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OESTERREICHISCHE NATIONALBANK The 2008 Great Financial Crisis and its global consequences sharply changed monetary policy from what had been considered best practice during the “Great Moderation.” Central banks had to deal with the deepest financial and economic crisis since the 1930s. As a result, financial stability concerns dominated monetary policy consid­ erations for some time around the world. A sovereign debt crisis in several euro area countries jeopardized the very existence of the currency union, prompting the Eurosystem to take far-reaching steps to preserve the integrity of the monetary union. These crises caused inflation to temporarily drop below zero, with inflation and inflation expectations deviating persistently from central banks’ targets. With official monetary policy rates approaching the effective lower bound, new territory was tested both for interest rates and “unconventional” monetary policies. Now, more than ten years after the onset of the crisis, the world economy and the euro area are enjoying a long period of robust economic recovery with unem­ ployment rates receding markedly. However, financial and real asset prices have risen in many countries, reflecting improved economic prospects and expansionary monetary policies, but raising concerns about new price bubbles and possible ­ financial imbalances. Central banks have become key arbiters in a fast-changing financial sector, acting alongside newly created regulatory and supervisory bodies. 1 Oesterreichische Nationalbank, Economic Analysis Division, ernest.gnan@oenb.at, claudia.kwapil@oenb.at, maria.valderrama@oenb.at. The views expressed in this paper are exclusively those of the authors and do not necessarily reflect those of the OeNB or the Eurosystem. We thank Clemens Jobst, the referee and Doris Ritzberger-Grünwald for their helpful comments and valuable suggestions, as well as Gerald Hubmann and Beate Resch for their excellent research assistance.
Refereed by: Rafael Gerke, Deutsche Bundesbank Monetary policy after the crisis: mandates, targets, and international linkages The global financial and economic crisis of 2008 has raised several questions on the future of central banking in general, and of monetary policy in particular. This paper focuses on three of these questions: central bank mandates, price stability/inflation targets and international monetary policy linkages. While the crisis has effectively moved financial stability to the center stage of central banks’ policymaking, no consensus has emerged on the extent to which financial stability needs to be reflected formally in central bank mandates.
There has, however, been a change in how financial stability concerns are reflected in monetary policy analysis. We do not see that the crisis has produced any new arguments in favor of dual central bank mandates that include growth or employment in addition to price stability. Despite ongoing debate, the crisis has not prompted constraints on central bank independence as central banks’ consistent drive for more transparency has enhanced their accountability commensurately with their broader scope of action. Regarding inflation targets, we discuss the pros and cons of several proposals, in order to cope with a possible secular decline in the natural rate of interest and a flatter Phillips curve.
The most promising strategies in our view are those with a flexible interpretation of the inflation target, e.g. with flexible time horizons for reaching the target or with tolerance bands. Finally, unconventional monetary policies have highlighted international monetary policy spillovers and raised concerns about global competitive devaluations and monetary easing cycles. Attempts toward closer international coordination have, however, been muted. It seems that future generations of policymakers will also have to deal with spillovers from large countries as best as they can.
Ernest Gnan, Claudia Kwapil, Maria Teresa Valderrama1 JEL classification: E58, E61, E65 Keywords: central bank mandate, monetary policy strategy, price stability/inflation target, international monetary policy spillovers, international policy coordination
Monetary policy after the crisis: mandates, targets, and international linkages MONETARY POLICY & THE ECONOMY Q2/18
9 Income pressure from low interest rates and cost pressures from financial innovation, combined with more stringent financial sector regulation, have induced a surge in less regulated shadow banks and prompted financial firms to adjust their business models and change their lending behavior. Hence, monetary policy faces a different environment than the one before the crisis. Wage and price developments seem to have changed their response to growth and unemployment, keeping consumer price inflation low. In addition, the level of the “natural rate of interest” may be lower than before the crisis. Expansionary “uncon­ ventional” monetary policies (including large-scale purchases of various asset classes and zero or negative policy rates) have replaced pre-crisis standard monetary policy measures. Through large-scale asset purchases, central banks have become promi­ nent holders of government and corporate debt, influencing asset prices, yields, risk premiums and market liquidity. The monetary policy stimulus injected – or eventually removed – in major countries also accentuates potential spill-overs to other countries. Against this background, this paper discusses three topics. Section 1 provides an overview of the ongoing discussion whether the pre-crisis consensus on the central bank mandate(s) warrants adjustments. In this context, box 1 addresses the question of whether the increased responsibilities of post-crisis central banks are compatible with current arrangements for independence and accountability. Based on this, section 2 discusses recent developments and arguments relating to the definition of price stability. In this context, box 2 outlines the implications of the zero (or effective) lower bound of interest rates. Section 3 addresses international monetary policy spillovers and reflects on lessons to be drawn from the crisis. ­ Finally, section 4 offers a summary and draws conclusions. 1 Central banks’ mandates between monetary and financial stability 1.1
Flexible inflation targeting as central banks’ pre-crisis best practice during the “Great Moderation” ... Central bank mandates reflect both the evolution of economic thinking as well as society’s preferences, which in turn reflect economic developments. The prevailing consensus in central bank mandates – the pursuit of price stability – is the product of lessons from previous crises. In the past, flawed monetary policy regimes were often the cause of both economic and financial crises (Bordo and Siklos, 2017). The policy responses, as well as the growth and inflation experiences (“stagflation,” “Great Inflation”) after the 1974 and 1981 oil price shocks, prompted economists and policymakers to fundamentally reconsider their understanding of macroeconomics and the role of monetary policy in stabilizing the economy. The consensus that arose, and still prevails, is that economic growth is driven by real economic factors (such as the capital stock, labor force and technological progress). Monetary policy can mitigate fluctuations in growth and employment around potential or trend growth only in the short run, but is neutral in the long run. Moreover, since central banks can only control nominal variables, they should provide a nominal anchor and therefore be primarily accountable for consumer price stability. This is the best contri­ bution the central bank can make to stabilize the economy (Mankiw and Reis, 2017). In Europe many countries pegged their currencies to the Deutsch mark after the breakdown of the Bretton Woods System. Thus, the Bundesbank provided the nominal anchor in a fixed-exchange rate system – a system that would eventually be replaced by the Economic and Monetary Union (EMU). During the 1990s, inflation
Monetary policy after the crisis: mandates, targets, and international linkages 10
OESTERREICHISCHE NATIONALBANK targeting became the standard global approach to monetary policy (Bordo and Siklos, 2017; Cobham, 2018). Inflation targeting − understood as “the commitment to a quantitative objective for medium-term inflation” (Reichlin and Baldwin, 2013) − has evolved since its introduction in New Zealand in 1991. Its implementation and exact definition varies across central banks (Mishkin and Posen, 1998). “Flexible inflation targeting” refers to an approach where a central bank’s response to ­ economic shocks depends on the type of shock. This gives the central bank some leeway in the speed at which it should return to its inflation target. While the European Central Bank (ECB) does not pursue an inflation targeting strategy, it does aim for consumer price stability, which it defined as reaching an inflation rate of below, but close to, 2% over the medium term. The EU Treaty relegates the pursuit of growth and full employment to a secondary level. In ­ practice, the state of the business cycle and the labor market feeds into the ECB’s assessment of the outlook for price stability.
By contrast, the U.S. Federal Reserve (Fed) has a dual mandate that considers both full employment and price stability, for which the Fed adopted an explicit (numerical) inflation target of 2% in 2012. Advocates of a dual mandate argue that there are situations where a tradeoff between output stability and price stability exists (in the short run). For example, a cost-push shock (e.g. an oil-price shock) increases consumer prices, while it slows down economic activity. In such a ­ scenario, the central bank should, according to advocates of a dual central bank mandate, take into account both economic and price stability.
Assuming long-run neutrality of money, this means in practice that the speed at which price stability is restored is slower than if economic stability is ignored. Another example is a ­ situation in which growth is vigorous but inflation is below target, due to structural and global factors. In such a situation, a dual mandate might give the central bank more leeway in the speed at which it normalizes its monetary policy stance, by temporarily tolerating below-target inflation.
1.2 ... but then came the Great Financial Crisis The two decades up to 2007 are often called the “Great Moderation,” reflecting the smooth path of growth at consistently low rates of consumer price inflation. Part of the reason for this success was attributed to independent central banks pursuing the primary objective of consumer price stability (mostly by using ­ inflation-targeting strategies). However, in 2008 the Great Financial Crisis prompted an abrupt reconsideration of this assessment. In the aftermath of previous crises, monetary policy was often perceived either as having sowed the seed of the crisis (due to an overly expansionary pre-crisis monetary policy stance) or as a reason why the crisis was not adequately managed (e.g.
too little accommodation too late, undue accommodation weakening the necessary adjustment incentives of other actors, etc.). This time has been no different, and the notion that price stability is a necessary and sufficient condition for economic and financial stability has been questioned (Reichlin and Baldwin, 2013). The long-term neutrality of monetary policy and the existence of a natural rate of interest2 serving as a guidepost for monetary policy are seen as the foundations 2 The natural rate of interest is broadly defined as the rate at which the economy is at full capacity and the rate of inflation is constant.
The monetary stance is considered restrictive if the policy rate is above this natural rate, because in this case inflation will fall, and vice versa.
