Central bank announces it will achieve a certain value (the target) of the annual growth rate of a monetary aggregate. Central bank then is accountable for hitting the target Monetary targeting was adopted by several countries: Germany, Switzerland, Canada, the U.K., Japan and the U.S.
Copyright 2011 Pearson Canada Inc. 18 - 1 Chapter 18 What Should Central Banks Do? Monetary Policy Goals, Strategy and Tactics Copyright 2011 Pearson Canada Inc. 18 - 2 Monetary Targeting Strategy • Central bank announces it will achieve a certain value (the target) of the annual growth rate of a monetary aggregate. • Central bank then is accountable for hitting the target • Monetary targeting was adopted by several countries: Germany, Switzerland, Canada, the U.K., Japan and the U.S. Copyright 2011 Pearson Canada Inc. 18 - 3 Monetary Targeting • Flexible, transparent, accountable • Advantages – Almost immediate signals help fix inflation expectations and produce less inflation – Almost immediate accountability • Disadvantages – Must be a strong and reliable relationship between the goal variable and the targeted monetary aggregate Copyright 2011 Pearson Canada Inc. 18 - 4 Inflation Targeting • Public announcement of medium-term numerical target for inflation • Institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal • Information-inclusive approach in which many variables are used in making decisions • Increased transparency of the strategy • Increased accountability of the central bank Copyright 2011 Pearson Canada Inc. 18 - 5 Inflation Targeting in New Zealand • Reserve Bank of New Zealand Act 1989 • Minster of Finance and Governor of Reserve Bank to make Policy Targets Agreement • Governor of the Reserve Bank was held accountable for the success of monetary policy. • Inflation brought down from above 5% to below 2% by the end of 1992 • Since 1992 NZ growth rate has been high and unemployment declined significantly Copyright 2011 Pearson Canada Inc. 18 - 6 Inflation Targeting In Canada • In 1991, the Minister of Finance and the Governor of the Bank of Canada established formal inflation targets • The target range was 2-4% by the end of 1992, 1.5-3% by June 1994 and 1-3% by December 1996 • After a new government took office in 1993, the target was set at 1-3% and has been kept at this level ever since • Canadian inflation has fallen dramatically since the adoption of targets, falling from 5% in 1991, to zero in 1995 and between 1-2% in the late 1990’s Copyright 2011 Pearson Canada Inc. 18 - 7 Inflation Targeting in the U.K. • Adopted inflation target as nominal anchor in October 1992 • Inflation target was initially set at 1-4% • May 1997 inflation target set at 2.5% and Bank of England was given power to set interest rates (provided independence) • December 2003, target was changed to 2%. • Growth in U.K. economy has been strong leading to reduction in the unemployment rate Copyright 2011 Pearson Canada Inc. 18 - 8 Inflation Rates and Inflation Targets Figure 18-1(a) Copyright 2011 Pearson Canada Inc. 18 - 9 Inflation Rates and Inflation Targets Figure 18-1(b) Copyright 2011 Pearson Canada Inc. 18 - 10 Inflation Rates and Inflation Targets Figure 18-1(c) [...]... with periodic “pre-emptive strikes” by monetary policy against threat of inflation • Monetary policy has long lags • Cannot wait to respond until inflation has begun • Needs to be forward-looking and pre-emptive Advantages and Disadvantages to the U.S Approach • Does not rely on a stable money-inflation relationship • Discourages overly expansionary monetary policy • Lack of transparency • Uncertainty... financial markets, doubt among producers/general public • Strong dependence on the preferences, skills and trustworthiness of the central bank staff Summary of Advantages and Disadvantages of Different Monetary Policy Strategies Tactics: Choosing the Policy Instrument • Tools – – – – Open market operation Government deposit shifting Last resort lending Overnight interest rate • Policy instrument (operating... which there is no tendency for inflation to change Taylor Rule and the Overnight Interest Rate Central Bank’s Response to Asset-Price Bubbles • Two Types of Asset-Price Bubbles – Credit-Driven Bubbles – Bubbles Driven by Irrational Exuberance • Central Banks Response to Bubbles • Monetary Policy and Asset-Price Bubbles • Other Appropriate Policy Responses – Macroprudential regulation Bank of Canada Historical... CB adopted key monetary aggregates as intermediate targets of monetary policy Interest Rates - Canada and U.S., 1941-2009 Monetary Targeting, 1975-1981 • Rising inflation lead Bank of Canada to control M1 growth • Announce 1 year in advance the target a path for growth of M1 • Attempted to influence expectations to reduce inflation more quickly • Nominal exchange rate depreciated • Nov 1982 – monetary. .. Reserve aggregates – Interest rates – May be linked to an intermediate target • Interest-rate and aggregate targets are incompatible Linkages Between Central Bank Tools, Policy Instruments, Intermediate Targets and Goals The Price Stability Goal • Low and stable inflation • Inflation – Creates uncertainty and difficulty in planning for future – Lowers economic growth – Strains social fabric • Nominal...Inflation Targeting • Advantages – Does not rely on one variable to achieve target – Easily understood – Reduces potential of falling in time-inconsistency trap – Stresses transparency and accountability • Disadvantages – – – – Delayed signaling Too much rigidity Potential for increased output fluctuations Low economic growth Monetary Implicit Nominal Anchor • U.S does not use explicit nominal anchor... Reserves Result of Targeting Overnight Funds Criteria for Choosing the Policy Instrument • Observability and Measurability • Controllability • Predictable effect on Goals The Taylor Rule, NAIRU, and the Phillips Curve Overnight interest rate = inflation rate + equilibrium overnight rate + ½ (inflation gap) + ½ (output gap) • An inflation gap and an output gap – Stabilizing real output is an important concern... a path for growth of M1 • Attempted to influence expectations to reduce inflation more quickly • Nominal exchange rate depreciated • Nov 1982 – monetary policy was abandoned Inflation Targeting, 1989 – Present, II • In 1991, the Minister of Finance and the Governor jointly announce series of declining inflation targets • Bank uses the rate of change in the CPI as its inflation target • Core inflation... directly rather than intermediate variable represent a shift in policy • Uses overnight interest rate as the operating target Inflation Targeting, 1989 – Present, III • During 1960s and 1970s the Bank’s operation characterized by instrument and goal opaqueness • Explicit inflation-control target, fixed action dates have moved Bank towards openness and accountability Pre-emptive Strikes by the Bank of Canada... Bank of Canada easy policy stance • Cut overnight interest rate by 25 basis points in December of 2007 • Continued easing of monetary policy resulted in overnight funds rate of 0.25% in April 2009 • Large injections in liquidity into credit markets International Considerations • Growing interdependence of national economies – Globalization • Requires international cooperation (policy coordination) . Canada Inc. 18 - 1 Chapter 18 What Should Central Banks Do? Monetary Policy Goals, Strategy and Tactics Copyright 2011 Pearson Canada Inc. 18 - 2 Monetary. 18 - 8 Inflation Rates and Inflation Targets Figure 18- 1(a) Copyright 2011 Pearson Canada Inc. 18 - 9 Inflation Rates and Inflation Targets Figure 18- 1(b)