Bruno Gehrig: Monetary policy in a changing world
Speech by Prof Dr Bruno Gehrig, Member of the Governing Board of the Swiss National Bank at the
3rd Conference of the Swiss Society for Financial Market Research (Schweizerische Gesellschaft für
Finanzmarktforschung, SGF), held in Zurich on 7 April 2000.
* * *
The title of my speech may sound somewhat ambitious. It signals all-encompassing breadth and
profound depth. These are demands that I will hardly be able to meet. What follows are a few
reflections on selected aspects of monetary policy by a practising economist. I should like to begin
with a brief historical review leading to the 1990s, which have become known - and justly so - as the
decade of successful disinflation. Then I will turn to the changes in monetary policy concepts.
Following these rather retrospective remarks, I should like to deal with topics of broad general interest
in today's discussion - under the headings "independence", "new economy" and "asset prices".
1. A brief historical review
In a historical dimension, central banks are comparatively young institutions. While payment
instruments can actually be traced back to prehistoric eras, central banks have emerged only very
gradually over the last 300 years.1 When one considers that the Bank of England was founded when
Johann Sebastian Bach was nine years old, one might even regard central banks as somewhat
"baroque" institutions. Indeed, the original missions of central banks must strike us as highly bizarre.
"A money-raising machine"! This is how a historian termed the Bank of England in the early days of
its existence. At that time, the Bank basically acted as banker to the state and manager of national debt,
thereby contributing to financing wars and imperial expansion.
With their roots going back to the Age of Enlightenment, early central banks stood for the economic
emancipation, ambition and power of the states that established them. Due to their potency as state
banks they gradually assumed functions such as the bankers' bank, lender of last resort, regulator of
financial activity and privileged issuer of money. In the case of Switzerland, the National Bank was
founded (in 1907) in order to unify a somewhat chaotic system of banknote issues and to simplify the
payment system. All these functions have remained predominant and gained profile over large parts of
central bank history. By contrast, monetary policy as it is practised today is a comparatively recent
central bank discipline. It became permanently relevant only after World War II, when the gold-linked
money standard was abandoned in favour of a US dollar standard. In fact, individual central banks
gained control over "their" money supply only when the US dollar pegs were given up in the early
1970s.
For a long time, the policy objectives of many central banks oscillated between financing the state and
maintaining the (internal and external) value and reputation of the currency. These fundamentally
conflicting objectives provoked many currency crises and caused tremendous economic harm and, as a
result, heightened people's desire for monetary stability. Today, the public's aversion to, and
politicians' awareness of, inflation may have reached a peak in the developed world. This was
certainly a necessary condition for the global disinflation process of the 1990s.
Historically, the most effective device for keeping the price level down was the gold standard.2 In the
US, for example, accumulated inflation between the founding year (1776) and World War II was just
30%, whereas since then, the price level has multiplied by factor 8. The figures for Europe look
broadly similar when the war-driven hyperinflations are left out of account. This makes central banks'
seemingly unique policy performance in the nineties look slightly more modest.
In the past decade, three main factors facilitated a return to purchasing power stability. First, a lesson
was learned from the negative experience with inflation. Price stability gained considerably in
importance in the political process. Majorities in both governments and parliaments voted in favour of
monetary discipline, which in many places amounted to priority being given to budget discipline and
pronounced central bank autonomy. The Maastricht Treaty impressively illustrates this changed
approach with respect to the European area. This new political focus was also a reaction to the
disillusionment with regard to the central banks' ability to generate permanent growth effects. There
was fairly widespread agreement that price stability should be the prime monetary policy objective.
Second, it was of decisive importance that the currencies of the two leading countries, the US and
Germany, achieved a high degree of price stability. Numerous countries gained credibility by pegging
their exchange rates to the US dollar and the DM, thus seizing the opportunity to successfully import
the stability policies of the Federal Reserve and the Deutsche Bundesbank. Third, the deregulation and
globalisation of financial flows have increasingly disciplined the national authorities. These days, an
excessively relaxed monetary policy is sanctioned much more severely and much more quickly than in
the past by growing inflationary expectations, rising long-term interest rates and a persistent
devaluation pressure. Correspondingly smaller are the incentives to run the higher risk of a long-term
inflationary problem for reasons of short-term opportunism.
