Activist Monetary Policy in the Fed and the ECB

By Mark Thoma

Recent remarks by Jean-Claude Trichet, President of the European Central Bank (ECB) at the Federal Reserve Symposium in Jackson Hole, Wyoming discuss monetary policy generally and highlight important differences between the U.S. Federal Reserve Bank and the European Central Bank’s approaches to monetary policy.  I’d like to focus on the specific topic of the appropriate degree of activism by central banks, a place where the Fed and the ECB appear to differ. 

In a previous post, I noted one argument made by ECB president Trichet against an activist stance, difficulties in obtaining accurate data soon enough to make activist policy feasible.  This post continues the discussion on activism.

Trichet argues that when examining different degrees of activism, care must be taken to separate differences in the implementation of policy from differences in economic fundamentals that can motivate differences in policy.  He claims it is possible to fully explain differences in recent degrees of policy activism purely on the basis of differences in economic conditions.  But he also argues there is more to it than that, there is also a difference in views regarding the appropriate degree of activism that motivates policy differences.

Here’s one way to think about this issue.  There is a difference between individual credibility and institutional credibility.  Because Greenspan enjoyed a large degree of individual credibility, he was able to craft policy to individual conditions more than most central banks with the full faith of markets as he did so. 

But much like the star player on a sports team, the hope is that the team can remain of championship caliber even without its star player in the lineup, particularly if given a fairly unrestricted chance to pick a replacement.  In a monetary policy setting, this requires the central bank to establish credibility over and above the credibility of any individual within the institution in order to have the full faith of markets behind it.  Imagine the worst, that a central banker falls ill and must be immediately replaced.  In such a circumstance only the credibility of the institution itself will avoid financial turmoil.

Greenspan favors a flexible approach to monetary policy rather than an approach that commits to a particular rule with well defined targets.  But not all agree for the reasons just noted, a position I find myself in agreement with.  I believe much of the recent economic stability we observe comes from anchored inflationary expectations, and this in turn comes from the credibility emanating from the central bank. 

No one can be sure who a particular president might choose to be Fed chair, and nobody can predict for sure the economic conditions that the central bank might encounter in the future.  For these reasons and others, the credibility of the central bank rather than the credibility of the individual must come first.  This argues for commitment to rules and to explicit, well-defined, transparent policy targets as well as transparent procedures for attaining those targets.

In the U.S., this issue is important for another reason, it provides a means of sorting potential replacements for Greenspan into those favoring the ECB non-activist explicit inflation targeting approach and those favoring Greenspan’s more activist position.  The choice of a new chair will help to shape the degree of activism the Fed pursues in the future.  But enough of my thoughts, here are the remarks of ECB president Trichet on the topic of activism:

Monetary Policy and 'Credible Alertness,' by Jean-Claude Trichet, President of the ECB at the Symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming: … Since 1 January 1999, when the European Central Bank (ECB) officially became the monetary authority of the euro area, ... [t]he fact that we have moved less frequently than the Federal Reserve, in particular over the last 2 years, has generated a very interesting discussion on central bank activism. ... I could explain at length why in 2001 the highest rates in the euro area were only at the level of 4.75%, when they were at 6.5% in the United States and why the cumulative reduction in the easing cycle has been larger in the United States, only taking into account objective measures of the differences of amplitude of the economic swings that have characterised both sides of the Atlantic. But I would like to share with you today some thoughts on a different sort of difference in “activism”: …

I will argue that, whilst the central bank must always be ready to take aggressive action if needed, a well-designed institutional framework, which undisputedly assigns the central bank the primary objective of price stability, and the adoption of a clear monetary policy strategy, which quantitatively defines price stability and does not pretend to fine-tune directly the business cycle, can make the latter type of policy activism unnecessary in many circumstances. The reason is that this framework reduces uncertainty about the central bank’s ultimate motives, provides a stronger anchor for inflation expectations and makes it easier for the markets to map the expected path of the policy rate to the evolution of macroeconomic conditions … Importantly, as a side effect, this policy would better sustain economic activity and minimise macroeconomic volatility.

In practice, the central bank would normally make use of all available options – as circumstances dictate – to counteract situations that have the potential for undermining confidence and perturbing market conditions for a lasting period. We have done that in the past and we will do it in the future. As an example, … we took immediate decisions after the dramatic events of 9/11, pouring very large amounts of liquidity in euro, ... This has demonstrated very clearly that the ECB was eager to act decisively and immediately when appropriate … At first thought, a “discretionary” response to shocks might seem exactly what one would expect of a professional central banker. After all, each economic contingency is a unique combination of circumstances that, in its own way, is unprecedented, and will probably never repeat itself again in that precise form. So, each new contingency would seem to command a different, tailor-made response on the part of monetary authorities.

There is some grain of truth to this. But decades of reflections on the role of expectations in macroeconomics have taught us that monetary policy is not a sequence of isolated policy actions. When forming their expectations, agents seek to capture the general pattern of monetary policies, and it is that pattern that matters in shaping their economic behaviour. Therefore, the relevant problem to solve for central banks is not so much about the size and timing of a given interest rate move in response to a particular contingency. It is more about the strategy for repeatedly adjusting the policy instrument in response to the state of the economy, whatever this might be. If the central bank is able to convince economic agents and markets participants of its analysis and assessment of the outlook, and about the policy measures that it is going to take in response to it, this mechanism of anticipation will act in self-equilibrating manner.

