Mr Meyer discusses the new challenges for
monetary policy identified at the Jackson Hole conference
Remarks by Mr Laurence H Meyer, Member of the Board of Governors of the US Federal Reserve
System, before the Department of Finance Lecture Series, University of Missouri, Columbia, Missouri
on 12 October 1999.
* * *
Each year in late August, for the last 23 years, the Federal Reserve Bank of Kansas City has hosted a
conference where central bankers from around the world tackle issues relevant to the setting and
implementation of monetary policy. They are joined by academics, former Federal Reserve governors,
and private-sector economists. A core group returns every year and contributes a particularly strong
sense of camaraderie.
The lure of the conference is the extraordinary combination of an excellent choice of topics, a high
level of formal presentations and discussions, the opportunity to engage in a series of more informal
conversations over coffee, at meals, and on hikes, and to do all this in the shadow of the Tetons. I told
Tom Hoenig, the President of the Kansas City Fed, that when I was considering whether or not to
accept the nomination to join the Board of Governors, the deciding factor was the prospect that, by
doing so, I would receive a lifetime perk of an invitation to the Jackson Hole Conference.
The themes are always interesting, but I found this year's conference particularly stimulating - so
much so that I decided to use the presentations and discussions at Jackson Hole as the organizing
framework for today's lecture.
The title of this year's conference was "New Challenges for Monetary Policy." The papers described
both the emerging consensus about the objectives and strategies underlying the conduct of monetary
policy and highlighted a number of new challenges.
In the first section of today's lecture I will outline the framework and identify the objectives of
monetary policy, describe the operational procedures used to conduct monetary policy, and discuss the
strategy for carrying out monetary policy to achieve those objectives. A number of participants at the
conference suggested that there was an emerging consensus about the appropriate strategy -
specifically, flexible inflation targeting.
Then I will turn to the new challenges for monetary policy identified at the conference. Each is
illustrated by current or recent experience around the world. First, does a low-inflation environment -
and specifically the possibility that nominal interest rates might decline to zero in such an environment
- constrain the effectiveness of monetary policy, and if so, how can monetary policy adjust to maintain
its effectiveness? Second, how should monetary policy respond to movements in asset prices in
general and, specifically, to the possibility of asset-market bubbles? Third, what is the best option for
exchange rate and monetary policy regimes for small open emerging market countries, in light of
increased globalization and especially larger and more volatile international capital flows?
The basic theme of the conference was that flexible inflation targeting provides a constructive
response to each of these challenges. Careful design and implementation of the framework, including
the choice of an inflation target, would, for example, reduce the prospect that monetary policy might
lose its ability to stimulate the economy further because nominal short-term interest rates had fallen to
zero. Similarly, following such a disciplined monetary policy would mitigate, though not entirely
eliminate, the effect of asset bubbles. Finally, countries that move to a flexible exchange rate regime -
as many have done recently - need to put in place a disciplined monetary framework such as is offered
by this approach.
I. The monetary policy framework
Let me start this discussion by identifying what the objectives of monetary policy are, and should be,
and then discuss what strategies are useful in achieving the objectives.
A. Objectives of monetary policy
One of the themes of the conference was that there is an emerging consensus about the objectives of
monetary policy, one that has been reflected in the conduct of monetary policy in many countries for
some time and now is finding its way into the rhetoric of policymakers.
I would describe the consensus as an acceptance of a dual mandate for monetary policy. Monetary
policy seeks first to achieve and maintain price stability over the longer run and, second, to retain the
flexibility to dampen cyclical fluctuations in the economy around full employment. That is, I suspect,
a sharper statement than many (and indeed most) central banks today feel comfortable with. At the
conference, the consensus was described as "flexible inflation targeting."
Most central banks want to emphasize, with good reason, their price stability objective. This reflects a
couple of strongly held views. First, monetary policy, in the long run, principally affects nominal
variables such as nominal income, the price level, and the rate of inflation, but has lesser effects on
real variables - such as the level of employment or the level or growth rate of output. I expect all
central bankers would agree that an environment of price stability offers the best contribution that
monetary policy can make to the level and growth of output because it eliminates distortions to
resource allocation and disincentives to saving and investment associated with high and variable
inflation rates. It follows that a more accommodative monetary policy cannot foster a higher average
rate of real growth. The second strongly held view is that because monetary policy is the principal
determinant of the inflation rate in the long run, central banks have a responsibility to set an
appropriate target for long-run inflation and achieve it. And that target should be price stability or, at
the least, a low rate of inflation.
