OECD Economic Outlook, Volume 2020 Issue 2

Issue Note 3. Post-financial-crisis changes to monetary policy frameworks: Driving factors and remaining challenges

Several central banks in advanced economies have embarked on monetary policy reviews in the context of persistently low inflation, interest rates and potential GDP growth in past decades and increasing use of unconventional tools since the global financial crisis. These reviews are welcome as they allow central banks to rethink openly their targets, tools and communication in the context of a changing economic environment. The engagement with the public on these issues can strengthen their legitimacy and credibility.

Recently implemented and discussed changes to monetary policy frameworks, which depend crucially on the inflation expectations channel via committing to achieve higher inflation in the future and “lower for longer” interest rates, give hopes for improving the effectiveness of monetary policy and achieving stable higher inflation. However, as argued in this note, challenges with controlling inflation expectations, their uncertain demand effects and continued structural changes that hold down inflation all point to caution. Thus, future – ideally regular – reviews could focus more on longer-term determinants of inflation.

Monetary policy frameworks and their reviews

Monetary policy frameworks define the legal environment in which the monetary authority operates and provide operational guidance for the conduct of monetary policy. This includes an institutional structure (e.g. a governance mechanism and a decision-making process within the central bank), as well as a set of goals, operational targets, instruments, procedures and communications. Although some differences exist in the way monetary policy is conducted across jurisdictions, monetary policy frameworks have broadly converged across countries in terms of mandates (price stability), operational targets (around a 2% inflation rate over the medium term), and instruments (both conventional and unconventional tools) over the past 20 years (Table 2.2).

Table 2.2. Monetary policy frameworks in selected economies

	Mandate	Operational Targets	Instruments	Press conference and minutes release	Publication of forecasts
US Federal Reserve	Price stability, maximum employment & moderate long-term interest rates	2% inflation target on average, measured by the PCE	Conventional tools QE Forward guidance	Following FOMC meetings (8 times a year), the Federal Reserve holds a press conference and releases minutes	Staff and FOMC’s projections, including interest rate path
European Central Bank	Price stability	Inflation below but close to 2% over the medium term, measured by the HICP	Conventional tools QE Forward guidance Negative interest rate policy	Following Governing Council meetings (every 6 weeks), the ECB holds a press conference and releases accounts of the meetings	Staff’s projections
Bank of England	Price stability	2% inflation target at all times, measured by headline CPI	Conventional tools QE Forward guidance	Following MPC meetings (8 times a year), the BoE holds a press conference and releases minutes	Staff's and MPC’s projections, including interest rate path
Bank of Japan	Price stability	2% inflation target with overshooting commitment, at “the earliest possible time”, measured by CPI (all items less fresh food)	Conventional tools QE Forward guidance Negative interest rate policy Yield curve control	Following MPMs (8 times a year), the BoJ holds a press conference and releases minutes	Policy Board’s projections
Bank of Canada	Price stability	2% inflation target with a band (+/- 1%) over the medium term, measured by headline CPI	Conventional tools QE Forward Guidance	Following policy decisions (8 times a year), the BoC holds a press conference. No minutes are released	Staff’s projections, including interest rate path
Sveriges Riksbank	Price stability	2% inflation target with a band (+/- 1%), within 2 years, measured by the CPIF	Conventional tools QE Forward guidance	Following monetary policy meetings (5 times a year), the Riksbank holds a press conference and releases minutes	Staff’s projections, including interest rate path
Swiss National Bank	Price stability	Inflation range between 0% and 2% over the medium term, measured by headline CPI	Conventional tools QE FX interventions	Following monetary policy assessment (quarterly), the SNB holds a press conference (twice a year). No minutes are released	Staff’s projections

Note: QE refers to quantitative easing measures (asset purchases by central banks); PCE refers to the Personal Consumption Expenditure deflator; CPI is a consumer price index; CPIF is a consumer price index with a fixed interest rate; and HICP is a harmonised index of consumer prices. FOMC refers to the Federal Open Market Committee, MPC to the Monetary Policy Committee and MPMs to monetary policy meetings.