On looking ahead, most of these factors promise to remain relevant. Such confidence, however, should
not detract from the dangers and risks involved. Fiscal discipline is facing a difficult test phase in a
number of countries. It is foreseeable that the combination of demographic trends and non-funded
statutory pension claims will lead to intensive discussions on distribution in many places which, in
turn, might easily trigger a rise in public indebtedness. At the very least, it is not certain whether in
such a scenario central banks will be able to remain independent and continue to concentrate on price
stability. However, it should be clear that on a global level the future of price stability depends
decisively on whether, and to what extent, the Federal Reserve and the European Central Bank will
succeed in ensuring long-lasting purchasing power stability of the two major currencies.
2. Changes in concepts
The recent past has also brought about significant changes with respect to the implementation concept
for monetary policy.
Throughout the world implementation concepts have abandoned the use of money stock growth rates
as political intermediate
targets. This change of concept cannot hide the fact that monetarism was a
practical concept and one that promised success. It explicitly made the interconnection, then almost
forgotten, between excessive money supply growth and inflation the basis for steering monetary
policy, thus making it possible to achieve major stability successes. Two additional aspects proved
favourable in this respect. Steering the money supply facilitated communication and transparency.
Monetary aggregates show rapidly and in the form of an objective figure whether the monetary
authorities are actually implementing what they announced. Due to exceedingly long and variable
time-lags between measures and ultimate targets, this applies to a much lesser extent to inflation
targeting. Finally, money supply targeting also provides a measure of protection for central banks.
Reference to excessive monetary growth made central banks relatively immune to daily political and
fiscal pressure, even in places where institutional independence had not (yet) been established.
Control of the money supply lost some of its attractiveness because its central analytical basis was
subject to successive erosion. Money demand functions became increasingly unstable. Given some
differences between countries on the one hand and the aggregates employed on the other hand
- mainly M0 to M3 - the connection between the intermediate target and the ultimate target became
more and more unreliable. That was also the case in Switzerland, even if with a time-lag and to a
lesser extent than in other countries, notably English-speaking ones. We recorded shifts in cash
holdings which we could not even explain satisfactorily ex post, much less have forecast them with
any degree of accuracy.
The central banks reacted differently to this experience. Some rapidly threw money supply targeting
overboard. Others - including the SNB - changed from annual to medium-term targets. The extended
room for manoeuvre made it possible to consider various indicators in shaping the policy course. One
could use the term pragmatically adapted targeting of the money supply. In actual fact, this step came
close to a transformation of the money stock from an intermediate target to a monetary indicator, albeit
the most important one.
The destabilisation of money demand as previously set out has complex reasons on various levels.
Regulatory changes, adjustments in the structure of banks, and innovations in the fields of investment
opportunities and payments undoubtedly play a major role. Moreover, with receding inflation rates the
relative disruptive effect of such instabilities has increased. Certainly, it cannot be excluded that at
some point in the future we will again see a phase of greater stability in the demand for money, but in
the current environment such a change is not evident.
The policy concept implemented by the Swiss National Bank three months ago is made up of the
following three elements: an explicit definition - in terms of a figure - of price stability; publication of
three-year inflation operational implementation target
a forecast; and an in the form of a target range
consisting of 100 basis points for the three-month Swiss franc/Libor rate. I need not enter into this in
detail before this audience. The decisive test must be in the time path of the ultimate target variable
- the price level - which we will achieve on this basis. As regards the concept as such, I should merely
like to make two remarks pertaining to misunderstandings.
First, the interest rate target defined as a target range is not a substitute for the money supply target of
the concept formerly implemented by us. It is neither more nor less than an operational
implementation aid with a much shorter time reach relative to the formerly used money supply target.