11 of inflation targeting (Blanchard, 2018). Monetary policy is said to be neutral ­ because in the long run it only affects nominal variables (interest rates, prices, money stocks) but not real variables (GDP, consumption, employment, etc.). However, the Bank for International Settlements (BIS) argues in several studies that the expansionary monetary policies followed by most major central banks since the introduction of inflation targeting have led to a secular decline in real interest rates, which in turn contributed to a build-up of financial imbalances ­ (Borio et al., 2017). The main argument is that structural changes3 have altered the inflation process,4 so that monetary policy has less control over inflation. Since real interest rates are nominal rates minus inflation expectations, each time the nominal interest rate is cut (while inflation expectations do not change) real interest rates are pushed downward. As, however, inflation does not recover suffiently due to the aforementioned global factors, the central bank subsequently does not bring nominal and real interest rates back up to the initial level. As a result, monetary policy may in the long run turn out to influence the level of real interest rates and thus no longer be neutral. In this view, a protracted period of expansionary monetary policies geared narrowly toward consumer price inflation targeting can create ­ financial imbalances and a misallocation of credit, which as a further consequence can weaken potential output and therefore also may lower the natural rate of interest. Many argue that the natural rate of interest has fallen considerably since at least the onset of the crisis (but probably for longer), due to weaker productivity growth, a slower-expanding and aging population, cheaper capital entailing lower investment needs, higher income inequality, a global savings glut emanating from emerging economies, and higher risk premiums. There is no agreement, however, on the scale of this effect or its duration. Furthermore, looking at very long-term developments, Borio et al. (2017) question the very existence of this phenomenon and its frequently cited possible explanations. Due to the uncertainties ­surrounding estimates of the natural rate of interest, critics argue that it should not be used as a guidepost for monetary policy. The fact that inflation has recently not responded to monetary policy as fast as in the past, is considered by some as evidence that central banks are using a flawed economic model (Reichlin and Baldwin, 2013). As a result, there is an ongoing debate whether consumer price inflation targeting is still best practice, or whether central bank mandates should be extended to in­ clude financial stability.
What should be the relationship between monetary policy and financial stability? The Great Financial Crisis highlighted one of central banks’ core functions, namely to act as a lender of last resort, and prompted them to devote more attention and effort to maintaining and restoring financial stability. Central banks in many countries had to “mop up the mess” of the financial crisis. Many of the tools implemented in response to the crisis as well as the institutional arrangements developed in response to the crisis to bolster financial stability conferred major powers on central banks (see Aziz, 2013, for a detailed review of changes after the crisis). 3 Globalization, digitalization of the economy, etc. 4 Inflation responds less strongly/quickly to the level of slack in the economy.
Monetary policy after the crisis: mandates, targets, and international linkages 12
OESTERREICHISCHE NATIONALBANK More importantly, the financial crisis made clear that central banks cannot simply ignore financial stability. On one hand, the Great Financial Crisis disrupted the monetary transmission mechanism and the effectiveness of monetary policy, thus seriously hampering the achievement of price stability for a prolonged period. On the other hand, the financial crisis as well as the deployment of unconventional monetary policy measures, has also made clear that monetary policy has a large influence on financial stability (Papadia and Välimäki, 2018). Therefore, the crisis highlighted the need to analyze financial sector developments very closely and to integrate financial markets in central banks’ models and analytical tools (Reichlin and Baldwin, 2013).
... should central banks have a financial stablity mandate as part of their monetary policy function? There seems to be a broad consensus on the importance of microand macro­ prudential policies as separate tools to contain financial imbalances. At the same time, the hotly debated question as to whether monetary policy should additionally “lean against the wind” to avoid financial asset bubbles has still not been resolved. A related question is whether to include financial stability in the central bank mandate (Bordo and Siklos, 2017). This would mean that monetary policy not only considers price stability, but also its effects on financial stability. Thus, central banks would not just forecast economic activity and inflation: they would also have to perform stress tests to gauge the effects of the monetary stance on credit conditions, asset prices and ultimately financial stability. Such an approach would go beyond the hotly debated issue of whether central banks should “target asset prices” and would imply that central banks analyze and assess whether financial imbalances are building up. The task would then be to design monetary as well as microand macroprudential policies in an integrated manner so as to optimize economic ­ performance while minimizing risks (Eichengreen et al., 2011). Others argue that financial stability policies (rather than monetary policy) are better equipped to take measures to control the buildup of financial imbalances, in particular when they affect specific sectors. Macroand microprudential measures are more effective than monetary policy in preventing such imbalances. In this view, monetary and financial stability policies should remain distinct, with separate mandates, instruments and institutions (see e.g. Bordo, 2017). The most compelling argument is that price stability and financial stability may imply tradeoffs. For example, in a balance sheet recession the central bank would reduce interest rates to stimulate the economy, while the financial stability authority might wish to tightening regulation to avoid exaggerated risk-taking (Hellwig, 2014).
