Monetary policy rules: alternative strategies to inflation targeting

A rule-based monetary strategy for the European Central Bank: a call for monetary stability

This is the paper I wrote on the current review of the ECB strategy, just published in SUERF Policy Note series (Num. 192, September 2020). As you will see in the summary below, I discuss different alternatives to reform the current strategy of the ECB, including the adoption of a (1) higher inflation target, (2) price level target, (3) average inflation target or (4) a nominal income rate target in line with a stable growth of money. I explain in the paper why I favour number 4, so that the ECB aims at maintaining a stable rate of growth of broad money, compatible with a stable rate of growth of nominal income over the medium term. This strategy would allow the ECB to accommodate to supply shocks much easier and without the need to intervene in the market: in case of a positive supply shock, prices would tend to fall in a growing economy, thus resulting in a more stable rate of growth of nominal income. Under this strategy, the central bank would not need to offset such fall in prices by an increase in the amount of money but to do nothing (G. Selgin explains this point masterly in his pamphlet, ‘Less than Zero’). This means that the amount of money in the economy would not be as pro-cyclical as it has been in the last 15 years; with too much money growth in the expansionary phase of the cycle and too little during recessions. The stability in the rate of growth of money, broadly measured, would become key to maintain a stable nominal income growth throughout the cycle.

The ECB will announce the outcome(s) of the review of its strategy in 2021. The choices made by the ECB will surely shape the bias of monetary policy in the Eurozone for one or two decades. Other major central banks are conducting similar exercises. The US Fed just announced its new strategy (see G. Selgin excellent analysis on it here) and the Bank of England’s strategy is also currently under review.

Clearly, ‘inflation targeting’, at least as applied in the years running up to the Global Financial Crisis, is not the best policy strategy to maintain both monetary stability and financial stability over the long term. Central banks should not just take the ‘easy’ option and adopt a higher inflation target or an (asymmetric and vague) average inflation targeting (AIT) strategy. The latter seems to be the option taken by the Fed. And I say ‘seems’ because it did not make it clear in the announcement made last week. How many years will the Fed use to average inflation around? And will it react equally to long periods of inflation and to long periods of disinflation? If a symmetric AIT, the Fed would both (1) adopt a below target inflation rate after a period of too much inflation, and (2) an above target inflation rate after a period of too little inflation. However, it seems unlikely that the Fed would systematically target a lower rate of inflation (lower than 2%) when inflation has reigned over a long period of time. In the current juncture these options (the outright increase in the inflation target or the average inflation target) may well give central banks room to be more inflationary in the next few years, but they will also likely harm their credibility if they cannot contain the growth of inflation in the future. We will see in the next few months/years how the Fed effectively applies his new AIT strategy. My fear is that, in the absence of enough information communicated to the market to assess its policies over the long term, the Fed has just adopted a strategy to be more inflationary in the next few years.

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Summary of the paper on the ECB strategy review (full paper at https://www.suerf.org/policynotes/16571/a-rule-based-monetary-strategy-for-the-european-central-bank-a-call-for-monetary-stability):

‘The 2020-2021 review of the ECB strategy will shape monetary policy in the Eurozone in the years to come. Crucially, it will also determine the scope and capabilities of the ECB within the ever-evolving architecture of the euro. As in the aftermath of the Global Financial Crisis and the subsequent Euro Crisis, Member States are discussing new mechanisms to enhance economic recovery and further integration which, one way or another, will involve the support of, or the coordination of fiscal policy makers with the ECB. The impact of the new ECB strategy in the current debate about the future direction of the single currency should not be overlooked. In this note, we offer a proposal for the reform of the ECB strategy incorporating the lessons learned in the recent crises. We discuss several options for the ECB and set up a rule-based strategy suitable to operate in an environment of persistently low inflation and near zero interest rates. Under our proposal, monetary stability becomes the guiding principle for providing macroeconomic stability over the medium and long term, as well as for enhancing the transparency of the ECB communication policies.’

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Comments and feedback welcome.

Juan Castaneda

 

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The Institute of International Monetary Research: it’s all about money!

A new monetary research centre has been established in collaboration with the University of Buckingham early this year, the Institute of International Monetary Research, to study something we should not have ever forgotten, the importance of the analysis of money growth in any modern economy. I know, it sounds simple and even obvious but it happens that we have disregarded monetary analysis for far too long, perhaps under the overall  dominant presumption at the time that just by focusing on stabilising CPI inflation (around a low but still positive rate of growth) the economy could maintain a stable rate of long term growth. As stated on the Institute’s website, its mission is quite clear:

“The purpose of the Institute of International Monetary Research is to demonstrate and bring to public attention the strong relationship between the quantity of money on the one hand, and the levels of national income and expenditure on the other.”