While monetary policy cannot raise the level or rate of growth of output over the long run through any
means other than maintaining price stability, it is widely, though not universally, accepted that
monetary policy can affect the level and growth rate of output in the short run and, perhaps, therefore
contribute to smoothing out fluctuations in the economy around full employment. This is sometimes
referred to as the short-run stabilization objective for monetary policy. A central issue for monetary
policy is how to balance the dual objectives of price stability and output stabilization and how explicit
to be about the commitment to these dual objectives.
Both theoretical and, especially, empirical macroeconomics have established the existence of an
inescapable trade-off affecting the conduct of monetary policy. The trade-off is between the variability
of inflation around its target (zero or some low rate) and the variability of output around its target (the
full-employment level of output or potential output).
Autonomous increases or decreases in aggregate spending push output and inflation in the same
direction relative to their targets and, therefore, do not bring this trade-off into play. But supply shocks
- such as increases or decreases in oil or food prices - drive output and inflation in opposite directions
relative to their respective targets. The more quickly monetary policy reacts to restore inflation to its
target following a supply shock, the greater will be the variability in output relative to its target.
The reason for this trade-off is that monetary policy affects inflation primarily through its initial effect
on the amount of slack in the economy. Tightening monetary policy slows spending growth, opens up
some slack temporarily in labor and product markets, and allows the slack to reduce inflation. Once
inflation has returned to its target, policy can guide the economy back to full employment. It probably
takes a certain amount of slack over time to reduce inflation by a given amount, but reducing inflation
rapidly means opening up an especially large output gap for a short period - hence the trade-off
between inflation and output stability.
Several countries have moved to inflation-targeting regimes over the last decade or so, setting a
numerical target for inflation. This was generally part of a process of shifting responsibility for
monetary policy from finance ministries to independent central banks and often followed a period of
poor macroeconomic performance, especially high and variable inflation. The newly independent
central banks often identified inflation as the singular objective of monetary policy to gain credibility
and facilitate the transition to price stability. In addition, the government wanted to ensure
accountability of the central bank and hence often opted for a narrow and explicit objective. With price
stability now largely accomplished, some of these central banks are becoming more flexible in their
approaches to monetary policy by recognizing a role for short-run stabilization.
B. How explicit should the objectives be?
In the United States, Congress has set the objectives for monetary policy in the Federal Reserve Act,
as amended in 1977. The objectives are maximum employment and stable prices, which are mutually
consistent and achievable if maximum employment is interpreted as the maximum employment
sustainable without rising or falling inflation. This is an explicit expression of a dual mandate.
Inflation-targeting countries typically have goals of about 2% to 21⁄2% for inflation and sometimes
establish a range for inflation, for example, 1% to 3%. New Zealand, Canada, Australia, and the
United Kingdom are examples of countries with explicit numerical targets, and there are many others.
It was widely agreed at Jackson Hole that the United States has, without an explicit target, achieved
the same success in reducing inflation as countries with explicit numerical targets. I will not be
considering the pros and cons of an explicit numerical target for inflation today, although I recognize
this is an important question and one that warrants further discussion.
C. How should policy be conducted to achieve the objectives?
Once the objectives of policy are set, a central bank must choose an operating regime and then develop
a strategy for using its instruments to achieve the objectives.
Virtually all central banks carry out monetary policy operations by influencing - in effect setting -
some short-term nominal interest rate, typically the rate on overnight inter-bank loans. The FOMC at
each meeting sets a target for the federal funds rate and instructs the Manager of the Open Market
Desk to achieve that target over the intermeeting period by buying or selling securities. By adjusting
this single rate, the Federal Reserve affects the broader array of interest rates and asset prices in the
economy and, in turn, affects aggregate demand, the level of real economic activity, and inflation.