For a currency union like the euro area, this last argument is even more com­ pelling. In a monetary union, there will inevitably be countries and/or sectors at different phases of the business and financial cycle. Overheating could theoretically occur in one isolated market. Interest rate policies aimed at curbing this market may have unnecessary adverse effects for the rest of the economy. In this case, ­ national microand macroprudential measures are better suited to address the buildup of local imbalances.
13 2 Which inflation target/definition of price stability? Monetary policymakers face three major challenges which have prompted discussions about the optimal price stability aim or inflation target, and how to approach it in a flexible way. First, as outlined above, the natural level of real interest rates may, for an ­ extended period, remain considerably lower than in the past decades, due to ­ domestic and global structural factors. As argued in box 2, the zero or effective Box 1 Central bank independence and accountability The lessons drawn from the Great Inflation of the 1970s combined with new developments in economic theory (rational expectations, time inconsistency theory) have led to the consensus that central banks are more credible and thus effective when they are independent from their governments. Being exempt from the political decision-making process, with its short-term electoral pressures, central banks are seen to be in a position to react more consistently and effectively to safeguard price stability.
The concept of time inconsistency − the rational temptation of policymakers to renege on their initial promises in order to stimulate demand by allowing a higher rate of inflation − was a major theoretical breakthrough, prompting legislators worldwide to grant central banks ­ independence from governments (Kydland and Prescott, 1977). By delegating monetary policy to an independent central bank, the promise of stable prices becomes more credible with ­ economic agents. The resulting stabilization of inflation expectations allows the achievement of low inflation without foregoing growth or employment, thus maximizing economic welfare.
The corollary to central bank independence are mechanisms to ensure accountability, which give the central bank democratic legitimation (Eijffinger and Hoeberichts, 2000). In fact, the concept of inflation targeting goes hand in hand with a numerical target and reporting by the central bank to the government, parliament and the public on the success in meeting this target. This has made conventional pre-crisis monetary policy accountability fairly straightforward. The extension of central bank tasks to include macroprudential policies and financial ­ supervision as well as the use of unconventional measures have revived debates about central bank independence and accountability.
For example, the notion that unconventional measures affect the distribution of wealth more than conventional policies earned central banks criticism about their democratic legitimation (Goodhart and Lastra, 2017). The large-scale purchase of government debt by central banks is seen by some as blurring the frontiers between monetary and fiscal policies, again raising questions of democratic legitimacy. There are also different views regarding the need for independence of financial supervisors. On the one hand, some argue that financial stability authorities are subject to time inconsistencies in similar ways to monetary policymakers.
Independence may also be useful to withstand ­ regulatory capture. Only an institution with far-reaching delegated powers can react to financial crisis situations sufficiently quickly and effectively. On the other hand, there is no agreed ­ definition of what financial stability is, except the “absence of crisis.” Therefore, mechanisms for accountability seem much more difficult than for monetary policy. The decision to let banks fail (or rescue them) may have vast and highly uncertain consequences for welfare. ­ Bail-outs may have very damaging effects on fiscal balances, while bail-ins could have ­ negative effects on financial stability through contagion and uncertainty (Hellwig, 2014) and may be politically controversial.
Thus, the consequences are too far-reaching and too complex to allow adequate mechanisms for accountability and should thus be left to elected policymakers. Finally, the concentration of responsibilities for monetary policy and financial stability is sometimes perceived as conferring too much power on a single, unelected governmental body (Aziz, 2013; Cukierman, 2013; Hellwig, 2014).
Monetary policy after the crisis: mandates, targets, and international linkages 14
OESTERREICHISCHE NATIONALBANK lower bound on nominal interest rates could effectively limit the scope for an ­ expansionary monetary policy. Second, the relationship between domestic economic slack and inflation – the Phillips curve – has proven rather weak for several decades. Again, this may be due to structural factors. Thus, inflation responds more weakly to domestic ­output gap developments than in the past. Even if the natural level of real interest rates were known, using it as a guidepost would not reliably bring inflation back to target with the usual lag of one-and-a-half to two years, as had been the case in the past. Therefore, some economists spoke of a “twin puzzle” after the Great Financial Crisis: first, “missing disinflation” between 2009 and 2011 in response to the deep recession (Coibion and Gorodnichenko, 2015), and second, “missing inflation” ­ following the recovery after 2012, particularly in Europe (Constâncio, 2015). Third, the sum of structural shifts affecting the level of interest rates and the inflation process raises the issue of how monetary policy should best deal with these supply shocks in the pursuit of price stability and macroeconomic stability at large. In particular, we ask how the tradeoff between inflation and output volatility should be handled.
This section discusses various options, put forward in the literature, regarding post-crisis modifications to inflation targeting that would create a coherent frame­ work to explicitly address the above three challenges systematically. Box 2 Zero or effective lower bound When inflation and nominal interest rates approach zero, the central bank finds itself in a situation where monetary policy must be forceful and credible to avoid a deflationary spiral, while the normal policy instrument, the interest rate, cannot be cut any further. Until the Great Financial Crisis, the existence of the zero lower bound (ZLB) for nominal interest rates was mostly found in theoretical papers.
