Friday, October 2, 2009

On ex-ante evaluation of monetary policy alternatives

In order to address the liquidity trap posed by the ongoing recession and the zero-bound interest rates, the Swedish Central Bank, Riksbank, has been following a policy wherein the deposit rate is always a half percentage point less than the benchmark lending rate, even if that forces the former below zero. Therefore, when the Riksbank lowered its benchmark lending to 0.25% in July, the deposit rates were driven into negative territory, effectively penalizing banks if they simply parked their funds with the Central Bank.

In this context, in an NBER working paper, Lars Svensson, the Deputy Governor of the Riksbank and a former colleague of Ben Bernanke at Princeton, explores the challenges in evaluating inflation-targeting monetary policy, especially the problem of ex-ante evaluation of policy options with inflation targets given the time lags between rate changes and its impact on inflation. Central Banks rarely have control over inflation given the fact that it is affected by shocks that are difficult to identify or predict, and also because central banks with inflation targets conduct flexible inflation targeting so as to both stabilize inflation around its target and to stabilize the economy. In the circumstances, the best policy for Central Banks is in "choosing a policy-rate path so that the forecast for inflation and the real economy stabilizes inflation and the real economy as effectively as possible".

He therefore proposes using a modified Taylor curve, the forecast Taylor curve (which illustrates the efficient tradeoff between stabilizing the inflation forecast around the inflation target and stabilizing the resource utilization forecast around a normal level by representing the tradeoff between the variability of the inflation-gap and output-gap forecasts) to evaluate monetary policy ex ante (and in real time, on the basis of information available at that time). This approach uses the plots of mean squared gaps of inflation and output-gap forecasts for alternative interest rate paths and then compares them in their respective success in achieving (or forecasting the achievement) an efficient stabilization of both inflation and the real economy.

Since monetary policy is mainly about managing expectations, particularly those concerning future policy rates, Central Bank credibility is of paramount importance. The degree of correspondence between expectations and the central bank's forecasts for inflation and the real economy becomes a measure of the credibility of its analyses and forecasts. In the circumstances, the publication of the interest rate path also allows the evaluation of the Central Bank's credibility and the effectiveness of the implementation of monetary policy.

No comments: