Ebook Monetary Policy with Changing Financial and Labor-Market Fundamentals
A strong consensus has emerged, both among economists and central bankers, in favor of conducting monetary policy with a target for a short-term interest rate. The last vestiges of interest in monetary aggregates has vanished from monetary policy-making in the past decade. Today, central bankers around the world establish an interest rate target for the daily management of their portfolios, and change that target as needed to achieve the goals of policy, generally some combination of the exchange rate, the rate of inflation, and the level of economic activity.
In the United States—whose monetary policy is the focus of this paper—the international value of the dollar has a rather smaller role than does the exchange rate in other countries or in the Euro block. The most influential commentator on U.S. monetary policy, John Taylor, has proposed a policy rule that considers only inflation and aggregate activity. He describes the current policy of the Federal Reserve as placing a weight of 1.5 on recent inflation and 0.5 on the percentage departure of real GDP from potential when it sets the target for the federal funds interest rate (Taylor [1993]). Moreover, he sees this policy rule as roughly optimal.
In practice, however, the setting of the interest-rate target seems much more challenging than following the simple Taylor rule. First, as recent U.S. experience has amply confirmed, there appear to be important shifts in the natural unemployment rate and potential GDP over time. Today, the U.S. economy is humming along with 3.9 percent unemployment, a level that all experts thought was deeply inflationary only a few years ago. The Taylor rule should be adjusted for shifts of this type. Measuring the shift has proven to be a major challenge. This paper documents the importance of the shift both in data on unemployment and in a direct examination of the optimal monetary policy rule in a simple empirical framework.
Second, there is a concern that economic activity may surge to levels that are inescapably inflationary. The main recent focus of this concern is that high levels of wealth from the strong stock market will result in consumption demand that will propel the economy into inflationary territory. The relationship of this concern to the Taylor rule has been less clear than questions about potential GDP or the natural unemployment rate. I formulate the issue in the following way: Financial conditions enter the Taylor rule just as directly as potential GDP. The constant in the Taylor rule is the equilibrium real interest rate. Any increase in that equilibrium rate should translate into an equal increase in the interest-rate target. Observers who state that there is no cause for an increase in the interest rate until there is a threat of increased inflation are simply mistaken. Rather, any change in the equilibrium real interest rate should raise the target even with inflation unchanged.
Most of the recent discussion of this issue in the United States has considered a channel described as stock market values to consumption to aggregate activity. In that setting, the equilibrium real interest rate rises because of the increase in the demand for goods and services. In terms of the simple IS-LM model, a higher stock market shifts the IS curve outward and causes higher output and a higher interest rate.
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