1. A brief history of monetary policy
2. Monetary policy today
3. Challenges of the 21st century
For more than two decades has inflation targeting been shaping monetary policy. Inflation has successfully been brought down and stabilized. However, financial imbalances have arisen at the same time, resulting in the Great Recession that major economies are still struggling with. Monetary policy seems to have been overemphasizing price stability while underestimating the risks of financial imbalances. Even before the crisis did research point to this problem, but – as history teaches us – it does usually take events with major impact on the understanding of the economy for these to be decisively addressed. It seems legitimate to argue that the Great Recession is such an event. It is therefore of great importance to analyze possible consequences concerning monetary policy and inflation targeting in particular.
The first section gives a brief history of monetary policy that shows how it has evolved over time and how economic events initiated major changes. Section 2 presents the concept of inflation targeting and how the lessons of history have been implemented into this policy framework. Section 3 discusses the shortcomings of inflation targeting that were revealed by the Great Recession and introduces several suggestions for modification that address these shortcomings.
1. A brief history of monetary policy
Monetary policy has gone a long way to where it is today and it is clear that this process is still going on. In order to see where it might lead us it is insightful to look into history and identify the most important cornerstones that paved the way for contemporary monetary policy. The evolution can best be described as an ongoing learning process based on a trial-and-error approach disrupted by significant events with major impacts on academics’ and central bankers’ understanding of the economy.
In the beginning of the 20th century, monetary policy was mainly concerned about maintaining the gold standard without much room left for domestic stabilization. This changed with the introduction of fiat money, not covered by gold, and governments exploiting the printing press to cover the costs of World War I. Monetary policy was in general much too expansionary during this period and hence led to very high inflation, even hyperinflation, for example in Germany in 1923. In the 1930s, on the contrary, it was way too tight and thereby worsening the Great Depression. Both periods led to reevaluations of the conduction of monetary policy, but it was still far from being as sophisticated as it is today.
During World War II monetary policy was again abused to finance public military expenditures and monetize debt. The importance of central bank independence, from today’s perspective, became obvious, but it took almost 50 years, another period of high inflation and thorough research, for example by Lucas, Barro and Gordon, to fully appreciate and implement the concept.
After World War II, the Bretton Woods system was established in order to create an international monetary regime that could avert another Great Depression and support peace by bonding the major industrial nations. Monetary policy at this time was therefore mainly concerned with maintaining the fixed exchange rate with the US dollar and soon encountered the impossible trinity (coined by Robert Mundell), i.e. the incompatibility of a fixed exchange rate, free capital flow and independent monetary policy at the same time. This incompatibility, among other factors, eventually led to the breakdown of Bretton Woods and an abandoning of fixed exchange rates at the beginning of the 70s.
Around the same time Milton Friedman reshaped the role of monetary policy by pointing out its capabilities and limits (Friedman, 1968). His view that a central bank’s main objective should always be price stability and that there is no long-run tradeoff between inflation and employment is still the standard. Unfortunately, central banks around the world did not fully embrace Friedman’s insights until the late 70s after experiencing a period of low output, high inflation and unemployment. This experience laid the foundation for a new era of full commitment to price stability and the acknowledgement that “inflation is always and everywhere a monetary phenomenon” (Friedman, 1963).
In response to the Great Inflation another cornerstone of contemporary monetary policy was laid during the late 70s by the influential work of Lucas and Sargent on rational expectations in 1978 as well as Kydland and Prescott (1977) on dynamic inconsistency. Their theories stressed the importance of credibility, transparency and commitment in order to align private agents’ inflation expectations with monetary policy objectives successfully.
During the 80s did the close relation between money aggregates and inflation brake down due to financial innovation which made money demand more unstable (Bénassy-Quéré et al., 2010). Money supply ceased to be a good predictor of inflation and a new, more pragmatic approach of conducting monetary policy was required. Many central banks, instead of relying on money aggregates, started to favour the policy rate as the main tool. Because of its direct effects on market interest rates, asset prices and credit conditions (the transmission channels) was it assumed to have a major impact on future inflation. Monetary policy therefore started to forecast the future price level and set the policy rate in order to align inflation with its own target. Central banks, following this new approach, were and still are quite successful in doing so.
During the Great Moderation, starting in the mid-80s, inflation as well as volatility of output and prices was brought down to very low rates. Credit has to partly be given to globalization which – through increased global competition – has been pushing down production costs and restricting wage growth in developed economies. Nevertheless, the last thirty years can be seen as a major success of central banks in controlling inflation.
This rather sketchy representation of the development of monetary policy during the 20th century, of course, omits a lot of insights and controversies that are still going on. However, it is helpful to understand how and why monetary policy evolved over time to what it is today. Beyond research it usually took significant economic events to incorporate, for example, the ideas of independence, credibility or transparency into the code of practice. Such events also oftentimes exposed elementary flaws in the understanding of the economy and how to implement proper policy measures. By no means does this imply that monetary policy is at the end of its development. Instead, looking at the economic events of the 21st century, it seems that we have entered a period with major changes ahead.
“The great moderation lulled macroeconomists and policymakers alike in the belief that we knew how to conduct macroeconomic policy. The crisis clearly forces us to question that assessment.” (Blanchard et al., 2010)
2. Monetary policy today
The way in which inflation targeting is being conducted today surely varies widely. Strictly speaking does the European Central Bank (ECB), for example, not follow this strategy, because it does not solely rely on its forecasts of inflation, but still takes into consideration growth of monetary aggregates, a legacy of the German Bundesbank. Similarly, does the Federal Reserve not pursue fully-fledged inflation targeting, because of its dual mandate promoting employment, stable prices and moderate interest rates. Nevertheless, have these and many other central banks adopted the most important aspects of inflation targeting. Although the precise approach is not without controversy, there is at least some consensus about the general framework which is based on the lessons of the 20th century. Bernanke (2003) breaks down this framework into a deed and a word component, or in his words: the policy framework and the communications strategy.
The policy framework determines how to set the central bank’s instruments, e.g. the policy rate, in order to achieve the targeted inflation. In doing so it is of high importance to find a good balance between following a strict rule and staying flexible enough for unforeseen events (constrained discretion). A strict rule has the advantage of making monetary policy actions more predictable and thus anchors inflation expectations of private agents. It also addresses the problem of dynamic inconsistency, by constraining the central bank to change its behavior ex post, which would damage the bank’s credibility since it affects public expectations of future monetary policy decisions. Credibility and predictability always have to be maintained, because inflation expectations are partly self-fulfilling. With tightly anchored expectations, inflation objectives are therefore much easier to accomplish and give more space to follow secondary targets like output stabilization (Bernanke, 2003). Nevertheless, a central bank needs some flexibility to also be able to react to short run disturbances and macroeconomic indicators other than inflation.