Andrew Crockett: Changing views on how best to conduct monetary policy
Speech by Andrew Crockett, General Manager of the Bank for International Settlements, to 50th Anniversary Symposium of the Bank of Korea, Seoul, 8 July 2000.
With all the recent talk about New Era economics, driven by technological progress and deregulation, one might have thought that change in economics was somehow a novelty. Nothing could be further from the truth, as this audience surely knows. It would be hard to think of an economy which has changed more over the last 50 years than that of Korea. An astonishing increase in living standards is only the most visible manifestation of equally profound underlying changes. And, observing the corporate and financial restructuring currently being undertaken in Korea, one quickly concludes that your process of fundamental change is certainly not over yet.
Today, I also want to talk about change; in particular, changes in the way that academics and policymakers approach the problem of conducting monetary policy. To some extent, these changes have been needed to respond to shifts in the underlying structure of the economy. To some extent, they have been the result of new intellectual insights. But perhaps to the greatest extent, these changes have reflected the fact that previous approaches were no longer delivering the goods.
And the process of evolution is continuing. Consider how many countries have adopted inflation targeting in recent years. And consider too the spread of electronic money and the recent suggestion by Mervyn King, Deputy Governor of the Bank of England, that traditional money and the central bank's monopoly over its growth might eventually disappear. To repeat, the process of revaluation and change in the domain of monetary policy is by no means over.
Today I want to focus on a few broad issues which condition the conduct of monetary policy, and consider how our thinking has evolved over time. First, I will say something about the economic, political and philosophical framework within which policymakers must act. Second, I will discuss the consistency of the domestic monetary policy framework with the choice of exchange rate regime. And thirdly, I will touch on the practical issues of how to achieve broad strategic objectives.
As a by-product of this historical overview, we may get some insights as to why thoughtful people today still differ in their views, and why an approach to policy which is good for one country may not be seen as good for another. In monetary policy, as in many other areas, no one size fits all.
There are many aspects to this, but perhaps the most crucial is the empirical structure of the economy. All monetary policy decisions must be based on some idea of how decisions will affect the real world. In other words, policy makers must conduct their policy within the framework of a model. Economics may not be a precise science, but it should at least be conducted according to principles recognising cause and effect.
In this regard, there have been enormous changes over the years. Montagu Norman, Governor of the Bank of England in the 1930s once told an Adviser "Your job is not to tell me what to do, but to tell me why I have done what I did". He and many others relied heavily on intuition. Intuition still has a role, but in subsequent years, it has been increasingly complemented by more explicit modelling. Indeed, for a period of time, perhaps particularly through the 1960s and 1970s, it can be argued there was excessive reliance on such modelling in many central banks. More recently, policymakers have become increasingly aware of the limitations of their models and the need to recognise explicitly the remaining uncertainties.
The fact is that no one knows the underlying structure of an economy with precision. Moreover, the structure is constantly evolving. Time periods can be crucial. Monetary policy actions may have one consequence in the short-run, quite another in the long run. In addition, private sector behaviour may adapt in response to official actions (the so called "Lucas critique"). Finally, the data required to monitor the economy and its reactions to monetary policy are subject to error and revision. This is not a policy environment policy makers would choose. Unfortunately, it is the one we have been given and must learn to live with.
What is clear is that the economies we are trying to understand and influence are increasingly driven by market forces. A combination of deregulation and technological progress has led to widespread changes in the way economic variables interact. Production is more efficient and diversified. Everything happens faster and at a global level.
Such developments have clearly had profound implications for the job of central banking. Beyond the need to model changing structure, central bankers increasingly find that traditional control-based approaches no longer work. In the industrial countries in the 1950s and 1960s, it was still possible for central bankers to enforce interest rate ceilings, and to implement quantitative controls over the rate of growth of credit and monetary aggregates. But those days are over. In a market driven world, "control" has been superseded by "influence". Modern central bankers must use the few instruments which they can still directly control to convince the market, with its immensely deep pockets, of both the intention and capacity to achieve stated objectives. It is this underlying empirical reality, the growing force of markets, which has driven central bankers to become much more transparent over the course of recent years.
A second aspect of the framework within which monetary policy is conducted is the institutional setting. Here too major changes have taken place. Whereas previously the activities of most central banks were strongly influenced by their Treasuries, there has been a strengthening trend towards central banks being given some form of "independence". Independence is a rather misleading word. In a democratically ordered society, every agency has to function within a constitutional and legislative context. Any suggestion to the contrary runs the significant risk of needlessly antagonising both the executive and legislative branches of government.