Source: Samarina, A. and N. Apokoritis (2020), “Evolution of Monetary Policy Frameworks in the Post-crisis Environment”, DNB Working Paper, No. 664; Bank for International Settlements (2019), “Monetary Policy Frameworks and Central Bank Market Operations”, MC Compendium; and central bank websites.

In contrast, no standardised approach to reviewing monetary policy frameworks exists. With the exception of the Bank of Canada, which has been conducting reviews every five years,1 most countries have done so on an ad-hoc basis and with varying scope. The number of such ad-hoc reviews, however, has increased significantly over the past few years and some have led to several substantial changes, in particular to the frameworks of the Bank of Japan and the US Federal Reserve (Box 2.1). Other monetary authorities have also recently announced their intentions to conduct thorough reviews in the coming years.2 More generally, central banks have indicated their willingness to make reviews both public and recurrent to improve the transparency and accountability of monetary policy and ensure that monetary policy strategies are adapted to the economic environment, which is a welcome development.

Changes to monetary policy frameworks since the global financial crisis

A combination of deep structural changes and unexpected shocks has challenged the way monetary policy is conducted in many advanced countries. The secular decline in productivity growth and inflation, along with the reduction in neutral interest rates estimates, have significantly increased the risk that policy rates hit the zero lower bound (ZLB). The observed flattening of the Phillips curve, which has complicated the extraction of meaningful signals from labour market outcomes, also suggests that, other things being constant, monetary policy needs to be more aggressive to achieve a given change in inflation, with risks to central banks’ credibility.3 The global financial crisis and the COVID-19 pandemic, both of which prompted very accommodative policy and an enlargement of monetary policy tools, including purchases of public and private assets, forward guidance and negative policy interest rates, further highlighted the limits of conventional monetary policy measures. Both shocks also underscored the importance of financial stability issues when designing monetary policy.

Against this background, major central banks have not waited for formal reviews to amend, implicitly or explicitly, their monetary policy frameworks over the past decade to help reaching their targets (Samarina and Apokoritis, 2020). Although key building blocks (such as governance mechanisms and mandates) have generally been unchanged, tools and communication strategies have been significantly modified. The use of unconventional monetary policy tools, in particular quantitative easing (QE) and forward guidance, has become pervasive. This trend recently culminated in the issuance of a new statement on “Longer-Run Goals and Monetary Policy Strategy” by the US Federal Reserve in August 2020, which ended a review process that started in 2018.4 The new statement formalised many of the changes that had been made, de facto, to the US monetary policy framework to address the challenges posed by the “new normal” (Box 2.1).

Box 2.1. What is new in the US monetary policy framework?

On 27 August, the US Federal Open Market Committee issued a new statement on “Longer-Run Goals and Monetary Policy Strategy”, effectively modifying its monetary policy framework for the first time since 2012 in three important dimensions. First, the Federal Reserve moved to a flexible form of average inflation targeting (FAIT) and will now “seek to achieve inflation that averages 2% over time”. Although no formal metric was provided, the statement indicates that an inflation “moderately over 2% for some time” would be tolerated after periods of low inflation. Second, the statement reiterated the importance of its (full) employment mandate and indicated that monetary policy would now react to “shortfalls in” rather than “deviations from” the broad-based and inclusive maximum employment goal. In practice, this modification implies that improvements in the labour market, based on a set of indicators rather than estimated NAIRUs, would trigger a tightening only if they come with significant price pressures. Third, the statement made clear that financial stability concerns would play a role in shaping monetary policy decisions.

In some respects, these announcements represent small deviations from the existing framework. The general mandate of the Federal Reserve, which is decided by Congress, remains unchanged and focused on promoting maximum employment, stable prices, and moderate long-term interest rates. No major announcement was made with regard to either the Federal Reserve’s policy tools or communications practices. Moreover, while the statement consolidates the “flexible” way in which the Federal Reserve has been operating to achieve its objectives, it does not define how the target of 2% average inflation will be calculated.

