Central Banks and Monetary Policy Strategy

1. Central Banks and Monetary Policy Strategy ( Chap. 14; Chap 17, 434-444…454-457)

2. Principles of Monetary Policy Strategy Pt. I. Why Price Stability? There is no long-run tradeoff between unemployment and inflation. Price stability has important benefits. Inflation is always and everywhere a monetary phenomenon. A strong nominal anchor is the key to producing good monetary policy outcomes. Mishkin, Monetary Policy Strategy After the Crisis 2 Expectations, Policy Credibility, and Transparency

3. 1. No Long Run Tradeoff: The Phillips Curve • Overall goal of government economic policy is to increase wealth in the economy • High Real Economic Growth • High Employment Levels • Economic Consensus: Central banks cannot directly impact long-run real growth on the basis of decision to produce more (or fewer) bank notes but they can affect real output & employment in the short-run.

4. World Development Indicators Outline

5. 2. Benefits of Price Stability • High inflation leads to • Increased transactions costs • Tax on Cash Holdings • Distortions of economic decisions • Uncertainty • Over-investment in financial sector

6. 3. Inflation is Always a Monetary Phenomena • Trite at some level. Inflation is growth rate of prices. Prices are measured in money. QED. • Relevant Meaning – Monetary authorities own inflation. • Central Banks are monetary authorities in modern economies.

7. Central Bank: A special governmental organization or quasi-governmental institution within the financial system that controls the medium of exchange.

8. What is a central bank? • Central banks have two main roles: • Banker to the government • Manage many financial assets of the government. • Monopoly on the issue of banknotes/currency (true almost everywhere, but not HK) • Arm of government policymaking • Banker to commercial banks. • Operate the Payment System • Regulate Banking System • Lender of Last Resort during a crisis

9. Powers & Purpose • Unlike private sector banks which maximize profits, the central bank attempts to increase wealth of the entire society. • Main powers of central bank: • Deciding the quantity of the monetary base • Use this power to set short-term interest rates (?) • In some economies, including HK, will regulate the banking system.

10. Focus on Stability • Central banks can have much more impact by stabilizing the economy in the short-run (which may have indirect positive impact on growth). • But the central goal of most central banks is to maintain a stable price level meaning low inflation. Why? • Making an effort to keep inflation low overcomes key flaw of paper money or fiat money, its unlimited supply.

11. Policy Framework • Fed Objective Humphrey Hawkins Act (1978): Fed instructed by Congress to be “conducting the nation's monetary policy .. in pursuit of maximum employment, stable prices, and moderate long-term interest rates “ • ECB Objective “The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.” • Japan Objective: Bank of Japan Act Article 2Currency and monetary control by the Bank of Japan shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy

12. Genberg, H and D He (2009): “Monetary and financial cooperation among central banks in East Asia and the Pacific”, in R Rajan, S Thangavelu and R Parinduri (eds), Exchange Rate, Monetary and Financial Issues and Policies in Asia, World Scientific Publishing Co, pp 247 – 70

13. More Goals

14. “Thirty years ago, the public's expectations of inflation were not well anchored. With little confidence that the Fed would keep inflation low and stable, the public at that time reacted to the oil price increases by anticipating that inflation would rise still further. A destabilizing wage-price spiral ensued as firms and workers competed to "keep up" with inflation. … The episode highlights the crucial importance of keeping inflation expectations low and stable, which can be done only if inflation itself is low and stable.” Bernanke, 2006 4. A strong nominal anchorThe Wage Price Spiral 14 Expectations, Policy Credibility, and Transparency

15. The importance of the nominal anchor. If workers expect high inflation they will demand high wage growth. But if firms experience growth in labor costs, they will price in high inflation. A self-fulfilling prophecy! Only if central bank displays a strong commitment to low and stable inflation, will expectations be anchored toward low and stable inflation. 15 Expectations, Policy Credibility, and Transparency

16. Quantitative Anchors • Monetary Targets – Growth in monetary aggregates • Exchange Rate Targets • Inflation Targets Fatas, Mihov, and Rose (2006) find that countries with explicit targets have less inflation. They find that meeting pre-announced numerical targets leads to an improvement in macroeconomic outcomes; this matters more than the nature of the regime

17. What is Inflation Targeting? An increasingly popular choice of monetary policy framework first adopted in New Zealand in 1989. Many inflation targeting countries have successfully lowered inflation and inflation expectations. WEO (2005) presents an optimistic view. Gürkaynak, Levin, and Swanson (2006) show long-term inflation expectations are more stable under inflation targeting indicating better anchoring.