Most concluded that with an inflation target of around 2%, the probability of being restricted by the ZLB was negligible (Fischer, 2016). As most major central banks were dangerously close to the ZLB by 2009, the discussion shifted to, first, which monetary policy instruments can be used to avoid a deflation spiral and, second, whether nominal interest rates could actually fall below zero. Such a situation requires other monetary policy instruments that can increase inflation expectations and stimulate demand. The theoretical papers written in the previous decade foresaw the use of forward guidance as well as large-scale asset purchases to lower real interest rates and manage inflation expectations (Goodfriend, 2000; Eggertson and Woodford, 2003).
The argument was that setting negative interest rates would be ineffective because people would hoard cash and banks’ profits would fall due to legal or practical impediments to cut deposit rates below zero. Thus, negative rates would have little or no effect on aggregate demand and could even be counterproductive in managing inflation expectations. Despite these theoretical concerns, several major central banks, such as the ECB, have used slightly negative interest rates either to boost inflation and inflation expectations or to discourage capital inflows (e.g. the SNB). The jury is still out on the effects of negative interest rates.
Experience to date, however, shows that cash hoarding seems to be a negligible problem. The prevalent view now is that zero is not the lower bound because cash hoarding carries a cost (e.g. cash handling, transport, storage and insurance). At the same time, there are limits on how low negative nominal interest rates can be: estimates point to an effective lower bound (ELB) of –0.5% to –0.75%. In the same vein, interest rates clearly cannot be maintained at negative levels for too long without threatening financial stability.
When a lower level of the natural interest rate moves the effective lower bound closer ... 2.1.1 ... one could increase the inflation target In response to lower natural interest rates, central banks could raise inflation targets from the currently common 2% to, say, 3% or 4%. If the new target is credible, inflation expectations would adjust, and – based on the Fisher equation – nominal interest rates would rise accordingly. This would then give the central bank more space to cut rates in a downturn (see e.g. Ball, 2013). Dorich et al. (2017) find that such an increase in the level of the inflation target can indeed be helpful in enhancing macroeconomic stability in two cases: first, when unconventional monetary policy is not available; second, when the neutral real interest rate is persistently and deeply negative, forcing monetary policy to operate close to the effective lower bound. However, if the central bank has powerful unconventional policy tools and the real natural interest rate is positive, as generally assumed, these authors claim that increasing the inflation target only produces modest improvements in macro­ economic outcomes.
The potential gains must therefore be weighed against the costs of higher inflation, such as greater variability in relative prices, higher volatility of inflation itself (and thus increased probability of misallocations of resources) and greater distortions in the tax system. Finally, inflation expectations might become unanchored. For decades, central banks have worked hard to establish credible inflation targets anchoring inflation expectations. Increasing them once might be perceived as the beginning of an upward spiral. If a central bank changes its target once, why not a second time – or more often?
Eggertsson and Woodford (2003) as well as Krugman (1998) argue that raising the inflation target is an inefficient approach in dealing with the zero lower bound (ZLB). Under the theoretically optimal approach, inflation should rise only ­ temporarily when monetary policy is constrained by the ZLB. As Woodford (2012a) points out, raising inflation permanently would be suboptimal, as it forces society to bear the costs of higher inflation at all times, instead of only when needed. This raises the question of how the central bank might bring inflation ­ expectations back down after such a temporary intended hike in inflation.
The ­ experience of the 1980s suggests that this might incur considerable output costs (“Volcker recession”).
2.1.2 ... one could switch to a price level target An alternative – and according to Eggertsson and Woodford (2003) and Krugman (1998) more effective – monetary policy framework for managing temporary ­inflation expectations is price-level targeting. The idea is to keep the level of prices Looking ahead, the secular decline of nominal and real interest rates implies that compared to previous decades, the distance to the ELB will be small more frequently. Thus, the policy space will be more constrained. This is the consequence of low inflation combined with a lower natural rate of interest, which together have shifted the probability distribution of nominal ­ interest rates closer to zero, increasing the likelihood of falling below zero or of reaching the ELB (Kiley and Roberts, 2017).
