Monetary Policy Strategy

• Central banks target price and output gap stability, using limited policy instruments.
• Time lags and transmission channel uncertainties exist between monetary policy shifts and final goal impacts.
• Central banks face uncertainty due to unavailable real-time information about final targets.
• Need a monetary policy to realize price, output gap stability that is flexible enough to react to economic shocks.
• Monetary policy strategy and the 2 broad strategies i.e. intermediate and direct, are required.
• Focus on inflation targeting as the most prominent intermediate strategy and the Taylor rule as a direct instrument rule.

Need for a Monetary Policy Strategy

• Describes how decisions are made based on economic indicators to achieve goals using available instruments.
• Structures the decision-making process through indicator variables and policy actions.
• Acts as framework to guide monetary policy analysis and communication.
• Informs the public how the central bank responds to changes in economic variables.
• Builds credibility and represents a realistic commitment to monetary policy objectives.
• Transparency is required as the public need to know how decisions are being made and on which rationale.
• Supports central bank independence while ensuring accountability.
• Should be forward-looking and preemptive due to time lags and uncertainties.
• Typically allows the central bank some discretion.
• Low and stable price inflation has to be typically achieved in the medium term.

Strategy Choice

• Strategies include having an intermediate or operational target.
• Intermediate targeting rules could be monetary targeting, nominal income targeting, or inflation targeting.
• Direct policy instrument rules include the Taylor rule (interest rate) and McCallum rule (monetary base).
• With intermediate target strategy, the central bank targets an intermediate variable using its policy instruments.
• With a direct instrument approach, the central bank changes the policy interest rate or money base directly.
• An intermediate target variable must be controllable by policy instruments.
• It should have a strong and predictable ties with the final target.
• Should also be easy to measure with minimal information lags.

Example: ECB Strategy

• Monetary policy strategy includes a quantitative definition of price stability.
• Inflation target: a year-on-year increase of 2% in the Harmonized Index of Consumer Prices (HICP).
• For the euro area as a whole, is to be maintained in the medium term.
• Since July 2021, the target is symmetric as negative deviations are considered as bad as positive ones.
• Strategy relies on economic analysis, monetary and financial analysis and focuses on economic dynamics.
• The economic element evaluates risk to price stability and growth.
• The monetary and financial component examines monetary policy transmission.
• Examines the longer-term build-up of financial vulnerabilities and imbalances, forming the ECB's integrated analytical framework.
• A diversified approach to monetary policy is adopted for internal decision-making.
• Multiple intermediate variables are considered.
• Information is presented in the Economic Bulletin two weeks after each governing council meeting (8 times a year).

Inflation Targeting

• It is a dominant strategy since the 1990s.
• In early 1990, New Zealand was the 1st country to adopt it.
• Under IT, interest rates are the operational instrument.
• Inflation expectations and economic conditions are also targeted in the medium term, the policy rate is adjusted flexibly.
• Alternatives include monetary targeting, dominant in the 1970s and 80s, and nominal income targeting (NIT).
• Nominal income targeting focuses on economic growth and inflation with a nominal GDP target path.
• There is a target for price growth and for potential real income growth.
• In case of a negative supply side shock, the central bank can keep a given NIT at the expense of a higher increase in the price level.
• Nominal income growth advantages over a strict inflation target which might lead to few instances where policymakers justify deviation of inflation.
• A drawback to NIT is that central banks have to forecast the forthcoming business cycle.
• Nominal income growth targets also rely on the more complex relationship between nominal income and real output.
• Flexible inflation targeting takes into account that output/employment gaps are important indicators for future price stability.
• Strategies include:

Elements in Common

• Principal goal of long-run price stability
• Adoption of an explicit numerical target over a clearly-specified horizon
• High degree of transparency
• Clear criterion for accountability
• Inflation expectations frequently published, underlying models are not fully known

The Role of the Inflation Forecast

• Bases actions on forward-looking indicators, and uses inflation forecasts as an intermediate target.
• Align forecast inflation with the inflation target, the policy can be adjusted.
• Crucial assumption is the course of monetary policy, central bank behavior.
• Information content of forecasts varies based on if the interest rate is fixed or using market's forward interest rates.
• Conditional inflation forecasts assumes the central bank maintains a constant interest rate.
• It sends a simple message, that there is no action needed when the forecast coincides with the target.
• Conditional forecasts do not inform about inflation because the monetary policy stance can change.
• These conditionally act as a communication tool to provide the level of inflation without central bank action.
• Some central banks produce inflation forecasts based on the market's expectations of the future path of policy rates.
• Providing more reliable information compared to constant rate assumptions.
• Also makes communication easier, any discrepancies to external forecasts are more easily visible.
• Forecasts that are based on current market forward rates also give a more reasonable outlook for the future.
• Intermediate targets need to be controllable by the monetary policy instruments.
• Needs a stable relationship with the final target, a causal relationship to the final goal and be timely available.
• ELB environment limits conventional policy tools.

Caveats of Inflation Forecasting

• Optimism bias, preference for projecting future inflation rates that do not deviate much from the target.
• This bias is relevant during periods when inflation risks deviation.
• Can cause inappropriate policy recommendations and loss of central bank credibility.
• Circularity exists given conditional market expectations and policy behavior.
• Outcomes are based on beliefs about each side's actions.
• This can be virulent in periods of high inflation.
• Another issue is confusion if forecast deviates from target causing deviation from expectations.

Direct Instrument Rule

• Can use a direct policy instrument rule such as interest rate targeting.
• Offers a low degree of discretion as the instrument is adjusted by the prescribed formula.
• Short-term rate should be set at a neutral level when inflation is low and output at potential.
• Deviations measure the monetary policy stance, as the natural real interest rate is important.
• An unobserved variable, difficult to assess and estimate.

Taylor Rule

• The 1993 Taylor rule describes monetary policy stance shown my Fed decisions between 1982-1992.

• i_t = r* + Δp_(t+1)^e + a_y(y_t – y*) + a_p(Δp_t – Δp*)

• r* is the real equilibrium interest rate

• Δp_(t+1)^e is the expected inflation

• (y_t - y*) is the output gap

• (Δp_t – Δp*) is the inflation gap

• Gap between short-term real rate and equilibrium indicates the monetary policy stance.

• 1965-1980 rule suggested a higher interest rate than actual one which means high inflation in the 1970s could have been avoided.

• The equation relies on some non-observable variables, that have approximations.

• Measurement problems can occur in the Taylor rule around estimating equilibrium real interest rate and output gap.

• Weight determination also depend on features and structure of the economy which required estimation.

• The central bank must react to a change in inflation by bigger change in interest rates.

• Some caveats is that Taylor rule does not achieve any goal and there is no forward-looking nature.

• The rule has limited information, but many extensions exist such as the inclusion of smoothing parameters.

• The Taylor Rule can be extended with other variables, such as Exchange Rate.