BEE2037- MONEY AND BANKING

The conduct of monetary policy: strategy and tactics

Week 8
 Outline

1 Introduction

2 Price stability

3 Inflation targeting

4 Lessons for monetary policy strategy from the GFC

5 How should central banks respond to asset-price bubbles?

6 Summary

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 Last week

The nonconventional monetary policies implemented by centrals.

These include:
» Liquidity provision.
» Large scale asset purchases.
» Forward guidance.
» Negative interest rates on banks’ deposit.
Monetary policy at the ZLB.
How the nonconventional policies implemented by CBs operate by
lowering financial frictions (f¯), which lowers the real interest rate for
investments leading an increase in output.

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 Introduction

Introduction

Figure 1: Nominal anchor Source: Reddit Inc (2020)

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 Introduction

Introduction

Therefore, this week we address the following questions:

1 How do we define and recognise the importance of a nominal anchor?
2 What are the six potential goals that monetary policy makers may
pursue?
3 What is the distinction between hierarchical and dual mandates?
4 What is the brief background to the introduction of inflation targeting
as the primary monetary policy framework?
5 What are the four lessons learned from the global financial crisis and
what do they mean for inflation targeting?
6 What are the arguments for and against central bank policy response
to asset price bubbles?

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 Price stability

The price stability goal

Why should we be interested in the conduct of monetary policy?

Policy makers are increasingly aware of social and economic costs of
inflation.
Maintaining a stable price level is seen as a goal of economic policy.
Price stability is defined as low and stable inflation.
Highlights the importance of a nominal anchor.
» a nominal variable, such as the inflation rate or the money supply,
which ties down the price level to achieve price stability.
» Nominal anchor can also limit the time-inconsistency problem.

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 Price stability

Time-inconsistency problem

Policy makers attempt to pursue monetary policy that is more

expansionary than expected.
Why?
This policy would boost economic output (and lower unemployment)
in the short run.
Best policy, however, do not pursue expansionary policy, as this can
affect workers’ and firms’ expectations about inflation.
» Recall equation 10 from Week 7, and assume no inflation shock.
» Inflation can be determined by either rational expectations (strong
assumption) or adaptive expectations:

πt = πte + γ (Yt − YtP ) or πt = πt−1 + γ (Yt − YtP )

| {z } | {z }
output gap output gap

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 Price stability

Time-inconsistency problem

Might be tough to pursue better policy of inflation control due to

political pressure.
A nominal anchor acts as a ‘behaviour rule’. Set the rule and then
stick to it so that:
π = πe = πT
where π T denotes inflation target.
Time for our first task.
Task 1
You will see the task during the lecture.

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 Price stability

Other goals of monetary policy

Five other goals are continually mentioned by central bank officials

when they discuss the objectives of central banks:
1. High employment and output stability.
Natural rate of unemployment.
2. Economic growth.
3. Stability of financial markets.
4. Interest rate stability.
5. Stability in foreign exchange markets.

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 Price stability

Other goals of monetary policy

Figure 2: Weight of central bank objectives in the legislation (CB laws) of 47 CBs Bank for
International Settlements (2009)

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 Price stability

Should price stability be the main goal of monetary

policy?

Hierarchical versus dual mandates

» Hierarchical mandates put the goal of price stability first, then others
can follow.
» Dual mandates are aimed to achieve two coequal objectives: price
stability and maximum employment (output stability).
Time for task 2.
Task 2
You will see the task during the lecture.

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 Inflation targeting

Inflation targeting

A monetary policy strategy.

Inflation targeting involves a number of essential elements:
» Public announcement of medium-term numerical target for inflation.
» Institutional commitment to price stability as the primary, long-run goal
of monetary policy and a commitment to achieve the inflation goal.
» Information-inclusive approach in which many variables are used in
making decisions.
» Increased transparency of the strategy.
Communication to the public and financial markets: media, minutes,
reports etc.
» Increased accountability of the central bank.

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 Inflation targeting

Inflation targeting

Time for Task 3.

