Commentary
Although inflation has been falling in most of the advanced economies, the rates haven’t reached the targeted values. All central bankers claim success but don’t know when their rate hikes will successfully control inflation. This uncertainty refers not just to the long-term but to the lack of any forecasting in the lead-up to the next policy meeting. Judged this way, central banks are now employing an entirely discretionary strategy.
I address the outcome goals before discussing whether the current approach is sound.
Firstly, in almost all monetary models, a central bank’s objective is to minimize the volatility of inflation and output. The standard measure for achieving success in monetary policy is the central bank’s ability to carry out this process. The timeframe for minimizing volatility needs to be implemented from the present time and extend toward the horizon. It is also preferable for measures to be adjusted by a discount factor.
Secondly, the objective is to minimize the volatilities of the two variables rather than forcing them both towards specific levels. The specific numerical value of the inflation target is not as important as achieving stability and reducing volatility. However, the presence of a time-dependent trend is relevant, and it is typically removed when considering the business cycle context.
Thirdly, older models suggest that minimizing output volatility can be replaced by minimizing unemployment volatility, as they are inversely related. What is important is to achieve a positive volatility outcome for these variables.
Since inflation and output/unemployment are intrinsically opposite in nature, a lowering of one volatility may raise the volatility of the other. Thus, the objective also involves the inclusion of a subjective weight. Without a loss of generality, it can be assumed that the sum of the two weights equals one. The attached chart shows the weighted sum of volatilities from the U.S. core PCE YoY inflation and unemployment rates (core is used because the central bank cannot tackle any non-core inflation driven by supply shocks). The legend shows the weight on inflation, so unemployment is one minus the weight on inflation.
There are two conclusions. Firstly, the relative weight set on inflation as opposed to unemployment doesn’t matter, as the chart movements produce similar characteristics over time. Secondly, when comparing its performance to the performances of all its predecessors from the last six decades, there is no doubt that the current Fed is doing the worst job ever.
Now returning to the bad side of discretionary policy. Decades of research conclude that a rule-based approach is the preferred choice. It provides better central bank communication, accountability, and credibility, which is essential to contain inflation.
A discretionary plan should only be implemented briefly and under exceptional circumstances like the 2008 tsunami and the 2020 COVID-19.
The abuse of a discretionary policy is even worse than having no policy. Leaving the interest rate decisions to the market is not necessarily bad, as bad discretion magnifies volatility!