There are two ways of describing the strategy for monetary policy. One focuses on "instrument rules,"
which describe how the policy instrument - in this case a short-term interest rate - should be moved in
response to economic developments. Such a rule was designed by Professor John Taylor of Stanford
University. The Taylor Rule describes how the federal funds rate should be adjusted in response to
movements in output relative to its long-run sustainable level and to movements in inflation relative to
its target. The Taylor Rule thus explicitly embodies the dual objectives of monetary policy and is a
form of flexible inflation targeting.
In practice, no one expects monetary policy to be conducted according to a rigid rule. Such rules can,
however, be useful in informing policy decisions and helping policymakers calibrate their responses to
changes in utilization and inflation rates. Moreover, research on how such rules affect the quality of
macroeconomic performance can aid policymakers in arriving at their decisions.
A second strategy is to move the instrument in response to the inflation forecast. In this approach, the
policymakers start with a forecast of inflation over some interval, typically about two years. Policy is
then set over this interval to achieve the price stability target by the end of the period. The interval
chosen to reach the inflation target takes into account the fact that the more rapid the return to the
target, the greater the variability in output relative to its target. The time interval is thus a vehicle for
allowing policymakers to damp movements in output around full employment and at the same time
ensure that the inflation objective is eventually achieved.
Inflation forecast targeting has the advantage of being explicitly forward-looking. The Taylor Rule, in
contrast, appears to be backward-looking, though the contrast is not as clear in practice as it might
appear. Forecasts are exercises in processing information about current and past developments to yield
anticipated future outcomes. The Taylor Rule takes explicit account of only very recent observations
on inflation and output, but these are, to be sure, important determinants of future inflation. An
inflation forecast approach allows policymakers to consider a wider range of current and past
information in projecting future outcomes.
D. Setting the inflation target
Setting the inflation target to be consistent with price stability sounds straightforward, but an
important theme at this summer's conference was the variety of options and implications of this
choice. The obvious choice would be a target of zero for inflation, taking into account biases in
published price measures. But an intriguing alternative is to set a target for the price level. If a
disturbance results in a period of inflation, under a zero inflation target, the objective is to return to a
zero inflation rate. When inflation has been returned to zero, however, the price level will be higher
than it was before the disturbance. Under a constant price level target, the aim is to return to the initial
price level, requiring a period of deflation to offset the effect of the period of higher inflation. This can
produce a more predictable price level in the long run, but many analysts are concerned about how the
economy would respond to a period of deflation.
Yet another alternative is to target a low positive inflation rate - specifically an inflation rate
somewhat above a level that reflected estimates of the bias in published measures. One of the issues I
will discuss shortly is whether targeting a low, positive rate of "true" inflation (what I call price
stability plus cushion) might result in better cyclical performance of the economy than a zero inflation
target.
Still another choice is an average inflation target. If the target was 2% and inflation temporarily moved
to 3%, an average inflation target policy would encourage a decline in the inflation rate to below 2%
for a while, moving the average back to 2%. This allows for a predictable (albeit rising) long-run price
level, while avoiding the deflationary episodes that would occasionally be called for under a constant
price level target.
II. Monetary policy in a low-inflation environment
I turn now to the challenges associated with the conduct of monetary policy in a low-inflation
environment. The issue here is whether, at very low inflation rates, the cyclical performance of the
economy would deteriorate. If this were the case, the objectives or strategy of monetary policy would
need to be adjusted. Among the possible responses is adjusting the definition of the inflation target, so
I will be building on the preceding discussion.
A. Keynes' liquidity trap and the zero nominal bound problem
The General Theory of Employment, Interest and
John Maynard Keynes, in his classic work, Money,
warned that monetary policy might become ineffective once interest rates fell to some low level at
which wealth owners might become indifferent as to whether they held money or bonds. In the
language of economists, money and bonds might become perfect substitutes. In this case, it would be
impossible for monetary policy to affect interest rates by affecting the composition of portfolios,
specifically the amount of money held relative to bonds. Keynes called this situation a "liquidity trap."
