Chapter

Chapter 14. A Robust and Adaptable Nominal Anchor

Author(s):
Tobias Adrian, Douglas Laxton, and Maurice Obstfeld
Published Date:
April 2018
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Author(s)
Tobias Adrian Douglas Laxton and Maurice Obstfeld

Even if it is now all too evident that the stabilization of inflation and inflation expectations does not by itself guarantee that macroeconomic instability will never be an issue, there remain excellent reasons to believe that success on this dimension is conducive to macroeconomic stability more broadly. —M. Woodford (2013)

Over the past quarter-century, flexible inflation targeting has provided a resilient nominal anchor for monetary policy. Inflation-forecast targeting is an efficient, operational form of this regime, and countries that have adopted it have had relatively good macroeconomic outcomes. In fact, no central bank that has implemented inflation-forecast targeting has later abandoned it. Its adoption does not, however, confer automatic credibility. Monetary policy under any regime earns credibility by delivering, over an extended period, a stable monetary standard.

With respect to inflation targeting, earning credibility does not mean that the inflation rate must always remain close to the official target rate. The nature of economic disturbances is such that actual inflation may sometimes be well wide of the target. Lags in the effect of monetary policy and the short-term trade-off between inflation and output make it unfeasible to quickly eliminate inflation shocks. The important thing for credibility is that the central bank consistently acts in a way that returns inflation to target within the usual time lag for the effect of monetary policy (in practice, a couple of years or so). Survey evidence and financial market data from countries that have adhered to inflation-forecast targeting show that, over time, long-term expectations do converge to, and hold steady at, the official target rate, notwithstanding variations in the actual rate of price increases.

Anchoring Policy Expectations

The nominal anchor under inflation targeting is the firm expectation that long-term inflation will adhere to the announced target rate. It follows immediately that monetary policy is fundamentally about expectations. As Woodford (2005) puts it, “For not only do expectations about policy matter, but, at least under current conditions, very little else matters.”

One might ask why inflation-forecast targeting has apparently provided a wider range of economies with a superior means of managing expectations than other regimes, including a fixed exchange rate (or an announced path for the rate), rules for money or central bank credit growth, or eclectic systems with multiple objectives. The answer would lie in the transparency and flexibility of inflation-forecast targeting. It does so by anchoring long-term inflation expectations, while allowing policy to guide short- to medium-term interest rate expectations. Announcing a fixed numerical target for the rate of increase in consumer prices over the long term clarifies without ambiguity the policy objective and sets an objective standard for monetary stability. It concerns the behavior of a variable that affects everybody directly and materially. The regime does not ignore real variables such as output and employment but recognizes them consistently with macroeconomic theory and evidence: the short-term trade-off between output and employment and inflation affects the speed with which policymakers will return inflation to target; and in the long term steady inflation at the target rate is consistent with output at the highest sustainable level.1 Furthermore, the flexibility of the exchange rate under inflation targeting helps the economy adjust to shocks with minimal harm to output and employment. The consistency of the objectives with basic economic principles makes it easier for an inflation-forecast-targeting central bank to communicate policy and to build confidence that its targets will be met.

Under alternative regimes it is more difficult to manage expectations.

  • For many small open economies, a fixed exchange rate regime can provide a clear target that is publicly understood. However, history shows that a fixed exchange rate standard is liable to collapse, especially following an asymmetric shock: the fragility of the official commitment undoes the usefulness of its clarity.
  • Monetary standards based on rules for money or credit growth have had major communications problems, as well as substantive issues. The aggregates that are targeted are neither objectives of interest to the general population nor instruments under the control of policymakers.
  • Financial innovation has undermined attempts to target money growth. Policymakers have been drawn into arcane discussions about the definition of money and about the instability of the links from money and credit aggregates to inflation and output caused by financial innovation. This can detract from their more important policy commitment: holding inflation to a low rate.
  • Central banks espousing systems with eclectic objectives—inflation control, high employment, money growth, credit conditions, the balance of payments, exchange rate management, and so on—may have worried less about financial innovation, but they have often been unable to present a clear vision to the public of what they ultimately sought to achieve.

