Following the recent financial crisis, major central banks have introduced several types of unconventional monetary policy measures, including liquidity and credit facilities, asset purchases and forward guidance. To date, these measures appear to have been successful. They restored market functioning, facilitated the transmission of monetary policy and supported economic activity. They have potential costs, however, including challenges related to the greatly expanded balance sheets of central banks and the eventual exit from these measures, as well as the vulnerabilities that can arise from prolonged monetary accommodation.
Topics: Central bank research; Financial markets; International topics; Monetary policy frameworkWe study the cyclical properties of sales, regular price changes and average prices paid by consumers (“effective” prices) using data on prices and quantities sold for numerous retailers across many U.S. metropolitan areas.
Topics: Inflation and prices; Monetary policy framework; Transmission of monetary policyThe financial crisis of 2007-09 and the subsequent extended period of historically low real interest rates have revived the question of whether economic agents are willing to take on more risk when interest rates remain low for a prolonged time period. This increased appetite for risk, which causes economic agents to search for investment assets and strategies that generate higher investment returns, has been called the risk-taking channel of monetary policy. Recent academic research on banks suggests that lending policies in times of low interest rates can be consistent with the existence of a risk-taking channel of monetary policy in Europe, South America, the United States and Canada. Specifically, studies find that the terms of loans to risky borrowers become less stringent in periods of low interest rates. This risk-taking channel may amplify the effects of traditional transmission mechanisms, resulting in the creation of excessive credit.
Topics: Financial Institutions; Monetary policy frameworkWe explore the macroeconomic effects of a compression in the long-term bond yield spread within the context of the Great Recession of 2007-2009 via a time-varying parameter structural VAR model.
Topics: Econometric and statistical methods; Interest rates; Monetary policy framework; Transmission of monetary policyWe examine the relative ability of simple inflation targeting (IT) and price level targeting (PLT) monetary policy rules to minimize both inflation variability and business cycle fluctuations in Canada for shocks that have important consequences for global commodity prices.
Topics: Economic models; Inflation and prices; International topics; Monetary policy frameworkIn the years since the 2006 renewal of Canada’s inflation-control agreement, monetary policy regimes have faced significant shocks, including the global economic and financial crisis. This article reviews the recent experience with inflation targeting, including the debate about the appropriate role of monetary policy in maintaining financial stability. In the aftermath of the crisis, both the United States and Japan adopted numerical inflation objectives. Overall, a flexible inflation-targeting framework, supported by central bank independence, accountability and clear communications, remains a robust monetary policy regime for promoting economic welfare.
Topics: Credibility; Financial stability; Inflation targets; Monetary policy frameworkIn an investigation of banks’ loan pricing policies in the United States over the past two decades, this study finds supporting evidence for the bank risk-taking channel of monetary policy. We show that banks charge lower spreads when they lend to riskier borrowers relative to the spreads they charge on loans to safer borrowers in periods of low short-term rates compared to periods of high short-term rates.
Topics: Financial Institutions; Monetary policy frameworkThis paper examines the interaction between monetary policy and macroprudential policy and whether policy makers should respond to financial imbalances. To address this issue, we build a dynamic general equilibrium model that features financial market frictions and financial shocks as well as standard macroeconomic shocks.
Topics: Economic models; Financial markets; Financial stability; Monetary policy frameworkThis paper assesses the merits of countercyclical bank balance sheet regulation for the stabilization of financial and economic cycles and examines its interaction with monetary policy.
Topics: Economic models; Financial Institutions; Financial system regulation and policies; Monetary policy framework; Transmission of monetary policyIn this paper, we use an economics decision-making experiment to test a key assumption underpinning the efficacy of price-level targeting relative to inflation targeting for business cycle stabilization and mitigating the effects of the zero lower bound on nominal interest rates.
