Since the global financial crisis, the scope of central banking has expanded and new challenges have arisen. Marika Santoro interviews Doug Laxton, one of the authors of the IMF book Advancing the Frontiers of Monetary Policy. In their discussion, Doug will guide us through the development of new tools and frameworks at central banks. The conversation will also review central banks’ communication strategies and how transparency has become key in managing expectations and engendering macroeconomic stability.
Photo: Stephen Jaffe
Marika: I am here with Douglas Laxton who, together with Tobias Adrian and Maurice Obstfeld, has come out with a new book on advancing the frontiers of monetary policy. The book highlights state-of-the-art approaches in inflation targeting and has earned outstanding reviews from some very prominent policymakers, including Raghuram Rajan, former governor of the Reserve Bank of India, and Adrian Orr, the current Governor of the Reserve Bank of New Zealand. The book argues that Flexible Inflation Targeting is the state of the art and that Inflation-Forecast Targeting is at the frontier for inflation-targeting central banks. What is it all about, and why do we need a new book about inflation targeting?
Doug: The book is based on our experiences at the IMF over the past quarter century advising or working with central banks setting up modern, forward-looking monetary policy frameworks. This goes all the way back to New Zealand, which was the very first country to adopt inflation targeting. Let me explain first what inflation targeting is. The label “inflation targeting” is really a misnomer because the approach, as practiced by the best central banks, is not just about targeting inflation. It is also about what central banks can do to contribute to macroeconomic stability. The term “Flexible Inflation Targeting” was used to dispel the misconception that central banks only care about inflation.
Marika: So the book tells us about central bank experiences developing and implementing a Flexible Inflation-Targeting framework. How difficult is it for a central bank to adopt it?
Doug: Good question. Turns out not so difficult. Many central banks practice Flexible Inflation Targeting. The most transparent and advanced central banks have moved on to the next step, that is “Inflation-Forecast Targeting,” and other central banks that have seen the benefits from other country experiences are investing to be able to move in this direction.
Marika: What exactly is Inflation-Forecast Targeting, and what are the benefits?
Doug: Under Inflation-Forecast Targeting, the central bank’s inflation forecast is an ideal intermediate target that is used to communicate how the central bank is managing the short-term output/inflation trade¬off. Several central banks that have adopted Inflation-Forecast Targeting have been very successful anchoring long-term inflation expectations at the target and efficiently managing the short-term output/inflation trade¬off. In order to do that, central banks need to have an analytical framework or model where interest rates, output, inflation, and financial conditions are jointly determined. This enables them to forecast not only inflation but also real variables such as GDP and unemployment. Those forecasts, when published with the future path of the policy rate, serve as forward guidance for financial markets to help central banks influence longer-term interest rates and asset prices that matter for households and firms.
Photo: Michael Spilotro
Marika: Can you tell us a bit about the history of Inflation-Forecast Targeting?
Doug: In 1990, New Zealand was the first country to adopt inflation targeting. But they lacked an analytical framework to implement a forward-looking approach to monetary policy. Canada was the second country to adopt inflation targeting, in 1991. Unlike New Zealand, they had invested heavily over the years in developing a forward-looking analytical framework. After Canada started using that approach, New Zealand and other early adopters then borrowed that framework and adapted it to their economies. In fact, some central banks such as the Czech National Bank (CNB) continued to refine the framework and moved right to the top of the transparency ladder.
Marika: You mentioned that Inflation-Forecast Targeting is not just about targeting inflation. How can Inflation-Forecast Targeting help improve macroeconomic stability?
Doug: Many of the countries that adopted Inflation-Forecast Targeting had excessive variability in their economies because long-term inflation expectations were allowed to ratchet upwards. This then required disinflationary episodes such as the Volcker disinflation in the early 1980s. The cost of reducing inflation included significant periods of high unemployment that were necessary to not only reduce inflation but to re-anchor long-term inflation expectations at low levels. Effectively, Inflation-Forecast Targeting was successful in helping eliminate the excessive variation in output and unemployment that was a result of inefficient monetary policies.