An approach which better recognises the necessary subtlety of these relationships emphasises three interrelated aspects of the institutional setting; namely the mandate, powers and accountability of the central bank. As to the first of these, many central banks traditionally had a mandate which was very broad and sometimes implied the simultaneous pursuit of potentially conflicting objectives (such as price stability and economic growth, or internal and external balance). In recent years, there has been a trend to specifying clearly a much more limited mandate, generally some form of price stability, with other objectives being explicitly subordinate to the primary objective. Sometimes the central bank determines the mandate itself, but increasingly it is the government which does so. While this might seem a threat to independence, it can also be argued that explicit government support of the mandate strengthens the hand of the central bank in exercising its powers to pursue that mandate.
As for the independent exercise of powers, which is what most people really mean by independence, there is here a clear trend towards central banks doing this without any guidance from government. The objective in this regard is to insulate the central bank from short-term political influences and ensure a consistent pursuit of medium term objectives.
Finally, accountability increasingly means that central banks explain both to parliament and to the general public how and why they conduct policy in the way they do. Only by retaining broad public support can central banks expect to retain the powers they need to pursue their mandate.
The last aspect of the framework conditioning the conduct of monetary policy is rather more philosophical but no less important for that. Central banks need to define an approach or a process for taking decisions in a highly uncertain and unpredictable world. The key issue here used to be thought of as "rules versus discretion". Rules are useful in that they greatly simplify the policymaking process; one simply cannot look at everything all the time. Rules also aid transparency. At the same time, discretion and judgement will always be required in some measure, to respond to unexpected events, or unforeseen changes in the behaviour of the economy. Indeed, the exercise of discretion must also extend to a willingness to reevaluate periodically and, in the limit, change the rules themselves when they fail to produce the desired results. Nowadays it is generally recognised that one cannot choose between rules and discretion: the two need to be skilfully blended. That is why many central bankers describe their approach to policy (the use of inflation targeting, for example) as the exercise of "constrained discretion".
When considering a strategy for the consistent conduct of monetary policy over time, the first and most important choice is that of the exchange rate regime. The reason for focussing on the exchange rate regime issue is the existence of the so-called "impossible trinity". That is, a country cannot have, at the same time, free capital mobility, a fixed exchange rate regime and an independent monetary policy. This was an early insight for which, in part, Robert Mundell recently received the Nobel Prize in economics. What has not changed over time is that countries can still choose only two out of the three policy goals. What does seem to have changed has been the weight given to each of them.
At the time of the gold standard, the ultimate fixed rate regime, the desirability of free international capital flows went virtually unchallenged. The implied giving up domestic monetary independence. Many commentators took this loss as a positive advantage, since they actively distrusted the actions of politicians and the state.
Under the Bretton Woods system, domestic monetary and fiscal policy autonomy were regarded as essential tools of macroeconomic stabilisation. And fixed exchange rates were seen as necessary to avoid the competitive devaluation of the 1930s. Capital mobility was therefore the leg of the trinity that was allowed to lapse. It was anyway considered to be much less important for economic welfare.
Where do we stand today? An important evolution has been a reevaluation of attitudes to capital flows. In part this is a recognition that capital mobility makes an important contribution to the transfer of real resources and technological know-how needed to foster economic growth. In part it is a reflection of the sheer impracticality of administrative controls on capital flows in an increasingly integrated world. So viewed from the perspective of the "impossible trinity", the choice often appears to be between exchange rate fixity and monetary policy autonomy.
For a while it was thought that compromises were possible. That is, countries could trade a measure of exchange rate stability for a measure of monetary policy autonomy. However, capital mobility seems to be making intermediate exchange rate regimes (fixed-but-adjustable rates) more and more difficult to sustain. The conventional wisdom now seems to be that countries must choose "corner solutions", either genuinely fixed rates (perhaps of a currency board type) or free floating. And since most countries are not in a position to credibly commit to permanent exchange rate fixing, this means a system in which most economies of any size are likely to have more flexible exchange rate regimes than in the past.
This conclusion may be a little too stark, since none but the largest economies can afford to neglect their exchange rate - and perhaps not even then. Nevertheless, it does seem to me to contain an important element of truth. In other words, thinking about the "impossible trinity" has changed yet again. Nearly all countries want the freedom to use monetary policy to pursue domestic price stability goals. And nearly all wish to retain free access to international capital markets. This means that the exchange rate has to adjust more flexibly than in the past.
The analysis of an independent monetary policy within a floating exchange rate regime was first made by Keynes in 1923 in the "Tract on Monetary Reform". Needless to say, there has been a significant evolution since that time in both thinking and practice about the objectives of monetary policy, the transmission mechanism of monetary policy, and the processes used to formulate and implement policy.
