Money, Financial Markets, and Monetary Policy
Monetary Policy in the United States, the Euro Area, and Japan
The conduct of monetary policy typically depends on specific economic conditions within a country such as its inflation, its level of production, and its level of employment. It also depends on the mandate of its central bank and the bank’s objectives in terms of price stability, employment, and growth (among other things). For instance, the European Central Bank pursues price stability as its primary goal, while the Federal Reserve System seeks maximum employment, stable prices, and moderate long-term interest rates. The Bank of Japan aims for price stability and for the stability of the payments and settlement system. Thus, in principle, different countries should be expected to run different monetary policies. But when we focus on the United States, the Euro area, and Japan, we see that while monetary policies differ across those countries, some general patterns in their approaches can be identified.
Policy Instruments: Overnight Rates
To achieve their objectives, central banks set overnight interest rates: the federal funds rate in the U.S., the minimum bid rate in the Euro area, and the uncollateralized overnight call rate in Japan. Since 2000, interest rates have followed a somewhat similar pattern in the US and the Euro area: they declined substantially from 2001 to 2004 and gradually increased after 2004 ( U.S.) or 2005 (Euro area). The amplitude of the changes has been higher in the U.S. than in Europe. In contrast, overnight rates in Japan remained close to 0 percent, the minimum that is feasible to achieve, from 2001 to 2006.
Short-term Interest Rates1
By changing overnight rates, a central bank affects interest rates at different maturities, thereby influencing the real economy and prices. For instance, three-month interest rates closely follow overnight rates closely.
To understand changes in short-term interest rates, it helps to look at the simple relationship that links the policy rate to core inflation and output growth. This relationship, which can be estimated with a simple regression (known as the Taylor rule), aims to capture in some crude way how policy reacts to economic conditions.2 While it includes only a few variables, it explains the path of short-term interest rates in the U.S. and the euro area reasonably well.3
The Policy Rate's Estimated Response to a One-Percentage-Point Change in Core Inflation and GDP Growth, 1996-2006
Note that from 1996 to 2006, the estimated response of the monetary policy rate to a change in GDP growth was larger than that of the euro area’s. Such a result is consistent with the Federal Reserve's dual mandate. Note also that a change in core inflation has a much larger effect on policy rates in the euro area and in the U.S. than in Japan. This response—known as the Taylor principle—is considered essential for price stability. The idea is that when inflation increases, the central bank must raise its interest rate high enough to increase the real interest rate and reduce inflationary pressures. If inflation rises one percentage point, for example, the central bank must raise rates by more than one percentage point.
Over the last decade or so, the Bank of Japan has faced a far different situation—deflationary, rather than inflationary pressure—to which the relationship captured by the Taylor rule did not apply. Interest rates varied minimally, hovering near their lower bound of zero.
Inflation over the Past 25 Years
As the regressions above illustrate, inflation is a key explanatory variable of central banks’ behavior. It is remarkable that the three economies under consideration here have experienced a common disinflationary process over the last 25 years. In the U.S. and Europe, inflation has decreased from about 15 percent to about 2 percent–3 percent; in Japan it has decreased from about 8 percent to 0 percent, and even went negative between 2000 and 2004. The phenomenon is the same for core inflation, which excludes food and energy. This convergence from two-digit inflation rates to very low inflation rates reflects the common view that inflation, even at relatively moderate levels, is costly for society.
Inflation since 2000
Over the past seven years, inflation has been stable in the U.S. and Europe. Currently, the average inflation rate is slightly higher in the U.S. (about 2.75 percent) than in the euro area (2 percent). The difference between their core inflation rates (2.19 percent and 1.75 percent, respectively) is smaller. Core (12-month) inflation in the U.S. decreased from about 2.7 percent in January 2001 to a low of 1 percent in November 2003, allowing the Fed to cut its rate from 6.5 percent to 1 percent. U.S. core inflation has rebounded since 2004, reaching almost 3 percent in January 2006. The Fed has responded to this inflationary pressure by raising its rate to 5.25 percent.
Compared to the U.S., the euro area's inflation has been less volatile; the maximum 12-month core inflation rate in the euro area was 2.3 percent in March 2002, and the minimum was 1.3 percent in January 2006. This seems consistent with the fact that the primary objective of monetary policy in Europe is price stability, whereas the Fed has multiple objectives.
Japan’s recent inflation experience is entirely different from that of both the U.S. and Europe. Japan’s core inflation rate has been consistently negative over the last seven years. However, since January 2001 it has increased from about -1 percent to nearly 0 percent. One reason for such inflation rates is low output growth, which the country has suffered since the beginning of the 1990s.
GDP Growth since 2000
As suggested our Taylor rule estimates suggest, monetary authorities also care about output growth. Since 2000, the U.S., the euro area, and Japan have undergone a recession and a recovery. In the U.S., the four-quarter growth rate of GDP declined from 4.8 percent in April 2000 to 0.2 percent in October 2001. In the euro area, the corresponding decline was from 4.6 percent in April 2000 to 0.48 percent in April 2003. Although the recovery was slower in the euro area, both it and the U.S. posted a growth rate of slightly less than 3 percentin July 2006. As we noted earlier, the Fed and the European Central Bank responded to the recession by cutting overnight interest rates and to the recovery by gradually increasing rates. The recession in Japan was much more severe than in the U.S. and Europe, with GDP contracting 4.7 percent from October 2000 to October 2001. Although the country was facing deflationary pressures, the Bank of Japan could not lower interest rates below zero percent. This zero boundary limited the bank's ability to counteract deflationary pressures or to stimulate growth. As a result, Japan’s policy rate does not show a strong response to either inflation or growth in the policy rule.
On the basis of quarterly observations, we regress (using ordinary least squares) the three-month interest rate on 12-month core inflation, the four-quarter GDP growth rate, and the lagged policy interest rate.
There is voluminous literature on estimating monetary policy rules. See Charles T. Carlstrom and Timothy S. Fuerst, "The Taylor Rule: A Guidepost for Monetary Policy,”the Federal Reserve Bank of Cleveland, Economic Commentary (July 2003). The original Taylor rule is evaluated using the output gap, that is, the difference between potential and actual GDP, but we use GDP growth instead.
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