WHATSHOULDCENTRALBANKSDO?byFrederic S. MishkinGraduateSchool ofBusiness,ColumbiaUniversityandNationalBureauofEconomicResearchUris Hall 619Columbia UniversityNewYork,NewYork10027Phone:212-854-3488,Fax:212-316-9219720-2630E-mail:fsm3@columbia.eduMarch 2000Prepared for the Homer Jones Lecture, Federal Reserve Bank of St. Louis, March 30, 2000I thank Dan Thornton, Bill Poole, Lars Svensson and the participants in the Macro LunchatColumbiaUniversityfortheirhelpful comments.Anyviewsexpressed inthispaperare those of the author only and not those of Columbia University or the NationalBureauofEconomicResearch
WHAT SHOULD CENTRAL BANKS DO? by Frederic S. Mishkin Graduate School of Business, Columbia University and National Bureau of Economic Research Uris Hall 619 Columbia University New York, New York 10027 Phone: 212-854-3488, Fax: 212-316-9219720-2630 E-mail: fsm3@columbia.edu March 2000 Prepared for the Homer Jones Lecture, Federal Reserve Bank of St. Louis, March 30, 2000. I thank Dan Thornton, Bill Poole, Lars Svensson and the participants in the Macro Lunch at Columbia University for their helpful comments. Any views expressed in this paper are those of the author only and not those of Columbia University or the National Bureau of Economic Research
I.IntroductionIn the last twenty years, there has been substantial rethinking about how centralbanks should do their job.This rethinking has led to major changes in how centralbanks operate, and we are now in an era in which central banks in many countriesthroughout the world have had notable success -- keeping inflation low, while theireconomies experiencerapid economic growth.In this lecture,I outline what we thinkwe have learned about how central banks should be set up to conduct monetary policyand then apply these lessons to see if there is room for institutional improvement in thewaytheFederal Reserve operates.The lecture begins by discussing seven guiding principles for central banks andthen uses these principles to outline what the role of central banks should be.Thisframework is then used to see how the institutional features of the Fed measures up. Iwill take theviewthat despite the Fed's extraordinarily successful performance in recentyears,weshould notbe complacent.Changes inthewaytheFedis setupto conduct itsbusiness may be needed to help ensure that the Fed continues to be as successful in thefuture.II.Guiding Principles forCentral BanksRecent theorizing in monetary economics suggests seven basic principles that canserve as useful guides for central banks to help them achieve successful outcomes intheirconductofmonetarypolicy:1)price stabilityprovides substantialbenefits,2)fiscalpolicy should be aligned withmonetary policy,3) time inconsistencyis a seriousproblemtobeavoided,4)monetarypolicy should beforward looking,5)accountabilityis a basic principle of democracy, 6) monetary policy should be concerned about outputas well as pricefluctuations, and 7) the most serious economic downturns are associatedwith financial instability.We look at each oftheseprinciples in turn.1
1 I. Introduction In the last twenty years, there has been substantial rethinking about how central banks should do their job. This rethinking has led to major changes in how central banks operate, and we are now in an era in which central banks in many countries throughout the world have had notable success - keeping inflation low, while their economies experience rapid economic growth. In this lecture, I outline what we think we have learned about how central banks should be set up to conduct monetary policy and then apply these lessons to see if there is room for institutional improvement in the way the Federal Reserve operates. The lecture begins by discussing seven guiding principles for central banks and then uses these principles to outline what the role of central banks should be. This framework is then used to see how the institutional features of the Fed measures up. I will take the view that despite the Fed's extraordinarily successful performance in recent years, we should not be complacent. Changes in the way the Fed is set up to conduct its business may be needed to help ensure that the Fed continues to be as successful in the future. II. Guiding Principles for Central Banks Recent theorizing in monetary economics suggests seven basic principles that can serve as useful guides for central banks to help them achieve successful outcomes in their conduct of monetary policy: 1) price stability provides substantial benefits, 2) fiscal policy should be aligned with monetary policy, 3) time inconsistency is a serious problem to be avoided, 4) monetary policy should be forward looking, 5) accountability is a basic principle of democracy, 6) monetary policy should be concerned about output as well as price fluctuations, and 7) the most serious economic downturns are associated with financial instability. We look at each of these principles in turn
