Macro Perspectives

The Art of Monetary Policy

Art may now be making a comeback in monetary policy, and partly at the expense of science.

Economics is a science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world. It is compelled to be this, because, unlike the typical natural science, the material to which it is applied is, in too many respects, not homogeneous through time.

— John Maynard Keynes, letter to Roy Harrod, 4 July 1938

Almost 20 years ago, Richard Clarida, Jordi Galí and Mark Gertler published a seminal article in the Journal of Economic Literature entitled “The Science of Monetary Policy: A New Keynesian Perspective,” which quickly became required reading for students of monetary economics and aspiring central bankers alike. The trio summarized the theoretical macroeconomic framework for analyzing inflation targeting and interest rate rules that has been utilized by many central banks around the world over the past few decades.

While monetary policy making had traditionally been seen as mostly an art (sometimes a dark one) that was typically practiced by bankers, the scientific approach became more and more influential, culminating in the rise of leading academic economists like Ben Bernanke and Janet Yellen to the helm of the Federal Reserve. However, like it or not, art may now be making a comeback in monetary policy, and partly at the expense of science. Here’s why.

First, in the standard New Keynesian model, the only instrument of monetary policy is the nominal interest rate. Quantities such as the central bank balance sheet, credit or monetary aggregates play no role. Since the global financial crisis, however, central banks routinely use their balance sheet as an additional instrument of monetary policy (e.g., by purchasing vast sums of sovereign or other bonds, a practice termed quantitative easing or QE), which is difficult to incorporate into the standard model. Hence Ben Bernanke famously quipped in 2014 that the problem with QE is it works in practice, but it doesn’t work in theory.”

While there is some agreement among economists that QE worked, serious questions remain about exactly how. With economists unsure about how to explain and model QE, central bankers using the balance sheet thus require some artistic skills in calibrating the right dose of quantitative easing or tightening.

Second, a key ingredient of the New Keynesian model is the relationship between unemployment and inflation, the so-called Phillips curve. It posits that falling unemployment leads to rising inflation. However, empirically this link has become weaker recently (the Phillips curve has flattened) for reasons that economists keep debating. Whatever the main reason may be – lower productivity growth, demographic changes, hidden labor market slack or, as Alan Krueger argued in his lunch talk at the recent Jackson Hole conference, rising monopsony power by employers due to rising firm concentration and collusion that reduces workers’ wage bargaining power – a flat Phillips curve hugely complicates a central bank’s ability to steer inflation.

Third, in the New Keynesian model, changes in nominal interest rates have real effects because prices are assumed to be “sticky,” i.e., they change only slowly. However, as a paper by Alberto Cavallo also presented at Jackson Hole shows, the advent of Amazon and, more broadly, e-commerce has led to more frequent price adjustments by retailers, making prices less sticky. In the logic of the New Keynesian model, more flexible prices would reduce the impact of a given change in nominal interest rates on the real economy.

Fourth, Cavallo’s paper also argues that the growth of e-commerce has increased the pass-through of changes of cost factors, such as fuel prices and exchange rates, to consumer prices as retailers are quicker to pass on cost shocks into online prices. Central banks may therefore have a weaker grip on inflation, especially in the short run, as it will tend to be driven more by short-run forces outside their control. This means that central banks either have to adjust interest rates more frequently and more aggressively if they want to control inflation over shorter time horizons, or they will have to accept larger and more frequent deviations from their inflation targets, which may harm their credibility.

Fifth, Fed chair Jerome Powell in his introductory remarks at Jackson Hole went to great lengths to emphasize the large uncertainty about the true levels of the “stars” that have been guiding central banks and are key variables in the standard model. These are the neutral interest rate (r-star), the natural rate of unemployment (u-star) and the growth rate of potential output (y-star). In Powell’s own words, “Guiding policy by the stars in practice … has been quite challenging of late because our best assessments of the location of the stars have been changing significantly.”

Re-examining the framework

The bottom line is that the advent of quantitative easing and important structural changes in the economy have made the traditional science of monetary policy somewhat less useful for monetary policymakers. Some of the challenges noted above, e.g., the uncertainty about the exact location of the “stars,” relate to parameter uncertainty but don’t put the framework in question. Yet other challenges, such as prices becoming less sticky or the Phillips curve becoming entirely flat, question the usefulness of the model framework itself.

To be sure, the science of monetary policy is evolving and actively looking for ways to adapt the mainstream model or come up with new frameworks. In the meantime, however, policymakers will likely (have to) rely less on models and simple policy rules and become more “artistic” in reading and responding to economic and financial signals. Put differently, monetary policy is likely to become both less “boring” (remember Mervyn King’s quip?) and, unless you have a deep understanding of art, more unpredictable – yet another reason to brace yourself for more volatility!

A version of this material was circulated in Sunday Signposts on 26 August 2018.

The Author

Joachim Fels

Global Economic Advisor

View Profile

Latest Insights

Related

Disclosures

London
PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

Dublin
PIMCO Europe GmbH Irish Branch,
PIMCO Global Advisors (Ireland)
Limited
3rd Floor, Harcourt Building 57B Harcourt Street
Dublin D02 F721, Ireland
+353 (0) 1592 2000

Munich
PIMCO Europe GmbH
Seidlstraße 24-24a
80335 Munich, Germany
+49 (0) 89 26209 6000

Milan
PIMCO Europe GmbH - Italy
Corso Matteotti 8
20121 Milan, Italy
+39 02 9475 5400

Zurich
PIMCO (Schweiz) GmbH
Brandschenkestrasse 41
8002 Zurich, Switzerland
Tel: + 41 44 512 49 10

PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Irish Branch (Company No. 909462), PIMCO Europe GmbH UK Branch (Company No. BR022803) and PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Italian Branch, Irish Branch, UK Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; (3) UK Branch: the Financial Conduct Authority; and (4) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication.| PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2) . The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser.

All investments contain risk and may lose value. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2018, PIMCO.

Global Advisory Board
XDismiss Next Article
PIMCO