Effective management of expectations is important to ensure both the potency of the policy instrument and confidence in the objective. Again, inflation-forecast targeting benefits from clarity. In normal times, the instrument is typically a key short-term money market interest rate. At times when the policy rate is constrained by the effective lower bound, managing expectations becomes even more important as a means to reduce longer-term rates. A preannounced schedule of dates for setting the policy rate draws the attention of the public and provides a basis for pricing in financial markets—spot, forward, and futures. Media commentary highlights both the issues that a monetary policy committee may consider at its decision meeting and the pros and cons of any change in the policy rate. Academics test policy reaction functions for the rate in macroeconomic models. All this attention serves a useful purpose, since the focus on central bank decisions about the policy rate strengthens their impact on financial market expectations.

Using Transparency to Promote Accountability

All this attention matters, because, in and of itself, the policy interest rate is of negligible importance to the economy as a whole. If nobody notices the policy rate, nothing much will happen when it changes.2 The effectiveness of monetary policy stems from its impact on interest rates in the longer term, which are the rates at which households and firms borrow and lend. To shift the entire yield curve, changes in the policy rate must change expectations about future short-term interest rates. Under inflation-forecast targeting, the central bank prompts expectations to move in line with policy objectives by explicitly indicating the likely course of the policy rate at future monetary policy committee meetings. Given how clearly central banks now communicate their policy objectives, it is somewhat astonishing to recall that in the early 1990s central banks did not even disclose the level at which they intended to set the key interest rate under their control.

Policymakers have managed to clearly define for the public the nature and limits of the commitments imposed by inflation-forecast targeting. To achieve an inflation target, the policy instrument must be free to move in response to new developments—which is why the effective lower bound poses special difficulties. There can be no commitment to a given interest rate or to a given future path for the interest rate. Instead, the policy interest rate responds to the need to return inflation to target under inflation targeting. Thus, inflation-forecast-targeting central banks use models for forecasting and policy analysis in which the path of the short-term interest rate is endogenous, determined by a policy reaction function. Policymakers underline the conditionality of their forecasts of future interest rates by emphasizing the uncertainties in the outlook. In practice, it has proved relatively straightforward to communicate to financial markets and to the public in general the difference between the commitment to the fixed long-term inflation target and the conditional projections for the interest rate.

Inflation-forecast-targeting central banks have stepped up communications programs to maximize the impact on public expectations of the increased availability of information. Immediately after monetary policy committee meetings, there are press releases and press conferences with the central bank governor and other senior officials to explain the rationale for the committee’s decision. Monetary Policy Reports (usually quarterly) analyze recent outcomes relative to prior expectations and explain in detail how the central bank expects current policy actions to assist in the return of inflation to target. In most cases, this involves a verbal, qualitative description of the interest rate forecast. A few central banks publish their entire forecast, including the explicit numerical path of the short-term interest rate. By doing this, they provide forward guidance for the policy rate routinely after each policy decision. Based on the existing evidence, this increased openness has reduced the element of surprise in policy rate changes and strengthened the transmission of policy.

Feedback from increased political accountability, both formal and informal, reinforces the influence on expectations and credibility. The formal aspect involves relations between the central bank and the government or parliament. The informal aspect is more general, relating to the obligation of the central bank to explain itself to the public: what objectives it is trying to achieve; how its past, present, and future actions are in line with those objectives; and the reasons behind any failure to achieve its objectives. Transparency is therefore a key component of accountability. In turn, clear political accountability buttresses public trust in the system.

