Monetary policy, an inexact science

You should have some idea by now that monetary policy is an inexact science (or art). This brings up questions about what proper central bank objectives should be. Most economists agree that central banks should focus primarily on maintaining the credibility and purchasing power of a nation’s currency, implying they should concentrate on maintaining price stability. A few central banks, such as the Bank of England and the Bank of Canada, adopt fairly strict inflation targets. The Maastricht Treaty says the European Central Bank’s sole purpose is to maintain price stability, although in practice the ECB seems to be adopting multiple policy objectives. Some believe that central bankers should concentrate solely on maintaining a fixed rate of monetary growth, which in turn should insure that inflation is stable.Price and monetary objectives are a good thing, but in reality most central banks have multiple objectives. This is partly because they must answer to their governments and citizens, but also because the empirical support for strict rule driven monetary objectives is mixed. These days most central banks focus on a combination of monetary growth, inflation, economic growth, and (sometimes) exchange rate objectives. Although the Fed doesn’t set any specific targets, an economic growth objective seems to have become dominant at the Fed in recent years. But this is tied to other objectives, as the Fed tries to maintain growth consistent with “price stability”. Lately Fed Governors (and many others) have been confused because the U.S economy is soaring at “above potential growth” while inflation has stayed low. This has led to some rethinking about what the potential growth rate of the economy is (economists had thought it was around 2.5 %, but many have raised this number to 3% or higher in light of increasing measured productivity). You can see what a challenge monetary policy is.I would like to spend a few moments on the issue of central bank independence. There has been a concerted move during recent years to grant increased independence to central banks around the world. The thinking is that central banks should be charged with preserving a country’s currency and left to that goal with little interference from politicians. This is a good idea, but the reality is that no central bank is completely independent. As you know, all central bankers are appointed by politicians and they must ultimately answer to them. Also, they live in a political world and will thus react to pressures from politicians, businesses, and taxpayers.This brings up the issue of central bank transparency. Traditionally, central bankers have thought it necessary to carry out their deliberations in secret and to reveal few details about the thought process behind their decisions (the master in secrecy was the German Bundesbank, which only published its minutes with lags of more than 30 years). Recently, however, there has been a push for greater transparency. Thus, we see central banks publishing the minutes of their deliberations within a month or two after meeting and explaining their decisions in public forums more frequently. This is truly being played out now in Europe, where the Maastricht Treaty provides no obligation for the European Central Bank (ECB) to ever publish its minutes or provide any information about how it reaches its decisions. But ECB governors are being pressured to divulge their thinking publicly, which they have begun to do. The Bank of Japan, which was only granted independence in 1998, is also becoming more transparent. By laying out their views in a credible manner, central bankers in Europe and Japan have been able to pressure politicians to carry out more responsible fiscal and structural policies. Independent, but transparent, central banks seem the best way to go. But remember that a truly independent central bank is impossible to achieve in a political environment (nor perhaps desirable, though some economists would debate this). 

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