Essay title/Question number: Compare and contrast the advantages and disadvantages of three nominal anchors that could be adopted by a Central Bank. Discuss why you think asset prices should or should not be adopted as a target of a monetary policy.
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The primary goal of a monetary policy is always to control inflation to maintain price stability for any country in any period. However, the frequently asked question is that how the Central Banks can reach their objectives. Looking back the history, most countries have used a mechanism so-called “nominal anchor” which provides conditions for tying down prices. There are three types of nominal anchors, namely the exchange rate anchor, inflation anchor and monetary aggregates anchor. These nominal anchors play very important roles as intermediate quantitative targets which the Central Banks need to achieve in the long run. Although all three are one of type of nominal anchor, they each have their own strengths and weaknesses. This essay will compare and contrast the advantages and disadvantages of these three mechanisms in some striking aspects. Subsequently, asset prices problem which also has a large effect on inflation levels is discussed to consider whether it should or should not be conducted as another target of a monetary policy.
I/ Compare and contrast the three nominal anchors:
1/ The prerequisites:
Obviously, the use of any instrument requires some certain conditions, thus not all nations can also apply them as an intermediate target.
Regarding this, the inflation targeting has the most stringent preconditions. Firstly, inflation must be the main goal of monetary policy. For example, because the correlation between inflation and employment is positive, if the Central Bank must choose either of the two targets, inflation target should get priority. Secondly, in the interests of success for inflation targeting, the Central Bank definitely ensures independent from politicians. Particularly, the market economy institutions in the most of emerging market countries are in difficult positions to meet these two requirements. Consequently, the implementation of inflation targeting is just feasible in the developed countries.
Unlike inflation targeting, monetary targeting can be applied in both developed and emerging market countries. However, there still exist some disadvantages which limit the flexibilities of this target. If the relationship between money growth and goal variables is not enough strong and reliable, monetary targeting is not sensitive. In addition, the Central Banks do pursue seriously a price stabilization policy in the long run and must have sympathetic public support. In the past, Germany and Swiss are two outstanding examples for successful adoptions this target. In contrast, the United Kingdom failed because of the breakdown of relationship between monetary aggregates and goal variables, and the non-serious pursuit in the long run.
Similarly to monetary targeting, exchange rate targeting requires less stringent than inflation targeting. This implementation will work as long as the pegging country can choose another appropriate one which is large enough, owns sound currency, and has a low inflation level to fix its price of domestic currency.
2/ Anchoring inflation expectations:
Once the prerequisites are satisfied, these three mechanisms will promote their key advantages to anchor inflation expectation effectively.
Inflation targeting can stable the inflation, and builds monetary policy credibility. With this strategy, the final objective is always a low inflation rate, and the Central Bank also announces a specific inflation rate target. This number does not change over the target period, so makes this strategy more understandable and more observable. As a result, it can anchor inflation expectations more rapidly and durably than remaining strategies.
Although monetary targeting also constraints inflation expectations, its work seems to be more difficult than inflation targeting. The reason of this is that a second numerical target is introduced which obscures final target. (Batini, N., Kutter, K., and Laxton, D., 2005). Furthermore, it is easy to find that the relationship between the target monetary and goal variables is highly unstable experienced the history of economy. This results in failure of monetary aggregate targeting.
In contrast to monetary targeting, but like inflation targeting, on condition that the exchange rate targeting is trustworthy, it can constraint the inflation expectations to the inflation rate in the anchor country efficiently. For instance, in 1990, when the United Kingdom inflation rate was 10%, it pegged the value of Franc to German Mark. After two years, its inflation rate decreased dramatically to 3%.
3/ Central Bank transparency, accountability and communication:
Among three strategies mentioned, this respect is the greatest advantage of inflation targeting. Public always worry about changes in prices which directly affect their lives, so a small price volatility also catches public attention. This explains that inflation targeting is easily understood by the population and is thus more transparent. Moreover, the Central Bank frequently communicates with public through its speech and the Inflation Report, which is published monthly, or yearly. Therefore, the plans, and the objectives of monetary policymakers can be judged and be measured against a clearly target. These actions of the Central Banks improve their transparency and accountability for gaining the inflation goals. (Mishkin, Frederic S., 2007).
Compared to inflation targeting, the transparency and accountability of the Central Bank in monetary targeting is less. Monetary targets also promote immediate accountability for monetary policy to constraint inflation rate low, however when the relationship between the targeted monetary and inflation breaks down, Mishkin, Frederic S. (2007) states that “it is difficult for the Central Bank to be transparent and accountable to the public”. In addition, in regard to understand ability, the symbols stand for monetary aggregates such as M1, M2 and M3 are not familiar to population. Though the information is known immediately, there are not many people can understand clearly the meaning of these numbers. Therefore, inflation targets are more transparent than monetary targets.
