The Framework for the Conduct of Monetary Policy
Some Recent Developments (Notes for Presentation to the Ottawa Economics Association
January 25, 2000)
by C. Freedman, Deputy Governor, Bank of Canada
Almost nine years ago, in February of 1991, the Bank of Canada and the government of Canada jointly announced targets for the control of inflation, making Canada the second country in the world (after New Zealand) to adopt this new framework for monetary policy. There were a number of important elements in this approach to policy that were either announced at the time or were articulated over the following years. These included such matters as the ±1 percent range, the distinction between core and total (or headline) CPI inflation, the treatment of supply shocks (with the distinction between first-round effects and subsequent effects), and the speed of return of inflation to the center of the band following a shock. All this is well known to you and I do not propose to cover it again today.
By the mid-1990s, inflation targeting had been adopted by a number of countries and had become the subject of considerable academic interest. The spate of articles on the subject yielded an increasing number of insights, of which I will mention only two. First, as Lars Svensson has emphasized, the intermediate target in an inflation-targeting environment is the central bank's inflation forecast. Second, one can think of the process as similar to the minimization of a loss function that includes as arguments the squared deviations of inflation from its target and of the level of output from potential output. This implies that there is a trade-off between the variability of inflation and the variability of output and the central bank, by choosing the speed with which it tries to return to the inflation target following a shock, implicitly or explicitly chooses a point on the trade-off curve.
Among the issues that have recently attracted the attention of academic and central bank researchers have been the question of downward wage rigidity (its existence and its implications), raised by Akerlof, Dickens and Perry in the United States and examined by Pierre Fortin in the Canadian context, and how a price level target (with or without drift) would compare with an inflation target.
Rather than pursue these very interesting issues, what I would like to do today is to focus on some recent innovations in the way monetary policy has been formulated, implemented, and communicated in Canada in the recent period. More specifically, I will discuss four topics: (1) the use of the monetary conditions index; (2) the approach to intervention in the foreign exchange market; (3) the way in which the Bank forecasts future inflation, in particular the role of monetary aggregates in forecasting future developments; and (4) the way in which the Bank communicates its policy messages.
A few years ago, the Bank of Canada developed the concept of the monetary conditions index (or MCI) as a policy guide for a central bank in a small open economy. This concept was intended to capture in one measure both of the channels through which monetary policy actions affect the economy, namely interest rates and the exchange rate. Thus, for example, if a 25-basis-point increase in the central bank's benchmark interest rate led to a significant appreciation in the value of the currency, this would imply much more tightening overall than if the value of the currency remained unchanged or appreciated only a little in response to the policy action. Or, to put it slightly differently, the size of an interest rate increase required to achieve a desired amount of tightening in monetary conditions would depend on the extent of the currency appreciation that accompanied the interest rate increase.
One implication of this approach is that an exchange rate movement resulting solely from portfolio adjustments on the part of international or domestic investors would require an offsetting interest rate adjustment to keep monetary conditions unchanged. Now, it was made very clear in the original analysis that other kinds of shocks that affected the exchange rate, such as a terms-of-trade shock, would require a different kind of response. For example, a significant decline in the prices of raw materials, such as Canada experienced during the Asian crisis, would lead to both a weaker economy and a depreciation of the Canadian dollar. In such a case, the currency depreciation would be appropriate for the weakening economic and inflation situation, and there would be no reason to adjust interest rates in an offsetting manner.
The use of the MCI, while appealing, had three difficulties associated with it. First, there was a tendency on the part of some observers to treat the monetary conditions index as a precise short-term target for policy. The Bank has always made the point that the MCI should not be treated as a narrow, precise measure and, indeed, it began to use the term policy guide to describe the MCI in order to avoid the notion of its being a target. Second, the markets started to treat all exchange rate movements as portfolio shocks and therefore came to expect an offsetting interest rate adjustment every time there was a movement in the exchange rate, whether or not such an adjustment was appropriate. Third, and this difficulty faces all central banks in a floating exchange rate regime, the central bank itself had to make a judgment on the source of the shock to the exchange rate and the likely persistence of the shock in order to decide on the appropriate response.
Let me expand somewhat on the main issue facing the central bank and the markets in this context. When there is an appreciable movement in the exchange rate, the key question that should be asked is: what is the cause of that movement? The appropriate strategic response to an exchange rate adjustment depends on whether it was the result of fundamentals (and which fundamentals) or a portfolio readjustment on the part of investors unrelated to fundamentals. While, as I noted, this point was made clear in our original (published) analyses of the MCI, it seemed to have gotten lost in the market's search for a rule of thumb to characterize the Bank's behavior and had to be relearned (or in some cases learned for the first time) by the market.
