Oxford Anaytica takes a look at the future of monetary policy in the wake of the failure of exisiting approaches to avert a major recssion.
Excerpts from Monetary policy faces major rethink
The current recession poses a number of challenges for the development of future monetary policy. Academic economists have suggested possible modifications to the current inflation targeting regime:
Broader inflation target. Most major central banks target consumer prices. Measures include rents, but exclude mortgage payments and house prices. In the long run, rental cost of housing and house prices should move together. However, they can diverge for sustained periods, as in the early 2000s US housing boom.
Economist Stephen Cecchetti distinguishes between reacting to, and actively targeting, asset prices. In a 2000 paper, Cecchetti and co-authors Pok-sang Lam and Nelson Mark argued that a central bank should not target asset prices explicitly either directly as part of its objective function, or indirectly by broader measures of inflation. However, a central bank should react to asset price misalignments. By moderating or ‘leaning against’ large movements in asset prices, central banks may be able to stabilise medium-run fluctuations in inflation and output.
Price-level targeting. One alternative to inflation targeting is to target the price level itself. Economists Michael Woodford and Lars Svensson advocate this:
- The target does not need to be a fixed price level; it could be moving price level that increases 2% each year.
- The advantage of price-level targeting is that it avoids ‘base drift’ because it is automatically self-correcting.
Under inflation targeting it is possible for the actual price level to drift away from the desired price level because mistakes go uncorrected:
- An inflation-targeting central bank that misses its inflation target in one period does not attempt to ‘correct’ this mistake; instead it simply tries to hit the target in the next period.
- A series of small mistakes thus can lead to relatively large cumulative changes in the price level.
- Price-level targeting overcomes this because it commits the central bank to rectifying past errors.
- This increases private sector certainty about the path of future inflation, especially over the long run.
Nominal GDP targeting. Economist Scott Sumner advocates targeting the path of future nominal GDP. This includes house prices, so is a broader target than CPI, and is similar to price level targeting, implying that the central bank corrects past deviations. The most novel element of Sumner’s proposal is to rely on market forecasts for future GDP. In addition to ordinary open market operations, central banks will be empowered to buy and sell indexed futures contracts. This provides the central bank with feedback on what the market expects to happen to the economy.
The shape of future monetary policy will be characterised as more holistic, encompassing multiple measures of economic activity. However, no monetary policy will provide failsafe insurance against the vagaries and unexpected events of market capitalism.