Task 3
You will see the task during the lecture.

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 Inflation targeting

Inflation targeting: empirical evidence

Figure 3: Inflation rates and inflation targets for selected countries, 1980-2020

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 Inflation targeting

Inflation targeting: empirical evidence

Figure 4: UK inflation target and Bank of England policy instrument to keep it at

target, 2004-2023 Source: Bank of England, Monetary Policy Report (Nov, 2023)
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 Inflation targeting

Inflation targeting: empirical evidence

Figure 5: Inflation dashboard of Euro area countries Source: ECB (2023)

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 Inflation targeting

Inflation targeting empirical evidence

Figure 3 & 4 shows that:

» Inflation targeting countries have significantly reduced the rate of
inflation.
» However, currently inflation in UK is 6.7%.
Above its target of 2%.
Governor of BoE has to write a letter to the Chancellor of Exchequer
explaining why.
Exchange letters between the two happened in September 2023.
ECB’s inflation target is about 2%. Figure 5 shows that:
» ECB has not always met its target.
The Fed only started inflation targeting in January 2012.
» Target of 2% ... moved to average inflation targeting in 2020.

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 Inflation targeting

Inflation targeting: empirical evidence

Advantages:
» Does not rely on one variable to achieve target.
» Easily understood.
» Reduces potential of falling in time-inconsistency trap.
» Stresses transparency and accountability.
Disadvantages:
» Delayed signaling.
» Too much rigidity.
» Potential for increased output fluctuations.
» Low economic growth during disinflation.

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 Inflation targeting

Inflation targeting: monitoring inflation expectations

Every central bank devotes considerable amount of resources to

monitor inflation expectations.
» For example, BoE has a quarterly survey.
» Respondents expected prices to rise over the coming year by 2.8%
(households) in August 2023 and 4.9% (companies) in October 2023.
This is not the same as forecasting inflation:
» Forecasting is about what will (most likely) happen.
» Expectations are about what firms and households think will happen.
They can be wrong.
» Expectations, however, can be self-fulfilling.
If every firm expects 4.9% inflation and raise prices accordingly, then
inflation is going to be 4.9%.

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 Inflation targeting

Inflation targeting: monitoring inflation expectations

Can a CB be wrong when it forecasts its inflation?

Point estimates are typically wrong.
Implies the CB cannot stabilise the economy perfectly.
Figure 6 shows a fan chart of inflation projections (forecasts) by BoE.
» The fan chart depicts the probability of various outcomes for CPI
inflation in the future.
» Shows outlook of inflation is highly uncertain.
» BoE projects inflation not to return to its target soon.

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 Inflation targeting

Inflation targeting: monitoring inflation expectations

Figure 6: BoE’s CPI inflation projection based on market interest rate expectations, other
policy measures as announced Source: Bank of England, Monetary Policy Report (Nov, 2023)

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 Progress so far

Remember the questions that we are looking at this week...

1 How do we define and recognise the importance of a nominal
anchor?✔
2 What are the six potential goals that monetary policy makers may
pursue?✔
3 What is the distinction between hierarchical and dual mandates?✔
4 What is the brief background to the introduction of inflation targeting
as the primary monetary policy framework?✔
5 What are the four lessons learned from the global financial crisis and
what do they mean for inflation targeting? Next slides...
6 What are the arguments for and against central bank policy response
to asset-price bubbles? Next slides...

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 Lessons for monetary policy strategy from the GFC

Lessons for monetary policy strategy from the global

financial crisis (GFC)

1 Developments in the financial sector have a far greater impact on

economic activity than was earlier realised.
2 The zero-lower bound on interest rates can be a serious problem.
» Raises questions whether an inflation target of 2% is too low.
3 The cost of cleaning up after a financial crisis is very high.
4 Price and output stability do not ensure financial stability.
What are the implications of these 4 lessons for inflation targeting?
Task 4
You will see the task during the lecture.

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 How should central banks respond to asset-price bubbles?

How should central banks respond to asset price

bubbles?