Monetary policy after the crisis: mandates, targets, and international linkages 16
OESTERREICHISCHE NATIONALBANK on a steady growth path of, say, 2% per year. Shortfalls in inflation are matched by inflation lying above target at other times. Following this strategy, monetary policy keeps the expected real burden of nominal debts at what they were expected based on the central bank’s inflation target, and so the long-term risks for savers and ­ investors are smaller than in an inflation-targeting environment. Chart 1 shows hypothetical inflation gaps for the euro area, which would have accumulated because the actual path of the harmonised index of consumer prices (HICP) deviated from a hypothetical price stability path, assuming (purely for the sake of illustration) 1.7%, 1.8% and 1.9% as numerical values for the ECB’s price stability definition. Thus, monetary policy decisions become history dependent and must make up for past misses. Price-level targeting builds in a ­ commitment to higher inflation rates in the future, when inflation missed the ­ target in the past (see the middle and right panels of chart 1). The resulting “low for longer” interest rate path is, according to Eggertsson and Woodford (2003), the theoretically ­ optimal strategy in a zero lower bound environment. To make this strategy work, economic agents must be forward looking. If they are in a low-inflation situation, they will expect higher inflation rates in the years to come, which feed into lower real interest rates that stimulate demand and ­ encourage firms to raise their prices. However, Gaspar et al. (2007) show that if price expectations do not change at all, a price-level target may even be less effective than an inflation target. Similarly, Andersson and Claussen (2017) argue that if inflation expectations are adaptive, a price-level target implies greater fluctuations in the real economy than an inflation target.
Another drawback of this strategy is that the central bank cannot “look through” supply shocks, such as an oil-price hike that temporarily drives up inflation.5 5 Under a flexible inflation-targeting framework, the central bank can disregard the initial inflationary effect of a cost-push shock and can concentrate on mitigating second-round effects, if they materialize. Index: 1998=100 Absolute deviation in index points Index: 1998=100 Absolute deviation in index points Index: 1998=100 Absolute deviation in index points 160 150 140 130 120 110 100 90 80 24 20 16 12 8 4 –4 –8 Theoretical price-level target for the euro area HICP Chart 1 Source: ECB (forecast for 2018–2020).
Deviation from a 1.7% target path (right-hand scale) Actual HICP (left-hand scale) 1.7% target path (left-hand scale) 160 150 140 130 120 110 100 90 80 24 20 16 12 8 4 –4 –8 Deviation from a 1.8% target path (right-hand scale) Actual HICP (left-hand scale) 1.8% target path (left-hand scale) 160 150 140 130 120 110 100 90 80 24 20 16 12 8 4 –4 –8 Deviation from a 1.9% target path (right-hand scale) Actual HICP (left-hand scale) 1.9% target path (left-hand scale) 1998 2002 2006 2010 2014 2018 1998 2002 2006 2010 2014 2018 1998 2002 2006 2010 2014 2018
17 Instead, it has to commit to tightening in order to reverse the oil price effects on the price level. This will lead to bigger fluctuations in real output growth and ­ inflation rates, which casts doubt on the usefulness of this strategy in stabilizing inflation expectations. Furthermore, given that in the case of cost-push shocks, price-level targeting is costly in terms of output fluctuations, it might not be fully credible. Mester (2018) points out that apart from the Swedish Riksbank, which pursued such a strategy from 1931 to 1937, there is little international experience with this framework. Moreover, policymakers would have to contend with measure­ ment issues, such as the choice of the starting point and revisions to price-level data (which are, however, usually negligible).
Because of these serious drawbacks, Bernanke (2017b) suggests a compromise approach that he calls “temporary price-level target.” This applies a price-level target only to periods when the zero lower bound becomes binding. In normal circum­ stances the central bank follows an inflation target. This approach should combine the advantages of a price-level target at the zero lower bound and at the same time avoids the drawbacks during normal times, when cost-push shocks might hit the economy. However, it may be doubtful whether economic agents would under­ stand such changes or would find the announcement of a return to inflation target­ ing after the end of the crisis credible.
2.1.3 ... one could switch to nominal GDP targeting Proponents of stabilizing the level of nominal GDP around a targeted path, such as Romer (2011) and Woodford (2012b), argue in much the same way as the advocates of price-level targeting. Like price-level targeting, nominal-income targeting is also history dependent. Deviations from trend are to be corrected by subsequent deviations in the other direction. A central bank following this strategy could, for instance, aim to stabilize nominal GDP along a path that grows by 4% annually, EUR billion, seasonally and working-day adjusted data 3,500 3,300 3,100 2,900 2,700 2,500 2,300 2,100 1,900 1,700 1,500 Nominal GDP target Chart 2 Source: Eurostat, authors’ calculations.
Nominal GDP 3% target path 4% target path 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Monetary policy after the crisis: mandates, targets, and international linkages 18
OESTERREICHISCHE NATIONALBANK assuming that long-term potential growth averages 2% and annual inflation is 2%. Thus, the nominal growth target can be regarded as a combined inflation target and a target for real GDP growth. Central banks pursuing this strategy are indifferent whether they achieve the target because of inflation or real GDP growth. Both variables feature prominently in their reaction functions. Woodford (2012b) argues that a nominal GDP target path would not achieve quite the full welfare gains associated with a credible commitment to the price-level target as suggested in Eggertsson and Woodford (2003). However, such a proposal would retain several of its desirable characteristics. Additionally, it entails the central bank explicitly taking into account the real economy. Thus, the expectations channel not only works via inflation expectations, but also – as Romer (2011) argues – via economic confidence.
