Rethinking on monetary policy

First published by S S Tarapore in The Financial Express, India, 6 August.

The Federal Reserve Bank of Kansas City has for the past 25 years conducted an annual economic policy symposium. The 2002 symposium was dedicated to Rethinking Stabilisation Policy. The symposium discussed the potential scope for stabilisation policy in the current environment. The papers discuss the role of monetary stabilisation, its effectiveness and limitation and its compatibility with long-run stability and fiscal sustainability.

Alan Greenspan, chairman, US Fed, argues that in the 1990s shocks were more easily absorbed than in the past. Euphoria drives equity prices to unsustainable levels, creating problems when the inevitable adjustment occurs. He admits that despite all the cogitation by the Fed staff, it is difficult to definitely identify a bubble until after the fact. Prolonged periods of expansion encourage greater risk taking which is difficult to control with modest monetary tightening. He makes the telling point that if monetary tightening deflates stock prices without depressing economic activity, it merely results in an increase in stock prices.

As to the important question as to whether policy can limit the destructive fall out of a bubble, he candidly admits that the answer is "no". Bubbles appear when investors either overestimates the sustainable rise in profits or the rate of discount is unrealistically lowered. Human psychology being what it is, bubbles feed on themselves and are supported by implausible projections of potential demand. He cautions that a bubble cannot persist indefinitely. However, he admits that it is difficult to assess the degree of pre-emptive tightening necessary to neutralise a bubble.

Otmar Issing, member of the Executive Board of the European Central Bank (ECB), warns that in the absence of an unswerving mandate to maintain price stability, the task of identifying economic shocks can easily distract the central bank from the need to maintain a firm sense of direction. While there is always a theoretical decomposition of structural change and cyclical sources of fluctuations, in practice it is virtually impossible to separate the two on a real time basis. He argues that real time misperceptions and uncertainty are normal hazards for a central bank.

Despite a high degree of uncertainty, he argues that the ECB has remained unblemished. Underlying the ECB's monetary policy is the philosophy that markets are indeed powerful, sometimes overwhelming, but nevertheless in need of being guided by the central bank without meddling with markets. The medium-term orientation and aversion for short-term fine-tuning has given the ECB a compass to ride through transient turbulence. He makes the observation that central banks are bombarded by economic news and the risk is that the central bank gets hypnotised by the latest indicators. This could lead monetary policy astray from its central role of providing a firm medium-term anchor.

He claims that central banks have to respond to shocks but shocks do not come with labels. A central bank can benefit from keeping an eye fixed on a single long-term compatibility condition viz, money should grow at a rate consistent with the trend growth in real output and the central bank's definition of price stability. He argues that in the end, money supply has to be consistent with medium-term price stability. Ultimately, there can be no sustained inflation without systematic accommodation in monetary aggregates. He quotes Paul Samuelson; we have been given two eyes-one to watch money and credit aggregates and one to watch everything else. He recognises that money growth out of alignment with fundamentals can, under certain circumstances, fail to ignite an asset bubble. But he argues that the absence of a fire does not mean that we should not pay for fire insurance.

Conditions of easy credit and rapid monetary expansion while escaping simple checks based on inflation and output gap indicators can inflict lasting damage on the economy. A central bank cannot dismiss shocks as a nuisance. Mr Issing concluded that, first a central bank cannot but undertake analysis of economic change from shocks and noise. Secondly, the change in money demand is difficult to decipher. The conviction that money matters is universal to central banks irrespective of their monetary policy strategy. Thirdly, a central bank should never fall prey to myopia and react mechanistically to variables. He concludes that if deviations in measures of money from the long-run trajectory with price stability are ample and persistent, a central bank should intervene if the anchoring properties of money are to be reinstated and made operative.

Guillermo Ortiz, Governor of the Bank of Mexico, argues that the role of fiscal and monetary policies as tools of stabilising the business cycle have not received much attention in Latin America; rather policies have accentuated the effects of shocks on output and interest rates. Typically, monetary-fiscal policy fueled an overheated economy and these policies were strongly tightened when external constraints became binding. He stresses the need to develop a counter-cyclical monetary policy.

Yutaka Yamaguchi, deputy governor, Bank of Japan, claims that the bursting of the asset price bubble in Japan in the 1990s contributed to the decline in the trend rate of growth. The excessive optimism induced businesses to build up capital stocks, and debts that made sense only under sustained acceleration of growth. When the bubble burst, the ensuing adjustment and work out had to be all the more painful and prolonged. He recognises the criticism that the Bank of Japan should have gone in for more aggressive easing before monetary policy become constrained by the zero nominal bound. Mr Yamaguchi is however skeptical whether more aggressive easing would have moderated the fall of real estate prices.

David A Dodge, governor, Bank of Canada, stresses that while automatic or quasi-automatic stabilisation by monetary-fiscal policies is desirable, the real question is whether there is a role for a discretionary stabilisation policy. Mr Dodge makes the telling point that discretionary measures are difficult to initiate when the need arises and extraordinarily difficult to stop once the need is past.

The world over, central banks are undergoing an open evaluation of their past policies. One hopes that we, in India, would not shy away from such introspection.