Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 2 - Monetary Policy Framework : International Experience

Objectives of Monetary Policy - Intermediate Targets

While price stability and output stabilisation are final objectives of monetary policy, they are not directly under the control of central banks. Monetary authorities, therefore, typically set "intermediate targets" in terms of macroeconomic variables, which bear a stable relationship with the overall objectives of monetary policy. The choice of the intermediate target is critical. A macro variable, if too narrow, such as base money, may be fully within the central bank purview but could be incapable of providing an effective conduit to the overall objectives. At the same time, a macro variable, if too broad, such as nominal income, may not be amenable to central bank control. Besides, the selection of intermediate targets is also conditional on the channels of transmission of monetary policy. With the growing complexities of macroeconomic relationships, a number of central banks have, however, chosen to abandon single intermediate targets and directly target inflation. In the following paragraphs, a brief discussion is undertaken of the various intermediate targets of monetary policy.

Although central banks such as the US Federal Reserve did traditionally set credit targets, the concept of a formal intermediate target really came into its own with the monetarist emphasis on money targeting in the 1960s. In the 1970s, evidence of a stable relationship between money, output and prices, coming as it did in a climate of worsening inflation, prompted central banks to give more weight to money in their policy deliberations. A commitment to rules was thought to anchor inflation expectations. A number of central banks, starting with Switzerland and including Germany, Japan, the UK and the USA, adopted money targets in the mid-1970s.

At the heart of the monetary targeting framework is the assumption that money demand is stable. This, in turn, requires that income velocity of money is reasonably stable and predictable. Velocity of money is essentially the number of times the stock of money changes hands to finance transactions. In the long-run, the velocity of money generally follows a U-curve pattern, determined by a range of institutional factors. Velocity declines in the initial stages of economic development reflecting monetisation of the economy as a result of the spread of the banking network. It subsequently rises in the advanced stages, as the parallel sophistication in financial markets reduces the need for financial intermediation by the banking system. The 1970s and 1980s witnessed a spate of financial innovations such as money market mutual funds. The concomitant process of disintermediation began to impart volatility to the behaviour of monetary aggregates and the velocity of money, especially in market-based economies, such as the USA. The volatility & inelasticity of money undermined the efficacy of monetary targeting. Their central banks, therefore, gradually started de-emphasising the role of monetary aggregates in the conduct of monetary policy.

In contrast, bank-based economies, especially in continental Europe such as France, Germany and Switzerland were able to persevere with some version of monetary targeting as money demand continued to be relatively stable. This was due to the fact that financial innovations in these economies led to substitution towards instruments that could be considered as part of money and, therefore, could be taken care of by simply redefining monetary aggregates. Real money gaps (the gap between current real balances and long-run equilibrium real balances) appear to have substantial predictive power for future inflation in the euro area. Econometric results suggest that money demand continues to be stable in the euro area even after the adoption of the euro although the impact of wealth may have become more pronounced (ECB, 2004). In view of this, central banks in some advanced economies continue to lay stress on monetary aggregates in the process of monetary policy formulation (Box III.1).

Following the adoption of monetary targets in advanced economies, developing countries began to adopt money targeting in the 1980s. A money target was deemed particularly appropriate in their case because of the dominance of the quantum-based credit channel of monetary policy transmission, especially as the absence of developed financial markets alongside administered interest rates virtually ruled out the interest rate channel of monetary policy transmission. Given the under-developed financial markets, price signals were considered to be less reliable in these economies. Rapidly shifting levels of interest rates in an unstable inflation environment were believed to produce a noisy and distorted echo of the stance of monetary policy.

Money targets were also seen as the most effective way to discipline Government finances. They continue to be in vogue even now as money demand continues to remain stable in many developing countries, which are yet to witness large-scale financial liberalisation. Several studies on large EMEs, which have adopted bank-based systems and which have also seen a fair degree of financial innovations, also testify to a stable relationship between money demand, inflation and real economic activity. At the same time, in cases of relatively sophisticated market-based systems, such as the ASEAN economies, money demand tended to turn unstable very quickly under the impact of financial market development and liberalisation.

The breakdown of the money-targeting framework naturally set off a search for alternate intermediate targets. Following Poole (1970), it is believed that central banks can modulate aggregate demand by targeting interest rates in case of instability of money demand. An increasing number of central banks in advanced economies as well as EMEs emphasise the role of short-term interest rates as operating targets of monetary policy or as an instrument variable or as a key information variable. The reaction function of central banks that have adopted interest rates as instruments of monetary policy can be encapsulated in the Taylor rule. A Taylor-rule relates short-term policy interest rates to deviations of inflation and output from their target and potential, respectively. In particular, the Taylor principle requires that nominal interest rates should increase more than one-to-one with an increase in the inflation rate so that real interest rates also rise in order to dampen aggregate demand and bring inflation back to target. The use of interest rates as operating targets has revived interest in the natural rate of interest . While useful in theory, the concept of a natural/neutral/equilibrium rate of interest is difficult to implement in practice (see Module: 6 for a detailed discussion).

EMEs have witnessed significant structural changes and financial innovations during the 1990s. With financial liberalisation, central banks in these economies are progressively moving away from quantitative targets towards using interest rates as instruments in the conduct of monetary policy. However, in the absence of fully developed and integrated financial markets, central banks in these economies still need to rely upon quantitative targets in their conduct of monetary policy. In particular, due to high information and transaction costs, credit markets continue to be regulated in order to direct the flow of credit to productive sectors of the economy. Thus, even as central banks in developing economies make use of short-term interest rates, monetary policy continues to aim at influencing aggregate demand by altering the quantity of availability of credit along with changes in the price of credit. Thus, quantitative targets, although diminishing in importance, still play an important role in the transmission mechanism.

Finally, a number of central banks have switched away from any sort of intermediate targets. These inflation targeting (IT) central banks - at present, more than 20 - directly target inflation, attracted by the primary advantage of the transparency of an explicit commitment to an inflation rate target. As noted earlier, both IT and non-IT central banks were able to reduce inflation. The jury is still out on the extent to which inflation targeting policies have actually contributed to the reduction in inflation that has occurred. The adoption of IT in emerging market economies is, in particular, complicated by the lack of strong fiscal, financial and monetary institutions.

In sum, although there is widespread acceptance of price stability as a key monetary policy objective, the underlying monetary frameworks vary a great deal (Table 3). At one end of the spectrum, the overwhelming majority of central banks, which follow a broad price stability objective and even put out inflation forecasts, have not formally adopted inflation targeting. At the centre, stand the inflation targeters, with a formal inflation anchor. At the other extreme, are a few central banks, especially in developed countries, such as the European Central Bank, which follow implicit price stability but do not formally declare themselves as inflation targeting. Ultimately, it is the existence of explicit quantitative targets - exchange rates, money growth rates or inflation targets - and their achievement rather than any particular target which is associated with a better inflation performance.

There is now an emerging consensus that the growing complexities of monetary management require that the process of monetary policy formulation be guided by the information content available from a number of macroeconomic indicators rather than the reliance on a single intermediate anchor. Central bankers operate in an environment of high uncertainty regarding the functioning of the economy as well as its prevailing state and the future course of developments. These uncertainties have increased further since the 1990s due to ongoing structural changes and financial globalisation. In such a complex environment, a single model or a limited set of indicators is not a sufficient guide for monetary policy. Instead, an encompassing and integrated set of data is required. Thus, most central banks now monitor a number of macroeconomic indicators which have a bearing on the ultimate objective of price stability.