Monetary policy frameworks away from the ELB

Summary

Focus

In 2020 and 2021, the Federal Reserve, the European Central Bank and the Bank of Canada completed comprehensive reviews of their monetary policy frameworks. These reviews were largely motivated by the need to provide sufficient monetary stimulus to avoid or exit effective lower bound (ELB) periods, against the backdrop of a flat Phillips curve. Soon after their adoption, these revised frameworks were vigorously tested by the post-pandemic inflation surge. How did the frameworks perform during the inflation surge? And are they fit for the challenges ahead?

Contribution

We shed light on these questions using several approaches. First, we examine the anchoring of inflation expectations in major advanced economies during the inflation surge, as well as before and after the framework reviews. Second, we use a medium-scale dynamic stochastic general equilibrium (DSGE) model to assess the performance of alternative monetary policy rules during the inflation surge. Third, we compare the macroeconomic stabilisation properties of alternative rules in a hypothetical post-inflation surge world depending on the slope of the Phillips curve and the level of r*.

Findings

We find that inflation expectations remained well anchored in advanced economies during the inflation surge, irrespective of differences in monetary policy frameworks. Notably, there is no indication that the 2020/21 reviews weakened the anchoring of inflation expectations. We also document that an aggressive inflation targeting (IT) rule would have contained the inflation surge very modestly relative to an average inflation targeting (AIT) rule, and at the cost of larger negative output gaps. Looking ahead, we illustrate that (i) the benefits of a dual mandate relative to a single mandate increase when the Phillips curve is flatter; (ii) AIT tends to stabilise inflation and interest rates relative to IT but at the cost of higher output volatility; and (iii) AIT is more robust than IT to uncertainty regarding r*.

Abstract

We evaluate the performance of alternative monetary policy rules during and after the post-pandemic inflation surge. We first document that inflation expectations remained well anchored in advanced economies irrespective of differences in monetary policy frameworks. We then show that an aggressive inflation targeting (IT) rule would have contained the inflation surge very modestly relative to a benchmark average inflation targeting (AIT) rule, at the cost of larger negative output gaps. Finally, looking at the post inflation surge period, we compare monetary policy frameworks with respect to potential changes in the slope of the Phillips curve or changes in the level of r*. We illustrate that the benefits of a dual mandate relative to a single mandate increase when the Phillips curve is flatter; that AIT rules tend to stabilize inflation and interest rates relative to IT rules but at the cost of higher output volatility; and that AIT is more robust than IT to a possible misperception of r*.

JEL classification: E31, E42, E52, E58

Keywords: monetary policy frameworks, inflation targeting, average inflation targeting, dual mandate