Of course, central banks claim they have always paid attention to monetary aggregates; you may ask, ‘how could a central bank forget about money?!’ Well, let’s start saying that some have indeed forgotten more than others, and even those which did explicitly include a monetary analysis in its reports and in the communication with the public usually gave far more weight to other (macro) indicators in the making of monetary policy decisions, to say the least … . The facts well speak for themselves, and this is what clearly happened, at the very least in the 4-5 years prior to the outbreak of the Global Financial Crisis (GFC). We have seen again booming broad money growth during the last phase of the expansionary years prior to 2008 and then a sudden collapse in the midst of the GFC. The consequences and the impact on output growth have been enormous and this is another reminder on the key importance of keeping a stable rate of growth of money on long term basis as a policy goal. Those familiar with this blog will not find surprising my emphasis on monetary stability (see just a recent post on the topic here; let me say that I myself devoted my PhD dissertation to the distinction between monetary stability and price stability back in 2003! But of course nobody paid much attention to it then …).

Here you will find a video and the slides to the presentation of the Institute in London on the 11th of June (at the Royal Automobile Club), by its Director Tim Congdon. I have had the privilege to contribute to the Institute as one of its Deputy Directors and I do firmly believe there is ample room to both develop ourselves and cooperate with other colleagues and institutions to encourage much more monetary (and monetarist) research in the years to come so we can get a better understanding on the relation between broad money growth, overall inflation, asset price inflation and nominal income. More news and posts on the Institute’s events and agenda will follow.

Juan Castaneda

PS. The Institute’s website has not been chosen randomly of course, mv-pt.org, and requires no further explanation.

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Monetary stability is what matters Mr. Carney

Quite a lot is being said and written recently on nominal income targeting. Mr. Carney, the new elected governor of the Bank of England, has had a primary role in it. Even though there has been a debate amongst academics and central banks’ analysts for quite a long time, his recent suggestion in a public speech (see here) of a nominal income rule for the conduction of monetary policy by the Bank of England has been the true milestone that have triggered the debate on monetary policy strategies across the world, and particularly in the UK. Almost everyday many commentators and columnists are analysing this question in prestigious and influential business papers such as Financial Times or The Economist. This is not surprising at all, as nominal income targeting is presented as an alternative to inflation targeting, the monetary strategy framework used de facto or officially by most central banks during the last business cycle expansion, the years of the so-called Great Moderation.

This debate is needed and essential for the conduction of a more stable monetary policy in the near future, but we should analyse in more detail what is being exactly proposed and for which purposes.

Just a transitory solution?

First of all, it is important to remember that Mr. Carney suggested the adoption of a nominal income rule as a new (and more flexible) policy framework to provide even further monetary stimulus to the economy. And, in particular, he has suggested a nominal GDP level target. However, following his own words, it can be interpreted as just a transitory policy proposal to allow the central banks the injection of more money in the economy. This is confirmed by the tone of the comments/articles published on his proposal, which evidenced a warm welcome by all and sundry. Just see below the reaction of The Economist  (“Shake´em up Mr Carney”) last week as an example, even suggesting a nominal GDP rate of growth target to be adopted by the Bank of England:

“That is where the nominal GDP target comes in. By promising to keep monetary conditions loose until nominal GDP has risen by 10%, the Bank would provide certainty that interest rates will stay low even as the economy recovers. That will encourage investment and spending. At the same time an explicit target of 10% would set a limit to the looseness, preventing people’s expectations for inflation becoming permanently unhinged. It is an approach similar in spirit to the Federal Reserve’s recent commitment not to raise interest rates until America’s unemployment rate falls below 6.5%”.

Following this article, there is no doubt that this strategy is taken as a mere temporary solution, just for the current (very much extraordinary) time:

“The last problem is Mr Osborne. A temporary nominal-GDP target needs his explicit support. He should give it, because against a background of tight fiscal policy, monetary policy is the best macroeconomic lever that Britain has”.

So are we just discussing about a temporary solution for an extraordinary scenario or are we proposing a permanent change of the monetary strategy followed by the Bank of England since 1998? The test to evaluate the true commitment of central banks to a more reliable and stable monetary policy rule will come when the economy enters into a new expansionary phase in the near future. At that time, a nominal income rule committed to monetary stability will prevent money and credit from growing as much as they both did in the past; so it will become much harder to follow it. We will see then how committed central bankers, academics and market analysts are to the conduct of this monetary rule.

Not a single but many nominal income rules

Secondly, there is no a single nominal income rule. Many considerations matter in its operational definition: it could be adopted either in terms of nominal GDP levels or in rates of growth; if just current indicators or alternatively expected variables enter into the decision-making process, it could be either a backward or a forward-looking rule; depending on the ability given to the central bank to react to (registered or expected) deviations from the target, it could be a passive (or non-reactive) or an active rule; the selection of the inflation and GDP growth targets obviously matter a lot, … . So, as some of their critics suggest, I agree that they could be used by central banks to inflate the markets in an attempt to manage again aggregate demand and real variables (see some on the critics here; made by a true expert in monetary economics, professor Goodhart). However, I do not agree with the critics on their entire dismissal of these rules, as they do not  have to be necessarily inflationary and destabilising monetary rules at all; quite the contrary!

You can find more detailed explanations on nominal income targeting and the reply to its most common critics in two excellent blogs on monetary economics: Scott Sumner´s The money illusion and Lars Christensen´s The market monetarist. I wrote a brief article on these rules in 2005 for the Journal of the Institute of Economic Affairs: “Towards a more neutral monetary policy: proposal of a nominal income rule”. As you will see there, I proposed a nominal income rule committed to maintaining monetary stability and not price stability; one by which (broad) money supply grows at the expected  rate of growth of the economy in the long term, and at the same time allowing prices to fall. As evidenced in a more recent paper written with professor G. Wood (see the full version here), its application would have led to much lower rates of growth of money during the last expansion of the economy and, on the other hand, it can be said that it would have avoided the sudden collapse in money growth since 2008. In sum, it would have provided both a (1) less inflationary and (2) more stable rate of growth of money.

Leaving the details (some very important indeed) aside, I do support a permanent change in the monetary policy strategy of central banks. It is time to abandon inflation stabilising rules that, as it is evident for almost all now, have not led to monetary nor financial stability.

A solid theoretical background: monetary stability rather than price stability

There has been a long debate and controversy amongst the supporters and critics of price stabilisation as a criterion for the running of monetary policy (2). F. A. Hayek masterly stated in the 20s and 30s how inflationary the application of that policy criterion could be in the presence of growing economies. As he explained, those central banks committed to maintaining price stability have to inject more money into the markets just to offset the (benign) deflationary pressures accompanying the expansion of the economy; which leads to a rapid (and unsustainable) growth of money and credit that finally distorts financial and real markets (the so-called “boom and bust” business cycle theory). However, since the end of WWII, and after three decades of fine tuning monetary policies and central banks subject to the financial needs of a growing State, the proposal and adoption of (low though positive) inflation targets since the late 70s was received as a blessing by mostly all; especially by the academia, who had been claiming long ago for a more consistent policy rule committed to price stability in the medium to the long run.

The american economist George Selgin followed Hayek´s lead and proposed in his excellent 1997´s “Less than zero. The case for a falling price level in a growing economy” (entirely available at the IEA´s site) what he called a “productivity norm”; which, in a nutshell, allowed for some (mild and benign) deflation when productivity and the supply of real goods and services are growing.

A discussion on monetary policy rules is essential to avoid some of the (monetary) mistakes made during the last expansion of the business cycle. We have already seen how the adoption of price stability as a policy target, or worse (CPI) inflation targeting rules, do not necessarily contribute to financial stability in the medium to the long run. J. A. Aguirre and I have proposed recently (see more details on our book here) another policy rule; one committed to monetary stability that prescribes money growth in line with the real growth of the economy in the long run, and allows for disinflation and even mild deflation when productivity growth increases the output of goods and services in the economy. Nominal income targeting may well be a (only one of them) way to implement it.

We have been waiting for a debate on this question for quite a long time and is indeed very much welcome.

Juan Castañeda

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(1) However, both in the oral and written evidence provided to the UK Parliament´s Treasury select committee this week Mr. Carney was much more conservative, and in fact supported the current “flexible inflation targeting” strategy of the Bank of England.

(2) As to the critique on price stabilisation rules, see some of my previous entries to the blog:

– “Central banks price stabilisation rules creates inflation”

– An a paper I wrote with Pedro Schwartz on this question: “Price stability does not always lead to monetary stability nor to financial stability” 

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