…We have stepped up the number of gatherings in which we document our strategies and carefully explain our actions to broad audiences.  … This disclosure … helps to clarify the policy environment and anchors expectations. But unless deeds support words, words will be unconvincing. So, there is no better way to establish a reputation for actually following a strategy of monetary policy than letting the public infer and recognise it from our repeated behaviour. Consistent behaviour is a precondition for outsiders to understand our actions and believe our pronouncements.  …it is a precondition for our credibility. … [A]s a general principle …we should never fail to appreciate that our behaviour has durable significance. It can add to the asset of credibility, or detract from it in important ways…

If I had to draw some lessons for the future both from what has been observed on this side of the Atlantic, during Alan’s tenure, and what has been our experience in Europe, … I would stress more than ever for the future the concept of credibility. It is because the Fed has, throughout the last 18 years, been very highly credible that remarkable successes have been achieved on price stability, even without what I would consider as a precondition for anchoring inflationary expectations: a quantitative definition of price stability.

...In the case of the Governing Council of the ECB I have explained that our credibility has enabled us to regain full control of inflationary expectations with remarkable efficiency over the last two years. And this was because observers and market participants rightly had the intimate conviction that we intended to be absolutely ready to act at any time if needed and were not inhibited in any respect either by unconditional commitments … or by any kind of well intentioned public pressures coming from many circles, including the political sphere, of which we were not particularly deprived since the setting up of our Institution.

Comments

[Edward Hugh]

A lot of issues here Mark. I am, I suppose a lot more sympathetic to Greenspan than most, and especially on the 'rule' issues - new economist, our absent friend, is probably closer to you here. My guts tell me that central banking is more an art than a science, and that the most important thing is to keep them guessing. In that sense I would be most critical of the last phase of Gs stewardship, since I think he has boxed himself in too tightly with the measured rises, and the market is always trying to run ahead of him, so some freak adversity, or weakness in the eurozone (which I personally think very possible) could put pressure on him by driving up the dollar as he nudges up rates. This makes me nervous.

If you will permit me to go back to a post on your own blog, I couldn't disagree more strongly with Krugman when he says this:

"I think: the end of the housing bubble will automatically cure the trade deficit, too. Sorry, but no."

I almost think this argument verges on the dishonest, since Krugman knows better, but I don't like type M arguments so I'll put that aside. What K knows full well is that there are two principal policy options in reducing te deficit, change the value of the currency, or reduce the level of internal demand. (There is a third alternative which seems to be taboo, structural reforms to make the US enterprise more competitive and more able to face up to its German and Japanese rivals, but this would be longer term, improving the education level of the workforce eg).

Now..... we have a major structural problem with Bretton Woods (or if you like, bringing in the Chinese, Bretton Woods 2). For the dollar to go down, and adjust the deficit you need something else to go up, and the main candidate here is the euro. But the eurozone economies aren't strong enough (why is for another day) so we have the global imbalances, and the dollar is stuck at a higher level than the one needed to produce the correction.

So.... the only way to 'correct' is to turn the scew on domestic demand and stop it sucking in imports. Greenspan is trying to do this via the tightening, but a dramatic correction in house prices would have the same effet. At least this it appears to me is Gs argument, and I don't think i is so obviously false, at least I agree with it :).

"I believe much of the recent economic stability we observe comes from anchored inflationary expectations,"

The interesting thing here Mark is to ask the question just how anchored have the expectations been. My reading would be that many market participants have been surprised by the tame inflation we have had over the last couple of years (since their expectations were for more) and really what is striking is the low global inflation reading we are getting despite record annual global growth rates and high energy costs. I think there is something more going on here. What that more might be needs careful analysis, and calm discussion. The last annual report of the BIS might be a starting place.

Well that's enough on Greenspan, now for Trichet.

[Edward Hugh]

To try and put things in perspective, it is important to remember that many of these issues have a very different look depending on which side of the Atlantic you are based. Rather than the US and the eurozone, perhaps a better comparison would be between the non-Eurozone EU countries (like the UK and Sweden) where a more active approach is adopted and the ECB which seems esentially to go for a version of asymmetric risk based on the idea that doing something has more risks than doing nothing (and at least might attract more criticism since you have such divergent economies to cater for),so when in doubt, do nothing would seem to be the motto.The rest of the argument would seem to be post-hoc rationalisation. If BoJ policy is colloquially known as zirp, the ECBs is often reffered to as twirp (two % bla bla bla).

This impression is confirmed by a recent and relatively unprecedented assault on Trichet by LSE professor and former BoE MPC member Charles Goodhardt.He has written him an open-letter where he says, among other things, that the ECB demonstrates "conscious refusal" to be precise.

