Monetary policy regimes
Current global financial conditions have raised aspersions on
inflation targeting (IT) as a monetary policy framework, although
there is no evidence yet regarding the role of IT in undermining
financial stability due to an over-emphasis on inflation. The main
argument is that an inflation-targeting central bank focuses so
much on achieving low and stable inflation that its reaction
function has only output and inflation. IT generates an almost
mathematical focus on the short-term instrument and the path of
expected inflation. In the course of this "hawkishness", central
bankers often do not pay enough attention to financial stability as
one of their objectives.
This led me to re-visit various alternatives to IT as monetary regimes and see if there is less of a "conflict" between the inflation and financial stability objectives under these.
Monetary Aggregate Targeting: This involves targeting the monetary base, creating a vertical supply curve for money and allowing the market to determine the short-term interest rate. But since the demand curve is extremely volatile in the short run, there would be a very large fluctuation in interest rates, which is undesirable. The natural extension is then to target a monetary aggregate (M1, M2, M3 and so on). The three main criterion for choosing a monetary aggregate are as follows: Firstly, it must be related to the final goals of policy – usually the level or rate of growth of nominal income/GDP. Secondly, there should be a strong and stable link between the monetary instruments available and the chosen aggregate, i.e. the aggregate must be at least reasonably impervious to exogenous factors. And finally, there should be reliable information regarding the time path of this aggregate. However, the instability of the demand for money functions, especially under the evolution of financial innovation, the definitions of “money” and shifts in the demand for funds on precautionary grounds, have led to the decline of monetary targeting as a viable monetary regime
GDP or Nominal Income targeting: This is an approach that gained popularity in the early 1980’s after financial innovation and payments unpredictability led to the undermining of monetary aggregate targeting. Several economists postulated that a policy that smoothed out fluctuations in nominal GDP would be more effective in stabilizing real output and employment than one that smoothed the path of a monetary aggregate. The main merits of such an approach were that it did not require knowledge of the average velocity growth, nor the split of nominal GDP growth between inflation and real growth. However, the main issues with such targeting is the lack of satisfactory and accurate data, possible fiscal targeting of nominal income, “parameter uncertainty” due to lack of knowledge regarding the economy and its functioning, significant levels of the informal or black economy in certain developing countries making it impossible to ascertain or target nominal income etc.
Price Level Targeting/Inflation Targeting (IT): (Inflation Targeting differs from price level targeting in the sense that there is an objective numerical target which is the rate of growth of prices, and not prices themselves). This is the predominant monetary regime for most emerging and developed economies. The three main characteristics of IT as a framework are:
(1) an explicit quantitative (interval or point) target for the value of a pre-announced measure of inflation
(2) an operating procedure that can be described as ‘inflation-forecast targeting’: The Central Bank creates an instrument path that results in a inflation forecast which adheres to the target. This path is used to set the current values of the short-term instrument.
(3) a high degree of transparency.
Let us now a look at the financial stability objective of a central bank and how it fares under each of these regimes. Targeting monetary aggregates means that a central bank has its eyes trained on M1 (or any other measure of money). A financial stability concern would be reflected in M1 volatilty on a day-to-day level (liquidity crunch would manifest in the graphs). One can therefore see a greater connection between this regime and financial stability than with inflation and financial stability, because of the lag factors involved in expectations of inflation. Targeting GDP is pretty much an obsolete monetary policy regime. It has significant data problems. Short-term financial stability concerns would be reflected in GDP only with a definite lag, and that too since GDP figures are announced with a delay, this is probably a very ineffective manner of dealing with financial stability.
Does this imply that monetary aggregate targeting is back with a bang? Not at all. In fact, one can simply continue to target inflation and simply keep an eye on the short-term rate as an indicator of financial stability (in the Indian context, the call money rate or MIBOR).
This led me to re-visit various alternatives to IT as monetary regimes and see if there is less of a "conflict" between the inflation and financial stability objectives under these.
Monetary Aggregate Targeting: This involves targeting the monetary base, creating a vertical supply curve for money and allowing the market to determine the short-term interest rate. But since the demand curve is extremely volatile in the short run, there would be a very large fluctuation in interest rates, which is undesirable. The natural extension is then to target a monetary aggregate (M1, M2, M3 and so on). The three main criterion for choosing a monetary aggregate are as follows: Firstly, it must be related to the final goals of policy – usually the level or rate of growth of nominal income/GDP. Secondly, there should be a strong and stable link between the monetary instruments available and the chosen aggregate, i.e. the aggregate must be at least reasonably impervious to exogenous factors. And finally, there should be reliable information regarding the time path of this aggregate. However, the instability of the demand for money functions, especially under the evolution of financial innovation, the definitions of “money” and shifts in the demand for funds on precautionary grounds, have led to the decline of monetary targeting as a viable monetary regime
GDP or Nominal Income targeting: This is an approach that gained popularity in the early 1980’s after financial innovation and payments unpredictability led to the undermining of monetary aggregate targeting. Several economists postulated that a policy that smoothed out fluctuations in nominal GDP would be more effective in stabilizing real output and employment than one that smoothed the path of a monetary aggregate. The main merits of such an approach were that it did not require knowledge of the average velocity growth, nor the split of nominal GDP growth between inflation and real growth. However, the main issues with such targeting is the lack of satisfactory and accurate data, possible fiscal targeting of nominal income, “parameter uncertainty” due to lack of knowledge regarding the economy and its functioning, significant levels of the informal or black economy in certain developing countries making it impossible to ascertain or target nominal income etc.
Price Level Targeting/Inflation Targeting (IT): (Inflation Targeting differs from price level targeting in the sense that there is an objective numerical target which is the rate of growth of prices, and not prices themselves). This is the predominant monetary regime for most emerging and developed economies. The three main characteristics of IT as a framework are:
(1) an explicit quantitative (interval or point) target for the value of a pre-announced measure of inflation
(2) an operating procedure that can be described as ‘inflation-forecast targeting’: The Central Bank creates an instrument path that results in a inflation forecast which adheres to the target. This path is used to set the current values of the short-term instrument.
(3) a high degree of transparency.
Let us now a look at the financial stability objective of a central bank and how it fares under each of these regimes. Targeting monetary aggregates means that a central bank has its eyes trained on M1 (or any other measure of money). A financial stability concern would be reflected in M1 volatilty on a day-to-day level (liquidity crunch would manifest in the graphs). One can therefore see a greater connection between this regime and financial stability than with inflation and financial stability, because of the lag factors involved in expectations of inflation. Targeting GDP is pretty much an obsolete monetary policy regime. It has significant data problems. Short-term financial stability concerns would be reflected in GDP only with a definite lag, and that too since GDP figures are announced with a delay, this is probably a very ineffective manner of dealing with financial stability.
Does this imply that monetary aggregate targeting is back with a bang? Not at all. In fact, one can simply continue to target inflation and simply keep an eye on the short-term rate as an indicator of financial stability (in the Indian context, the call money rate or MIBOR).
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