There is no free lunch. Communications activity absorbs time and energy of senior management and staff. Furthermore, inside the central bank, inflation-forecast targeting implies an increased cost of policy implementation and an increased reliance on economic analysis, compared with a system that targets an intermediate variable like the exchange rate or a monetary aggregate. The direct focus on the objectives of inflation and output requires policymakers to make decisions based on an understanding of the complex linkages from the policy instrument. Between each monetary policy committee meeting a vast amount of new, relevant, data becomes available. The transmission mechanism famously involves long and variable lags and short-term trade-offs between goals. Inflation-forecast-targeting decisions are therefore based on forecasts and on judgments about the best path back to target, for example, fast or gradual. Each inflation-forecast-targeting central bank therefore invests in a structured forecasting and policy analysis system, which is designed to process the economic implications of the new data and to efficiently provide relevant macroeconomic information for each policy meeting. The forecasting and policy analysis system involves a team of economists who produce a model-based baseline forecast and alternative scenarios based on different assumptions about exogenous factors or policy responses.

The model at the core of the forecasting process has standard economic properties. These include an endogenous short-term interest rate set by a policy reaction function and forward-looking, model-consistent expectations on the part of policymakers and the public. The model provides an organizing framework for the mass of relevant data and solutions for the paths of endogenous variables that would otherwise be intractable, as well as for model-based bands of uncertainty around these paths. The internal economic consistency of model-derived forecasts helps central bank economists deliver a coherent economic narrative for their forecasts and related policy analyses, which is an asset in explaining the conduct of monetary policy.

Inflation-Forecast Targeting in Practice

Effective implementation of monetary policy requires frequent operations by the central bank, in wholesale money markets, to translate policy decisions into changes in economic incentives. The operational framework facilitates such actions and comprises the operating target—the variable the central bank targets to implement its policy stance—and monetary instruments—used to align market conditions with the operating target.

In most cases the operating target is a very short-term interest rate, although there are exceptions. Some countries, where financial markets are undeveloped or shares of imports in the consumption basket are exceptionally large, target the growth rate of base money or an exchange rate. In addition, central banks that generally target interest rates may also use the size of their balance sheet as an operational target as interest rates approach the effective lower bound, as happened in the wake of the global financial crisis.

While the traditional monetary instruments—reserve requirements, open market operations, and standing facilities—are well known, there are numerous variations on the choice of operating target and the configuration of the operating framework. Central banks generally choose between targeting a market rate (for example, the overnight unsecured interbank rate) or attaching their policy rate to a central bank instrument (either in the middle or at the floor of an interest rate corridor). The aim is to ensure strong transmission by establishing a stable and predictable relationship between the policy rate and the interest rates that have a direct bearing on economic activity.

In settling on an operational framework, central banks need to consider their own circumstances and constraints, and decide how to balance the trade-offs across different criteria. For instance, operational frameworks differ in the degree of liquidity risk they impose on participants with consequent impact on market activity and development. Operational and financial costs and risks, and the capacity of staff to calibrate and conduct operations, also matter.

The question naturally arises as to whether monetary policy should pursue the additional objective of minimizing risks of major financial crises, and occasionally raise interest rates more than required by regular flexible inflation targeting. Systemic financial crises may be infrequent, but their occurrence can impose heavy costs on the economy. Micro- and macroprudential policies would seem the most appropriate policy tools as they are designed to tackle specific financial vulnerabilities, and thereby mitigate the probability of financial crises. However, their effectiveness remains somewhat uncertain, though initial evidence is encouraging. Nevertheless, adding financial stability as a separate objective for monetary policy seems ill-advised. Historical evidence suggests that raising interest rates more than warranted by the price stability mandate in an attempt to preempt risks of a crisis generally implies costs that outweigh potential benefits.

This does not imply that monetary policymakers should remain oblivious to financial sector frictions and vulnerabilities, captured in financial conditions indices. These carry important information that can help the central bank manage the short- to medium-term inflation-output trade-off more efficiently, with an unchanged mandate—that is, with lower variance of inflation and output around the desired path. Financial conditions are shown to contain important information on continuously evolving downside risks to economic activity over the policy horizon—to be distinguished from risks of devastating, though infrequent, systemic crises.