Eg "Is the medium term two years, three years, five years, n years, or what? By refusing to define the term, you can never be accused of missing your target. [It] is just an exercise in obfuscation,"

and

"It is hardly desirable, nor does it lead ultimately to credibility, to suggest that consensus existed when, in practice, it did not,"

Goodhardt is himself possibly better known for Goodhardt's Law, the economist's version of Murphy's Law, which states: any indicator you target soon becomes unreliable. Some indication of what he is getting at can be found in this papersummarising findings of his time on the MPC:

http://fmg.lse.ac.uk/upload_file/429_dp495.pdf

where he says among other things:

"Nevertheless we have attempted to establish that the MPC responded aggressively to any deviation of ex ante forecast inflation from its target, so much so, and so successfully, that there is no residual significant relationship between ex post inflation at any horizon, from current actual to t + 8, and nominal interest rates in this period. It would not have been possible for an observer to deduce what the MPC was really doing if she was to run a Taylor-type reaction function using current actual data during this short period. We hypothesize that the success of prior empirical tests of finding significant effects of current inflation on nominal interest rates has been because inflation targeting was either not being attempted so wholeheartedly, or just less successfully. Be that as it may, it does call into question the whole exercise of attempting to identify how Central Banks may react to a complete set of current and future variables by a simple regression using only current variables."

"An even more complex problem arises because these results indicate that the MPC did not intend to build gradualism into its own behaviour, and yet gradualism in the shape of consecutive series of similarly signed small steps in interest rates occurred nonetheless. Our attempts to explain this conundrum are mostly to be found in two separate, but connected, papers (Goodhart 2004 b and c). Even so, we suggest that such (largely unintended) gradualism arose through two main routes, first - and probably less important - as a quasi-automatic effect of using the constant-interest-rate conditioning assumption for the forecast, and second as a result of strong auto-correlation in forecasting errors."

and

"There was absolutely no indication of gradualism, of short run response being much less than long-run responses, in these results. Yet simple observation of the time path of interest rates.... reveals that the actual auto-correlation of interest rate changes, with a high ratio of continuations of small steps of the same sign relative to reversals has been just as high during the MPC years as before."

"How come? This is a complicated and complex story, which is the subject of a separate paper. But let me give the gist of those findings here. Given the above econometric results, we dismiss those arguments ... that claim that gradualism may, of itself, be desirable, since this was *not* what the MPC was aiming to achieve. This auto-correlation of interest rates was not intended. Instead it came about primarily through two routes. One such mechanism, though from my analysis somewhat the less important, occurred as a direct consequence of using a constant interest rate (CIR) conditioning assumption in making the forecast. As it well known, holding nominal interest rates constant soon results in Wicksellian instability. So any trend developing at the horizon t + 8 is likely to persist, and perhaps to become more extreme, beyond the horizon........ Then rolling the forecast quarter by quarter could easily result in a series of small, similarly signed step changes. Since the Bank does not publish forecasts beyond the t + 8 horizon, we cannot test this directly."

There is more:

"The UK experience in the years of our sample, 1997-2003, was, however, remarkable for its success in stabilising inflation around its target level. The variance of actual inflation, as measured by RPIX, around the target of 2.5% was minuscule as measured either by historical standards, (see Benati, 2003), or compared to most other countries. Although there has been some systematic correlation in the deviation of actual inflation from target, it has been small enough to disregard. Outcomes have been less successful in previous periods, and perhaps in other countries. In so far as actual inflation deviates to a significant and worrying extent from target, pressures will build up on the authorities to respond, irrespective of the belief that only future inflation reacts to current interest rates. Moreover, given the autocorrelation in economies, current deviations of inflation from target may well indicate forecast, future deviations of inflation from target. Indeed, as noted in the Introduction, this is an argument for the use of such reaction functions. Thus, one seems to reach the rather odd conclusion that such reaction functions, using actual contemporaneous data, are effectively identified by their comparative failure to achieve their supposed objective."

and

"To give a taste of the results, the coefficients in this function change markedly (and highly significantly) as the (forecast) horizon alters, and, on the basis of this, admittedly very short data set, it would simply not have been possible to work out what the MPC was trying to do by running a conventional Taylor-type function using contemporaneous values alone."

A lot of puzzles for people to think about here.

[Edward Hugh]

Bloombergs Caroline Baum has a piece on this debate here. I don't really agree with her, but its's worth a read.

[Mark Thoma]

Great follow-up commentary. Thank you.

My next post will be another comparison that is a bit more speculative. I am anxious to hear what you will have to say!

[Dave Iverson]

Krugman's comments, Aug 29 "Greenspan and the Bubble":

"And here's where Mr. Greenspan is still saying foolish things. In his closing remarks he suggested that "an end to the housing boom could induce a significant rise in the personal saving rate, a decline in imports and a corresponding improvement in the current account deficit." Translation, I think: the end of the housing bubble will automatically cure the trade deficit, too.

"Sorry, but no. A housing slowdown will lead to the loss of many jobs in construction and service industries but won't have much direct effect on the trade deficit. So those jobs won't be replaced by new jobs elsewhere until and unless something else, like a plunge in the value of the dollar, makes U.S. goods more competitive on world markets, leading to higher exports and lower imports."

So Edward, exactly where do you feel Krugman "borders on the dishonest"? Just curious.. d.

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