It must be frequently adjusted in response to various changes and new information so as to enable the
stability goal to be reached. Against the background of our knowledge of the monetary policy
transmission process and its lag structure, it is obvious that it is hardly the level of money market rates
that is decisive, but rather the interest rate path optimised over time in uncertain circumstances. The
condition for success of the policy is not that the three-month Libor rate is exactly right today; rather,
it must be possible to constantly optimise the interest rate path - which leads to the set goal - in a way
that the deviations of the ideal line, which can only be defined ex post, will be as small as possible and
easy to correct. Interest rate steering will therefore often follow a fairly gradualistic pattern. This has
nothing to do with macroeconomic activism, quite the contrary. The macroeconomic fine-tuning
activists have lost their case because they have assumed totally unrealistic information conditions and
underestimated the uncertainty of political decision-making. With interest rate steering, the situation is
exactly the opposite. Precisely where there is considerable uncertainty and false steps are liable to
occur, there are good reasons for implementing a policy of small steps. The danger of slipping is
smaller, and a false step is easier to correct. But there are also valid grounds for fairly substantial
interest rate adjustments. For one thing, it may well happen that policymakers, in the light of new facts
and figures on ongoing developments, come to the conclusion that the interest rate pattern currently
followed needs to be corrected quite considerably. This would mean correcting a pattern that, from
today's vantage point, was not optimal in the past. For another, it may be desirable in certain situations
to take the markets by surprise and cause expectations to be revised.
Second, it is in the nature of the concept that the information content of a pre-announced interest rate
target is much smaller with respect to the time dimension than used to be the case for money supply
targets. Under the aspects of transparency and central bank accountability, this is a drawback. We have
therefore taken effective countermeasures by defining price stability and deciding to publish our
inflation forecast, thus submitting our decisions to public discussion. This has made it clear - and
equally clearly communicated - how our actions are oriented and how they are to be measured. I have
thus addressed issues that have all seen a particularly large number of changes in the past few years:
independence, transparency and accountability.
3. Independence - mandate - transparency
Independence
Right into the 1980s, independent central banks were the exception - such as those of the US,
Germany and Switzerland - rather than the rule. This has changed on a broad front in the past ten
years. The massive surge of inflation in the 1970s and 1980s and the reluctance of some finance
ministries (and their associated central banks) to combat it made economists and the public aware that
politicians may not have the appropriate incentives to bring or to keep inflation down.
Why are independent central banks more successful when it comes to bringing down inflation rates?
The reason is that politicians and central bankers tend to have somewhat different objectives and
largely different time horizons. Technocrats at central banks mandated to ensure monetary stability can
easily afford to take a long-term view, while politicians feel much more constrained by the pressure to
produce short-term results. This seems relevant since an inflation-preventing or inflation-combating
policy is usually associated with real costs in the short run, while the benefits appear only over time. A
government might be seduced into conducting an inflationary policy in order to reap benefits in the
short term, while the costs will only become evident years later. Therefore, there is a strong
probability (but, of course, no guarantee) that independent central banks will do a better job than
governments with regard to the issue of inflation. This insight - and perhaps the relative success of
most independent monetary authorities with the disinflation process in the 1970s - has paved the way
for granting more independence to monetary authorities.
Essential preconditions for the independence of a central bank include a solidly based consensus
concerning its mandate and a commitment to transparency and accountability.
Mandate
Most economists would agree that the core task is ensuring price stability. This consensus rests on the
conviction that in the long term, when all the lag effects have come to an end, monetary policy only
determines the price level, not, however, output or employment. Thus the primary obligation of a
central bank to maintain price stability does not imply that priority is given to price stability in
preference to full employment. Rather, it is in the economic nature of monetary policy instruments that
they are suited for influencing price level trends, not, however, growth or employment trends. Yet in
the short term, ie within the monetary policy transmission process, monetary policy does have real
effects.
The problem can easily be illustrated if one tries to picture a shock, eg a massive rise in oil prices. The
immediate consequence will be an increase in the price level and a fall in production. This
constellation confronts the central bank with a trade-off between price stability and growth. If the
bank's sole concern is a quick restoration of price stability, it will raise interest rates and consequently
exacerbate the loss of output. If, on the contrary, it reacts solely to the production effect, it will
strengthen the shock-induced deviation from the goal of price stability by lowering interest rates.
