Bloomberg News

Central Bankers Debate Best Criteria for Setting Interest Rates

March 24, 2012

Central bankers at a Federal Reserve conference in Washington rekindled a debate over the best criteria for altering interest rates, pitting simple rules against complex models that estimate growth and inflation.

Lars Svensson, a deputy governor for Sweden’s central bank, said policy makers when setting interest rates should learn from an array of models and indicators and monitor an economy’s changing structure, while pursuing specified goals such as inflation. European Central Bank governing council member Athanasios Orphanides argued for using a price rule when setting interest rates because of the inaccuracy of estimating the gap between real and potential economic growth.

Orphanides noted large errors in forecasting the euro area’s potential growth rate in recent years. “In the euro area, the whole history” of output gap forecasting “has not been very encouraging,” he said.

While persisting for decades, the debate among policy makers over whether to follow basic rules or more flexible approaches has taken on increased urgency as they try to sustain post-crisis economic growth.

The Fed has cut interest rates to near zero and purchased $2.3 trillion of assets in two rounds aimed at cutting an unemployment rate that peaked at 10 percent in 2009 and persists at 8.3 percent. The European Central Bank reduced its interest rate to a record 1 percent and provided euro-area banks with more than $1 trillion of three-year loans in so-called longer-term refinancing operations.

Imprecise Measures

Orphanides warned against setting interest rates according to imprecise measures and said focusing on price stability usually leads to the best economic outcomes. In contrast, the Fed’s current approach relies on assumptions about full employment and the potential growth rates and is increasingly incorporating information about credit and financial conditions.

Orphanides and his co-author, Volker Wieland from the University of Frankfurt, said central banks should have a numeric goal for inflation, and “no similarly fixed target for real economic activity.” They said in their paper, presented at the Fed conference on central banking, that policy makers should communicate their plans clearly and avoid “unnecessary discretion and unpredictability.”

“The ECB’s stability-oriented approach does not put great emphasis on output-gap estimates when policy decisions are made,” Orphanides and Wieland wrote. “One reason for this is the extreme unreliability of real-time estimates of the output gap for the euro area.”

Simple Rule

Svensson described a simple rule focused on an inflation goal as “not the best approach” because it “uses only part” of available information.

“In the real world there is updating, there is learning,” Svensson said. “No central bank follows” a simple policy rule.

Fed Chairman Ben S. Bernanke announced a numeric inflation goal of 2 percent in January and said it is on equal footing with the central bank’s other mandate, full employment. The Federal Open Market Committee in their January announcement noted that the “committee considers a wide range of indicators in making” assessments about the rate of full employment.

Svensson said the Fed had “moved to the forefront, the leading edge of monetary policy” in its adoption of flexible inflation targeting.

The San Francisco Fed’s director of research, Glenn Rudebusch, who also commented on the Orphanides-Wieland paper, indicated that, if anything, policy makers are looking at a broader array of variables to inform monetary policy after the financial crisis of 2008. He also said cautioned against over- reliance on models because that could produce a policy that is “crazy volatile.”

Orphanides said a simple rule focusing on stable prices should be a baseline for central banks, even those that want to incorporate more models and information into how they decide on interest rates.

“If we manage to achieve price stability, then we will be getting economic activity” around an economy’s potential growth rate, he said. “Most of us believe that works.”

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net;

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net


The Good Business Issue
LIMITED-TIME OFFER SUBSCRIBE NOW
 
blog comments powered by Disqus