Since the end of the Great Depression, many have interpreted Keynes' liquidity trap to be a theoretical
curiosity rather than a practical problem likely to confront policymakers. But with short-term rates
now at zero in Japan and low inflation almost everywhere in the industrialized world, the problem is
taken more seriously by central banks - to the point that it was one of the topics at Jackson Hole.
Keynes' views on the liquidity trap have, in my view, often been misunderstood. Keynes understood
that central banks could push rates on short-term government debt to zero. The liquidity trap, as
Keynes used the term, is better thought of as a term-structure trap or, more generally, a limit on how
low long-term and private interest rates can go once the interest rate on short-term government debt is
pushed to zero. When short-term government rates reached zero, Keynes believed that there would
still be positive interest rates on both longer-term government securities and private debt and that
monetary policy then would be unable to push those rates any lower.
The conventional view is that the level of long-term rates is determined by current and expected
shortterm rates. Given that market participants are unlikely to expect that zero short-term rates will be
sustained for 20 or 30 years, the maturity of long-term bonds, rates on long-term securities will remain
positive when short-term rates reach zero. Stated somewhat differently, shocks that would otherwise
lower short-term rates cannot do so at the zero bound, while shocks that would raise short-term rates
still will do so. In addition, private rates differ from government rates by an amount that reflects the
risk of default on private debt, assuming that government debt is viewed as being default free. Even if
the rate on government debt reaches zero, therefore, private debt will still carry positive rates.
The liquidity trap is sometimes referred to as the problem of the zero bound on nominal interest rates.
Nominal interest rates cannot be negative, because, in this case, everyone would want to hold cash.
Consequently, an environment of very low inflation would constrain how low monetary policy could
push real interest rates in response to a recession and, therefore, be associated with less-favorable
cyclical performance of the economy. If inflation were 2%, for example, monetary policy, by driving
the nominal interest rate to zero, could push real interest rates to minus 2%. If prices were stable, on
the other hand, the limit on the real interest rate would be zero, and this limit might constrain the
ability of monetary policy to offset downward shocks to the economy.
B. Nominal rigidities
Another long-standing explanation for why low inflation might result in a deterioration in
macroeconomic performance is the possible existence of nominal wage rigidities - specifically, a
reluctance to reduce nominal wages. Relative wage movements are important signals and incentives
that guide labor resources to their most highly valued uses. When inflation is very low, achieving this
variation in relative real wages depends on some wages falling. If nominal wage cuts are rare,
efficiency in the allocation of resources may decline, and as a result, output might be lower at price
stability than if there were some low rate of inflation. And in the absence of declines in nominal wages
for some workers, average real wages will be higher, and hence average employment lower, at price
stability. Although there is some evidence of downward nominal wage rigidity, there is no evidence
that this has an effect on aggregate wage and price inflation or the natural rate of unemployment in the
postwar period - even when inflation has been very low. In addition, it is not clear how much rigidity
would remain if we achieved and sustained steady low inflation.
C. Japan's current experience
As I noted earlier, Japan presents a laboratory for observing an economy with low inflation. Japan
enjoyed effective price stability through most of the 1980s. In the 1990s it was hit with a number of
adverse shocks, from bursting asset bubbles and associated banking system problems early in the
decade to the financial meltdown of its Asian trading partners in late 1997. In continuing its efforts to
move the economy toward recovery, the Bank of Japan last February lowered short-term interest rates
to almost zero. Although Japan registered surprisingly robust growth in the first half, most observers
see private-sector demand as still quite weak despite the low short-term rates.
Nevertheless, that the Bank of Japan has apparently exhausted its ability to stimulate the economy
through conventional policy. This raises two questions. How could monetary policymakers have
avoided this predicament, and once they were in it were there unconventional forms of monetary
policy that would have permitted them to provide additional stimulus to demand?