Reacting to shocks may lead to a trade-off between the variability of output and the variability of the
price level (King 1999, p 12). This trade-off in itself is an extremely complex phenomenon. It is
determined by the structure of the economic process and the dynamics of expectations. There is,
realistically speaking, no chance to deduce a general policy rule and to formally embody such a rule in
the central bank mandate. Any decision to correct slowly and gradually or in a single bold effort any
deviation from price stability, whatever its origin, can only be taken individually. Monetary history
has successful examples to show for both patterns of reaction, but also unfortunate episodes in which
central banks actually increased the variability of the price level and of output through activist
manoeuvres. It would thus appear reasonable that an addendum, unspecified as to substance, should be
made to the mandate of ensuring price stability. For example, to the effect that in fulfilling the
mandate due attention should be paid to the development of economic activity.
Art. 99 of the Swiss Federal Constitution obliges the SNB to conduct a monetary policy which serves
the general interests of the country. Endeavours are under way to spell out this vague formulation in
more detail in the forthcoming comprehensive revision of the National Bank Law. When revising our
monetary policy concept, we took a step in this direction by quantifying the stability target (CPI
inflation below 2%) and undertaking to adhere to the target in the medium term.
Transparency
A further aim was to continue to improve transparency. It is a fact that the call for more transparency
has sounded far and wide. This call is more than merely a short-lived fashion. There are two especially
valid reasons for the formerly rather reserved central banks to communicate openly and in good time.
For one thing, transparency - in particular, ex post transparency - is an indispensable precondition for
accountability and thus also a necessary correlative to independence. Beyond this, transparency is an
effective means of gaining the confidence of the public and the markets. Central banks depend much
more on this confidence in fulfilling their mandate than other institutions.
For another, the increased significance attached to transparency derives from the central role played by
expectations, also in macroeconomic processes. If the efficiency of forming expectations in the
financial markets and in the real sector can be improved with greater transparency, this serves to
enhance the productivity of an economy.
Transparency, however, should be optimised rather than maximised. Individual demands can
occasionally be quite unrealistic.
In my view, this even applies to ex post transparency, which is basically less problematic.
Accordingly, I do not see any merit in the popular practice which has gained ground in various
countries to publish the minutes of board meetings. Board members, too, are only human. Like anyone
else, they respond to incentives. My fear is that publication will lead to a certain amount of window
talk and probably also to critical discussions being held outside the recorded meetings. Experience has
taught me that every decision-making body needs a sheltered area away from the public where things
may be imperfectly stated and seemingly irrefutable truths may be called into question. If such a
sheltered domain is abolished, this will, in my view, have a negative effect on negotiating practices
and the quality of decisions.
Optimisation of ex ante transparency is, by its very nature, more critical. A clear and open
commitment to a monetary policy goal is of central importance. Thus the central bank must state
explicitly what it means by price stability, and it must also communicate how it assesses the long-term
development of the target figure. Both elements serve to enhance - or even facilitate - the predictability
of its policy and to reduce uncertainties. Conversely, it must be accepted in monetary policy that the
precise way to the goal is fraught with considerable uncertainties and that therefore too much ex ante
transparency can easily become counterproductive. In the context of our concept this applies in
the interest rate path to be
particular to followed. If a target range for the money market rate is
published at a particular point in time, this steering intention remains valid "for the time being". It is
quite understandable that market participants should wish to know more: how long the interest rate
target is to remain valid, and what interest rate steps are likely to follow. What they would prefer
above all else is information on the planned interest rate path for several quarters. Such far-reaching ex
ante transparency is, however, due to fail because of the uncertainty from which policymakers suffer
just like any other market players. As the cornerstone of policy implementation, the interest rate path
needs to be revised constantly and optimised conforming to updated information. When we fixed a
target range for the first time in December 1999 we simply did not know that as soon as the first
quarter of 2000 two interest rate increases would be necessary. The commitment to ex ante
transparency must take account of the knowledge and the uncertainty of decisionmakers. Thus, as a
rule, it is hardly meaningful to give information with regard to any other planned interest rate moves in
addition to the announcement of the current interest rate target. In so doing, the central bank would
lose essential room for manoeuvre, immobilise its internal decision-making process and give rise to
counterproductive changes in market expectations. For this reason, I am also sceptical with respect to
the somewhat softer practice of preparing the markets with a so-called bias statement for a probable
interest rate move. Such signals cause expectations to be revised, which is of small avail in the best
case, and ties the central bank's hands, in the worst case. Once a concrete decision - eg to raise the
interest rate - has been taken, it can be implemented without delay, ie without a prior announcement.
