One Economics, One Objective for Monetary Policy

Has the conduct of monetary policy become the routine application of a set of core principles, much like the science of treating a dental cavity? The answer is: “not quite”, according to Stefan Gerlach in his guest lecture at the Bank of Mauritius yesterday. But, he adds, the overriding objective of monetary policy should be the fight against inflation. What do economists agree upon and what do they disagree upon as far as monetary policy is concerned?

There are four main areas of agreement:

1. Inflation is always and everywhere a monetary phenomenon.

2. The public’s expectations of future inflation is crucial in the setting of current wages and prices. A corollary of this is that there is no long-run tradeoff between unemployment and inflation.

3. To anchor expectations, monetary policy has to be both active and to follow a rule. For instance, Taylor’s Rule states that, for monetary policy to stabilise prices, the nominal interest rate must be raised by more than the rise in inflation.

4. The need for monetary policy to be a “technical undertaking outside the realm of politics.” In other words, central banks ought to be independent.

Comparing Singapore and Switzerland, Gerlach finds two important parallels:

(1) Since the 1980’s, both countries have managed to keep inflation at remarkably low levels, as shown in the figure below:

Indeed, between 1992 and 2006, average inflation has been 1.1% and 1.7% in Switzerland and Singapore respectively. Much like Mauritius, these two small open-economies are subject to external shocks (high oil prices, etc). Yet, unlike in Mauritius where the inflation has averaged 6.4% since 1992, policy-makers in Switzerland and Singapore quickly took measures to reduce inflation to lower levels in response to external shocks. Low inflation is highly desirable in small financial centres because “high and unstable inflation creates random wealth transfers between creditors and debtors…since financial centres are characterised by large stocks of assets and liabilities, these effects are likely to be particularly large in them.”

(2) By maintaining low and stable inflation for a very long time, both countries have achieved a level of understanding by the public that the overriding objective of monetary policy is price stability.

There are differences in the two countries’s approaches:

(1) The instrument used for monetary policy is different. In Switzerland, monetary policy consists of affecting short-term interest rates and the exchange rate is left to adjust. In Singapore, on the other hand, policy makers directly impact on the exchange rate and the interest rates adjusts. Base on the Covered-Interest Rate Parity, it would seem that both approaches are functionally equivalent and ought to be equally popular around the world. Yet, Singapore’s approach is rather unusual. A possible reason is that using the exchange rate as an instrument require a lot of discipline to succeed in the fight against inflation. At times when exchange rate has to appreciate to contain inflation, it may be tempting not to do so to avoid hurting exports.

(2) Although in both countries monetary policy is isolated from politics, the Swiss National Bank (SNB) enjoys full independence while the Monetary Authority of Singapore (MAS) is not independent. Again, the Singaporean experience is an unusual one: countries that have been successful in fighting inflation are those that have given independence to their central banks. The figure below (from Mishkin) clearly shows this:

Interestingly, both the SNB and the MAS do not practice the increasingly-popular policy of inflation-targeting. Why? According to Gerlach, these central banks have been so successful in fighting inflation before inflation-targeting became popular that they thought, well, why change a winning team?

So, why has Mauritius been less successful in its fight against inflation? Here is my old but still relevant take on the issue:

The Bank of Mauritius is caught among three conflicting objectives : (1) fight inflation (2) ensure that the Mauritian rupee remains undervalued to boost exports and (3) keep interest low to reduce the interest burden of the biggest borrower of the country, the government. These three objectives are in sharp conflict: in order to fight inflation, it is not possible to also accommodate the deficit of a profilgate government; to keep an undervalued currency, one has to accept higher inflation, etc. In the long-run, however, only one objective of monetary policy ought to prevail, that of fighting inflation. The Lucas critique teaches us that it is not possible to keep consistently low real interest rates: at some stage, nominal interest rates will adjust to account for expected high inflation. It is also generally not possible to sustain an artificial advantage (what an undervalued currency is, in fact) without experiencing rising wages. There is the argument that, at an initial phase of a country’s development, an artificial advantage, such as an undevalued currency, may, by boosting exports, help the country overcome its inefficiencies and ‘create’ comparative advantages. However, Mauritius has been relying on this ‘drug’ for too way long.