There are, of course, circumstances in which the source of the shock is evident. Terms-of-trade shocks or asynchronous business cycle movements in Canada and the United States are obvious examples. But when the origin of an exchange rate movement is uncertain, how should the central bank react? Should such a depreciation of the Canadian dollar be interpreted as the result of the market anticipating a future weakening in raw materials prices or a slowing in the growth of Canadian domestic demand, or simply as the outcome of a portfolio readjustment by investors that is unrelated to the fundamental factors that influence economic developments? An offsetting interest rate response would be appropriate in the portfolio-readjustment case but not in the case of a shock to fundamentals (or what could be termed a "real" shock). And conversely, should an appreciation of the Canadian dollar be interpreted as the market anticipating a strengthening of raw materials prices or a pickup in Canadian economic growth, or simply as a portfolio readjustment unrelated to fundamentals?
In the first half of the 1990s, the portfolio shock was the more prominent source of shocks to the Canadian dollar, while in the latter part of the decade real shocks seemed to predominate. Therefore, our view of the "default" interpretation for cases in which the source of the shock was uncertain, which is often the case, moved away from a portfolio adjustment towards a real shock. Indeed, Smets (1997) has argued that the reason Canada chose to use the MCI (which is particularly helpful in explaining the response to a portfolio shock) and Australia did not is that the typical shock affecting the Canadian dollar at the time the MCI was adopted was a portfolio shock and the typical shock affecting the Australian dollar was a real shock. And with the increased importance of real shocks for the Canadian dollar in the later 1990s, the role of the MCI has diminished in Canada.
A final point on the MCI. While, in my view, monetary conditions remain a useful concept, the MCI has not proved to be especially helpful as a communications device vis-à-vis the markets at times of uncertainty regarding the source of the shock causing the movement in the exchange rate. Thus while the Bank continues to use the term "monetary conditions" in its description of policy, it places less emphasis on the MCI as a measure of these monetary conditions.
In light of experience, the authorities made a significant change in the approach to foreign exchange intervention in September 1998. Previously, there were two types of intervention, called symmetric and asymmetric. Symmetric intervention was automatic, with the Bank of Canada selling or buying foreign currency, on behalf of the Government of Canada, when the Canadian dollar declined or increased in value by a given amount during the day, at a pace that was fixed in advance. Asymmetric intervention involved intervening before the automatic limits were reached and/or in amounts that were larger than customary.
Symmetric intervention was originally done to maintain an orderly foreign exchange market when the market was not yet mature. Given that the market is now much deeper and more liquid, given that this sort of intervention can sometimes send confusing signals, and given that no other country intervenes in this way, it was decided in September of 1998 that we would no longer engage in symmetric intervention. However, as is the case with most countries operating in a floating exchange rate regime, we are prepared to intervene in a discretionary manner on occasions when it is deemed appropriate. For example, suppose we were in a situation when a loss of confidence in the Canadian dollar was occurring or there was considerable risk of it occurring, potentially leading to extrapolative expectations and a prolonged and sharp drop in the value of the currency. The erosion of confidence in the Canadian dollar is typically accompanied by a rise in interest rates on Canadian dollar instruments as savers and investors shift to financial instruments denominated in other currencies. In such circumstances intervention in the foreign exchange market by the Bank would be a signal to markets that the Bank was concerned about the developments and was acting to stabilize the situation, and that if the intervention was unsuccessful it would very likely be followed up with interest rate action by the Bank.
In order to enhance the signal effect of intervention we would announce when we were intervening in the foreign exchange market, in exactly the same way we signal a change in the band for the overnight rate. This would also avoid any confusion with normal government business in foreign exchange. As well, in order to maintain the effectiveness of the signal we would continue to intervene through brokers. There has been no foreign exchange market intervention since the introduction of the new approach.
IV. The Way in Which the Bank Forecasts Future Output and Inflation, in Particular the Role of Monetary Aggregates in Forecasting Future Developments
The central element in the Bank's process of forecasting inflation has been the formal staff forecast, based on the QPM model, as modified by judgmental adjustments. But money has always played a useful complementary role as a check on the staff forecast. For example, when monetary aggregates were growing rapidly at a time when the staff forecast did not indicate rapid growth in output or prices, it served as a yellow light and led to further analysis of the possible discrepancy. That is, did the rapid growth of money signal an inflationary risk to the staff forecast or were we going through another bout of financial innovation that could be explained by changes in financial structure or regulatory arrangements?
