Monetary policy debate

Group 3 Bernanke Camp:

CORBEHEM FANNY
DAO NGOC THU
DEBRUILLE AGATHE

What Taylor criticised: the monetary policy that the FED pursued during the pre-crisis period did not
base on the suggestion of the Taylor rule ( which was applied successfully the periods before 2000s).
The main critic is that the interest rate should have not been pushed to the low level during the period
2001 2007 and raised slowly, which could have saved the economy from the crisis in 2008. Taylor
said that the Fed interest rates were lower when compared to the rates that should be according to
Taylor rules

What Bernanke responded to this critic of low interest rate is

followed:
(From the speech Monetary policy and the housing bubble by Ben S Bernanke, January
2010)

Were low rates appropriate? Bernanke discusses Taylor rules in details (excellent explanation)
and says Taylors version is based on current inflation/output levels. As monetary policy
works with a lag we should instead use forecast values. When we use forecast values, we get
the fed funds rate closer to what Fed actually did. So, given the macro conditions, the low rates
are justified.
Did low rates lead to housing bubble? He points to a recent research model. As per the model,
house prices increased much higher with low fed funds rate and other fundamentals. He then
looks at whether innovations in housing finance that promised low interest rates now and
adjustments later. He says again monetary policy tightening would have led to a marginal hike
in interest rates and would have not kept people away from the housing sector.
He also looks at international evidence on link between monetary policy and housing sector:
Let me turn now to the international evidence on the link between monetary policy and house
price appreciation. Some cross-country evidence on this link is shown in slide 9.
As Slide 9 shows, the relationship between the stance of monetary policy and house price
appreciation across countries is quite weak. For example, 11 of the 20 countries in the sample
had both tighter monetary policies, relative to the standard Taylor-rule prescriptions, and
greater house price appreciation than the United States. The overall relationship between house
prices and monetary policy, shown by the solid line, has the expected slope (tighter policy is
associated with somewhat slower house price appreciation). However, the relationship is
statistically insignificant and economically weak; moreover, monetary policy differences explain
only about 5 percent of the variability in house price appreciation across countries.

Figure 1 Slide 9

He adds what explains the rise in housing prices is not monetary policy but capital inflows:
In previous remarks I have pointed out that capital inflows from emerging markets to industrial
countries can help to explain asset price appreciation and low long-term real interest rates in
the countries receiving the fundsthe so-called global savings glut hypothesis (Bernanke, 2005,
2007).
Also as in the previous slide, house price appreciation is shown on the vertical axis of the figure.
The downward slope of the relationship is as expectedcountries in which current accounts
worsened and capital inflows rose (shown in the left half of the figure) had greater house price
appreciation over this period. However, in contrast to the previous slide, the relationship is
highly significant, both statistically and economically, and about 31percent of the variability in
house price appreciation across countries is explained.

So where does the blame lie? Weak financial regulation and supervision as Bernanke has
always specified in his previous speeches.
I noted earlier that the most important source of lower initial monthly payments, which allowed
more people to enter the housing market and bid for properties, was not the general level of shortterm interest rates, but the increasing use of more exotic types of mortgages and the associated
decline of underwriting standards. That conclusion suggests that the best response to the housing
bubble would have been regulatory, not monetary. Moreover, regulators, supervisors, and the
private sector could have more effectively addressed building risk concentrations and
inadequate risk-management practices without necessarily having had to make a judgment about
the sustainability of house price increases.

