Rewriting the Monetary-Policy Script
Many central bankers, intoxicated by rigid neo-Keynesian models of the effects of interest rates on demand and inflation, are ignoring a major lesson from decades of experimentation: the impact of monetary policy cannot be predicted with a high degree of certainty or accuracy. To manage risk, flexibility is key.
MUNICH – How long will major central banks blindly rely on rigid rules to control inflation and stimulate growth? Given the clear benefits of nimble monetary policy, central bankers need to open their eyes to the possibilities that flexibility affords.
The rule of thumb for monetary policymakers has long been that if inflation is below official target ranges, short-term interest rates should be set at a level that spurs spending and investment. This approach has meant that once interest rates reach or approach zero, central banks have little choice but to activate large asset-purchase programs that are supposed to stimulate demand. When circumstances call for it, policymakers default to the predetermined scripts of neo-Keynesian economic models.
But in too many cases, those scripts have led us astray, because they assume that monetary policy has a measurable and foreseeable impact on demand and inflation. There is plenty of reason to question this assumption.