19. List of Inflation Targeting CountriesRose, 2006A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed Outline

20. New IT Italics indicate possible non-FFIT. Reference: IMF Working Paper; Bank of England Handbook; Various central banks.

21. Inflation Targeting

22. Characteristics • An explicit central bank mandate to pursue price stability as the primary objective of monetary policy, • Explicit quantitative targets for inflation; • Policy actions based on a forward-looking assessment of inflation pressures, taking into account a wide array of information; • Increased transparency of monetary policy strategy and implementation. • Mechanisms of accountability for performance in achieving the objective; Laxton and Freedman, 2009, Why Inflation Targeting

23. 1. Commitment to Price stability as primary goal Central Bank has commitment to achieve low and stable inflation in the short-run and in the long-run “Like most other central banks, the Bank of Korea takes price stability as the most important objective of its monetary policy. The current Bank of Korea Act clearly sets out price stability as the purpose of the Bank of Korea's establishment and stipulates that it should seek to bring about price stability by setting an inflation target in consultation with the government and do its utmost to attain this target.” BACK

24. 2. Medium term numerical targets for inflation. Public announcement of specific inflation rate goal (w/ room for error) over specific term or period. • Based on Article 6, Clause 1 of the 「Bank of Korea Act」, the Bank of Korea sets the mid-term inflation target to be applied for three years in consultation with the government. The inflation target measure during the period from 2013 to 2015 is set at 2.5~3.5%, based on consumer price inflation (year-on-year).  Numerical goal subject to change BACK

25. 3. Policy actions based on a forward-looking assessment of inflation pressures Forward looking operating procedure – monetary instruments operate only with some lag. Targeting medium term inflation means setting today’s policy for tomorrow’s economy. Must inevitably target the forecast. The Bank reduced the Base Rate that had been held at 2.75% a year since November 2012 by 0.25 of a percentage point in May this year against the background in which not only there were large downside risks to growth owing to the slow pace of the world economic recovery,…, but also inflation pressures were expected to stay at a moderate level for some time to come due to the unexpected stability of oil and agricultural product prices. LINK

26. Back Garcia-Herrero and Remolena, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1457506

27. Inflation Reports • Central bank publishes its inflation forecast with probability distributions to indicated degree of uncertainty. BACK

28. 4. Transparency Learning about policymakers’ plans can cause shifts in expectations The more unstable are market expectations, the greater will be the instability in macroeconomic performance Keeping agents’ expectations aligned with policymakers’ plans helps avoid big surprises Credible central bank communications has calming impact on agents’ expectations This approach stands in sharp contrast to previous central banking practice.

29. 4 Things for the Central Bank to Communicate About • Goals and Instruments Fun Fact: Until 1994, U.S. Fed did not reveal policy instrument was Fed Funds Rate • Policy Decisions and their Basis • Policy Statements & Meeting Minutes • Economic Forecasts • Monetary Policy Outlook • Specific or suggestive

30. 5. Mechanisms of Accountability • Under IT, central bank retains instrument independence but must thereby retain responsibility for achieving objectives. • Many IT regimes include an accountability mechanism.

