In this post I would like to briefly comment on three points raised by J. B. Taylor, George Selgin, and Scott Sumner. Though these points have been raised before, they are worth reviewing.
- B. Taylor delivered his lecture on the challenges of monetary policy in an international context. The first challenge, of course, is that the strategy, or policy decisions, of a major central bank affects the decision making of other major central banks. This could result in an unintended loose policy at the international level as central banks around the world react to an expansionary policy by a major central bank, like the Federal Reserve. Say, for instance, that after 2001 the Fed would have decided to reduce the federal funds rate target and expand monetary supply. Because of these, a major trade partner, say China, decides to peg it exchange rate with the U.S. dollar to avoid the effects on its trade with the U.S. To do this, China needs to mimic the Fed’s policy. The international effects of Fed’s policy are certainly significant. The two largest crises in Latin America happened after the two largest deviations by the Fed from Taylor’s rule (here). But to be conscious of these issues does not mean the solution is easy. Leith and Wren-Lewin (2009) show that when assuming open economies, the Taylor rule may be indeterminate or produce spill over to other economies.
Selgin draws a distinction between monetary policy rules and pseudo-rules. A pseudo-rule is a rule that fails to accomplish its objective because there is no reason by the monetary authority to actually observe the rule and hit a given target. The reason why a monetary authority may fail to observe a given rule is because it suffers no penalty in failing to achieve a given target (i.e. an inflation target.) This principle should make sense. If the CEO of a company fails to achieve the objectives mandated by the investors and owners of a firm, he can ultimately lose his job. But this is not always the norm in central banking. The “CEO” of a central bank may suffer no penalty for failing to adhere to a rule, which is tantamount to his mandate. Certainly there are reasons that are beyond the monetary authority that might result in failing to achieve a given target. Real shocks, international political and economic events, and other policy maker’s behavior- these are a few examples of unexpected effects that the central banker is unable to predict. Similarly, there are reasons beyond the CEO of a firm’s strategy of why he might fail to achieve his investors targets. Just as failures should not be excusable, not every failure to achieve a target is the fault of the monetary authority. This does not mean, however, that the monetary authority should go unchecked. It simply means that the designed rule should be as simple as possible and that its outcome should be isolated from factors outside of the control of central bankers.
Finally, Sumner says that Federal Reserve communications are not clear enough. What does it mean, exactly, when the Fed says that monetary policy has been tight or loose? To summarize his argument, it can be misleading to reason just from a change in interest rate. A fall in interest rates is associated with a loose monetary policy because it is associated with a shift of the credit supply. But it can be the case that credit demand has fallen. Sumner argues that this was likely the case after 2008. He further points out that a similar scenario that is labeled as tight in the Great Depression is now days labeled as loose. A way to think of a loose monetary policy is when money supply is expanded beyond money demand producing a monetary disequilibrium. This excess of money supply can be channeled through the credit market (as is usually the case in the U.S.) or through government spending (think of Argentina and Venezuela in recent years.) A tight monetary policy can be understood as the opposite scenario. Sumner suggested looking at Nominal Gross Domestic Product (NGDP,) a proxy of total nominal spending. In particular (as I understand it), a deviation from a stable NGDP trend means that nominal spending is exceeding (loose) or falling short (tight) with respect to expected nominal income.