Until recently, the cross-check provided by the aggregates to the staff forecast entered the process rather informally. Following the presentation to senior management of the staff forecast, the information contained in the aggregates was assessed as one of the potential risks to the staff forecast. Over the last year, however, we have formalized the role of the aggregates in terms of the way we assess the information contained in the aggregates and compare it with the staff forecast of output and inflation. Currently, in the meeting at which the staff forecast is presented and discussed there is also a formal and independent presentation of the output and inflation forecasts derived from the movements of the financial aggregates. As well, at this meeting the Bank's regional representatives give an assessment of the upcoming period based on their survey of businesses and associations across the country. Thus, all three sources of information are treated as useful inputs into the analysis of the future path of inflation.
That said, the weights that are placed on the various sources of information and analysis will depend over time on the success that they have in forecasting output growth and inflation. Thus, a good track record over time of the forecasts based on monetary growth or on the surveys of businesses will increase the weight that these approaches are given in management thinking and the seriousness with which their signals of future inflation problems are taken.
It is important to note in this context that the forecasts based on the monetary aggregates also contain a significant element of judgment. Those responsible for interpreting the monetary aggregates have been asked not simply to give us a mechanical forecast but to use their analysis of the recent behavior of the aggregates and the information they have on financial innovations affecting the aggregates to give us their considered judgment as to their best estimates of future inflation and output growth. After all, with a considerable number of aggregates and a variety of equations linking these aggregates to output growth and inflation, there could be a large number of aggregate-based forecasts of the path of output and inflation over time. The challenge to the staff is to derive their best forecast on the basis of these multiple forecasts.
I would note that in addition to the implications that movements in the money and credit aggregates have for output and inflation, the staff also assesses the implications of such financial measures as the term spread and the spread between conventional and indexed bonds for future developments. We are also currently examining alternative reaction functions to see how robust they are across different models.
At present, economic activity in Canada is approaching conventional measures of capacity, but there is considerable uncertainty about whether these measures are appropriately capturing possible changes in the economy's capacity to produce goods and services resulting from changes in policy (such as deregulation, NAFTA, the achievement of low inflation, deficit elimination, and the introduction of the GST, for example), as well as from corporate and government restructuring over the past decade. We have also taken note of the recent U.S. experience in which unemployment moved well below traditional measures of NAIRU without, thus far, leading to significant inflation pressures. With greater uncertainty about the measures of the output gap, the Bank is placing increasing weight on various indicators of future inflation, as discussed in Technical Box 4 of the May and November Monetary Policy Reports. And, clearly, the behavior of the monetary aggregates is one of the measures that will receive increased attention in these circumstances.
In recent years, central banks have aimed at becoming increasingly transparent. In part, this is related to the broader trend to openness and accountability in government and society. Equally important in the case of central banks was the acceptance of the view that monetary policy works better when the public and the markets understand the objectives of policy and the way in which the central bank views the transmission mechanism as operating, and when they know the central bank's position on the economic and inflation outlook. And central banks in countries that have adopted inflation-targeting regimes have been in the forefront of this movement to increased transparency, perhaps because these were the countries with relatively high rates of inflation, whose central banks initially lacked credibility.
As you know, the Bank of Canada has undertaken a number of measures to increase transparency. Let me just list some of them for you.
(1) the announcement of the inflation-control targets;
(2) the release of semi-annual monetary policy reports (also on our website), followed by a press conference and meetings of senior staff with economists, journalists and market participants across the country;
(3) the regular appearance of the Governor before the House of Commons Finance Committee after the release of the MPR;
(4) the explanation of the Bank's views on the transmission mechanism and of the monetary conditions index (MCI) as well as how the Bank operates to achieve its inflation-control targets;
(5) the introduction of a band around the one-day rate of interest;
(6) the issue of a press release when the Bank changes its operating band for the one-day rate;
(7) tying the Bank Rate to the top of the band;
(8) regional outreach and more frequent public presentations by members of Governing Council;
(9) regional presence, with economists in five locations across the country.
Let me expand on the role of transparency. Consider, first, transparency about the objective of price stability. This can help longer term savers and investors plan their behavior on the basis of the commitment by the central bank to stable prices in the long run. Clear explanations by the central bank of the benefits of price stability will also help build public support for the objective. In addition, it is essential to have a clear statement of objectives if one expects markets to understand the policy actions being taken.