These modifications, however, still represent a significant shift in the way the Federal Reserve carries out its mission. From an institutional perspective, the statement concludes the first-ever public review of the monetary policy framework, and generally signals the willingness of the monetary authorities to remain transparent and accountable in the future.1 On a conceptual level, those revisions also acknowledge the “new normal” environment in which the Federal Reserve operates and the constraints it puts on policy. On the inflation side, the accommodative stance implied by the new statement – which now allows for a temporary overshooting of the symmetric 2% long-run target – clearly highlights the risks associated with running persistently low levels of realised inflation (in particular a de-anchoring of inflation expectations), and the constraints imposed by the zero lower bound in such a scenario. On the real side, the shift away from “pre-emptive striking” reflects the difficulty in pinning down the equilibrium unemployment rate and, more generally, the uncertainty surrounding the link between labour market outcomes and inflation.

1. The process, which started in 2018, incorporated feedbacks from public “Fed Listens” events, academia, and the FOMC internal discussions. According to the statement, this review process will now take place every five years.

Although the revised frameworks all signal a strong commitment to push inflation higher, they have generally fallen short of the more radical and comprehensive alternatives discussed in both academic and policy circles, but which are based on the same premises. The alternatives include raising the inflation target and one of the so-called make-up strategies, like targeting an explicit price (or nominal GDP) level, where past misses of the target should be compensated in the future (Blanchard et al., 2010; Bean, 2013; Ball, 2014; Baker et al., 2017; Amano et al., 2020; Arias et al., 2020).5^,6 However, some frameworks can be now considered “soft” forms of these alternative options. For instance, the Bank of Japan’s “inflation‑overshooting commitment” announced in September 2016 can be regarded as a form of a make-up strategy. Similarly, the switch to a flexible form of average inflation targeting (FAIT) will take the US Federal Reserve closer to a price-level targeting, since the FOMC will de facto aim to make up for past inflation misses.

Old challenges

Monetary policy has been successful in influencing financial markets, the first stage of monetary policy pass-through to demand (in particular investment) and inflation. However, over the past two decades, core inflation in advanced economies has rarely risen above (implicit or explicit) targets.7 New policy frameworks based on make-up strategies give hope to overcome the low‑inflation challenge. However, there are reasons for caution. Their efficacy crucially hinges on the population’s understanding of, and reaction to, monetary policy commitments and strong effects of demand-supply imbalances on inflation – i.e. a steep Phillips curve (Hebden et al., 2020). As argued below, controlling inflation expectations to affect demand is difficult in practice and several structural factors have likely reduced the sensitivity of inflation to demand pressures.

Persistently low inflation

In the workhorse model used by central banks, inflation is determined by inflation expectations and the strength of demand relative to productive capacities (the so-called output gap). Assuming households and firms behave rationally, higher expected inflation can stimulate today’s household spending by lowering perceptions of real interest rates and encouraging firms to increase prices in order to prevent a fall in relative prices. Similarly, when demand persistently exceeds the supply of goods and services, producers will be encouraged to increase prices. However, when interest rates are low and close to the ZLB, the scope to stimulate demand through yield curve changes, and in turn inflation, is limited. In this case, inflation expectations become the main available channel to boost inflation, as assumed by the many make-up strategies discussed above (Svensson, 2003; Yellen, 2016; Bernanke, 2020).

Inflation expectations

Well-anchored inflation expectations are considered to be the primary factor behind the low and stable inflation observed over the past three decades (Yellen, 2016; Williams, 2020). By anchoring expectations around the target, central banks prevent temporary shocks to inflation from feeding into the wage and price formation processes. Some evidence suggests that higher inflation expectations can boost consumption and investment.8 However, three challenges may reduce the effectiveness of inflation expectations as a practical policy channel as intended by central banks (Mavroeidis et al., 2014; Bachmann et al., 2015; Coibion et al., 2020b).

