I came across this wonderful speech by Chile’s Central Bank Governor – Jose de Gregorio. The theme of the speech centres on Tinbergen Principle:
It is important to review jointly the issues of price stability and financial stability, because here the well-known Tinbergenprinciple is clearly present. This principle indicates that, to achieve a certain number of objectives, at least an equal number of instruments are needed. We often have used this argument when asked to achieve inflationary, output and exchange rate objectives with only one instrument, that is, the interest rate.
Gregorio then looks at whether interest rates alone are enough to manage asset prices, exchange rate and monetary aggregates. I liked his take on whether to use money or interest rates for inflation management:
What is inconsistent is to use both variables as monetary policy instruments, which certainly complicates the interpretation of the two-pillar strategy of the European Central Bank. Simply put, setting a monetary aggregate and the interest rate at the same time is tantamount to setting the price and the amount to be consumed for gasoline. Supply and demand constraints imply that you can peg either one, but not both. However, as I will discuss below, in practice the rationale for considering monetary aggregates is a little different.
He then says monetary aggrtegatesare more useful not to manage inflation but to indicate distortions in financial markets:
With respect to monetary aggregates, some efforts have been made to bring them back to monetary policy, but as I said before, not with the intention of setting money targets, but rather because they are useful indicators of future inflationary pressures. It is worth noting that the transmission mechanisms under study do not stem from the traditional recommendation of Friedman (1959) in his famous A Program for Monetary Stability , where the focus is on money demand stability and the role of money as a price anchor, and whose analytical base is the quantitative theory of money.
Actually, recent works that assign a role to money, and to credit in general, do so because it can reveal future inflationary pressures or because it can contribute to achieve increased stability (Christiano et al., 2007; Goodfriend and McCallum, 2007; Kilponen and Leitemo, 2008).
Nonetheless, the empirical evidence on the ability of money to provide information to forecast inflation is not so favorable to monetary aggregates. It is more promising to conceive monetary and credit aggregates as indicators of potential distortions in financial markets, an issue I will discuss in the next section.
Read the speech for further details. Full of interesting references and ideas on monetary policy.