Marika: You mentioned that the Czech Republic moved right to the top of the transparency ladder. What is the role of communication in this new era of monetary policy transparency?
Doug: Communication is very important and is covered extensively in the book. For example, the book has a chapter that covers the experiences of the Czech Republic. The CNB adopted a very effective form of communication, what we refer to as conventional forward guidance. Effectively the CNB uses a consistent macroeconomic forecast to help explain the logic of monetary policy decisions. Knowing how the central bank will likely respond to economic shocks helps financial market participants develop their own views about the economy and, more importantly, helps them understand the implications of their views for the expected path of the policy rate. Since 2002, the CNB has been using conventional forward guidance very effectively. Going a step forward, starting in 2008, they decided to publish the staff’s expected path for the policy rate. This consistent macroeconomic forecast developed by the staff is used as an important input by the policymakers to explain their own views about the economy and the implications of these views for monetary policy.
Marika: What is the most challenging aspect of central bank communication? Could you give us an example that could serve as a blueprint for future challenges?
Doug: After the global financial crisis, central bank communications were complicated because of the effective lower bound on interest rates. Again, the CNB provides a good example of how a central bank dealt with the problem. The effective lower bound on interest rates represented a challenge, given that most central banks were used to thinking in terms of using interest rates to achieve their inflation and output objectives. In the case of the Czech Republic, a very small open economy whose financial system was not in trouble, the central bank decided that the exchange rate was probably the best instrument in this case. The challenge was to communicate how new policies affecting the exchange rate would help raise inflation to the target. The central bank decided to announce that they were going to depreciate the exchange rate by about 5 percent and that they were prepared to buy unlimited amounts of euro area assets. They explained clearly that they were using the exchange rate as an instrument and were prepared to depreciate further if conditions warranted it. They explained the logic of the depreciation in their inflation reports and, in fact, published forecasts of inflation that showed planned overshooting in inflation from the long-term target.
Marika: Did that strategy work?
Doug: Yes. It was very successful in helping to stimulate the economy and reduce the risk of deflation. Interestingly, when a central bank is implementing such a policy, it actually does not have to buy many assets. Most investors are not going to challenge central banks in such circumstances because they have unlimited ability to purchase assets. The policy is going to be very credible. What is important as a lesson for future challenges is that, even though the Czech Republic ran into the effective lower bound on interest rates, they made it clear that they still had a framework guiding their policymaking, which still involved using instruments to achieve their output and inflation objectives. They were effective in communicating that they were just switching from one instrument to another.
Marika: Are there examples of central banks that used different types of forward guidance?
Doug: There is a chapter in the book that covers the experience of the United States. In 2009, the Fed was facing expectations of the future path of the policy rate that were much higher than what would be consistent with a dual mandate. At that point with very high unemployment and low inflation, the Fed decided to complement its large-scale asset purchases with a new communication strategy, so-called unconventional forward guidance, where it announced its intentions to keep the policy rate low. This strategy, along with the quantitative easing measures, was successful in reducing longer-term interest rates. However, unconventional forward guidance can be problematic when the economy recovers and financial market participants are unsure about when and how the policy might be tightened in the future.
Photo: Stephen Jaffe
Marika: Is Inflation-Forecast Targeting the end or is there more work that needs to be done?
Doug: Inflation-Forecast Targeting has been very successful in improving the transparency of monetary policy, anchoring long-term inflation expectations, and managing the short-term output/inflation trade-off. After the financial crisis, central banks have started to also focus more on financial stability issues. Micro- and macroprudential policies seem most appropriate for mitigating the risk of a financial crisis. These policies are designed to target risk at their source with minimal distortions on other sectors and to strengthen the resilience of the financial system to potential shocks. However, the effectiveness of macroprudential policy is not yet firmly established, though early evidence seems promising. And the ultimate effectiveness of such policies could suffer from inaction bias, implementation lags, and a scope that is too narrow to affect newly emerging risks. As a priority, prudential policies, both micro and macro, should be designed and improved to overcome, or at least minimize, these hurdles. The book highlights how the IMF, as well as other institutions, is working to develop analytical frameworks to support macroprudential policy analysis.