Open questions in central banking:

Pre-2008 crisis: ‘risk
management’ á la Greenspan or
rigid inflation targeting?
During 2008 crisis: What should
central banks do about asset
Source: Fishel (2018), Polk (2018), price bubbles?
Creative commons (2003)

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How should central banks respond to asset-price bubbles?

How should central banks respond to asset price

bubbles?

Asset-price bubble: pronounced increase in asset prices that depart

from fundamental values, which eventually burst.
» The fundamental value of an asset is the present value of the stream of
income or services the asset entitles its owner to. E.g.
∗
P∞ rentet+s
house pt = s=0 (1+r)s
P∞ dividendse
stock p∗t = s=0 (1+r)s
t+s

» In general price of an asset is: p∗t + zt , where zt is the bubble.

Types of asset-price bubbles:
1 Credit-driven bubbles e.g. subprime mortgages.
2 Bubbles driven solely by ‘irrational exuberance’.

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How should central banks respond to asset-price bubbles?

How should central banks respond to asset price

bubbles?
Top ten financial bubbles that have occurred in the last 400 years?
1 Dutch tulip bulb bubble in 1636.
2 The South Sea bubble in 1720.
3 The Mississippi bubble in 1720.
4 The late 1920s stock price bubble in 1927-29.
5 Surge in loans to developing countries in the 1970s.
6 Real estate and stocks in Japan in 1985-89.
7 Real estate and stocks in Scandinavia (Finland, Norway and Sweden) in
1985 - 89.
8 Real estate and stocks in SE Asia in 1992-97 and surge in foreign
investment in Mexico 1990 - 99.
9 Over-the-counter stocks in US in 1995 - 2000.
10 Real estate in the US, UK, Spain, Ireland and Iceland and the Greece
government debt in 2002-2007.

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How should central banks respond to asset-price bubbles?

Should central banks respond to bubbles?

The ‘lean versus clean’ debate.

Strong argument for not responding to bubbles driven by irrational
exuberance.
The ‘Greenspan Doctrine’ reflects five arguments.
» Bubbles nearly impossible to identify.
» Raising interest rates may be ineffective in restraining bubbles.
» Interest rates are a blunt tool.
» Pricking bubbles can have harmful effects on the aggregate economy.
» Better to ease monetary policy aggressively when bubble bursts
(supports ‘clean’ argument).
Monetary policy should not be used to prick bubbles.

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How should central banks respond to asset-price bubbles?

Should central banks respond to bubbles?

Strong argument for responding to bubbles.

» The GFC did demonstrate that credit-driven bubble bursts are hard to
‘clean up’.
Important to distinguish between the two bubbles.
» Instead of ‘leaning’ against potential asset-price bubbles (both types),
rather lean against ‘credit booms’.
» If asset price bubbles are rising at the same time that credit is
booming, then it is likely that asset prices are deviating from
fundamentals - lax credit standards.

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 How should central banks respond to asset-price bubbles?

What policies are effective in restraining

credit-driven bubbles?

Macropudential policy:
» regulatory policy to affect what is happening in credit markets in the
aggregate.
Monetary policy:
» Central banks and other regulators should not have a laissez-faire
attitude and let credit-driven bubbles proceed without any reaction.
Task 5
You will see the task during the lecture.

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 Summary

Summary

Six basic goals of monetary policy with price stability being the
primary goal.
A strong nominal anchor is a key element of a successful monetary
policy.
Advantages and disadvantages of inflation targeting.
The lessons of the global financial crisis:
» provide support for perhaps a flexible inflation targeting possibly with
higher inflation target...(many questions about this).
» suggest that monetary policy should lean against credit booms but not
asset price bubbles.

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 Next week...

Financial innovation and inclusivity

What is financial innovation?

How can mobile banking promote financial inclusivity?
What happens when financial innovation turns toxic?
» Crisis - we shall only focus on the 2007- 2009 GFC.
Reading material and resources:
» Mishkin (2022), Chapter 11 section 11.2 (only this section is relevant
to our topic and examinable).
» External video.
» Journal article.

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