Friday, March 4, 2011

Monetary Policy Strategy

This past couple of years has been a fascinating laboratory for assessing the effectiveness of alternative strategies of monetary policy. In the wake of the collapse of the Bretton Woods arrangements in the early 1970s, we’ve seen the rise and fall of monetarism (money base targeting), and the spreading hegemony of interest rate targeting (IRT), which involves using an intermediate target – typically overnight interbank rates – to influence price stability and the level of economic activity.

With the latter, successful as it has been, you can immediately see one glaring problem: you’re using one instrument (the short term interest rate) to try and target two variables which often move at odds with each other. Aim for higher growth and you’re ipso facto accepting potentially higher price increases i.e. inflation, and reaching for price stability (and especially absolute price stability) will sacrifice economic growth. There’s also the fact that you’re depending on a stable transmission mechanism between short term nominal interest rates to longer term real interest rates, which are the ones that actually matter for credit creation, consumption and investment.

Hence the Federal Reserve’s actions during the crisis, which involved quantitative easing to try and influence longer term rates, when the Fed Funds Rate was nominally close to zero yet economic activity continued to decline.

IRT’s close cousin, inflation targeting (INT), has also gained popularity over the past few decades as the defining strategy of monetary authorities, as outlined in this paper (abstract):

Inflation Targeting
Lars E.O. Svensson

Inflation targeting is a monetary-policy strategy that is characterized by an announced numerical inflation target, an implementation of monetary policy that gives a major role to an inflation forecast and has been called forecast targeting, and a high degree of transparency and accountability. It was introduced in New Zealand in 1990, has been very successful in terms of stabilizing both inflation and the real economy, and has, as of 2010, been adopted by about 25 industrialized and emerging-market economies. The chapter discusses the history, macroeconomic effects, theory, practice, and future of inflation targeting.

Inflation targeting makes explicit one of the main objectives of monetary policy – price stability. More precisely, the target is now people’s expectations of the future path of inflation. In doing so you’ll bypass one of the main criticisms of IRT, which is using an intermediate target to affect multiple real variables, and afford greater flexibility to the monetary authorities in their choice of instruments.

INT also promotes considerably more transparency in central bank actions, and enhances the credibility of the monetary authorities – assuming of course they keep to the target. As long as their actions are consistent with achieving the inflation target (or inflation range), then all should be well.

In practice, inflation targeting is rarely precise – typically you’re talking about a plus or minus 1% around the central target – which affords considerable latitude for central bank discretion, as well as potentially higher volatility in real economic activity. That means that it’s actually difficult to distinguish between IRT and INT strategies in the real world, especially since many ostensibly IRT implementations operate much like INT implementations, with the main difference being an unannounced inflation target.

There’s also the small matter that in targeting inflation, you’re potentially sacrificing any influence over the other goal of monetary policy, that of maintaining economic activity. And what matters most to people on the street is jobs, incomes and purchasing power, and not just purchasing power alone.

If that’s the case, why not then target nominal economic activity in the first place? That’s the basis of the writings of Scott Sumner at The Money Illusion, and the idea is gaining ground and academic credence in advanced economies. To my knowledge, it has yet to be put to the test, but the idea has a lot of attractions. To be clear here, we’re actually talking about targeting a path for nominal economic activity (i.e. nominal GDP), and not necessarily the growth rate.

Consider the handling of the US financial crisis in 2008-2009 – Scott writes (and I agree) that the Fed didn’t ease enough during the last months of 2008, despite cutting the Fed Funds Rate to zero. Moreover, during the recovery phase, the problem wasn’t that the Fed was printing money (quantitative easing), but that they didn’t print enough.

Now there are a few stumbling blocks – you have to have some way to gauge expectations of the future path of nominal economic activity, and I suspect policy instruments such as interest rates, exchange rates and the money base might exhibit much higher than normal volatility. But that’s true of any alternative monetary regime, such as Singapore’s exchange rate target or Hong Kong’s currency board. A rule of thumb I’ve adhered to with respect to monetary policy is that you’ll gain stability in whichever instrument you use, but you’ll see higher volatility in all the others.

And there’s one more advantage of using a nominal GDP target path as the monetary policy objective – what if, as in a fully Islamic financial system, there aren’t any interest rates? That’s the basis of this new paper from Pakistan (abstract; H/T Islamic Finance Resources):

Central banking and monetary management in islamic financial environment
M. Nadim Hanif and Salman Sheikh

Continuous growth in Islamic finance calls for studying the framework in which the monetary policy maker (i.e., central bank) performs its functions. Central banks in Muslim countries are using various instruments for monetary policy purpose including interest rate. As a result, Islamic financial institutions (IFIs) are facing issues in benchmarking the price of financial instruments. Acceptable solution to benchmarking lies in the presence of a real economic activity in the base of any proposal and its feasibility for business performance when put against conventional banking. This paper presents empirical evidence of statistical equivalence of nominal GDP growth rate and official interest rate for ‘advanced,’ ‘all,’ and some Muslim countries. We propose nominal GDP growth rate as benchmark for pricing domestic financial transactions of IFIs as well as for pricing external bilateral/ multilateral loans. The paper also suggests nominal income targeting as monetary policy regime and provides a liquidity management mechanism for banking system in Islamic financial environment.

Alternative monetary policy rules for Islamic monetary systems can probably be constructed using money base targeting or exchange rate targeting, but the former causes too much real volatility while the latter only really works well in countries with large external sectors.

A common criticism is that GDP forecasts and reports are too few and far between to be useful as market pricing benchmarks or as a monetary policy target, but there have been some successful efforts to build high frequency GDP measures such as here (warning pdf link), here, here and here – it’s actually nearly possible to do GDP estimates in real time (i.e. daily). Scott Sumner actually advocates a GDP futures market, which allows for direct measurement of expectations. Hanif and Sheikh (2009) suggests a government appointed shariah council to establish GDP targets and forecasts, much like in a IRT environment where BNM’s OPR or the Fed’s FFR determine market interest rate benchmarks.

So the tools are there, or potentially there. All it takes is someone to be the guinea pig.

Update (March 4, 2011):

I forgot to mention, you can read more about nominal GDP targeting at David Beckworth’s blog.

Technical Notes:

  1. Svensson, Lars E.O., "Inflation Targeting", NBER Working Paper No. 16654, December 2010
  2. Hanif, M. Nadim and Sheikh, Salman, "Central banking and monetary management in Islamic financial environment", Journal of Independent Studies and Research , Vol. 8, No. 2 (July 2010)


  1. bro hishamh nice piece...

    having seen inflation targeting in action i wonder if it has any real impact...when real problem lies in the lack of infrastructure investments in Indonesia which created a massive supply chain bottle neck...

    Not only that it becomes more of managing "perception" of inflation prior to any rates announcement...

    To top it all.. banks operates at ridiculous margins...real sector impact hancus giler babeng...

    BTW I tot Schiller was the first to promote Macro Markets?

  2. Thanks.

    The theory is: get expectations of price stability right, and the rest will fall into place. But that presumes a belief that general equilibrium holds, and economies "self-correct" towards full utilization - not necessarily true of developing economies.

    And yes, managing expectations not actual policy moves becomes the name of the game. But then that's become true of interest rate target regimes as well.

    I thought Sumner was the first to link GDP futures markets as an explicit monetary policy target. But I'd be glad to be corrected.

    If Shiller came up with it first - damn, has that man ever come up with a bad idea?