The Evolution of Monetary Policy: More Art and Less Science

IMF Blog, April 7, 2014

Source details

Canonical URL

The Evolution of Monetary Policy: More Art and Less Science

Other formats

• Markdown version
• Structured JSON version
• Bundle manifest

Bibliographic details

• Authors: Giovanni DellAriccia, Karl Habermeier
• Published: April 7, 2014

Overview

• Authors: Giovanni Dell’Ariccia, Karl Habermeier
• Date: April 7, 2014
• Context: Post-global financial crisis reassessment of monetary policy; conference on April 13 during the Spring Meetings of the World Bank and IMF.

Key observations from the review

• The global financial crisis disrupted a long-standing monetary policy routine characterized by:
  • "Simply keep inflation low and stable, target a short-term interest rate, and regulate and supervise financial institutions."
  • Success attributed to Paul Volcker’s Fed beating inflation in the United States in the early 1980s and over 20 years of “Great Moderation” — low inflation and output volatility.
• Ideas once marginal before the crisis have moved to center stage, with a "vast volume of new work by academics and central banks in just the last two or three years."
• Monetary policy going forward: "more art and less science" — greater uncertainty about decision rules and transmission mechanisms.

Objectives: price stability and financial stability

• Primary finding:
  • "Long-term price stability has been a primary objective of monetary policy" and the review "found no good reason why this should change."
  • Benefits: makes planning easier for households and businesses; allows the economy to operate efficiently.
• Crisis lesson:
  • "Dangerous financial imbalances can brew under the apparently tranquil surface of low and stable inflation."
  • Traditional prudential policy focusing on stability of individual banks proved inadequate for system-wide risks.
• Policy implications and recommendations:
  • "Macroeconomic policy needs to pay greater attention to financial stability."
  • First line of defense should be instruments targeting financial stability more directly and efficiently, including:
  • Macroprudential tools, such as loan-to-value and debt-to-income limits.
  • Capital flow management measures.
  • Acknowledge limits: "when these tools prove insufficient, we may have to accept a new tradeoff for monetary policy, and the interest rate may have to lend a hand to maintain financial stability."
  • Political tradeoff example highlighted rhetorically: "Would you put two million people out of work because banks are too leveraged or house prices are rising too fast?"

Policy decision rules: changed structure and uncertainty

• Structural changes:
  • "Tectonic shifts in the structure and regulation of the financial sector" during the crisis have altered monetary policy transmission.
  • The short-run relationship between inflation and unemployment "seems to have changed."
• Consequences:
  • "The details of how the central bank can best achieve its objectives are probably not the same as before the crisis."
  • "We still have a lot to learn about how things have changed and by how much."
  • For the foreseeable future, monetary policy will require greater judgment: "more art and less science."
• Political economy risk:
  • "A less mechanical and predictable monetary policy may be more exposed to political interference."

Central bank independence: challenges under an expanded mandate

• Historical role:
  • Independence has been helpful to maintain price stability; analogy: Ulysses tied to the mast to resist sirens.
  • A simple and measurable mandate enables accountability and makes independence politically feasible.
• Two central questions explored:
  • Can independence be extended to cover financial stability?
  • Can central banks retain independence for price stability if there is greater government oversight over financial stability?
• Assessment:
  • The answer to the first question "is not clear."
  • Financial stability is "far more difficult to measure than inflation," and actions would often have clearer winners and losers than interest rate policy, complicating accountability and creating political challenges.
  • Institutional arrangements vary across countries:
  • Central bank leads financial stability policies in some countries (Singapore, United Kingdom).
  • Ministry of finance is ultimately in charge in others (United States).
  • "So far, there are no final answers on what works best."

Parting thoughts and outlook

• Near-term expectations:
  • Only some questions will be settled in the short term; many require years of experience and observation.
  • Policymakers will need to make decisions on new policies and institutional arrangements "often under great uncertainty."
• Bottom line: "The art of central banking is alive and well."

The Evolution of Monetary Policy: More Art and Less Science — Giovanni Dell’Ariccia, Karl Habermeier, April 7, 2014.

Content in this bundle

• Staff Discussion Note
  • Staff Discussion Note (Markdown version)
  • Staff Discussion Note (PDF)