D. How to avoid the problem
At the Jackson Hole conference, Mervyn King and Lars Svensson argued that a flexible
inflation-targeting regime would help policymakers avoid this problem in the first place. While King
in particular had some doubts about the zero nominal interest rate bound and especially about the
existence of nominal rigidities, both he and Svensson noted that opting for a positive inflation rate as a
target was a prudent way of avoiding testing either of these hypotheses. Indeed, they both noted that
inflation-targeting central banks virtually always opt for inflation targets greater than zero and greater
than estimates of the inflation bias in published measures of inflation. Recent research suggests that
even a cushion of 1 percentage point (above an amount equal to the expected bias in inflation
measures) can go a long way towards avoiding the problem of deteriorating cyclical performance at
low inflation rates.
The second key to avoiding this problem is to have a symmetrical inflation target. This means one that
evokes an aggressive response to both falling below and to rising above the inflation target. One could
take this further. Monetary policymakers can always choke-off inflation by raising real interest rates,
because there is no limit to how high real interest rates can be pushed. There is a limit, however, to
how low real interest rates can decline, given the zero nominal interest rate bound. Therefore, to the
degree that any asymmetry is called for, it might be to move more quickly and more decisively with
respect to downward than to upward disturbances to aggregate demand, at least when beginning from
already low nominal interest rates. This allows policymakers to substitute speed for the magnitude of
decline when responding to downside shocks.
A third possibility is that the zero nominal bound problem can be reduced or eliminated either by a
credible price level target or by an average inflation target. If the price level falls in response to
downside shocks, a price level target will imply that monetary policy will move more aggressively to
stimulate the economy, once demand recovers and monetary policy has regained its effectiveness, than
would have been the case with a traditional inflation target. This would ensure that a period of
deflation will be followed by a corresponding period of inflation. Assuming bondholders take into
account this more aggressive stimulus, bondholders will project that zero nominal short-term interest
rates will be maintained longer than would otherwise be the case, justifying lower long-term interest
rates today.
A similar result could be achieved by an average inflation target. If inflation was zero for a while,
bondholders would project a period of inflation above the long-run inflation target - for example, 3%
or 4% instead of 2% - until the average inflation rate returned to 2%. This would lead to expectations
that short-term interest rates would remain low for a longer period and contribute to a decline in real
long-term rates today.
E. What to do if nominal rates fall to zero?
If a target for price level, positive inflation rate, or average inflation rate had not been implemented
and made credible before a central bank was confronted by zero nominal interest rates, the central
bank could, of course, introduce them at that time. However, such a move might lack credibility. It
might be seen as an emergency program that might not be sustained once the economy recovered and
moved away from the zero nominal bound. Moreover, with prices falling and the economy in
recession, one could imagine a good deal of skepticism about the ability of the central bank to meet its
objective.
Paul Krugman has urged the Bank of Japan to move to a positive inflation target as a way of lowering
real interest rates and stimulating the economy. The Bank of Japan has resisted, arguing that, given its
inability to increase aggregate demand, there would be little credibility in setting a positive inflation
target. Even if the Bank of Japan today cannot expect to stimulate demand and thereby raise inflation,
they will almost surely have this opportunity well before today's long-term bonds mature. They could
therefore commit today to maintaining a positive inflation rate when it becomes possible and thereby
raise inflation expectations today and lower real interest rates. However, such a distant increase in
inflation might not have much impact on the real cost of borrowing today, so I continue to be skeptical
that initiating an inflation targeting approach, once confronted by the zero nominal bound, offers a
reliable way out of the zero nominal bound problem.
A second approach would be to undertake unconventional monetary policy operations. Conventional
monetary policy is implemented, as I described, by employing open market operations concentrated in
repurchase agreements or in the short end of the government debt market. An alternative approach,
sometimes referred to as a monetization strategy, focuses on increasing the money supply rather than
on the level of short-term interest rates. At Jackson Hole, Allan Meltzer offered a clear framework for
the way such a policy direction might allow additional stimulus after conventional operations had
lowered nominal short-term interest rates to zero.
In the typical model, money and bonds become perfect substitutes at some low interest rate, perhaps
zero, and we have a liquidity trap where monetary policy loses its power to add further stimulus by
lowering interest rates on bonds. Meltzer suggested this result reflects more the limits of the typical
model than the limits on monetary policy. He suggested that in a more realistic model incorporating
multiple assets - for example, long-term as well as short-term government bonds, private as well as
government debt, and equities as well as bonds and money - there are two ways in which the economy
can escape from the apparent liquidity trap. In an activist approach, monetary policy would increase
the sum of the money supply and short-term government debt - the assets that have become perfect
substitutes - by widening the scope of open market operations to include purchases of long-term
government debt and perhaps private debt and foreign exchange. Such operations might lower interest
rates on long-term and private securities and/or result in a depreciation of the currency, in all cases
stimulating aggregate demand.
