Guest post by Kevin English
In the last blog post, I took the opportunity to briefly dive into the “nuts and bolts” of the inflation targeting (IT) framework. In this post, I will summarize the great presentation by Ted Carmichael, which lays out how the Bank of Canada (BoC) arrived at an IT framework, and how it and other central banks have struggled to adapt the framework to the exigencies of the post-crisis world.
Carmichael began his presentation by drawing on a classic 1982 lecture by former BoC Governor Gerald Bouey. Carmichael summarized three stages in the evolution of the early Bank’s remit - i.e. how the Bank and Government interprets the Bank’s mandate[1] - that Bouey outlined. These are:
- 1935-50: when the Bank attempted to produce low and stable interest rates through the Great Depression and Second World War;
- 1950-75: when the Bank actively managed the cost and availability of credit;
- 1975-82: when the Bank used a monetary targeting framework;
As Carmichael explained, the adoption of monetary targeting was designed (in the words of Governor Bouey) to provide “a better place to stand against the constant pressures…for easier money and lower interest rates.” In targeting a monetary aggregate (in the BoC’s case a narrow measurement of money known as M1[2]) the Bank was attempting to exploit, what at the time appeared, to be relatively stable relationship between money supply growth and both the total level of spending in an economy and to short-term interest rates. During the inflationary episodes of the 1970s, money supply growth was rapid. Analyzing changes in money supply provided a guide to the Bank in determining what short rates were consistent with long-run price stability. Because targeting a monetary aggregate was believed to be relatively easy to communicate to the general public, this provided a shield against pressure for looser policy. As is the case with IT, monetary targeting also brought with it a key ingredient: a way to help manage inflation expectations.
So why didn’t monetary targeting succeed? Several different arguments have been put forth[3]. However, according to Bouey, rapid developments in financial innovation quickly broke down the relatively stable relationship between M1 growth (or put slightly differently the demand for the M1 components of the money supply) and changes in price level. Monetary targeting did not prove the “solid place to stand” that its proponents had hoped. As history would show, the Bank was actually running a far looser policy than it realized, as broader measurements of money supply (for example M1 and M2) continued to grow at very high rates during the 1975-82 period.
The central thrust of Carmichael’s presentation, was that just as monetary targeting failed to provide a solid place to stand, inflation targeting as practised pre-crisis also has proven less capable of delivering a solid footing than once thought. Simply put, financial markets are increasingly viewed as being just as prone to market failures and inefficiencies as the real economy. This realization has led to a shift in the BoC’s (and other IT central banks’) remit from, in Carmichael’s words, Inflation Targeting I (Clean) to a remit based on Inflation Targeting II (Lean).
By “clean,” Carmichael is referencing a famous Jackson Hole speech by former Fed Chair Alan Greenspan, in which the governor argued that the only role for monetary policy in directly[4] promoting financial stability was insuring that the central bank was there to clean up the “mess” once asset bubbles collapsed. Attempting to identify asset bubbles ex ante was far too difficult, and the policy rate far too blunt of an instrument to deal with the problem efficiently. By “lean,” Carmichael is drawing on the same Hanson Lecture by Carney referenced in my last post. In that speech, the former Governor lays out BoC’s current thinking on the role of monetary policy in promoting financial stability. While stressing that monetary policy must remain the last line of defence against financial instability, under certain circumstances it may be appropriate for a central bank to “lean” against the build-up of credit growth and asset bubbles. This is made explicit in the 2011 renewal of the BoC’s inflation-control target that sets forth the Bank’s current remit: “A framework anchored on a solid and credible inflation target provides the flexibility for monetary policy to play an occasional role in supporting financial stability.” Importantly, this implies that the Bank may vary the time-scale over which it achieves its inflation control objective, in order to manage systemic financial risks.
As Carmichael explained, “(the) pursuit of the remit and choice of policy instrument(s) is based upon an analytical policy framework chosen by the central bank.” As the analytical policy framework — i.e. how the a central banks views the functioning of an economy and the transmission mechanisms of various policy instruments — shifted, then so too has both the remit and (potentially) the choice of instruments used. Because financial variables and the interaction between the real and financial sectors are now viewed as intrinsically linked to macroeconomic outcomes, the pre-crisis IT framework has been forced to adapt.
But as Carmichael outlined, the problem that develops is that there is no longer a clear one-to-one matching of policy tools and policy objectives (a rule known in economic circle as the “Tinbergen Rule”). Central bankers now find themselves in the difficult position of potentially having to use a single policy instrument (the policy interest rate) to achieve multiple objectives (for example price stability and financial stability); or potentially having to use multiple instruments (the policy rate and central bank balance sheet) to achieve a single objective (for example price stability). Given that the success of inflation targeting is widely held to rest on clear communication strategies and a strong dose of transparency, this muddying of the relationship between instrument and objective risks undermining the hard-won successes achieved by central bankers since the early 1980s. In the pre-crisis period, successive BoC Governor’s repeated their support of the “clean” doctrine; now the Bank is in the unenviable position of effectively communicating why it has embraced the “lean” doctrine and how it will implement its new remit.
To the extent that central banks are also dragged into policy realms historically dominated by finance ministries and regulators of securities markets and banks, this also could risk jeopardizing central bank independence. Finally, to the extent that central banks fail to clearly communicate their new remits and their use of unfamiliar policy instruments, they may also come under political fire for their decisions. As Carmichael noted, popular trust of the Federal Reserve has dropped markedly in the US over the past five years, as its balance sheet swelled to unprecedented levels. The US Congress, for its part, has also pushed backed against many of the emergency lending facilities deployed by the Fed at the height of the crisis. Under the Dodd-Frank Act (2010), new limits have been placed on the Fed’s ability to extend liquidity support to different financial institutions and foreign central banks.
More than three decades have passed since Governor’s Bouey’s historic speech. It appears that central bankers have, indeed, yet to find a stable place to stand.
In the next post we will dive into the presentation by the University of British Columbia’s Paul Beaudry, where the professor takes the opportunity to critically access several of the macroeconomic assumptions implicit in the IT framework.
[1] The Bank’s mandate is laid down in the 1935 Bank of Canada Act. The preamble to the Act outlines the Bank’s mandate as being to: “regulate credit and currency in the best interests of the economic life of the nation, to control and protect the external value of the national monetary unit and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada.”
[2] M1 consists of all demand deposits and the traditional liabilities of central banks, reserves and cash in circulation.
[4] The word ‘directly’ is used here in order to recognize that pre-crisis it was held in many experts circles that the greatest contribution monetary policy could make towards delivering financial stability, was through delivering price stability. Hence, financial stability was pursued indirectly.