At the same time, nominal GDP level targeting poses several problems. The most challenging one is already evident in chart 2, and relates to uncertainty and changes to the long-term growth potential of GDP. If potential output growth changes, for example due to a crisis, what will be the correct target path afterwards? Should it be adjusted, and if so, by how much? If the long-term sustainable real growth rate changes and the central bank’s targets are not adjusted accordingly, there will be undetected changes in the implicit inflation target. Anchoring inflation expectations will prove to be a difficult task in this regime.
This task might also be problematic because there is no explicit inflation target guiding expectations. Moreover, the built-in inflation objective is defined in terms of the GDP deflator. If the link between the GDP deflator and inflation as measured by a consumer price index is weak, or if the public does not understand the link, the anchoring of inflation expectations may be weak. Bean (2013) highlights two more problems. First, overshooting the (implicit) inflation target deliberately might be perceived by the public as an attempt to inflate away debt burdens. Inflation expectations might become unanchored.
Second, maintaining low interest rates for too long carries financial stability risks.
A practical problem with nominal GDP targeting is that GDP data are published with a time lag and tend to be revised frequently and substantially. It is difficult to determine monetary policy without data on the current level of the target variable. If GDP data are revised, it might prove difficult for central bankers to explain their policy decisions after the event. 2.2 When structural changes in price-setting depress inflation ... 2.2.1 ... one could adjust the inflation target downward Several reasons have been put forward why the Phillips curve has become flatter. One explanation is the greater anti-inflation credibility that central banks have gained over the past decades, making actual wage and inflation developments less responsive to domestic cyclical activity (Bernanke, 2007a).
Moreover, the indexation of wages to domestic inflation developments has become less prevalent, reducing inflation persistence. Wage dynamics have also changed because of globalization and increased global labor competition (Freeman, 2007). At the level of goods markets, Auer et al. (2017) argue that the expansion of global value chains has ­ intensified global interconnectedness, making the global output gap more important in driving domestic inflation (“globalization of inflation hypothesis”). Hence, ­ Constâncio (2015) points out that “a flatter slope of the Phillips curve would make
19 controlling inflation either more costly or more difficult.” Thus, it might prove hard for monetary policy to achieve an inflation target of 2% (BIS, 2017). One conclusion might be to adjust the inflation target downward to a level which is more easily achievable, such as 1% or 1.5%. This would lower the risk of overheating and the same time scale down financial stability risks. The major risk associated with such a move is that inflation expectations might adjust downward or become unanchored altogether, further reducing the future scope of monetary policy to counter economic downturns and deflationary episodes. 2.2.2 ... one could use target intervals for inflation instead of point targets Another option would be to replace inflation point targets by target intervals. Thus, instead of a point target of 2%, a central bank could aim for a range between 1% and 3%. This seems especially appealing if global forces pushing down inflation were to be only temporary. As long as they are at work, the central bank can ­ (internally) aim for the lower region of the target interval. Once they fade out, it can slowly return to the middle of the corridor, without changing its target. Only a few central banks (e.g. the Reserve Bank of Australia, South African Reserve Bank) follow a target interval in the sense that within the target interval there is no preferred target point.
A central bank that utilizes a target range to change the point target from time to time may, however, experience instability in inflation expectations. Economic agents are bound to notice that the central bank is aiming for a different part of the target interval, so inflation expectations will adjust accordingly. Furthermore, absent explicit central bank guidance on inflation expectations, different economic agents might expect different levels. Hence, inflation expectations may become more heterogeneous and unstable, leading to more volatile wage and price changes. Svensson (2001) argues that it is more difficult to anchor inflation expectations with a target range than with a point target. Also, real economic stabilization ­ becomes trickier and there will be larger fluctuations in economic activity. In essence, there is little difference between aiming for different regions within a target interval and changing the point target every now and then. Apel and Claussen (2017) conclude that “if the motivation for a target range is to be able to adjust for changes in the optimal rate of inflation, it seems more reasonable to discuss and evaluate the appropriate level of a point target.” This argument becomes even more relevant should the global forces currently dampening inflation persist for longer. 2.3
When supply shocks create a tradeoff between inflation volatility and output volatility in the short to medium term ... 2.3.1 ... one could target core inflation The conventional wisdom (see e.g. Mishkin, 2007) is that policymakers should “look through” cost-push shocks, as long as inflation expectations remain anchored. This insight is rooted in the experiences gained in the 1970s. When an oil-price shock pushes energy prices up, headline inflation will rise in line with energy prices. However, once energy prices have reached their (permanently) higher level, headline inflation will revert to its underlying trend rate. As the long transmission lags mean monetary policy can do little about such first-round effects of unexpected cost-push shocks, and as headline inflation will ultimately revert to trend anyway, central banks should refrain from monetary policy intervention. If, however, the
Monetary policy after the crisis: mandates, targets, and international linkages 20
OESTERREICHISCHE NATIONALBANK temporarily higher headline inflation rates lead to higher inflation expectations feeding into wage negotiations and bring about second-round effects in inflation dynamics, then there needs to be monetary policy action (see e.g. Clarida et al., 1999). The challenge of cost-push shocks is that they drive up inflation and depress GDP growth (or vice versa). So monetary policy must decide whether to bring ­ inflation back to its target level or to close the output gap. However, it cannot do both at the same time. Put differently, it faces a tradeoff in the short term between output and inflation volatility.