A more passive approach would allow deflation to raise the real value of the sum of money balances
and short-term debt. This will be the outcome of deflation as long as the central bank does not let the
nominal money supply decline as the price level falls. An increase in the real money supply would
then result in increased purchases of a wide array of financial assets, including longer-term
government bonds and private debt and perhaps even equities. The net result will be lower interest
rates on long-term and private securities and higher values of equities that, in turn, will stimulate
spending, over and above the stimulus that results from the wealth effect associated with increased real
money balances.
This analysis raises an interesting set of questions about which reasonable people can disagree. Theory
would seem to leave open the possibility that such wider operations might provide incremental
stimulus, but I read the empirical evidence and historical experience as raising doubts about the
effectiveness of such actions. Important questions relate to both the theoretical structure of asset
demands and empirical evidence about portfolio behavior and asset markets. The issue of whether
relative supply of short and long-term bonds affects the term structure of interest rates is crucial.
The most widely accepted theory of the term structure, called the pure expectations model, holds that
long-term interest rates are a weighted average of current and expected future short-term rates. This
approach leaves no room for relative supply effects and is consistent with the term structure trap that I
have associated with Keynes. There is, however, a competing theoretical model, often referred to as
the market segmentation approach, which allows for the effect of relative supplies. I have never given
much weight to the role of relative supply effects in affecting the term structure or exchange rates,
given the failure of empirical studies to find much evidence of such effects. Of course, at the extreme,
the Bank of Japan could set the price and hence interest rate on long-term bonds if it was prepared to
take all these assets onto its balance sheet. But such operations almost certainly blur the distinction
between monetary and fiscal policies.
Another reason for skepticism is that the domestic channel through which monetary policy works in
Japan operates very importantly through the banking system. The continuing banking sector problems
suggest that this channel remains weak, if not inoperative. Specifically, if additional reserves were
injected into the banking system, a larger share of them would likely be held as excess reserves rather
than to be lent out. In this case, attention shifts to the effect of monetization on exchange rates and to
the recommendation that the Bank of Japan raise the money supply by purchasing foreign currency, an
operation sometimes referred to as unsterilized exchange rate intervention.
There is a case in which unsterilized intervention has a more powerful effect on exchange rates than
sterilized intervention (where the central bank absorbs any reverses introduced as part of exchange rate
intervention). But this incremental effect arises because unsterilized intervention is expected to lower
the country's interest rates and the lower interest rates would, in turn, put downward pressure on the
country's exchange rate. If the interest rate channel does not operate because of a liquidity trap, this
could raise questions about the effect of unsterilized foreign exchange intervention.
Even in this context, however, there may be some positive effects of unsterilized intervention. This
operation, like open market operations conducted in long-term securities, is a way of raising the sum
of money and short-term government securities. As portfolios are rebalanced, the increase in the
money supply may result in purchases of long-term government securities, private securities, and
foreign currency denominated assets. This could affect a range of interest rates and the exchange rate.
Though once again there is a question about the degree to which relative supplies of assets have an
important bearing on relative rates of return.
Moreover, such a strategy faces other obstacles. First, in Japan, foreign exchange operations are at the
discretion of the Ministry of Finance. Therefore, implementing a monetization strategy in this way
would appear to shift the decision about the timing and magnitude of monetary policy from the newly
independent central bank back to the Ministry of Finance. Second, pursuing a stimulus program
focused on yen depreciation might exacerbate tensions related to the already wide current account
imbalances in Japan and the United States as well as possibly interfere with the recoveries under way
among Japan's Asian trading partners.
So I remain skeptical that there is much leverage in the monetization approach. Nevertheless, if the
Japanese economy fails to respond to the policies now in place, one could argue for some
experimen