Surprise policy announcements by central banks can have damaging consequences, according to new research by Irfan Qureshi to be presented at the Royal Economic Society''s 2015 annual conference. The study looks at the possible implications of gradual changes in the US inflation target by comparing the costs and benefits of this policy action through its effect on output and employment. The findings indicate that:
• It costs almost four times more in terms of lost output when a policy change is implemented by surprise changes in the interest rate.
• When the implicit inflation target is changed gradually, firms and households have time to adjust to the new target by adjusting their wages and prices accordingly, which means that less output and worker hours are lost.
• On the flipside, if such an action is volatile (and unannounced), it may have large and negative implications for inflation, employment and interest rates.
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Do central banks change their behaviour over time? After all, a central bank is run by people, who in turn have preferences over particular macroeconomic variables. To be precise, the behaviour of the central bank can be summarised by a simple monetary policy rule in which central bankers assign certain preferences to their objectives such as inflation and output around explicit or implicit targets.
In the United States, after the retirement of Ben Bernanke and before the appointment of the new Federal Reserve chairman, there was concern about the behavioural inclinations of the new chairman. One of the main questions was related to their preferences; would the new chairman attach a high weight to achieving their inflation and unemployment objectives?
In a similar vein, most of the literature focuses on an inflation target as a fixed policy objective in these policy rules, and similar to other monetary policy objectives, preferences for the implicit inflation target may change over time. This study looks at the consequences and policy implications of this behaviour.
Traditionally, a monetary policy rule of the type discussed above is decomposed into systematic movements, such as preferences and objectives, which are under the control of the central bank, and unsystematic variations. The inability of agents to differentiate between actual policy changes and unsystematic changes may have negative welfare impacts on economic agents.
By allowing the systematic part of the monetary rule to evolve over time – through a time varying inflation target – the research argues that this may improve identification of unsystematic monetary policy from systematic changes. This modification makes it possible to explain almost half of the exogenous variations in interest rates.
The study analyses the impact of this result in light of the Great Moderation in the United States – the dramatic fall in inflation, output and interest rate volatility post-1984 – and shows that this modification explains almost a third of the total variability in inflation and interest rate volatility during that period.
The finding suggests a new channel to analyse how a volatile monetary policy rule may be responsible for macroeconomic instability, and therefore reduce economic welfare through high and volatile inflation.
Since the time varying inflation target is shown to have important quantitative implications, the study looks at this modification in light of policy actions of the central bank. Therefore, this finding may contribute to the debate on raising the inflation target to avoid hitting the zero lower bound (ZLB).
The researcher studies the possible implications of gradual changes in the inflation target by comparing the cost and benefit of this policy action through its effect on output and employment. The findings suggest that it costs almost four times more in terms of lost output when a policy change is implemented by surprise changes in the interest rate.
When the implicit inflation target is changed gradually, economic agents have time to adjust to a new inflation target by adjusting their wages and prices accordingly, therefore less output and worker hours are lost. On the flipside, if such an action is volatile (and unannounced), it may have large and negative implications for inflation, employment, and interest rates.
