Credibility of an Inflation-Targeting Regime

Along with moral suasion, persuasion to get consumers to buy, and open market operations, the buying and selling of government securities in financial markets, the easy money policy can only help supply-side economics in it's route to ending a recession and gaining economic stability. All of these policies combined, supply-side, easy money policy, open market operation, and moral persuasion, can all have an impact on important issues. Some of these issues are employment, international trade, and inflation.

Another version of this theory maintains that the optimal rate of inflation is the actual rate. For example, if an economy currently has a 6-percent inflation rate, 6 percent is the optimal rate. The inflation itself does not matter and in the long run the Phillips curve is vertical but, lowering the equilibrium rate of inflation results in lower output. It is costly to lower inflation because economic agents have inflation expectations, which are difficult to adjust. A period of higher unemployment results from getting agents to lower expectations and this implies lost output. Since there is no benefit to reducing inflation, the implication is evident - the Fed should stick with the actual rate.

The Federal Reserve should utilize a balanced approach to monetary policy. The current state of the economy—undershot employment and inflation goals—presents no conflict in achieving a neutral state. In fact any action that supports employment growth also moves inflation up toward our target (Evan

In the late 2007, early 2008 the United States and the world was hit with the most serious economic downturn since The Great Depression in 1929. During this time the Federal Reserve played a huge role in assuring that it would not turn into the second Great Depression. In this paper, we will be discussing what the Federal Reserve did during this time including a discussion of our nation’s three main economic goals which are GDP, employment, and inflation. My goal is to describe the historic monetary and fiscal policy efforts undertaken by the U.S. Government and Federal Reserve including both the traditional and non-traditional measures to ease credit markers and stimulate the economy.

The last five years have shown that traditional monetary policies predicated on interest rate management by the Federal Reserve no longer deliver the economic growth they were once believed to. Keynesian economics has proved to not be as effective as once thought, which has led to the Federal Reserve choose alternative means to stimulate the economy and indirectly manage exchange rates (Hakkio, 1986). The uncertainty over interest rate polices has fortunately not led to increases in inflation, which has typically been the case in the past (Kopcke, 1988). The current economic conditions and the approaches the Federal Research are taking however are cause for concern, and from a personal standpoint many decisions are being evaluated more precisely.

“Just the simplest tweaking of these instruments/“tools” gives The Fed the ability to manipulate the amount of money in the circulation... With this command of the money supply, The Fed is able to affect the macro-economic indicators and in-turn steer the economy away from runaway inflation or a recession (CrashCourse).”

Monetary policy is a more effective lever to reduce unemployment and smooth the business cycle, due to its shorter implementation lag and ability to act in small multiples.

It widely recognized that the monetary policy within a country should be primarily concerned with the pursuit of price stability. However, it is still not clear how this objective can be achieved most effectively. This debate remains unsettled, but an increasing number of countries have adopted inflation targeting as their monetary policy framework. (Dr E J van der Merwe, 2002) This topic of Inflation targeting is a subject which immediately conjures different perceptions from different people. Many feel that low inflation should be a main aim of monetary policy, while others (such as trade union activists) believe that a higher growth rate to stimulate jobs should be the main concern.

Unfortunately, the increased importance of policy language has increased the scope for misinterpretation, as well as ambiguity. A hawkish view of future Fed policy can be taken from the decision to abolish the Evans Rule, named after the President of the Chicago Fed. This formed the bedrock of the policy thresholds. The Evans Rule was designed to tell markets that policy rate settings would not change until certain economic conditions were satisfied. Consistent with its dual mandate, the FOMC announced policy thresholds covering both unemployment and inflation. The unemployment threshold (6.5%) always dominated the inflation equivalent (2.5%), even though the Fed never had an explicit long-term target rate for unemployment. In contrast, the Fed has a long-term inflation target of 2%. Under the Evans Rule, given that the threshold was above the target, there was scope for inflation to overshoot. The abolition of the Evans Rule and the policy thresholds now means that the 2% inflation target effectively becomes the ceiling. The importance of inflation in setting the policy rate has increased: low interest rates will only prevail if inflation remains below 2%. This potentially marks an important shift in the Fed’s thinking on the trade-off between unemployment and inflation. Previously, Fed Chair Yellen believed the costs of overshooting the inflation target were lower than those associated with elevated unemployment.

The Federal Reserve went into action in response to the 2008 recession by rapidly reducing interest rates with the hopes of encouraging economic growth. The federal funds target rate was decreased to between zero and .25 percent. The results of the rate changes caused what is called “zero bound”, this reduced the effectiveness of monetary policy with the near non-existence of interest rates.

Monetary policy, ‘The government’s policy relating to the money supply, bank interest rates, and borrowing’ (Collin: 130), is another tool available to the government to control inflation. Figure 4 shows, that by increasing the interest rate (r), from r1 to r2, the supply of money (ms) is reduced from Q1

At the same time, monetary policy authorities must always bear in mind that monetary policy can only create favourable conditions for growth temporarily. The central bank tries to focus on a goal which is achievable with the resources at its disposal, namely ensuring price stability. Price stability is not an end in itself. By ensuring price stability, monetary policy creates conditions favourable for companies and households, and thereby makes an important contribution to stable economic

After the Global Financial crises of 2008, UK economy was severely affected and had dipped into recession. Thus, this led to a fall in market confidence, lower GDP growth and higher levels of unemployment. In order to boost the economy, expansionary monetary policies were adopted by the Bank of England. Interest Rates were cut to historic low of 0.5%. However, the economy was still not out of recession and conventional monetary policies failed to work even when interest rates were near zero bound. So, the central bank used unconventional monetary tools such as Quantitative Easing i.e. buying government bonds and injecting money into the economy. This policy was accompanied by a rather new policy known as the Forward Guidance in August,

Monetary policy involves manipulating the interest rate charged by the central bank for lending money to the banking system in an economy, which influences greatly a vast number of macroeconomic variables. In the UK, the government set the policy targets, but the Bank of England and the Monetary Policy Committee (MPC) are given authority and freedom to set interest rates, which is formally once every month. Contractionary monetary policy may be used to reduce price inflation by increasing the interest rate. Because banks have to pay more to borrow from the central bank they will increase the interest rates they charge their own customers for loans to recover the increased cost. Banks will also raise interest rates to encourage people to save more in bank deposit accounts so they can reduce their own borrowing from the central bank. As interest rates rise, consumers may save more and borrow less to spend on goods and services. Firms may also reduce the amount of money they borrow to invest in new equipment. A

The manner in which US Federal & other central banks of advanced countries are shaping their monetary policies in order to avoid another economic downturn, is going to precisely result in that – claimed Mr. Raghuram Rajan, RBI Governor at LBS last week1 (Refer Box-1). The practice of zero-lower-bound interest rates of Fed and ECB in order to fuel industrial growth is unconventional and exposing other markets as well to the macro-economic risks. While saying this, Mr. Rajan also ensures to sound confident on the prospects of India and Indian Banks despite the external influences like these.