Weekend Reading: Ben Bernanke: Monetary Policy in the Future
...This policy framework is backed by substantial explanation and analysis, via the chairman's press conferences, FOMC meeting minutes, FOMC economic projections (including projections of the federal funds rate), testimony, and speeches.... In [this] targets-based framework, the central bank forecasts its goal variables—inflation and employment, in the case of the Fed—and describes its policy strategy for bringing the forecasts in line with its stated objectives. Although targeting rules are not mechanical, they do provide a transparent framework....
Of course, no policy framework is without drawbacks, as attested by the difficulties the FOMC has faced in dealing with the zero lower bound.... If the Committee were to contemplate changing its framework, there are two directions it might consider. The first would be to... specif[y]... the federal funds rate... as a relatively simple function of a few variables.... I am... sure that, in a complex, ever-changing economy, monetary policymaking cannot be trusted to a simple instrument rule.... I found a nice statement... which I'll quote in its entirety:
Even with many such modifications, it is difficult to see how... algebraic policy rules could be sufficiently encompassing. For example, interpreting whether a rise in the price level is temporary or permanent is likely to require looking at several measures of prices (such as the consumer price index, the producer price index, or the employment cost index). Looking at expectations of inflation as measured by futures markets, the term structure of interest rates, surveys, or forecasts from other analysts is also likely to be helpful.
Interpreting the level and the growth rate of the economy's potential output—which frequently is a factor in policy rules—involves predictions about productivity, labor-force participation, and changes in the natural rate of unemployment. While the analysis of these issues can be aided by quantitative methods, it is difficult to formulate them into a precise algebraic formula. Moreover, there will be episodes where monetary policy will need to be adjusted to deal with special factors. For example, the Federal Reserve provided additional reserves to the banking system after the stock-market break of October 19, 1987 and helped to prevent a contraction of liquidity and to restore confidence. The Fed would need more than a simple policy rule as a guide in such cases...
As some will have guessed, the quote is from John Taylor... ‘Discretion versus Policy Rules in Practice’....
The second possible direction... would be to... change the target... raising the inflation target, targeting the price level, or targeting some function of nominal GDP.... I don't see anything magical about targeting two percent inflation.... Continued research on alternative intermediate targets for monetary policy would certainly be worthwhile.... The current policy framework... [is] transparently connected to the Fed's mandate from Congress to promote price stability and maximum employment.... Alternative approaches could involve the Fed aiming for a relatively high inflation rate at times. Explaining the consistency of that with the statutory objective of price stability would be a communications challenge.... We are not starting with a blank slate. For several decades now, the Fed and other central banks have worked to anchor inflation expectations in the vicinity of 2 percent.... A change in target would face the hurdles of re-anchoring expectations and re-establishing long-term credibility....
Finally, a principal motivation that proponents offer for changing the monetary policy target is to deal more effectively with the zero lower bound on interest rates. But economically, it would be preferable to have more proactive fiscal policies and a more balanced monetary-fiscal mix when interest rates are close to zero. Greater reliance on fiscal policy would probably give better results, and would certainly be easier to explain, than changing the target for monetary policy. I think though that the probability of getting Congress to accept larger automatic stabilizers and the probability of their endorsing an alternative intermediate target for monetary policy are equally low....
The FOMC has indicated that it intends to let the Fed's portfolio run off over time, so that excess reserves in the banking system eventually return to levels comparable to those before the crisis.... I wonder if the case for keeping the balance sheet somewhat larger than before the crisis has been adequately explored.... Most other major central banks have permanently large balance sheets and are able to implement monetary policy without problems.... Another potential advantage of a large balance sheet is that it facilitates the creation of an elastically supplied, safe, short-term asset for the private sector, in a world in which such assets seem to be in short supply.... The Federal Reserve was created, in part, to provide 'an elastic currency'.... The principal objection to a permanently large balance sheet financed in part by a reverse repo program appears to be a concern about financial stability.... Regulatory action to minimize the risk of or incentives for runs would seem to be the more direct way to deal with the issue...