Topics: Monetary policy frameworkThis article describes the Bank of Canada’s version of the Global Economy Model structured to incorporate an active banking system that features an interbank market and cross-border lending. After describing the new model, the authors use it to examine the responses of selected U.S. and Canadian macroeconomic variables to a “credit crunch” in the United States and also to study the impact of changes in the regulatory limits to bank leverage in Canada. They also discuss the relative merits of a monetary policy framework based on inflation targeting and one based on price-level targeting in the presence of shocks to the U.S. and Canadian banking sectors.
Topics: Economic models; Financial Institutions; Financial system regulation and policies; Monetary policy frameworkAs part of their policy response to the financial crisis of 2007–09, central banks introduced numerous unprecedented monetary policy measures to provide monetary easing. This article defines and documents these measures, focusing on central bank asset purchases and their impact on central bank balance sheets. It then discusses the challenges of identifying the effects of these measures and explores possible exit strategies. The potential costs of these policies are also analyzed, as well as the broader implications for monetary policy frameworks.
Topics: Central bank research; Financial markets; International topics; Monetary policy frameworkBuilding on an earlier Review article, the authors critically reassess the premise that exchange rate pass-through (ERPT) has declined in light of recent studies of the issue in the context of a dynamic stochastic general-equilibrium framework. This recent work helps to emphasize the pitfalls of previous studies based on reduced-form models. For example, ERPT to import prices may be larger than the estimated parameters of reduced-form models would indicate. On the other hand, the authors find fairly convincing evidence that measured short-run ERPT to consumer prices has declined because of a shift to more credible monetary policy regimes. In this case, the findings from DSGE models confirm the results from reduced-form models. Insights from recent studies of ERPT based on microdata are examined, and policy implications are discussed.
Topics: Economic models; Exchange rates; Inflation and prices; Monetary policy frameworkThe recent financial crisis and global economic slowdown have renewed interest in monetary policy options when the policy interest rate is at or near zero. This article examines how different monetary policy frameworks might help to lower the risk and economic cost of such a scenario. The authors present an analytical framework for examining monetary policy at the zero bound, particularly the role of inflation expectations in lowering the real interest rate. The influence of inflation targeting on inflation expectations and how forward guidance or a conditional commitment to future monetary policy may augment traditional monetary policy actions are also examined. The authors then examine recent research on the efficacy of price-level targeting (PLT) at the zero bound, which demonstrates that a credible PLT framework can reduce the likelihood of hitting the zero bound and lessen the economic costs of remaining there. PLT is also found to offer stabilization advantages in "normal" times, although these hinge critically on the degree of credibility of the PLT regime.
Topics: Inflation targets; Monetary policy frameworkStephen Murchison reviews the findings of recent Bank of Canada research on the relative merits of inflation targeting and price-level targeting (PLT) for a small open economy, such as Canada's, that is susceptible to large and persistent terms-of-trade shocks. These shocks have been identified as a potential threat to PLT, since central bankers have to induce large fluctuations in output if they are to unwind all pass-through to the price level. The balance of evidence suggests that PLT and inflation targeting, implemented through simple policy rules, are fairly similar in their ability to stabilize inflation, the output gap, and interest rates. The author shows that this conclusion is robust to the inclusion of several types of relative-price shocks, including shocks to the terms of trade. Research on the optimal price index under PLT is also discussed, and Murchison concludes that, conditional on adopting PLT, the overall CPI would represent close to an ideal index to target.
Topics: Central bank research; Inflation targets; Monetary policy frameworkThe authors examine whether monetary policy should and could do more to lean against financial imbalances (such as those associated with asset-price bubbles or unsustainable credit expansion) as they are building up, or whether its role should be limited to cleaning up the economic consequences as the imbalances unwind. Effective supervision and regulation are the first line of defence against financial imbalances. An important question is whether they should be the only one. The authors argue that the case for monetary policy to lean against financial imbalances depends on the sources of the shock or market failure and on the nature of the other regulatory instruments available. To the extent that financial imbalances are specific to a sector or market and that a well-targeted prudential tool is available, monetary policy might play a minor role in leaning against the imbalances. However, if the imbalances in a specific market can spill over to the entire economy and/or if the prudential tool is broad based, monetary policy is more likely to have a role to play. In such a case, there may be a need to coordinate the use of the two policy instruments.