One way to shield monetary policy decisions from being distracted by ­ commodity-price shocks is to use core inflation instead of headline inflation as ­ target. Wynne (2008) argues that the basic idea of core inflation is that there is an aggregate inflation component in the inflation process (besides a relative price change component) strongly influenced by monetary policy. Consequently, abstracting from shocks to relative prices, core inflation captures the underlying rate of inflation going forward and hence is a better guide to where headline inflation itself is moving. However, there is no single measure capturing the underlying rate of inflation.
The most commonly used measure excludes food and energy and dates back to the 1970s. Depending on the type of shocks commonly hitting the economy, specific product categories can be excluded from core inflation measures. Having compared different subindices of the HICP, the ECB (2013) concludes that none of them ­ satisfies the criteria for an unbiased underlying-inflation measure for the euro area. Any core measure will itself likely be subject to transitory shocks. New ­ approaches to core inflation measurement, such as one isolating the common ­ component in monthly price statistics, might improve upon simple subindices of headline inflation (see e.g.
Vega and Wynne, 2003). However, Mishkin (2007) concludes that no measure of core inflation will work in all situations, because the nature of shocks changes over time.
Furthermore, a strand of literature challenges the conventional wisdom that monetary policy should look through commodity price shocks. Filardo et al. (2018) argue that oil price rises due to worldwide exuberant demand would call for a different monetary policy response than if caused by a supply shortage; ­ particularly if the currency area for which the central bank is in charge makes up a significant fraction of global demand. In this case, targeting core inflation measures that exclude energy prices can lead to poor policy outcomes.
Consequently, as Wadsworth (2017) points out, most central banks – like the Bank of Japan, the Bank of Canada, the Bank of England, the Swedish Riksbank, the Reserve Bank of Australia and the European Central Bank – target headline inflation.
Headline inflation is based on the theory of the cost-of-living index,6 which is by far the most well-developed and coherent framework for inflation measurement. Because households care about the prices of all the items they buy, controlling headline inflation, instead of some subset of it, is the ultimate target for most central banks.
6 The European Central Bank targets the harmonized index of consumer prices (HICP) which captures “final household monetary consumption”. For example, the HICP omits the cost of owner-occupied housing, which is – by Eurostat’s definition – no monetary consumption of households. Hence, the HICP’s conceptual framework does not follow the theory of the “cost-of-living index” like most other consumer price indices.
21 2.3.2 ... a medium-term orientation of monetary policy creates some leeway Most (formal or informal) inflation-targeting frameworks have built-in room for maneuver, as central banks are not required to bring back inflation to its target immediately after a shock. Wadsworth (2017) shows that most central banks of advanced economies are given several years for inflation to return to its target level. Their policy frameworks state that inflation should return to target within “two years” (Swedish Riksbank), “in the medium term” (e.g. European Central Bank, Swiss National Bank, U.S. Federal Reserve), “over time” (e.g. Bank of ­ Canada, Reserve Bank of Australia, Norges Bank), or over a time horizon that ­ depends on the shock (Bank of England). This more or less concrete “time to ­ target” (Wadsworth, 2017) gives central banks some leeway to find the right ­ balance between inflation and output variability. When Borio (2017) calls for lengthening the horizon over which monetary policy brings inflation back toward target at the current juncture, he refers to the inflation-output tradeoff. If inflation is indeed pushed down by various global forces, bringing inflation quickly back up to target might imply an overly expansionary monetary policy and a significant overshoot of the output gap. By contrast, a more gradual upward convergence of inflation to target would reduce output volatility. Take the ECB’s price stability target, which aims for an HICP inflation rate for the euro area of below, but close to, 2% over the medium term. Starting in 2013, inflation dropped and deviated from its target for five consecutive years after a – severe double-dip recession (see chart 3). At the same time, for almost the same period, the euro area has experienced a robust economic recovery. The ECB’s flexible medium-term orientation provides the necessary leeway to allow for a smooth return of inflation to the price stability definition, without undue risks to output volatility.
1 HICP inﬂation in the euro area Chart 3 Source: ECB. Monthly value Annual average (forecast for 2018–2020) 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
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