Targets for Monetary Policy After the Global Financial Crisis Michael Woodford Columbia University
12th Annual Neemrana Conference, December 2011
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
1 / 18
After the Crisis A consensus had developed among many CBs: importance of clear commitment to a low inflation target simple rules of thumb such as “Taylor rule” to conduct policy in accordance
that was often claimed to have brought about a new era of stability
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
2 / 18
After the Crisis A consensus had developed among many CBs: importance of clear commitment to a low inflation target simple rules of thumb such as “Taylor rule” to conduct policy in accordance
that was often claimed to have brought about a new era of stability After the crisis: how much of that consensus should be reconsidered?
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
2 / 18
Two Questions
Are conventional policy prescriptions still appropriate when financial markets are disrupted?
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
3 / 18
Two Questions
Are conventional policy prescriptions still appropriate when financial markets are disrupted? Is a commitment to control inflation still helpful when policy is constrained by the interest-rate lower bound?
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
3 / 18
Issue 1: Policy When Financial Markets Malfunction Early in financial crisis (by Dec 2007-Jan 2008), Fed was already aggressively cutting fed funds rate target — though real GDP not yet falling, inflation possibly rising — apparently a departure from “Taylor rule,” yet ex post justified?
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
4 / 18
Issue 1: Policy When Financial Markets Malfunction Early in financial crisis (by Dec 2007-Jan 2008), Fed was already aggressively cutting fed funds rate target — though real GDP not yet falling, inflation possibly rising — apparently a departure from “Taylor rule,” yet ex post justified? Proof that a sole focus on inflation and aggregate activity is too narrow a perspective?
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
4 / 18
Policy When Financial Markets Malfunction “Taylor rule” would indeed be too simplistic approach under such circumstances — but for reasons fully consistent with conventional theory
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
5 / 18
Policy When Financial Markets Malfunction “Taylor rule” would indeed be too simplistic approach under such circumstances — but for reasons fully consistent with conventional theory What New Keynesian models imply: inflation and output gap measure important distortions that should be minimized criterion for optimality of policy can be formulated in terms of a relation between paths of inflation, output gap that must hold for optimal balance between competing concerns path of policy rate should be adjusted so as to imply projected paths for inflation, output gap that satisfy this relation (“flexible inflation targeting”) Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
5 / 18
Flexible Inflation Targeting In general, this will not imply that realized inflation, output gap are only relevant information for setting interest rates — other information may indicate changes in the interest rate path required to achieve desired paths of output, inflation — e.g., real determinants of “natural rate of interest”
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
6 / 18
Flexible Inflation Targeting In general, this will not imply that realized inflation, output gap are only relevant information for setting interest rates — other information may indicate changes in the interest rate path required to achieve desired paths of output, inflation — e.g., real determinants of “natural rate of interest” Evidence of financial market disruption — in particular, anomalous behavior of spreads — indicates that linkages between policy rate and the economy are no longer what they ordinarily are — hence required path of policy rate will be different, without any change in target criterion Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
6 / 18
LIBOR-OIS Spread (US$) 400
1m
3m
6m
350
300
basis points
250
200
150
100
Michael Woodford (Columbia)
Monetary Policy Targets
01 0 2/
18
/2
9 20 0 9/
1/
9 20 0 2/ 3/
8 9/
1/
20 0
8 20 0 3/ 3/
7 20 0 3/ 9/
7 20 0 1/ 3/
6 20 0 1/ 9/
3/
1/
20 0
0
6
50
ICRIER December 2011
7 / 18
C´urdia-Woodford (2009) Illustrates that the problem when credit markets are disrupted is not necessarily a need for a target criterion different from the standard one quantitative DSGE model which introduces credit frictions into otherwise standard New Keynesian model consider the effects of a disturbance to the severity of credit frictions, under alternative assumptions about monetary policy
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
8 / 18
C´urdia-Woodford (2009) Illustrates that the problem when credit markets are disrupted is not necessarily a need for a target criterion different from the standard one quantitative DSGE model which introduces credit frictions into otherwise standard New Keynesian model consider the effects of a disturbance to the severity of credit frictions, under alternative assumptions about monetary policy
Monetary policies to compare: welfare-optimal policy commitment Taylor rule commitment to a target criterion of form πt + φ∆xt = π ∗ Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
8 / 18
Numerical Results: Alternative Policy Rules π
Y 0
0
−0.2
−0.05
−0.4
−0.1 0
4
8
12
16
0
4
d
8
12
16
12
16
b
i
i 0.1
0 −0.2 −0.4
0.05
−0.6 −0.8
0 0
4
8
12
16
0
4
8
b 0 Optimal PiStab Taylor FlexTarget
−0.5 −1 −1.5 0
4
8
12
16
Responses to financial shock, under alternative monetary policies Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
9 / 18
Simple Proposal: Nominal GDP Targeting Numerical results in C´urdia-Woodford model also indicate that the exact value of φ in the target criterion is not too crucial, for this type of disturbance A case where the target criterion is relatively easy to explain: φ = 1, in which case it can equivalently be written as ∆(pt + yt ) = π ∗ + ∆yt∗ — a form of nominal GDP target, intended to be consistent with the desired medium-run inflation rate π ∗
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
10 / 18
Issue 2: The Interest-Rate Lower Bound
An important change in the conduct of monetary policy by the Fed (and many other CBs) in 2009-2010: short-term interest rate targets reached effective lower bound, below which CBs were unwilling to push them
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
11 / 18
Issue 2: The Interest-Rate Lower Bound
An important change in the conduct of monetary policy by the Fed (and many other CBs) in 2009-2010: short-term interest rate targets reached effective lower bound, below which CBs were unwilling to push them
Conventional guidelines such as “Taylor rule” cease to be useful and CBs look for alternative means through which to provide further stimulus
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
11 / 18
Issue 2: The Interest-Rate Lower Bound The existence of a lower bound on nominal interest rate is a constraint on stabilization, if implies a floor on real rate higher than the rate required for output at potential, stable inflation
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
12 / 18
Issue 2: The Interest-Rate Lower Bound The existence of a lower bound on nominal interest rate is a constraint on stabilization, if implies a floor on real rate higher than the rate required for output at potential, stable inflation But the real rate floor is only high if low expected inflation no coincidence that lower bound problems have arisen only in period with widespread commitments to low inflation
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
12 / 18
Issue 2: The Interest-Rate Lower Bound The existence of a lower bound on nominal interest rate is a constraint on stabilization, if implies a floor on real rate higher than the rate required for output at potential, stable inflation But the real rate floor is only high if low expected inflation no coincidence that lower bound problems have arisen only in period with widespread commitments to low inflation does this mean inflation targets too low? (Summers, Blanchard) or at least that inflation target should be temporarily suspended if one hits the interest-rate lower bound? (Krugman)
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
12 / 18
Would a Commitment to Inflationary Policy Help? In standard models, yes (Eggertsson-Woodford, 2003) higher expected inflation makes real rate lower, stimulating current spending reduced fear of premature policy tightening also lowers expected future path of short rates, reducing long rates and depreciating exchange rate anticipation of looser future policy also increases income expectations, encouraging current spending
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
13 / 18
Would a Commitment to Inflationary Policy Help? In standard models, yes (Eggertsson-Woodford, 2003) higher expected inflation makes real rate lower, stimulating current spending reduced fear of premature policy tightening also lowers expected future path of short rates, reducing long rates and depreciating exchange rate anticipation of looser future policy also increases income expectations, encouraging current spending
Of course, this depends on successfully changing expectations — might be more effective if words accompanied by current actions consistent with the commitment to reflation Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
13 / 18
Should Inflation Targets Be Higher? Should inflation targets be permanently raised, to provide a “buffer” against binding lower bound?
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
14 / 18
Should Inflation Targets Be Higher? Should inflation targets be permanently raised, to provide a “buffer” against binding lower bound? Not necessary, if can credibly commit to temporary relaxation of target following period of binding ZLB
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
14 / 18
Should Inflation Targets Be Higher? Should inflation targets be permanently raised, to provide a “buffer” against binding lower bound? Not necessary, if can credibly commit to temporary relaxation of target following period of binding ZLB Calculations of optimal policy commitments in New Keynesian models (Eggertsson-W, Werning 2011): commitment to maintain low rates for a period, even after achievement of conventional targets would again be possible allows brief inflationary boom but commitment to rapid return to price stability thereafter
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
14 / 18
Does It Mean Suspension of Usual Rules? This might seem to imply that usual rulebook should simply be thrown out when ZLB is reached But this raises questions: are any commitments about future policy really meaningful? should anyone believe that the suspension of former inflation target isn’t permanent?
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
15 / 18
Does It Mean Suspension of Usual Rules? This might seem to imply that usual rulebook should simply be thrown out when ZLB is reached But this raises questions: are any commitments about future policy really meaningful? should anyone believe that the suspension of former inflation target isn’t permanent?
A superior approach: commitment to reflation as part of a consistent approach that applies when ZLB binds, and when it doesn’t Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
15 / 18
A Targeting Framework What is needed is a commitment to error-correction: — if interest-rate lower bound prevents policy targets from being hit, aim to correct for the target miss later
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
16 / 18
A Targeting Framework What is needed is a commitment to error-correction: — if interest-rate lower bound prevents policy targets from being hit, aim to correct for the target miss later Example: commit to target path for nominal GDP, expected to be consistent with desired medium-run inflation rate if undershoot due to ZLB, appropriate to aim for higher than usual nominal growth rate, until “nominal GDP gap” is closed
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
16 / 18
A Targeting Framework What is needed is a commitment to error-correction: — if interest-rate lower bound prevents policy targets from being hit, aim to correct for the target miss later Example: commit to target path for nominal GDP, expected to be consistent with desired medium-run inflation rate if undershoot due to ZLB, appropriate to aim for higher than usual nominal growth rate, until “nominal GDP gap” is closed automatically implies should not expect policy tightening soon but also allows confidence that resulting inflation will be bounded Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
16 / 18
A Nominal GDP Target Path for US Percentage Points
Percentage Points
30
30
20
20 Trend at 4.5%
10
10
0
0
-10
-10 Nominal GDP Gap
Nominal GDP -20
-20
-30
-30 2004
•
2005
2006
2007
2008
2009
2010
2011
2012
2013
Growth of nominal GDP increases from about 4.5% to about 6.5%, cutting the gap in half by the end of 2013
Conclusion
CBs have faced many extraordinary challenges as a result of the cris[es] simple formulas inadequate in such complex circumstances: must instead return to principles underlying them but not obvious that there needs to be a change in basic goals of monetary policy
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
17 / 18
Conclusion
Important for dealing well with the particular kinds of challenges just discussed: commitment to a target criterion, rather than to a pre-specified list of variables to be used as indicators commitment to error-correction, rather than to a purely forward-looking target that “lets bygones be bygones”
Michael Woodford (Columbia)
Monetary Policy Targets
ICRIER December 2011
18 / 18