Further discussion of Ben Bernanke on the Taylor rule and his

suggestion of constrained discretion as a way how policy is set:
Bernanke has been criticized the idea of setting a package of policy based on long term and unchanged
rules. To be more specific, he seems against the interest rate setting process suggested by Taylor, also
known as the Taylor rule. His main arguments and supported arguments from other economists,
policy makers and journalists are below:

From the article The Taylor Rule: A benchmark for monetary policy? by Ben Bernanke
on www.brookingsedu.com

The rule can be modified when changing the input factors, here are the output gap and the
inflation rate

To check the robustness of John's claims, I calculated the policy predictions of a Taylor-type
rule that was modified in two ways that seem sensible to me. First, I changed the measure of
inflation used in the Taylor rule. In his 1993 paper, John chose to measure inflation using a price
index known as the GDP deflator. However, when talking about inflation, economists (and the
FOMC) usually mean the rate of increase of consumer prices. The GDP deflator incorporates not
only the prices of domestically produced consumer goods and services, but also other categories
of prices, such as the prices of capital goods and the imputed prices of government spending (on
defense, for example). It also excludes the prices of imports, including imported consumer
goods.
Bernanke also emphasizing the change in coefficients. The choice of coefficients for the equations
are important and it is not easy and realistic to set unfixed coefficients.
Second, it's important to consider how policy responds, quantitatively, to changes in inflation
and the output gap. The original Taylor rule assumes that the funds rate responds by a halfpercentage point to a one percentage point change in either inflation or the output gap (that is,
the coefficient on both variables is 0.5). In principle, the relative weights on the output gap and
inflation should depend on, among other things, the extent to which policymakers are willing to
accept greater variability in inflation in exchange for greater stability in output. Some research
subsequent to John's original paper, summarized by Taylor (1999), found a case for allowing a
larger response of the funds rate to the output gap (specifically, a coefficient of 1.0 rather than
0.5). In my experience, the FOMC paid closer attention to variants of the Taylor rule that
include the higher output gap coefficient. For example, Janet Yellen has suggested that the
FOMC's "balanced approach" in responding to inflation and unemployment is more consistent
with a coefficient on the output gap of 1.0, rather than 0.5. In my modified Taylor rule I assumed
the higher coefficient on the output gap.
Bens opinion is that if policies can be set only by such a rule (or a mathematic equation), the
process of making policies seems simple and automatic. In fact, there are plenty of things that are
not easy to define, to collect data and to calculate. The mistake in measuring the input factors can
have impacts on the result, which, in turn, affects the efficiency of decisions. Moreover, in
exceptional period such as during the 2008 crisis, we observed that the rule is not applied. There
is always a possibility that the exceptional situation may come again, and that the fixed rule like
Taylor rule will not hold.
The simplicity of the Taylor rule disguises the complexity of the underlying judgments that
FOMC members must continually make if they are to make good policy decisions. Here are just
a few examples (not an exhaustive list):
The Taylor rule assumes that policymakers know, and can agree on, the size of the output gap. In
fact, as current debates about the amount of slack in the labor market attest, measuring the output
gap is very difficult and FOMC members typically have different judgments. It would be neither
feasible nor desirable to try to force the FOMC to agree on the size of the output gap at a point
in time.
The Taylor rule also assumes that the equilibrium federal funds rate (the rate when inflation is
at target and the output gap is zero) is fixed, at 2 percent in real terms (or about 4 percent in
nominal terms). In principle, if that equilibrium rate were to change, then Taylor rule projections
would have to be adjusted. As noted in footnote 2, both FOMC participants and the markets
apparently see the equilibrium funds rate as lower than standard Taylor rules assume. But
again, there is plenty of disagreement, and forcing the FOMC to agree on one value would risk
closing off important debates.
The Taylor rule provides no guidance about what to do when the predicted rate is negative, as
has been the case for almost the entire period since the crisis.

Jerome Creel and Paul Hubert, Constrained discretion in Sweden, Research in Economics,
March 2012, Vol. 66, Issue 1, pp. 33-44
The concept of constrained discretion that he (Ben Bernanke) promoted required the adoption of
a full inflation-targeting regime. This kind of institutional setting hence required the adoption of an
official inflation target and available forecasts on the economy that help anchor private expectations,
and communication, transparency and accountability of the central bank to the public at large to help
explain possible deviations from the inflation target.