1.PriceStabilityProvides SubstantialBenefitsto theEconomy.In recentyears a growing consensus has emerged that price stability -- a low and stable inflationrate --provides substantial benefits to the economy.Price stability preventsoverinvestment in the financial sector, which in a high inflation environment expand toprofitably act as a middleman to help individuals and businesses escape some of thecosts of inflation.1 Price stability lowers the uncertainty about relative prices and thefuture price level, making it easier for firms and individuals to make appropriatedecisions, thereby increasing economic efficiency? Price stability also lowers thedistortionsfrom the interaction ofthetax system and inflation.3All of these benefits of price stability suggest that low and stable inflation canincrease the level of resources productively employed in the economy,and might evenhelp increase the rate of economic growth. While time-series studies of individualcountries and cross-national comparisons of growth rates are not in total agreement,there is a consensus that inflation is detrimental to economic growth, particularly wheninflation is at high levels.4 Therefore, both theory and evidence suggest that monetarypolicy should focus on promoting price stability.2.Align Fiscal Policy with Monetary Policy.One lesson from the"unpleasantmonetarist arithmetic"discussed in Sargent and Wallace (1981)and therecent literatureon fiscal theories ofthepricelevel (Woodford,1994 and1995)is that irresponsiblefiscalpolicymay makeitmoredifficult for themonetary authorities to pursue price stability.Large government deficits may put pressure on the monetary authorities to monetizethe debt, thereby producing rapid money growth and inflation. Restraining the fiscalauthorities from engaging in excessive deficit financing thus aligns fiscal policy withmonetary policy and makes it easier for the monetary authorities to keep inflationundercontrol'For example, see English (1996).2E.g., see Briault (1995),E.g., see Fischer (1994) and Feldstein (1997).tSee the survey in Anderson and Gruen (1995)2
2 1. Price Stability Provides Substantial Benefits to the Economy. In recent years a growing consensus has emerged that price stability - a low and stable inflation rate - provides substantial benefits to the economy. Price stability prevents overinvestment in the financial sector, which in a high inflation environment expand to profitably act as a middleman to help individuals and businesses escape some of the costs of inflation.1 Price stability lowers the uncertainty about relative prices and the future price level, making it easier for firms and individuals to make appropriate decisions, thereby increasing economic efficiency.2 Price stability also lowers the distortions from the interaction of the tax system and inflation.3 All of these benefits of price stability suggest that low and stable inflation can increase the level of resources productively employed in the economy, and might even help increase the rate of economic growth. While time-series studies of individual countries and cross-national comparisons of growth rates are not in total agreement, there is a consensus that inflation is detrimental to economic growth, particularly when inflation is at high levels.4 Therefore, both theory and evidence suggest that monetary policy should focus on promoting price stability. 2. Align Fiscal Policy with Monetary Policy. One lesson from the "unpleasant monetarist arithmetic" discussed in Sargent and Wallace (1981) and the recent literature on fiscal theories of the price level (Woodford, 1994 and 1995) is that irresponsible fiscal policy may make it more difficult for the monetary authorities to pursue price stability. Large government deficits may put pressure on the monetary authorities to monetize the debt, thereby producing rapid money growth and inflation. Restraining the fiscal authorities from engaging in excessive deficit financing thus aligns fiscal policy with monetary policy and makes it easier for the monetary authorities to keep inflation under control. 1 For example, see English (1996). 2E.g., see Briault (1995). 3E.g., see Fischer (1994) and Feldstein (1997). 4 See the survey in Anderson and Gruen (1995)
