Academic journal article Federal Reserve Bank of St. Louis Review

Targeting versus Instrument Rules for Monetary Policy

Academic journal article Federal Reserve Bank of St. Louis Review

Targeting versus Instrument Rules for Monetary Policy

Article excerpt

Svensson (2003) argues strongly that specific targeting rules--first-order optimality conditions for a specific objective function and model--are normatively superior to instrument rules for the conduct of monetary policy. That argument is based largely on four main objections to the latter, plus a claim concerning the relative interest-instrument variability entailed by the two approaches. The present paper considers the four objections in turn and advances arguments that contradict all of them. Then, in the paper's analytical sections, it is demonstrated that the variability claim is incorrect, for a neo-canonical model and also for a variant with one-period-ahead plans used by Svensson, providing that the same decisionmaking errors are relevant under the two alternative approaches. Arguments relating to general targeting rules and actual central bank practice are also included.

1 INTRODUCTION

In the recent literature on monetary policy analysis, several writers have emphasized the distinction between instrument rules--i.e., formulae for setting controllable instrument variables in response to current conditions--and targeting rules, as proposed by Svensson (1997, 1999). (1) In a major contribution, Svensson (2003) has presented a sophisticated and comprehensive case for the use of targeting rules, arguing that "monetary-policy practice is better discussed in terms of targeting rules than instrument rules" (2003, p. 429). (2) The superiority of targeting rules is, moreover, claimed to pertain to both normative and positive perspectives (pp. 428-30). Svensson's paper is rich in both analytical and practical content and provides insights that can be usefully pondered by all students of monetary policy analysis.

It is our belief, nevertheless, that the paper seriously overstates the relative attractiveness of targeting rules, from both normative and positive perspectives, and describes inaccurately the properties of instrument rules. The purpose of the present paper is to develop this argument. As a major part of our argument, we study in detail one concrete and important claim of Svensson's regarding interest rate variability induced by instrument rules with strong feedback. In the wide variety of cases considered, we find all results to be inconsistent with the claim.

The outline of the present paper is as follows. Section 2 presents explanations of the basic concepts and an introduction to the issues. Section 3 then takes up, and disputes, four particular criticisms of instrument rules that are central to the argument in Svensson (2003), after which Section 4 does the same for two additional criticisms. In Sections 5 and 6, the paper turns to the precise analytical claim mentioned above and develops results in a number of settings that show it to be incorrect. Finally, Section 7 provides a brief recapitulation.

2 BASIC IDEAS AND TERMINOLOGY

What is the distinction between instrument and targeting rules? A rule of the former type refers, quite simply, to some formula prescribing settings for the monetary policymaker's instrument as a function of currently observed variables. Well-known examples include the Taylor rule (1993), several interest rate rules studied by Henderson and McKibbin (1993a,b), and the activist monetary base rules of McCallum (1988) and Meltzer (1987). Precisely which variables are observable is, of course, a matter that can be debated in practical analyses, but is one on which the analyst has to take some explicit position. Note that expectations (based on current information) of present or future variables may be among the variables that the instrument in the rule responds to. (3)

The definition of targeting rules is somewhat more complex. There has been some evolution since Svensson's (1997, 1999) introduction of the concept, (4) but his current terminology recognizes both general and specific variants. Basically, a general targeting rule is the specification of a central bank objective function, (5) whereas a specific targeting rule is an optimality condition implied by an objective function together with a specified model of the economy (pp. …

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