A few country experiences are worth highlighting:

  • Canada is an advanced economy with a mature policy framework. The Bank of Canada’s record for inflation control is excellent. Expectations of long-term inflation have been steady at the 2 percent target rate through all the fluctuations of the actual rate. One change is recommended: publication of the forecast path for the short-term interest rate. This, combined with an aggressive risk-avoidance strategy, might be especially useful in the event of another large negative shock, to reinforce the effectiveness of a stimulative policy when the policy rate is near the effective lower bound.
  • The Czech economy went through a deep structural reform and a transition from an emerging market to an advanced economy. In the middle of this process the Czech National Bank adopted inflation-forecast targeting. It has implemented the regime with remarkable success. Like the Bank of Canada, it has managed to establish firm long-term expectations of 2 percent inflation. The Czech National Bank has become an international leader in central bank transparency.
  • India is an emerging market that more recently embarked on flexible inflation targeting. The Reserve Bank of India has had to deal with various special issues, among which are a weak transmission mechanism and the strong influence of volatile food prices on the short- to medium-term dynamics of inflation. Time will tell if the new regime will help to anchor the previously drifting inflation rate, but the early days indicate that the approach holds promise, with a decline in inflation in line with the announced long-term target.
  • The United States had a lower rate of inflation than the preceding countries in the late twentieth century and therefore did not face the same imperative to reform its monetary policy framework. Internally, the Federal Reserve had all the elements of an efficient forecasting and policy analysis system for inflation-forecast targeting: a well-honed process of internal communication between forecasters and policymakers and a long-standing schedule for policy meetings and announcements. It also had sophisticated communications arrangements. By 2012, when it announced the 2 percent inflation objective, the US monetary policy committee, the Federal Open Market Committee (FOMC), was already following an inflation-forecast-targeting policy in all but name. That the regime has been adopted gradually, over many years, indicates that at each step the Fed liked how it worked. The FOMC kicked the tires and took a long test drive before buying the vehicle.
  • Finally, an examination of issues in low-income countries confirms that a wide range of countries might benefit from espousing the principles at the heart of inflation-forecast targeting.

A broader summary of the international history is in order.

The 15 years before 2008 comprised a period of remarkable economic stability for advanced economies, with steady growth and low, stable inflation. During that time, emerging market economies achieved an enormous expansion of output and vastly improved standards of living. This period was not without shocks, however. In 1997–98, severe financial crises in Asia and Russia, and the related failure of the giant hedge fund Long-Term Capital Management, exposed large systemic weaknesses and imbalances. In 2000–02, trillions of dollars were wiped from stock markets with the bursting of the dot-com bubble. The September 11, 2001, terrorist attacks on the United States shook confidence further, causing severe damage to the financial infrastructure of New York City and triggering another plunge in stock markets. Yet with adept monetary policy actions, the global economy weathered these crises.

One could have been forgiven for concluding that central bankers had found the key to providing a firm nominal anchor while avoiding cyclical instability. Stock and Watson (2002) wrote of “the great moderation.” Nobel Laureate Robert Lucas declared that the “central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades” (Lucas 2003). Blanchard and Galí (2005) noted a “divine coincidence” in that under certain conditions the appropriate policy interest rate response to hold inflation at the target rate following a demand shock would also stabilize output—for example, following a negative demand shock the central bank would cut the rate to keep inflation on target and to keep the output gap at zero. Blanchard (2009)—the initial draft of which was written before the failure of Lehman Brothers in September 2008—surveyed the field and concluded that “The state of macro is good.” It seemed to be smooth sailing.

The global financial crisis that began with the failure of Lehman Brothers made it clear that the lessons about financial stability offered by previous crises had not been absorbed. The Great Recession in the United States spread and exposed underlying weaknesses that contributed to a decade of lackluster growth in advanced economies. Adverse longer-term trends—the decline in the global real equilibrium interest rate, lower productivity growth, aging populations—became more visible. Key macroeconomic variables fell significantly out of line with historical business downturns. It became untenable to continue applying convenient assumptions about the linearity of trends in existing forecasting and policy analysis. For example, these models were ill-equipped to handle the effective lower bound on interest rates or the strains in the financial sector.