Jennifer Smith - University of Warwick, ECONOMIC POLICY IN THE UK

MACROECONOMIC POLICY
The support for the policy framework constrained discretion by Bernanke focuses on the belief that
it is flexible and at the same time constrained enough to help setting the monetary policy, with the
help of the inflation targeting method. It provides conditions for policy makers to prepare in advance
for any economic situation. This discretion makes it possible to pursuit the inflation forecasting which
Bernanke et al. believe that inflation targeting is best characterized as a framework, not as a rule.
They believe the rules-discretion distinction to be too sharp to capture the reality of monetary policymaking in practice: there is no such thing in practice as an absolute rule for monetary policy
(p.5). They believe that inflation targeting has provided a framework that is clearly articulated
and in which the general objectives and tactics of the policy-makers although not their specific
actions are committed to in advance (p.6). This they term constrained discretion. By imposing
a conceptual structure and its inherent discipline on the central bank, but without eliminating all
flexibility, inflation targeting combines some of the advantages traditionally ascribed to rules with
those ascribed to discretion (p.6).
At a technical level, inflation targeting does not provide simple, mechanical operating instructions
to the central bank. Rather inflation targeting requires the central bank to use structural and
judgmental models of the economy, in conjunction with whatever information it deems relevant, to
pursue its price-stability objective. In other words, inflation targeting is very much a look at
everything strategy, albeit one with a focussed goal. (p.22). No specific set of variables nor specific
model are prescribed by inflation targeting.
Mervyn King (2004), in a response to a speech/paper by Alan Greenspan (Fed Chairman) on
monetary policy, made some comments that clarify how he (and the Bank) view inflation targeting.
In his 1997 paper, King had argued that any sensible regime could be written as an inflation target
plus a response to supply shocks. In other words, monetary policy should aim to maintain the optimal
inflation rate, and should decide how quickly to get back to target after shocks. The constrained
discretion that characterises such a regime allows a central bank to get (close) to the optimal
state contingent rule (King (2004), p.5).
Explaining the phrase constrained discretion, he argues that the discretion in responding to shocks
afforded by inflation targeting allows the central bank to adapt its strategy to new information
the great attraction of an inflation target is that it is a framework that does not have to be changed
each time we learn about aspects of the economy such as the velocity of money or the underlying rate
of productivity growth, as was the case in the past with frameworks based on targets for money
aggregates or nominal GDP growth. It is a framework designed for a world of learning

Rules vs discretion in macroprudential policies

Mario Quagliariello, Massimo Libertucci, 24 February 2010
A rule-based approach, however, would require a very high degree of confidence that the
predefined variables would always correctly perform as intended, without noisy signals. This is
difficult to achieve for inflation targeting, much more so for identifying financial instability.
Indeed, the adoption of a purely rule-based framework focusing on a macroeconomic indicator (as in
either a simple rule such as Friedmans or an inflation target framework) has faced several drawbacks
including, for instance, the inability to face unexpected structural changes. A discretionary
framework successfully addresses this issue, by allowing policymakers to actively learn from
observing the interaction of relevant stakeholders.

Svensson (2004, Asset prices and ECB monetary policy,

www.princeton.edu/~svensson/papers/EP404.pdf, pp1-2
So, the principles of good monetary policy are simple: perform flexible inflation targeting, which
means aiming to stabilize inflation around an explicit low positive numerical inflation target with
some weight also on stabilizing the real economy, which can be expressed more precisely as
stabilizing the output gap, that is, stabilizing output around a measure of potential output. Because
of the lags between monetary-policy actions and the effect on inflation and output, the best way to do
this is to look forward and perform forecast targeting. This means setting the central banks
instrument rate (more precisely, to choose an instrument-rate plan, a path for the current and future
instrument rate) such that the corresponding inflation and output gap forecasts look good, which
in turn means that the inflation and output gap forecasts approach the inflation target and zero,
respectively, normally some 1-3 years ahead (but, more precisely, the whole future forecast paths
should look good, not just the forecast at some fixed horizon).
.