If, however, the central bank still harbours an uncertainty and - for example - still wishes to await the
disclosure of figures, it should refrain from making a prior announcement as it would then find itself
under a constraint. For if, in response to a signal received, the markets anticipate the interest rate
move, the central bank will hesitate, out of concern for its credibility, not to implement the signalled
move. This may well result in an endogenous interest rate policy: the central bank becomes, through
its own fault, the prisoner of market expectations - an absurd notion. A central bank should inform
openly about its long-term designs. At the same time, it should not hesitate to make interest rate
decisions, if necessary, which come as a surprise to the majority of market participants.
4. The "new economy" - fact or fiction?
The term "new economy" is certainly vague, which may be the very reason why it is popular. Coined
in the United States, it is used as a label for several hypotheses which strive to explain the
performance of the US economy in the second half of the 1990s. Poorly explained by most
conventional macroeconomic models, this economy is characterised by continued high growth rates,
unexpectedly robust productivity, and long-running low unemployment, combined with very little
inflationary pressure. These attempts to explain the phenomenon termed "new economy" refer to two
deregulation and the opening of markets
prominent areas of change. On the one hand, for products and
factors and, on the other hand, the phenomenal progress in information and communications
technology.3 On a macroeconomic level, the explanations lead to three possible conclusions.
First, to the conclusion that the economy has lost some of its cyclical dynamic, a change which is
explained by the increased transparency and more efficient steering of entrepreneurial processes as
well as the fact that inventories have been cut or completely eliminated.
Second, that there has been a permanent reduction in the natural rate of unemployment which results
in an upward shift of the potential output curve and thus to significantly higher growth rates in the
transition phase.
Third, that there is a gain in long-term productivity growth, ie a steeper potential output curve in
future.
Academic economists usually react with scepticism to these basically supply-side hypotheses. In fact,
they are assumptions which, plausible as they may be, have not been empirically tested. Monetary
policymakers cannot simply ignore them because they relate to interconnections which are important
for the formulation of policies. It would be just as foolish, however, to accept such theories
uncritically and to include them in the decision-making process simply because they sound plausible.
In any case, the assertions put forward under the label "new economy" create additional uncertainties.
In this particular state of uncertainty, there is growing interest in an ongoing analysis and
interpretation of indicators. In this way, one searches for early evidence for the pros and cons of these
hypothetical changes. The risks for success inherent in a bold pre-emptive strike are bigger. The
famous notion of "acting ahead of the curve" presupposes having solid confidence in one's own
forecasts. Notably the fact that the Federal Reserve has lost this confidence in the late 1990s and that it
has refrained from taking big, bold steps, has apparently turned out to be the right strategy. In an
environment of increased uncertainty, a tendency to take small, careful steps makes sense. It is hardly
possible to chart the ideal course that way, but there is a good chance that deviations remain limited
and can be corrected within a reasonable time frame.
In Switzerland - perhaps with a time lag - we are also affected by such uncertainties. This is the case
even though the factor of a declining natural rate of unemployment cannot play a central role in this
country. Economists in Switzerland would certainly be well-advised to critically analyse the
hypotheses and phenomena propagated as "new economy" - not with preconceived ideas, but with an
open mind.
5. How relevant are asset prices?
A topic which is related to the "new economy" is the phenomenon of extreme price fluctuations of
individual assets. Even previously, the bitter lessons learned on the heels of the recession in Japan had
stimulated a discussion of whether and how asset prices are important for monetary policy. The
question of whether they are relevant can be answered quickly. There is a broad consensus on several
interconnections.
Equity and real estate prices determine household wealth and therefore influence consumer demand.
