Short-sighted Monetary Policy: A Winning Horse or a Scapegoat?

The Fed and the ECB are by now like the Pythia of the Oracle of Delphi: they speak little, and poorly. They must always be interpreted, with all of the related unknowns. It’s an opportunistic strategy, that increases the risk of stagflation.

To understand why, let’s set some ground rules. We’ll start from the fact that both central banks want to fight inflation, and bring interest rates onto a path in which the remuneration of assets, both real and financial, and thus interest rates, is compatible with price growth of 2%, by 2024.

To be clearer, the starting assumption means basing monetary policy strategy on four pillars. The first pillar is that in a long-term horizon there exists a level of equilibrium for returns on real and financial assets, that is called the natural rate. Each central bank has an estimate of the natural rate. Given an inflation goal – that is in fact 2% for both the Fed and the ECB – if we sum that goal and the natural rate, we obtain the neutral rate. The name neutral rate derives from the fact that it corresponds to an equilibrium level of interest rates, such that the central bank is not required to do anything, so to say. Monetary policy need be neither expansionary nor contractionary; conduct must be passive, or neutral, as the name says. 

The second pillar, moving to the horizon that is relevant for monetary policy, that of the medium term – two years in our case – is that a central bank’s strategy can be passive or active. The central bank’s conduct is passive when the rate is neutral, and becomes active when inflation is higher or lower than the target. In the first case, the central bank will have to implement a contractionary monetary policy; in the second, an expansionary one. The reactiveness of the central bank to deviations in inflation from the target measures its aversion to inflation. 

The third pillar is given by the fact that the action of the central bank, defining the nominal rate, and given inflation expectations, determines the expected real rate. The expected real rate is crucial in determining economic growth, because investment and debt decisions depend on it. Thus, the phases of monetary policy are identified by the difference between the expected real rate and the natural rate, or the rate gap. From time to time, monetary policy will be contractionary, neutral, or expansionary if the rate gap is positive, null, or negative, respectively.

The fourth and last pillar is that inflation expectations depend on what the central bank does, and above all what it says. To paraphrase Nanni Moretti, today central bankers’ words are increasingly important. And to cite Nobel Prize Winner Ben Bernanke, “today monetary policy is 98% talk and 2% action.” 

The four pillars have a fundamental consequence: the trend of inflation in the medium term will depend on two factors, that intersect with and condition each other: the degree of contraction of monetary policy, measured by the rate gap; and the trend of expectations, that in turn is measurable with the expectation gap. The expectation gap is given by the difference between expectations of inflation and the inflation target; the higher the gap, the more the expectations are defined as unmoored, that is, their trend is not consistent with the inflation target. The expectation gap is considered an index of the central bank’s credibility: the broader the gap, the less credible the central bank.

If inflation expectations also depend on the actions and words of the central banks, the more general hypothesis is that expectations depend on two effects: the Ulysses effect and the Delphi, or Pythia effect. The Ulysses effect is when families, businesses, and markets believe completely in the central bank, and do not interpret what it does and says. The Delphi effect is the opposite, when central banks are not credible and/or not comprehensible, such that expectations are based on interpretations. 

A crucial question arises here: how credible are central banks today? It should be recalled that the credibility of central banks may have been damaged in the past year and a half, due to the systematic error in inflation forecasts. If the error in the forecasts is reflected in a wrong rate gap, monetary policy becomes too expansionary, for too much time. The excess inflation we have seen so far can also be attributed to the central banks. But the past is past. What counts now, for the future, is what the Fed and the ECB do and say from now on. The central banks have two strategies at their disposal: the cold shower or gradualism.

The cold shower is based on action: since after the inflation flare-up the rate gap is likely to be negative, it must be closed immediately, implementing a monetary squeeze. The squeeze will continue until the cooling of the economy allows rates to return to the neutral level. Monetary contraction and expectations should interact rapidly and radically: closing the rate gap should avoid the opening of an expectation gap. Hawks usually like the cold shower strategy. The risk is that the so-called cost of the monetary squeeze – the probability of a recession, multiplied by how costly the recession will be in terms of income and employment – is very high.

Gradualism is based on talk: the Fed and the ECB should announce the anticipated process of monetary contraction – how the rate gap should evolve – and then act accordingly. Thus, the central bank’s action becomes a compass for expectations, reducing the risk of the expectation gap. The path announced can be calibrated based on new data as it gradually becomes available. Doves like gradualism more, because the unknown of the recession cost is reduced. The risk here is all for the central bank, that assumes the responsibility of being the compass. Yet this is not new at all. It is what the central banks, Fed and ECB included, have done in the past decade. All of the empirical results agree: the policy of announcements has been effective.

But the Fed and the ECB have chosen a third way, that of a short-sighted monetary policy: decisions are made month by month. It is Pythia in action. Is it a cold shower? We don’t know, we will let the markets interpret it and make bets. Is it gradualism? We don’t know, because the fundamental component of gradualism – the announcement – is lacking. The result? If the trend of inflation, and the risk of recession, depends on the interaction between the degree of contraction of monetary policy and expectations, the final effect of the short-sighted policy is absolutely unpredictable.

Who benefits? Central banks certainly assume fewer risks. Economic analysis of bureaucracy, but also behavioral economics, tells us that the defense of power, and/or psychology, counts: I can be a hawk or a dove, but being an opportunist – a pigeon – is convenient. So everyone be quiet, hawks and doves.

To learn more : 

• Choi J., Doh T., Foerster A., Martinez Z., 2022, Monetary Policy Stance is Tighter than Federal Funds Rate, Federal Reserve Bank of San Francisco, Economic Letter, n. 30.
• Favaretto, F., Masciandaro, D., 2016, Doves, Hawks and Pigeons: Behavioral Monetary Policy and Interest Rate Inertia, Journal of Financial Stability, 27, 50-58.
• Hofmann B., Xia D., 2022, Quantitative Forward Guidance Through Interest Rate Projections, SUERF Policy Brief, n.480.
• Reis, R., 2022, What Can Keep Euro Area Inflation High? Economic Policy Panel, 20-21 October, mimeo.
• Walsh, C.E., 2022, Inflation Surges and Monetary Policy, mimeo.

Donato Masciandaro is a Professor of Political Economy at the Bocconi University, where he holds the Intesa Sanpaolo Chair in Economics of Financial Regulation. Since 1989 he has written for the newspaper il Sole 24 Ore. Since 2005, he has contributed to Economia & Management drawing on and developing his comments and analysis published in that economic-financial daily.