First, although firms set prices of most goods and services, little is known about their inflation expectations. Surveys of firms’ aggregate inflation expectations are rare and of limited quality, in contrast to surveys of households’ expectations (Coibion et al., 2020a). According to theoretical predictions, inflation expectations of firms and households are key for consumption, investment and wage-price setting decisions, as opposed to inflation expectations of financial market participants and professional forecasters.9

Second, both households and businesses are generally poorly informed about realised and expected inflation, or inflation targets, and their expectations have been persistently above targets. They are also rather inattentive to monetary policy changes. This general lack of knowledge about inflation is not surprising in a low‑inflation environment, where the (costly) process of gathering information about prices might not be worth pursuing. Inferring about inflation from personal experience is also complex. As a result, households tend to form their views about aggregate inflation from few frequently purchased items, like gasoline, electricity and processed food (Shioji, 2015; Coeuré, 2019; Coibion et al., 2020a), resulting in “perceived” inflation at much higher levels than actual inflation (Figure 2.12), and with views varying widely across individuals.10 Recent evidence also shows that households have a rather limited understanding of monetary policy announcements and that expectations of neither households nor firms seem to respond much to such communications (Coibion et al., 2020a; Coibion et al., 2020b).

Figure 2.12. Household inflation expectations tend to exceed realised inflation and targets

1. Personal consumption expenditure deflator, including food and energy prices.

2. Harmonised index of consumer prices, including food and energy prices.

Source: Bureau of Economic Analysis; Eurostat; European Commission; Refinitiv; and OECD calculations.

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Third, evidence is mixed about the impact of inflation expectations on households’ consumption (Bachmann et al., 2015). Under some circumstances, households’ expectations about future price changes can have a powerful impact on their consumption decisions. This is for instance the case with VAT rate increases, when their announcements tend to boost consumers’ purchases prior to the tax change (Kueng, 2014; D’Acunto et al., 2016).11 However, a durable boost to household consumption due to monetary policy forward‑guidance, even when well understood by consumers, may be less powerful. Higher expected inflation may not stimulate aggregate consumption durably if real income is expected to decline or stagnate. With constant nominal income, higher inflation could just shift demand from non-essential goods and services to necessities. Higher inflation may also increase perceived uncertainty and result in higher household saving. Indeed, according to psychological studies, most people resent inflation and associate it with bad times for buying and having negative effects on their finances (Katona, 1974; Ranyard et al., 2008). Moreover, the effects of monetary policy are uncertain and refer to a distant future, which may be discounted by households and businesses in their consumption and investment decisions.

Structural shifts in supply and demand

Over the past three decades, a combination of structural changes in advanced economies, related to the production and distribution of goods and services, firms’ business models and demand structure, have limited pressures on aggregate inflation and led to persistent and large relative price changes of certain categories of goods and services (Figure 2.13). The persistence of such forces, which are largely beyond monetary policy decisions and communications, have aggravated the challenge for central banks in attaining their inflation targets.

Figure 2.13. Persistent deflation has taken place for some categories of goods and services

Average annual percentage change between the first eight months in 2000 and 2020

Note: The selected categories are not exactly identical across the three economic areas.

1. For the euro area, services and goods inflation include prices of food and energy.

Source: Eurostat; Ministry of Internal Affairs and Communications, Japan; US Bureau of Economic Analysis; and OECD calculations.

