability? This is a very controversial issue.
Part of the academic literature assumes that policymakers or their staff form priors over the models
and choose the approach which minimises average expected loss (Bayesian approach).
In contrast, the robust control approach assumes that policymakers are completely agnostic with
respect to the probability that a specific model may represent the actual economy and thus choose the
approach which minimises the maximum loss across all models (minimax preferences).
In order to implement the Bayesian approach, policymakers need to be able to attach a specific
probability weight to each of the competing models. While this may be a very difficult task, the minimax
approach also suffers from several drawbacks.3
One fundamental problem is that such an approach is vulnerable to policy makers giving excessive
weight to low probability, but high-cost scenarios. Therefore, as was pointed out by Chris Sims in his
2001 paper, this approach should only be seen as one method for generating reference priors. Its
results should be compared to more direct approaches to assessing prior beliefs.
At the end of the day, and here I am happy to quote Mervin King, "there is no escaping the need to
make judgements about which models are more plausible than others".4
Another important lesson we can learn from recent research is that the problem of model uncertainty is
compounded by measurement problems regarding key variables like real output and its components.
Moreover, a number of studies have shown that the problem of measurement error is likely to be
particularly severe for variables that cannot be observed directly. Take the output gap and the "neutral"
level of real interest rates as two variables which figure very prominently in much of the recent
literature on optimal monetary policy.
As a consequence, every attempt to fine-tune the economy bears the risk of policy errors with the
corresponding negative effects on price stability. In my view, this line of research has very much
strengthened the case against output stabilisation as a target of monetary policy - a case which was
already made by Milton Friedman as early as 1961.
Let me give you another example of a measurement problem which also shows how closely linked
data and model uncertainty are. In a current research project at the Bundesbank we try to shed some
light on the factors that drive the recent strong money growth in the euro area.
Our study shows that economic agents tend to increase their money holdings when the financial
environment is characterised by low yields, high volatility and a change in risk perception. Such an
environment may be referred to as one of heightened macroeconomic uncertainty.
Trying to integrate this uncertainty into a model for money demand poses a severe measurement
problem. A variable has to be revealed which cannot be observed directly. We at the Bundesbank try
to uncover such uncertainties from a variety of observable variables which describe the financial
market situation and economic sentiment. The estimated proxy for macroeconomic uncertainty - or risk
sentiment - helps us to explain recent monetary developments in the euro area.
Against this background, we believe that difficulties with standard specifications of money demand
should not be taken as an argument for abandoning monetary indicators and monetary analysis all
together. Rather, in our view, we need to deepen our understanding of the link between money and
prices by integrating uncertainty into our analysis of money demand.
Recent research on data uncertainty has also strengthened the case for a cautious, gradual approach
to monetary policy as advocated by William Brainard as early as 1967. In particular, this research has
taught us that monetary policy makers should not react strongly to first releases of data which could
easily be revised. They should rather make a broadly-based estimate of such variables, taking into
account information from other, less revision-prone sources as well as the past history of revisions to
the variable in question.
You may have realised that by now, I have already presented a number of arguments which favour
caution boldness
rather than as the adequate approach to monetary policymaking. However, recent
research has also shown that under certain conditions monetary policy makers may be well advised to
take the kind of bold decisions advocated by Ovid and Schiller.
In this respect, the idea that both the private sector and the central bank possess only limited
knowledge about the "true" structure of the economy is particularly relevant. Therefore we have to
continually update our estimates for the specific parameters. Moreover, learning by the private sector
has to be taken into account when taking monetary policy decisions.
With this kind of learning, a series of inflation shocks can easily turn into a high degree of inflation
persistence perceived by the private sector. And this makes it more difficult for the central bank to
stabilise inflation at the desired low level.
Few central bankers would dispute the need to firmly anchor long-run inflation expectations at a low
level. However, there may be different ways to achieve this aim.
For instance, the ECB is not known for responding aggressively to short-run fluctuations of inflation
around target. Instead, it relies on a clear definition of its ultimate objective, an explicit medium-term
orientation, and its two-pillar approach as the primary means to anchor inflation expectations.
I am very much in favour of the ECB's approach. At the same time, I do not want to dispute that there
may be situations when central banks have to act rather aggressively. In particular, this may be the
case when an economy is subject to large negative shocks which could trigger off extremely
unfavourable developments. I am thinking here of major shocks like a stock-market crash, a financial
crisis or other extreme events.
Unfortunately, in such situations, the log-linear approximate models currently available for monetary
policy analysis provide little guidance. Therefore, in times of large idiosyncratic shocks,
decision-making at central banks involves significant judgement - judgement which can be drawn, for
example, from evidence about past behaviour of markets and the economy as a whole.
While monetary policymakers are well-advised to follow a cautious "steady-as-she-goes" approach
under more normal circumstances, boldness may be required in exceptional situations.
However, this is by no means a case yet closed. Thus I am very interested to see what results come
out of the studies that will be presented here today and tomorrow. I wish you stimulating discussions
and a pleasant stay in Berlin. Thank you very much for your attention.