This aspect must certainly be taken into account. Another factor impacting monetary policy is the
demand for capital
interdependence between equity prices, the cost of capital, and the goods.
Moreover, asset prices, especially real estate prices (as collateral in the credit business) can change
financing conditions. This can undoubtedly have repercussions for the economy, at least if the prices
fluctuate sharply. As indicators for the development of overall demand, these effects must feed into
economic forecasts which unavoidably exert an influence on monetary policy.
Above and beyond these aspects, there is a general consensus that, in the event of an asset price crash,
central banks must react to the sharp increase in liquidity demand. Such willingness to react is the
consequence of the central banks' responsibility for the stability of the financial system.
In addition to this accepted premise, however, the discussion - especially in the financial press
focuses on two calls for action that go even further. Most central banks, however, are sceptical or
opposed to such demands.
First, some claim that central banks should not remain passive when confronted with a bubble in the
making, but rather take a proactive stance so that an abrupt or even dramatic adjustment does not
occur at all. There are convincing counter arguments to this opinion. It is impossible to determine with
some degree of accuracy whether such a bubble, in the sense of a speculation-driven price increase,
has indeed formed. Central bankers are not more ignorant than investors and traders, nor are they more
intelligent or better informed when it comes to the valuation of companies.
One might argue that a crash is not so much the result of exuberant cash flow expectations for
individual companies but rather the consequence of a sudden increase in discount rates, causing a
dramatic downward adjustment of all present values. The relevant discount factors are the combined
result of time preference, risk preference, and the prevailing perception of uncertainty. History has
taught us convincingly that time preference is a relatively stable factor. The problem, therefore, lies
more in a sudden shift of risk preference and the perception of uncertainty. If these two determinants
could be stabilised, much would be achieved already. This task, however, also presupposes some
"superior knowledge" and "deeper insight" on the part of central banks relative to the market. Such
assumptions are unrealistic.
Moreover, central banks, with the instruments they have at their disposal, do not have the possibility to
deflate a presumed bubble all on their own. Interest hikes would certainly be a possibility. In so doing,
however, one would have to accept consequences in the real sector which could be completely
counterproductive. Finally, if central banks were obligated to avoid stock market excesses, this would
have extremely disastrous moral hazard implications. To be realistic, a simple recommendation is all
that is in order: those who buy equities bear the price risk themselves. People who, out of greed and
carelessness, buy and sell in such a way that they cannot survive a brutal crash have only themselves
to blame. They must bear the consequences alone, even if it means their economic ruin.
Second, there is also an argument that price stability as the relevant goal of monetary policy should be
defined more broadly and measured in such a way as to include the development of important asset
prices.4 The demand that monetary policy, in its use of the concept of monetary conditions, should not
only take account of interest rates and foreign exchange rates but also of equity prices does not go
quite as far. On a technical level, such an expansion of the price index would not be a trivial
undertaking, but certainly doable. There are some serious economic concerns, however, which are
mainly due to the ambivalent nature of equity price fluctuations. Equity prices may rise in anticipation
of a pick-up in total demand, which - if anything - would indicate some restrictive monetary policy
correction. If the stock market expects business activity to pick up, the central bank will, in assessing
the situation, hopefully realise this as well. It is for that purpose not necessary to expand the price
index or the monetary conditions index as has been suggested. On the other hand, equity prices can go
up as a result of real changes, eg due to achieved or expected productivity improvements. Such
supply-side driven equity price increases signal a higher productivity potential and would - if
anything - be a reason for an expansive but certainly not a restrictive monetary policy correction. This
example illustrates the central banks' scepticism against the suggested changes. From the Swiss
vantage point, there is well-founded additional scepticism. Our stock market is dominated by
companies whose activities are concentrated abroad and thus have little direct connection with our
economy.
It is possible that new insights will lead to different conclusions. For the time being, however, it seems
advisable to stay with the generally accepted "consensus view", but to do that job as well as possible.
Conclusion
I am about to come to the end of my reflections, fully aware that my journey through a changing world
is far from complete. I did not mention payment transactions, for example, even though this is an area
undergoing various changes with potent