There seems to be a general consensus today that the primary objective of monetary policy should be domestic price stability, commonly measured using some variant of the consumer price index. However, this was not always so. Until at least the late 1960s, and even later in many countries, it was generally accepted that there was a trade-off between inflation and unemployment. That is, it was thought that unemployment could be permanently lowered by accepting a slightly higher level of inflation, and it was the task of policy to achieve the welfare-maximising trade off. Academic work (in particular that of Friedman and Phelps) caused a revision of this view, by demonstrating there could not be a long-run trade-off. If unemployment was pushed below the natural rate, inflationary expectations would continuously accelerate, not just rise to a higher level. This analysis was convincingly validated by the inflationary experience of the 1970s.
The pursuit of price stability largely reflects the view that monetary policy cannot, sustainably, affect the inflation/growth trade off. If growth is stimulated by expansionary policies, the effects on output will be short-lived, while inflation will both rise and become more unpredictable. In so doing, it will undermine the basis for efficient intertemporal resource allocation, retarding, not promoting, growth. But other reasons for pursuing price stability, and indeed what that phrase itself really means, have also become clearer as experience has accumulated.
The period of high inflation and low productivity growth in the 1970s provided evidence (i) that inflation lowered the information content of the price system; (ii) that it interacted in undesirable ways with the tax system; (iii) that inflation raised risk premia and discouraged investment; and (iv) that it eroded the social consensus, with implications for political stability.
Of course these consequences of inflation are problems of price instability more generally. The recent risk of price deflation in Japan and China, now thankfully abating, focussed attention on the dangers of persistently falling prices. Deflation can threaten a cumulative downward spiral if real wages rise and profits suffer; if real interest rates and real debt service costs increase; and if spending is postponed to wait for lower prices still. The upshot of this most recent insight is that the objective of price stability is now recognised as implying a certain symmetry. Price stability today thus means more than just avoiding high inflation.
Views have also evolved over time as to the speed with which a high inflation rate should be brought down, as well as the specific numerical objective thought to be consistent with price stability. As to the speed issue, the possibility of a non-linear short-term trade off between inflation and unemployment argues for going slow. So too does the existence of a weak banking system that could be further hurt by a very vigorous disinflationary policy. In contrast, if inflation is originally so high as to have materially adverse effects on the economy, this would be an argument for more speed.
As for what the inflation objective should be in numerical terms, the consensus in the unstable 1970s and 1980s seemed to be the lower the better. More recently, as inflation has come down to levels not seen in thirty years or more, many commentators have argued the merits of a "small" positive rate of inflation. It is argued that this could facilitate needed real wage adjustments and would also allow negative real interest rates in spite of the zero lower bound on nominal interest rates. As to what one means by "small", there seems general agreement that it means less than three percent, though there remain important differences about how much less.
A by-product of the last few years of low inflation has been a growing recognition that macroeconomic problems can arise from asset price and exchange rate movements, not just from domestically generated inflation in the price of current output. The credit-fuelled asset price bubble in Japan in the late 1980s occurred when inflation was very low, yet the collapse of the bubble had devastating effects on the banking system and in turn on the real economy. Still more recently, concerns have been expressed about asset prices in the United States, even though CPI inflation has remained quite well behaved. Henry Kaufman's recent book has some characteristically trenchant observations about the dangers involved.
Could monetary policy do something about such asset price increases? And should it? The arguments against are both practical and normative. As a practical matter, it is very hard to distinguish between an unjustified bubble and a rational adjustment in asset prices. More normatively, if central banks are supposed to pursue stability in the price of goods and services, they should take account of asset prices only insofar as wealth effects feed through to prices of goods included in the CPI. These are persuasive arguments. Still, I find it hard to ignore the experience that financial bubbles can lead to economic instability, with hard-to-control deflationary consequences. I suspect the current debate on the proper attitude of monetary policy to asset prices is only just beginning
Once the objective of monetary policy has been specified, the next issue is how to achieve it in practice. A first requirement is some understanding of the transmission mechanism which links the central bank's policy instruments to its ultimate objectives. Milton Friedman famously noted that monetary policy affects prices only with "long and variable lags". "Long" because regulated prices, long-term contracts of various sorts and overlapping wage settlements impede rapid price adjustments. And "variable" because at each stage of the transmission mechanism, expectations of economic agents about the future are a crucial determinant of their behaviour. But questions are beginning to be raised about whether lags in monetary policy might themselves be affected by underlying changes in economic structures.