31. Mechanisms Open Letter to the President To ensure accountability in cases where the BSP fails to achieve the inflation target, the BSP Governor issues an Open Letter to the President outlining the reasons why actual inflation did not fall within the target, along with the steps that will be taken to bring inflation towards the target. Open Letters to the President have been issued on 16 January 2004, 18 January 2005, 25 January 2006, 19 January 2007, 14 January 2008 and 26 January 2009.For 2010, the BSP met the target and no open letter was issued. Bank of England Handbook

32. What measure of Inflation should be used?Headline Consumer Price Index ‘Core’ versus ‘headline’ CPI Headline CPI ~ Index of All Consumer Goods Core Inflation ~ Index of Consumer Goods less volatile price goods (i.e. food and energy). Tradeoffs ‘core’ more stable and better predictor of future inflation Food and Energy large share of emerging market consumer baskets and hard for public to ignore. Back

33. Targeters and theirTargets Bank of England Handbook

34. Over what horizon should inflation be measured? Usually over a range of 1 year at the shortest to 3 years at the outside. Keeping inflation near target even in the short-run offers greater credibility…if it can be accomplished. Short-term programs often adopted for disinflation. Longer term targets allow the economy more flexibility to adjust to temporary shocks.

35. Bank of England Handbook

36. Korea Adopts Inflation Targeting in 1998

37. IT Lite • Some central banks will use inflation as a nominal anchor, even announcing numerical goal for inflation without adopting full-fledged inflation targeting (FFIT defining targets, ranges, horizons, accountability mechanisms). • Ex. U.S. Federal Reserve Monetary Policy Strategy The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. FOMC Monetary Policy Strategy & Longer Run Goals • How much credibility will this build.

38. The Structure of Central Banks Chapter 17

39. Principles of Monetary Policy Strategy Pt. II Building Credibility Monetary policy is subject to the time-inconsistency problem; Central bank independence helps improve the efficacy of monetary policy. Mishkin Monetary Policy Strategy: How Did We Get Here? 39 Expectations, Policy Credibility, and Transparency

40. 5. Time Inconsistency Central banking goals benefit from anchoring inflation expectations but if inflation expectations become successfully anchored, a myopic policymaker might take advantage to push up output. Low inflation targets might not be time consistent. Since gov’t often has a short-term focus, it might be difficult to build credibility for low inflation expectations. 40 Expectations, Policy Credibility, and Transparency

41. Four Principles of Central Bank Design • Society should design the state such that central bank is able to resist the short-run imperatives of government but still implement the goals of society • Independence • Decision Making by Committee • Accountability and Transparency • Policy Framework

42. Principles of Central Bank Design1. Independence • Strategies for Insulation • Policy Independence: Central Bank sets day-to day monetary policy free of direct government control. Policy not reversible. • Personal Independence: Long-terms of Office for Central Bank Policymakers, difficult for Central Bankers to be Fired. • Revenue Independence: Central Bank has independent sources of revenue.

43. Federal Reserve Structure Board of Governors Washington D.C. (Direct Policy) New York Fed (Implement Monetary Policy in Financial Markets, Handle FX Transactions) Regional Banks (Monitor Regional Economy, Local Interbank Payments)

44. Independence of US Federal Reserve • Policy Independence: Monetary policy set by directors of Federal Reserve of USA controlled & Regional Bank • Personal Independence: Chairman of Fed serves across Presidential terms. Presidents appointed by executive and approved by legislature. Other policymakers serve terms of either 5 or 14 years. They cannot be fired without votes of ⅔ of Congress. • Revenue Independence: Fed earns profits through its payment operations which constitute its budget.

45. Formation of a New Currency 11 Countries adopt a single currency in 1998, 18 countries by 2013. • The countries of Euroland needed to replace national central banks with a single policy maker. Structure of the ECB ECB Website

47. Independence of ECB • Policy Independence: Monetary policy of ECB controlled by Executive Council & National Bank Presidents. Decisions cannot be reversed by national governments. • Personal Independence: National Bank managers serve 5 year terms across Presidential terms. Board members serve 8 year terms. • Revenue Independence: Budget provided by national central banks which conduct most profitable operations

50. Independence of Bank of Japan • Policy Independence: Monetary policy set by board. • Personal Independence: Governor and Board members have terms of five years, appointed by Cabinet approved by Diet and House of Councillors. • Budgetary Independence (?): Ministry of Finance must approve budget.