3.Time Inconsistency is a Serious Problem to be Avoided. One of the keyproblems facing monetary policymakers is the time-inconsistency problem described byCalvo (1978), Kydland and Prescott (1978) and Barro and Gordon (1983). The time-inconsistency problem arises because there are incentives for a policymaker to try toexploit the short-run tradeoff between employment and inflation to pursue short-runemployment objectives, even though the result ispoor long-run outcomes.Expansionary monetary policy will produce higher growth and employment in theshort-run and so policymakers will be tempted to pursue this policy even though it willnot produce higher growth and employment in the long-run because economic agentsadjust their wage and price expectations upward to reflect the expansionary policy.Unfortunately,however, expansionary monetary policywill lead tohigherinflation inthelong-run, with its negative consequencesfortheeconomy.McCallum (1995) points out that the time-inconsistency problem by itself doesnot imply thata central bank will pursue expansionary monetary policy whichleads toinflation. Simply by recognizing the problem that forward-looking expectations in thewage- and price-setting process creates for a strategy of pursuing expansionarymonetary policy, central banks can decide not to play that game.From my first-handexperience as a central banker, I can testify that central bankers are very aware of thetime-inconsistency problem and are indeed extremely adverse to falling into a timeinconsistency trap.However, even if central bankers recognize the problem, there stillwill bepressures onthecentral bank to pursueoverly expansionarymonetarypolicybypoliticians. Thus overly expansionary monetary policy and inflation may result, so thatthe time-inconsistency problem remains. The time-inconsistency problem is just shiftedback one step;its source is not in the central bank, but rather resides in the politicalprocess.Thetime-inconsistencyliteraturepoints outbothwhytherewill bepressuresoncentral banks to pursue overly expansionary monetary policy and why central bankswhose commitment to price stability is in doubt are more likely to experience higherinflation. In order to prevent high inflation and the pursuit of a suboptimal monetarypolicy,monetary policy institutions need to be designed in order to avoid the time-inconsistencytrap.4. Monetary Policy Should Be Forward Looking. The existence of long lags3
3 3. Time Inconsistency is a Serious Problem to be Avoided. One of the key problems facing monetary policymakers is the time-inconsistency problem described by Calvo (1978), Kydland and Prescott (1978) and Barro and Gordon (1983). The timeinconsistency problem arises because there are incentives for a policymaker to try to exploit the short-run tradeoff between employment and inflation to pursue short-run employment objectives, even though the result is poor long-run outcomes. Expansionary monetary policy will produce higher growth and employment in the short-run and so policymakers will be tempted to pursue this policy even though it will not produce higher growth and employment in the long-run because economic agents adjust their wage and price expectations upward to reflect the expansionary policy. Unfortunately, however, expansionary monetary policy will lead to higher inflation in the long-run, with its negative consequences for the economy. McCallum (1995) points out that the time-inconsistency problem by itself does not imply that a central bank will pursue expansionary monetary policy which leads to inflation. Simply by recognizing the problem that forward-looking expectations in the wage- and price-setting process creates for a strategy of pursuing expansionary monetary policy, central banks can decide not to play that game. From my first-hand experience as a central banker, I can testify that central bankers are very aware of the time-inconsistency problem and are indeed extremely adverse to falling into a timeinconsistency trap. However, even if central bankers recognize the problem, there still will be pressures on the central bank to pursue overly expansionary monetary policy by politicians. Thus overly expansionary monetary policy and inflation may result, so that the time-inconsistency problem remains. The time-inconsistency problem is just shifted back one step; its source is not in the central bank, but rather resides in the political process. The time-inconsistency literature points out both why there will be pressures on central banks to pursue overly expansionary monetary policy and why central banks whose commitment to price stability is in doubt are more likely to experience higher inflation. In order to prevent high inflation and the pursuit of a suboptimal monetary policy, monetary policy institutions need to be designed in order to avoid the timeinconsistency trap. 4. Monetary Policy Should Be Forward Looking. The existence of long lags