One change is that, in most economies, there have been significant efforts to reduce rigidities in both product and labour markets. Moreover, recognising the importance of expectations in the transmission mechanism, central banks have become increasingly transparent about what they are trying to achieve, how they see the economy working, and what their policy reaction might be in certain circumstances. The real world remains far removed from that of a frictionless Rational Expectations model. Nevertheless, these developments seem to work in the direction of making the lags in the effects of policy on prices shorter.
If this is the good news about changes affecting the transmission mechanism, there is, unfortunately, bad news to go along with it. Advances in theory, as well as practical experience, lead us to the conclusion that the economy is actually much more complicated than we used to think. For example, thirty years ago, the primary impact of higher interest rates on spending would have been presumed to come through intertemporal substitution effects; spending would have been delayed. Today, any competent analyst would also have to factor in distribution effects, feedback effects on government debt service and deficits, and balance sheet effects having to do with both debt levels and asset values.
Similarly, exchange rate depreciation would once have been deemed unequivocally expansionary, due to substitution effects. But today, taking account of terms of trade losses and balance sheet effects, even the sign of the effect could be a topic for debate. Moreover, as evidenced in the recent crisis in Indonesia, these contractionary effects could be even stronger if trade credit dries up and exports cannot be shipped out because, with no imports to carry, no ships have landed.
A final requirement for the conduct of monetary policy is a set of operational procedures for changing the setting of policy instruments. Here too, major changes have occurred over the years. Broadly put, the trend has been from informal processes, with policy decisions taken at irregular intervals, to more formality and more regularity. As a complement to this, there has also been a trend away from vesting sole responsibility for policy decisions in a single individual, towards votes by Committees established specifically for this purpose.
At the heart of these more formal processes in most industrial countries is a forecast of how the economy seems likely to perform given certain assumptions about exogenous variables. Of particular interest in recent years has been the outlook for inflation, given that most countries either explicitly ("inflation targeting" regimes) or implicitly have medium term objectives for that variable. In effect, the policy instrument will be set with a view to achieving the medium term objective. At some regular interval, this procedure will then be repeated, incorporating all new information, and the setting of the policy instrument will be adjusted accordingly. At this level of generality, the policymaking process would seem pretty straightforward. However, as in many areas of human endeavour, the devil is in the details.
The first practical complication is, what do we mean by the policy instrument? Here too there has been a significant evolution over time. Some decades ago, the academic literature would have emphasised the importance of the reserves supplied by the central bank to the banking system, and the implications (via the money multiplier) for the growth of money and credit. Today, it is more broadly understood that no industrial country conducts policy in this way. Recognising how unstable in practice is the demand for cash reserves, and the associated implications for interest rate volatility, there has been a decisive shift towards the use of short-term interest rates as the policy instrument.
The second practical complication is that forecasts of output and inflation are notoriously unreliable, for all the reasons noted above. This is one reason why many policymakers still like in practice to keep at least one eye on the rate of growth of monetary and credit aggregates. The heyday of monetary targeting in the industrial countries was in the 1970s and early 1980s, when decisions on policy rates were decisively influenced by money supply growth. While this is no longer so, due to observed instability in demand for money functions, the Eurosystem in particular still looks upon money growth as an important pillar supporting its monetary policy decisions. Most central banks, however, now use their main policy instrument (short-term interest rates) to directly pursue their objective (medium-term price stability) whether or not they formally categorise their approach as inflation targeting.
A third complication is that information pertinent to policy decisions arrives continuously rather than discretely. Should such information be allowed to have an effect on policy variables in the period between the regular updates of the forecast? An important example of this problem might be a sharp decline in the exchange rate, with potential implications for inflation, raising the issue of whether the policy rate should be allowed to rise almost automatically in response. Thinking in this area continues to evolve, but in recent years there has been a movement away from such quasi-automatic responses. One reason for this has been the growing appreciation that the underlying causes of observed phenomena are pertinent to how policy should react. For example, downward pressure on the exchange rate due to a sharp fall in the terms of trade would have different inflationary implications than one arising from a speculative currency attack.
If I have left you with the impression that views have changed significantly over the years with respect to virtually every aspect of the conduct of monetary policy, that was my intention. If I have also left the impression that similar changes are likely to be ongoing, that too is consistent with my analysis. The modern central banker needs to be open to the reality of continuing structural changes and to keep an open mind as to how monetary policy might best be used to enhance economic welfare more generally.
Still, it would be wrong to ignore more durable aspects of the current consensus. A long term commitment to price stability as the principal objective for monetary policy is likely to be a lasting, because hard learned legacy. So too is the need to foster a robust banking system. However, each of us has to make our own judgements, reflecting country specific circumstances, as to how these objectives can most efficiently be achieved.