While a publicly announced longer term objective of price stability (or very low inflation) is the centerpiece of the policy strategy in most countries, many central banks have found it to be very useful to make the policy objective more concrete. This is the role of the targets for inflation. The central bank can then build credibility by achieving its announced targets. In this context, it is worth noting that a discussion in advance of how the central bank will react to various contingencies will have the benefit of helping the public and markets to understand the thinking of the central bank, and will reduce the likelihood of a misinterpretation of the action of the central bank (or lack of action) when one of the contingencies occurs. For example, an assertion in advance that the central bank would accommodate the first round or price level effects of a rise in a sales taxes or VAT, but not the second round effects or a resulting wage-price spiral, would forewarn the market and public that there would be one year in which growth in the overall CPI would rise above the target (although other measures such as the CPI less food, energy and indirect taxes would be largely unaffected by the tax change), while policy action would be taken if the initial price effect fed into a wage-price spiral.
Transparency with respect to the views of the monetary authorities regarding the transmission mechanism and the economic situation is likely to result in the market having a better understanding of why the central bank is taking action to change the benchmark rate of interest. Indeed, in cases where markets are in full agreement with the central bank's interpretation of economic and inflation developments, money market rates may well move in advance of the adjustment of the benchmark rate on which the central bank operates, as the markets correctly anticipate action by the authorities. For example, the release of surprisingly weak inflation or output data in 1996 indicated that future inflation would likely be lower than previously anticipated, that an easing of monetary conditions would be appropriate, and that a decline in the benchmark rate was likely to be forthcoming. In these circumstances, the market's response to the newly released data was a decline in money market interest rates and, to some extent, in interest rates further out the maturity spectrum, as the markets acted in anticipation of a decline in the benchmark rate. This type of response facilitated policy actions by signaling that the market agreed with the central bank's interpretation of economic developments and the need for some easing to achieve the targets, without loss of credibility. And conversely, if inflation and output data were stronger than expected and raised the specter of overheating and upward pressure on inflation, markets would act in anticipation of higher benchmark rates.
Many central banks issue periodic reports on inflation or on monetary policy to explain their actions in the recent past and to indicate some of the factors likely to play a role in their future actions. Speeches by senior officials and testimony in Congress or Parliament can also play an important role in this regard, although a situation in which different officials provide differing interpretations of economic developments may be confusing to the markets.
In Canada, there have also been a number of changes in operating tactics aimed at helping markets to understand central bank actions. These included, as I noted earlier, the use of a narrow band for the benchmark 1-day rate to signal the range desired by the central bank for this rate; the linking of Bank Rate to the top of the band for the 1-day rate rather than to the 91-day treasury bill rate in order to lessen the confusion arising from two sometimes conflicting signals of the policy stance of the Bank; and the issue of a press release when the band and Bank Rate are changed, explaining the reasons for the change. The outcome, in my view, has been a much better understanding by the markets of central bank actions, a more favorable backdrop against which to take action, and less likelihood of an unfavorable reaction by the markets to a change since it is less likely to be a surprise to them.
In sum, transparency and more open communications can be very helpful in building credibility and in obtaining the desired outcome from policy actions. In the end, however, it is the achievement of price stability or the pre-announced target path for inflation that is the key to the development of credibility.
Are there limits to transparency? On the surface, this may seem like an odd question. Can there ever be too much of such a good thing? But let me rephrase the question. Does increased transparency always lead to increased clarity? Here, the answer, in my view, is "not always".
On a conceptual level, I would draw your attention to a recent paper by Winkler (1999) for an illuminating discussion of the meaning of transparency, including, most importantly, the relationship between transparency and clarity. On a practical level, I would draw your attention to two recent cases, one American and one Canadian, where the attempt to be more transparent ended up confusing or unsettling markets.
In the United States, the Fed's announcement of a "bias" appears to have been misleading for the markets rather than clarifying the Fed's intentions. And, indeed, the Fed recently announced that it would no longer announce a bias toward higher or lower rates. Instead, according to a press release issued last Wednesday the Fed will issue a statement immediately after every FOMC meeting. The language in this statement will describe the FOMC's consensus about the balance of risks to the attainment of its long-run goals of price stability and sustainable economic growth. More specifically, the announcement will indicate how the Committee assesses the risks of heightened inflation pressures or economic weakness in the foreseeable future. This time frame in the new language is intended to cover an interval extending beyond the next FOMC meeting.
The Canadian example comes from a statement in the May 1998 MPR and its aftermath. Although the Asian crisis had begun the previous year, its full effects were not yet apparent at the time the May 1998 Report was issued. The Bank continued to expect relatively strong output growth for the coming year. Nonetheless, this involved a downward revision to our earlier expectations. This led us to remove the near-term tightening perspective that had been a key element of the message of the two previous reports and to arrive at the following conclusion. "When all these factors are considered, it is the Bank's judgment that between now and the next Report, monetary conditions in the recent range would be broadly appropriate in the absence of further shocks." The Report went on to emphasize the degree of uncertainty likely to persist over the coming period and also to indicate that some tightening was still a likely prospect over the longer term.