Topics: Financial system regulation and policies; Monetary policy frameworkAlthough the current inflation-targeting regime has served Canadians well, sound public policy demands the continuous exploration of possible improvements in the monetary policy framework. At the Bank of Canada's 2009 conference, distinguished scholars from academic institutions and monetary authorities around the world discussed two central questions regarding the design of monetary policy: (i) Would an inflation target lower than 2 per cent lead to better economic outcomes? And (ii) What are the costs and benefits of price-level targeting relative to inflation targeting? The conference agenda included work that shed new light on these two questions. Other work explored the causes of zero-bound episodes and the efficacy of potential policies.
Topics: Central bank research; Inflation targets; Monetary policy frameworkInflation-targeting central banks around the world often state their inflation objectives with regard to the consumer price index (CPI). Yet the literature on optimal monetary policy based on models with nominal rigidities and more than one sector suggests that CPI inflation is not always the best choice from a social welfare perspective.
Topics: Inflation and prices; Inflation targets; Inflation: costs and benefits; Monetary policy framework; Monetary policy implementationThis article examines recent research on the influence of various forms of economic uncertainty on the performance of different classes of monetary policy rules: from simple rules to fully optimal monetary policy under commitment. The authors explain why uncertainty matters in the design of monetary policy rules and provide quantitative examples from the recent literature. They also present results for several policy rules in ToTEM, the Bank of Canada's main model for projection and analysis, including rules that respond to price level, rather than to inflation.
Topics: Econometric and statistical methods; Economic models; Monetary policy framework; Uncertainty and monetary policyVarious papers have suggested that Price-Level targeting is a welfare improving policy relative to Inflation targeting. From a practical standpoint, this raises an important yet unanswered question: What is the optimal price index to target?
Topics: Monetary policy frameworkThere appears to be a disconnect between the importance of the zero bound on nominal interest rates in the real-world and predictions from quantitative DSGE models. Recent economic events have reinforced the relevance of the zero bound for monetary policy whereas quantitative models suggest that the zero bound does not constrain (optimal) monetary policy.
Topics: Monetary policy frameworkUsing the Bank of Canada's main projection and policy-analysis model, ToTEM, this paper measures the welfare gains of switching from inflation targeting to price-level targeting under imperfect credibility. Following the policy change, private agents assign a probability to the event that the policy-maker will revert to inflation-targeting next period.
Topics: Monetary policy framework; Monetary policy implementationWe study a model with repeated moral hazard where financial contracts are not fully indexed to inflation because nominal prices are observed with delay as in Jovanovic & Ueda (1997). More constrained firms sign contracts that are less indexed to the nominal price and, as a result, their investment is more sensitive to nominal price [...]
Topics: Economic models; Financial markets; Monetary policy framework; Transmission of monetary policyIn 2006, the Bank initiated a research program exploring two alternatives to the current inflation-targeting framework: (i) lowering the inflation target and (ii) shifting to a price-level target. This article discusses progress to date, places the Bank's findings in the context of a broader literature, and identifies avenues for future research. Earlier literature and recent studies at the Bank suggest that an inflation target below two per cent is likely preferable to the status quo, though it is unclear how much lower policy-makers should aim and also how much Canadians would benefit from a shift. With regard to the price-level target, evidence is more mixed, with need for study concerning (i) the target's influence on contracting behaviour and inflation expectations; (ii) strategies for ensuring credibility in the commitment to price-level targeting; and (iii) the Canadian economy's vulnerability to shocks that the literature identifies as particularly detrimental to the target's performance.
Topics: Central bank research; Economic models; Inflation and prices; Inflation targets; Inflation: costs and benefits; Monetary policy framework