from monetary policy actions to their intended effects on output and inflation suggeststhat monetary policy should be forward looking. If policymakers wait until undesirableoutcomes on inflation and output fluctuations actually arise, their policy actions arelikely to be counterproductive. For example, by waiting until inflation has alreadyappeared before tighteningmonetary policy,themonetary authorities will betoo late;inflation expectationswill alreadybeembedded intothewageand price-settingprocess,creating an inflation momentum that will be hard to contain. Once the inflation processhas gotten rolling, the process of stopping it will be slower and costlier.Similarly, bywaiting until the economy is already in recession, expansionary policy may kick in wellafter the economy has recovered, thus promoting unnecessary output fluctuations andpossibleinflation.To avoid these problems, monetary authorities must behave in a forward-lookingfashion and act preemptively.For example, if it takes twoyears for monetary policy tohavea significant effect on inflation, then even if inflation is quiescent currently but withan unchanged stance of monetary policy policymakers forecast inflation to rise in twoyears time, then they must act today to head offthe inflationary surge.5.Policymakers Should be Accountable. A basic principle of democracy is thatpublic should have the right to control the actions of the government: in other and morefamous words,"thegovernment should beof the people,bythe people and forthepeople." Thus the public in a democracy must have the capability to "throw the bumsout" or punish incompetent policymakers through other methods in order to controltheir actions. If policymakers cannot beremoved from office or punished in some otherway, this basic principle of democracy is violated.In a democracy, governmentpolicymakers needtobeheld accountabletothepublic.A second reason why accountability of policymakers is important is that it helpsto promote efficiency in government. Making policymakers subject to punishmentmakes it more likely that incompetent policymakers will be replaced by competentpolicymakers and creates better incentives forpolicymakers todo their jobs well.Knowing that they are subject to punishment when performance is poor, policymakerswill strive to get policy right. If policymakers are able to avoid accountability, thentheir incentives to do a good job drop appreciably, making poor policy outcomes morelikely.4
4 from monetary policy actions to their intended effects on output and inflation suggests that monetary policy should be forward looking. If policymakers wait until undesirable outcomes on inflation and output fluctuations actually arise, their policy actions are likely to be counterproductive. For example, by waiting until inflation has already appeared before tightening monetary policy, the monetary authorities will be too late; inflation expectations will already be embedded into the wage and price-setting process, creating an inflation momentum that will be hard to contain. Once the inflation process has gotten rolling, the process of stopping it will be slower and costlier. Similarly, by waiting until the economy is already in recession, expansionary policy may kick in well after the economy has recovered, thus promoting unnecessary output fluctuations and possible inflation. To avoid these problems, monetary authorities must behave in a forward-looking fashion and act preemptively. For example, if it takes two years for monetary policy to have a significant effect on inflation, then even if inflation is quiescent currently but with an unchanged stance of monetary policy policymakers forecast inflation to rise in two years time, then they must act today to head off the inflationary surge. 5. Policymakers Should be Accountable. A basic principle of democracy is that public should have the right to control the actions of the government: in other and more famous words, "the government should be of the people, by the people and for the people." Thus the public in a democracy must have the capability to "throw the bums out" or punish incompetent policymakers through other methods in order to control their actions. If policymakers cannot be removed from office or punished in some other way, this basic principle of democracy is violated. In a democracy, government policymakers need to be held accountable to the public. A second reason why accountability of policymakers is important is that it helps to promote efficiency in government. Making policymakers subject to punishment makes it more likely that incompetent policymakers will be replaced by competent policymakers and creates better incentives for policymakers to do their jobs well. Knowing that they are subject to punishment when performance is poor, policymakers will strive to get policy right. If policymakers are able to avoid accountability, then their incentives to do a good job drop appreciably, making poor policy outcomes more likely