Conjunctural problems have been aggravated by a decline in manufacturing and international trade. A strong rebound in China from 2009 to 2011 contributed to a commodities boom—often referred to as a commodities “supercycle”—that lifted exporters of industrial materials, including many emerging market economies. But commodity prices too have retreated. Negative output gaps and below-target inflation rates have persisted around the globe. Forecasts of growth were repeatedly downgraded, and the risk assessments of the IMF and the World Bank have been conspicuously tilted to the downside.

The decline in the global equilibrium interest rate is evident in the large drop in long-term bond yields since the 1990s and in the fact that historically low interest rates have not stimulated a strong increase in private investment or consumption. With inflation expectations at—or in the euro area and Japan, below—target rates (typically 2 percent), the global level of nominal rates consistent with maintaining output at its potential level today is well below the pre-2008 level; estimates group around zero (for example, Summers 2015).

This poses a serious obstacle to the main instrument of monetary policy, since the effective lower bound on the policy rate is about zero.3 With rates already extremely low, central banks have had little room to cut further. It is therefore questionable whether monetary policy can effectively respond in the event of a new negative shock to the international economy. A relevant danger is a shock that is big enough to push a large part of the global economy into a trap of low inflation or deflation. In this dark corner, with the nominal policy interest rate at the effective lower bound, the real rate rises as expectations adapt to the central bank’s failure to raise the inflation rate to the target rate. The feedback loop, through a further weakening of demand, puts the economy deeper into the hole. A breakdown in the management of expectations is obviously a big part of the problem.

The situation is one in which the best policy response would involve concerted action on all macroeconomic policy fronts: fiscal, monetary, financial stability, and structural (Gaspar and others 2016). The focus though in this book is on monetary policy. Central banks have resorted to less conventional tools to stimulate output when the policy rate is near the floor. For example, forward guidance on the future path of the rate brings down the expected rate, and hence longer-term bond yields. Quantitative easing and outright purchases of longer-term bonds lower longer-term interest rates by reducing term risk premiums. The evidence suggests that these tools have had positive, albeit small-scale, results.

Credible Forecasts Illuminate Dark Corners

Without doubt, assertive, credible policy actions under a transparent inflation-forecast-targeting regime reinforce the potency of monetary policy. The essence of avoiding a bad equilibrium, when expectations of interest rates and inflation get stuck in an undesirable place, is to continue to effectively manage expectations. The most expeditious way to do this is for the policy framework to incorporate this principle rather than to rely on ad hoc forms of forward guidance. This principle has long been accepted with respect to the objective of monetary policy. Central banks that target inflation have always insisted that they will achieve their explicit targets, and they have used the communications tools at their disposal to convince the public to expect long-term inflation at the target rate. From the outset, they have published a forecast path for the inflation rate that achieves the target over the medium term.

Expectations are, as argued throughout the book, just as important with respect to the instrument of monetary policy. The simplest, most transparent way for central banks to encourage appropriate movements in longer-term interest rates is to publish their own forecast paths for the endogenous short-term rate, along with the inflation rate and the other main variables in its macroeconomic forecast. For the few central banks that have been this transparent, including the Reserve Bank of New Zealand and the Czech National Bank, the results have been good. We call such an open communications strategy conventional forward guidance to distinguish it from the unscheduled forward guidance used on occasion by the Federal Reserve and other central banks. Financial markets have readily understood that the rate forecast (unlike the long-term inflation forecast) is subject to change and conditional on unpredictable economic developments.