Likewise the inflation targeting, exchange rate targeting has simplicity and clarity because the Central Banks also announce a simple numerical figure which makes it easily understood by the public. Furthermore, a definition of hard currency is not strange to the population. As far as the accountability is concerned, exchange rate target can weaken it, particularly in the emerging market countries. Because only the emerging countries implement this strategy to fix their exchange rate, it removes important signals which can help constraint monetary policy from too expansionary. Fixing the exchange rate to another currency makes the public to be less able to track the Central Bank. This makes the transparency in exchange rate targets less than in inflation targets.
4/ Time-inconsistency problems:
Both three nominal anchors can prevent the time-inconsistency problems by providing an expected constraint on discretionary. Therefore the price stability target in the long run is more likely to be achieved. However there exist some limitations when solving time-inconsistency problems.
Regarding this aspect, inflation targeting has more advantages than two remaining strategies. Because the time-inconsistency problems often come from political pressures involving in expanding monetary policy, inflation targeting has the opportunity focusing on the political debate on what a central bank can do on a sustainable basis. (Mishkin, Frederic S., 2007). Nonetheless, normally, inflation targeting was not adopted if a substantial disinflation has not been reached. As a result, inflation targeting dose not provide immediate signals which help anchor inflation expectations and decrease inflation to the public and market about the stance of monetary policy. The time-inconsistency problems can not be solved immediately.
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Similarly, the monetary targeting can send immediate signals to the public about the stance of monetary policy, thus can constraint inflation expectations. However, if the relationship between the targeted money and inflation is weak, the monetary targeting strategy does not work and cannot send the signals about the stance of monetary policy. This leads to the same result of inflation targeting.
With a strong commitment mechanism, an exchange rate target provides an automatic rule that helps weaken the time-inconsistency problems. However, in practice, it makes this problem more serious because it might make Central Bank actions less transparent and accountable.
5/ Domestic considerations and shocks:
Both inflation targeting and monetary targeting enable monetary policy to focus on domestic considerations and to respond to shocks to the domestic economy.
On the contrary, with open capital markets in the exchange rate targets, the targeting country loses the ability to use monetary policy to respond to the domestic shocks. Since the targeting country follows the interest rate of the anchor country, it can not stabilize outputs in the short run. Moreover, there exists the possibility of speculative attacks because this strategy creates a sense of safety from currency risk, so as (Batini, N., Kutter, K., and Laxton, D. (2005) quoted Flood and Marion (1999), Sachs, Tornell and Velasco (1996) who argued that it “”can encourage unhedged currency mismatches, implying that successful speculative attacks are often followed by financial and banking crises and debt defaults””.
II/ Asset Prices Problems in Monetary Policy:
The health of an economy much depends on the monetary policy strategy which the Central Bank is pursuing. Apart from three strategies analyzed, there is the asset prices targeting as an alternative choice which is worthy to consider. Asset prices are classified into three types: stock market prices, real estate prices and exchange rate. Movements in asset prices play a very important role in monetary transmission mechanism because they affect spending and in turn affect output and inflation. A real question to be asked here is whether the Central Bank should adopt asset prices as a target of its monetary policy.
Some economists figure out that “the Central Banks should respond to asset prices fluctuation to stop bubbles from getting too far out of hand” (Mishkin, Frederic S., 2007) because subsequent collapses of the asset prices might be serious damaging to the economy. The bubble burst in Japan in 1989 is a good evidence for this point. In addition, these economists also suggest that outputs are better when the Central Bank adopts policy to prick asset price bubbles. However, there is a limitation is that they assume the Central Bank knows the development of bubble. Actually, this never happen in practice, and thus their assumption is definitely wrong.
On the contrary, if the Central Banks conduct the asset prices as a target of their monetary policy, is this good mechanism to control inflation and improve output? The answer seems to be wrong because the facts show that an asset prices targeting can lead to worse outcomes. There are three key drawbacks which prove this.
Firstly, the optimal react to a movement in asset prices much depends on nature of the shocks to these asset prices and the duration of the shocks. A prominent example of the trap of concentrating on asset prices was the tightening of monetary policy in New Zealand. In 1998, when the exchange rate depreciation came from a negative terms of trade shock which had happened in Thailand (1997), the Reserve Bank raised the overnight cash rate by 9%. This led to a severe recession and a deflation happening in 1999.
Secondly, the relationship between monetary policy and asset prices as stock prices is weak. Thus, the ability of the Central Bank to control stock prices is limited and these prices can move in the opposite direction of the Central Bank.
Finally, the asset prices targeting may weaken support for Central Bank because it seems that it is controlling too many elements which cause the failure of monetary policy. On the other hand, the public is also worry that the Central Bank is too powerful and having much influence over all aspects of the economy.
According to the analysis above, there are a number of serious drawbacks which prevent adopting asset prices targeting. However, a fact can not be controversy that changes in asset prices have the great impacts to an economy. Therefore, the most optimal solution is that the Central Banks should not target to resist a fluctuation of asset prices, but should ease potentially effects which cause economic instability of unexpected changes in asset prices.
Choosing an appropriate monetary policy strategy to adopt is not a simple task of the Central Banks because it depends on a large number of complex factors. Basing on each nation’s economic circumstance, advantages and disadvantages of strategies and the world experience, the Central Banks may pick out the most suitable target for itself.