Archive for May 14th, 2019

What differentiates central bank approach of monetary policy from financial stability policy?

May 14, 2019

Sir Jon Cunliffe in this speech speaks about Brexit risks to UK.

In the speech he serves this useful reminder on what differentiates mon policy from financial stability policy:

It cannot be repeated too often that the Bank’s approach to its financial stability objective is, in one key respect, very different to its approach to its monetary
stability objective. For the latter, the Monetary Policy Committee makes the best forecast we can of the path of the economy and the path of inflation – the central case. We set out clearly and graphically the risks around those forecast, but it is the central case – what we think most likely to happen – that informs our policy decisions.

For financial stability, the focus of the Financial Policy Committee (FPC) is not on the central case – on what is most likely to happen; rather it is on the risks – on what could happen even if it is not the most likely scenario. It is the risks, what could happen, that inform our policy decisions.

A colleague of mine recently asked me why the financial stability side of the Bank was so gloomy, always pointing to risks on the horizon and seeing the glass as half empty at best? My answer was that it was our job to worry about what could plausibly happen – and to ensure that if it did happen, the glass did not
suddenly empty entirely.

This is important. Monetary Policy looks at the mean while addressing risks. Financial stability while looking at the mean has to look at risks. Clarifies a lot on how we think about the two sets of policies…


Models, Markets, and Monetary Policy: From Friedman to Taylor to Data dependent policy

May 14, 2019

Nice speech by Richard Clarida.

Let me set the scene with a very brief—and certainly selective—review of the evolution over the past several decades of professional thinking about monetary policy. I will begin with Milton Friedman’s landmark 1967 American Economic Association presidential address, “The Role of Monetary Policy.”2 This article is, of course, most famous for its message that there is no long-run, exploitable tradeoff between inflation and unemployment. And in this paper, Friedman introduced the concept of the “natural rate of unemployment,” which today we call u*.3 What is less widely appreciated is that Friedman’s article also contains a concise but insightful discussion of Wicksell’s “natural rate of interest”—r* in today’s terminology—the real interest rate consistent with price stability.

But while u* and r* provide key reference points in Friedman’s framework for assessing how far an economy may be from its long-run equilibrium in labor and financial markets, they play absolutely no role in the monetary policy rule he advocates: his well-known k-percent rule that central banks should aim for and deliver a constant rate of growth of a monetary aggregate. This simple rule, he believed, could deliver long-run price stability without requiring the central bank to take a stand on, model, or estimate either r* or u*. Although he acknowledged that shocks would push u away from u* (and, implicitly, r away from r*), Friedman felt the role of monetary policy was to operate with a simple quantity rule that did not itself introduce potential instability into the process by which an economy on its own would converge to u* and r*.4In Friedman’s policy framework, u* and r* are economic destinations, not policy rule inputs.

Of course, I do not need to elaborate for this audience that the history of k-percent rules is that they were rarely tried, and when they were tried in the 1970s and the 1980s, they were found to work much better in theory than in practice.


That vacuum, of course, was filled by John Taylor in his classic 1993 paper, “Discretion vs. Policy Rules in Practice.” Again, for this audience, I will not need to remind you of the enormous impact this single paper had not only on the field of monetary economics, but also—and more importantly—on the practice of monetary policy. For our purposes today, I will note that the crucial insight of John’s paper was that, whereas a central bank could pick the “k” in a “k-percent” rule on its own, without any reference to the underlying parameters of the economy (including r* and u*), a well-designed rule for setting a short-term interest rate as a policy instrument should, John argued, respect several requirements.



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