Assertive policy measures can illuminate dark corners. From a weak starting point, any further large negative shock to the global economy should be met with an aggressive, stimulative monetary policy response. When the policy interest rate is already at the effective lower bound, this would mean making a conditional public commitment to holding the rate at that low level for an extended time to bring long-term rates further down. Inflation might then temporarily overshoot the official target.4 There is nothing alarming in such a prospect. Indeed, the implied increase in medium-term inflation expectations would reduce real interest rates, even if nominal rates are at the floor, and thereby boost the desired monetary stimulus. In view of the costly losses of output and employment that would ensue from a slide into a trap of low inflation or deflation at the effective lower bound, tolerance for a brief period of high inflation would constitute prudent risk avoidance.

Credibility widens the tactical room for discretionary policy actions. When policy has established a reputation for consistent actions in line with announced goals, the occasional tactical detour does not raise concerns that these goals have been abandoned. Short-term room for maneuver might be useful for dealing with short-lived financial stability issues. There is a debate about the extent to which financial stability considerations should affect the conduct of monetary policy. Svensson (2015) argues that monetary policy should focus on inflation control and that other instruments should be used to maintain financial stability. The Bank for International Settlements (2017) criticizes inflation targeting as the basis for monetary policy on grounds that it does not adequately recognize the financial stability objective. The position emphasized in this book is closer to that of Svensson (2015): the comparative advantage of the monetary policy instrument is for inflation control; inflation-forecast-targeting central banks should not generally pursue the additional mandate of mitigating the risks of major financial crises (IMF 2015).

Confidence in the underlying policy framework likewise underlies the effectiveness of some unconventional measures. It also allows policymakers to experiment with new tactical approaches, without a material risk of sending long-term inflation expectations off target—the recent Czech experiment with exchange market intervention being a case in point. Conversely, a tactical deviation is necessarily short-lived, because the stability of the nominal anchor depends on a consistent strategy of returning inflation to the official target rate.

Conclusions

The global financial crisis and its aftermath exposed challenges for the effective conduct of monetary policy that have yet to be adequately resolved. Monetary policy at the frontier faces substantial unknowns and challenges. These include heightened uncertainty about underlying variables previously thought to be relatively stable, for example, potential growth and the equilibrium interest rate. The effective lower bound on nominal interest rates limits the extent to which central banks can stimulate output growth and raise inflation back to target. In recent years, with the policy interest rate already near its lowest feasible level, the main danger has been the risk of a bad quasi-equilibrium in which inflation becomes stuck at a very low, even negative, rate. Some analysts fear that extremely low interest rates, and the associated expansion of central bank liquidity, might eventually have negative effects on financial stability.

Central bankers will doubtless be confronted with major surprises as monetary policy is normalized. Our main argument is that inflation-forecast targeting provides superior management of expectations compared with alternative regimes. It bolsters confidence in the long-term inflation target and strengthens the transmission of policy actions. It is consistent with proactive, assertive measures that avoid bad quasi-equilibriums, when expectations of long-term inflation drift with the actual inflation rate. The regime has proved to be resilient and adaptable to advanced and emerging market economies with very different structures. Inflation-forecast targeting offers a state-of-the-art standard of monetary stability for the unpredictable challenges that lie ahead.

References

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1

For various inflation-forecast-targeting central banks (for example, Bank of Canada, US Federal Reserve) maximizing employment or output is part of the statutory central bank mandate. However, output or employment objectives are not defined numerically, either in the mandate or in the specification of inflation targets. The dual mandate as defined by the Fed in 2012 is equivalent to flexible inflation targeting or inflation-forecast targeting.

2

In some non-inflation-targeting regimes, the central bank has not highlighted a policy rate. Not surprisingly, changes in an official rate then have had little impact on other interest rates. The lack of emphasis breaks a key link in the policy transmission mechanism.

3

Depending on institutional arrangements, and on the opportunity costs of holding large stocks of cash, the effective lower bound may be a fraction above or below zero.

4

Simulations in which policymakers minimize a quadratic loss function often show this result. The quadratic loss function implies a risk-avoiding policy strategy.

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