Now I want to draw your attention to the conditional nature of this short-term outlook for monetary conditions. The key phrase is "in the absence of further shocks". The statement in the Report was a judgment, based on information available at the time and our interpretation of that information, and on the assumption of no further major shocks. It was not a commitment to maintain monetary conditions unchanged regardless of what might transpire in the future.
As you know, there were a number of major shocks that did take place over the next few months. The world-wide outlook continued to weaken in the summer and fall of 1998, most notably in Japan and in a number of emerging economies. The financial crisis spread from Asia to Russia, with a sharp shock to confidence as the Russians announced a moratorium on debt payments, and from there to Latin America. The perception of sharply increased riskiness of emerging country debt and of lower quality corporate debt, combined with high leverage on the part of some financial sector participants, led to an unprecedented loss of liquidity in markets for all but the highest quality instruments and to fears of a world-wide credit crunch. And commodity prices continued to fall sharply.
How did all this affect Canada in the May to November period of 1998? Initially, while the weakening commodity prices and the safe-haven repercussions of the world-wide flight to quality caused a weakening in the Canadian dollar, the depreciation was gradual and markets were orderly. However, by mid-July, with increasing concerns about the world economy and with the Russian situation deteriorating, the pace of decline of the value of the Canadian dollar had accelerated and extrapolative expectations had begun to take hold. Canadian medium-term and long-term interest rates were rising at a time when their U.S. counterparts were falling. The Canadian authorities intervened heavily in the foreign exchange market in early August with a view to stopping out these extrapolative expectations, reinstituting some two-way risk in the market from the Canadian dollar, and preventing a loss of confidence in Canadian dollar instruments. While this action initially stabilized markets, the announcement of the Russian moratorium led to further strong adverse pressures on the Canadian dollar and in Canadian bond markets, leading the Bank of Canada to raise its official rate by one percentage point. This ended up steadying the markets. And as U.S. interest rates were reduced by 75 basis points through the autumn in response to financial market volatility and liquidity problems, Canada was able to follow suit.
What conclusion can we draw from this episode? It should be clear that the policy stance will change as the outlook for the economy and the rate of inflation changes. It follows from this that the Bank has to take great care in how it expresses its views about future developments in monetary conditions. Even though the words used in the May 1998 MPR made it clear that the assertion about monetary conditions was a judgment conditional on our expectations at the time of future economic and inflation developments and that this judgment would change if there were unanticipated shocks (or, more generally, if the world unfolded differently from our expectations), the markets and the media seem to have treated it as an unconditional statement or commitment, and to have been surprised when unforeseen events resulted in a different outcome. Following discussions with market participants, the Bank decided to focus its discussion of future developments on aggregate demand and inflation pressures, and associated risks, and to leave it to the financial markets to draw their own conclusions about the likely future path of monetary conditions.
Let me conclude by noting that this issue of possible limits to transparency deserves further attention from academics and policy makers. And perhaps the best way to address it would seem to be in the context of models that deal with the effect of uncertainty both on optimal ways of making policy and on the best ways of communicating with markets and with the public.
Ball, L., 1999, "Policy Rules for Open Economies," in Monetary Policy Rules, ed. by J. Taylor, (Chicago: University of Chicago Press) pp.127-56.
Freedman, C., 1994, "The Use of Indicators and of the Monetary Conditions Index in Canada," in Frameworks for Monetary Stability: Policy Issues and Country Experiences, ed. by T. Baliño and C. Cottarelli, (Washington: International Monetary Fund) pp. 458-76.
_____, 1995, "The Role of Monetary Conditions and the Monetary Conditions Index in the Conduct of Policy," Bank of Canada Review (Autumn), pp. 53-59.
Smets, L., 1997, "Financial Asset Prices and Monetary Policy: Theory and Evidence," in Monetary and Inflation Targeting, (Sydney: Reserve Bank of Australia) pp. 212-37.
Srour, G., 1999, "Inflation Targeting Under Uncertainty," Bank of Canada Technical Report, No. 85.
Winkler, B., 1999, "Which Kind of Transparency? On the Need for Clarity in Monetary Policy Making," paper presented at the Conference on Monetary Policy-Making Under Uncertainty, European Central Bank, Frankfurt.