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• Globalisation, technological progress and market concentration: The integration of low-wage emerging‑market economies, in particular China, into global value chains (GVCs) combined with trade liberalisation over the past three decades has led to a substantial decline in production costs, expanded supply massively and increased import competition, putting a downward pressure on domestic producer goods prices (Autor et al., 2013; Andrews et al., 2018). Globalisation has also coincided with a rapid technological progress in production of many goods or their components, including electronics, adding to downward price pressures. These two powerful structural changes have been associated with increased market concentration in manufacturing (Autor et al., 2020). Stronger import competition and rising market concentration can reduce the pass-through from wages to prices in goods-producing sectors, partly explaining the lack of higher goods inflation and thus overall inflation in the recent expansions in the United States (Heise et al., 2020).

• Retail sector and network industries: There has been increasing interest in the role of gradual structural changes in the retail sector for determining goods inflation. In the United States, over the past three decades, the retail sector has changed from one with many small firms to one dominated by large firms, with large retailers increasingly sourcing from China (Smith, 2019). Direct sourcing from low-cost countries has helped to eliminate substantial mark-ups of intermediaries (Ganapati, 2018), contributing to the closure of small shops (Smith, 2019). The rise of general merchandisers selling goods from different industries could have led to reduced margins on some goods to attract clients as profits are maximised at the chain level and not for individual goods.12 Low retail margins have also been possible due to weak wage growth in the sector.13 The past decades have also witnessed a rise of e‑commerce, which could have damped prices by increasing price transparency and eroding profit margins, notably in some traditionally face-to-face businesses. Indeed, online inflation for some categories of goods and services is found to be lower than inflation measured by the official consumer price index (Goolsbee and Klenow, 2018), but e-commerce is estimated to explain only a small part of the recent low inflation (Ciccarelli and Osbat, 2017). A growing importance of network industries in services (like communication, TV and music streaming services, air transport) has also likely contributed to muted inflation developments. These sectors are characterised by high fixed costs, low marginal costs of extra supply (enabled by technological progress), and strong competition. Maximisation of their profits depends on market share gains, limiting possibilities to increase prices persistently.

• Weakening demand and large supply: Limited price pressures resulting from globalisation and technological progress may have been weakened further by relative saturation of demand for many durable goods compared with ample production capacities. This mechanism is based on the premise that when a new product is developed, demand for it grows very fast and income elasticity of demand is high. This stimulates production capacity and technological progress, leading over time to lower prices. At the same time, the income elasticity of demand falls with rising ownership of the product by households and higher population income (Matsuyama, 2002; Yoshikawa, 2003; Bessen, 2018). Ultimately, when the desired level of possession of the product has been attained, “new demand” for buying the good for the first time vanishes and demand is driven by replacement or renewal motives only (Komiyama, 2014). As this phenomenon may affect many durable household products in advanced economies (cars, home appliances, etc.), the scope to increase prices for such goods, that still account for a considerable part of the consumption basket, may be limited by the fear of a fall in demand. The saturation of demand could be accelerated by the fall in prices (Bessen, 2018) and population aging, which tend to decrease per-capita consumption growth (Fujita and Fujiwara, 2016) – the two phenomena observed in many advanced economies in the past decades.

If the above structural trends persist in advanced economies, central banks may continue to struggle to achieve persistently higher inflation in the future. There is, however, large uncertainty about future structural developments, partly related to uncertain long-term impacts of the COVID-19 crisis. In the absence of protectionist policies or a large-scale reshoring of manufacturing production motivated by strategic considerations, globalisation forces are likely to continue limiting upward pressures on prices in advanced economies. The COVID-19 experience may encourage reshoring though. Changes more amenable to policy interventions – such as a quick catch-up of wages in low-cost-production countries or market regulation – are not likely to materialise in the medium term. Also, deeper forces – such as technological progress and population ageing – are unlikely to alleviate the “saturated” demand problem in the medium to long term. In contrast to the experience of past decades, inflationary pressures and inflation volatility could result from disruptive climate changes. Disruption to production, shipping and migration patterns induced by exogenous climate events, for instance, could all increase the costs of production and distribution around the world, in particular for food. Policies to address climate changes, such as the implementation of a carbon tax or the suspension of fossil fuel subsidies, could also push up prices.

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