"...in response to a rise in expected inflation above target, each central bank on average raised nominal rates enough to raise real interest rates."
On the eve of the European Monetary Union, squabbling between Germany and France over governance dominated the headlines in the financial press. Beneath this bickering over leadership, however, lies a more fundamental debate: What kind of monetary policy will the new European Central Bank undertake? In addition, are there some lessons from previous historical experience with fixed exchange rate systems that may be pertinent to future policymaking?
In Monetary Policy Rules in Practice: Some International Evidence (NBER Working Paper No. 6254), Richard Clarida, Jordi Gali, and Mark Gertler address these important policy questions by evaluating how the major central banks of the world have conducted monetary policy since 1979. Specifically, they analyze the behavior of monetary policy in two sets of countries: the "G3," which includes Germany, Japan, and the United States; and (what the authors term) the "E3," which consists of Germany's major trading partners in Europe, the United Kingdom, France, and Italy.
The authors begin with the observation that, while world monetary policy was largely viewed as being out of control during the 1970s, it is now, for the most part held in high regard. The source of this reputation has been the apparent ability of the major central banks to engineer their economies out of an era of double digit inflation, an effort they began in 1979, and into the current regime of relative price stability. By studying the behavior of the G3 central banks, the major central banks of the world, over a period in which monetary policy was considered effective, one can obtain lessons for how the new European Central bank might conduct policy in the future.
The authors find that a simple policy rule which has the central bank adjust the short-term nominal interest rate in response to inflation and output relative to their respective targets does a good job of characterizing monetary policy in each of the G3 countries. The kind of rule that emerges in each instance is what one might call "soft-hearted" inflation targeting: in response to a rise in expected inflation above target, each central bank on average raised nominal rates enough to raise real interest rates. The rule thus implies a clear focus on controlling inflation. At the same time, the rule allows for a modest stabilization component: holding inflation constant, it calls for some adjustment of rates to the output gap. The primary focus of policy, however, remains on controlling inflation, in contrast to policymaking in the pre-1979 era.
The second part of the paper considers the E3 countries. It is motivated by the observation that even though inflation is under reasonable control, international monetary policy has not been free of turmoil. A prime example is the crisis within the European Monetary System during late 1992. The inability of the major European central banks to sustain the existing fixed exchange rate system at that time obviously raises some questions about how the planned monetary union will fare. For this reason, the authors examine the behavior of the E3 over this period. They use the estimated policy rule for the Bundesbank as a benchmark to evaluate how interest rates are set in response to domestic inflation and output.
Given this benchmark, the authors find that prior to the exchange rate system's collapse, each of the E3 countries was maintaining interest rates that were much higher than domestic macroeconomic conditions warranted. The pressure from high interest rates, in turn, was a likely source of the system's collapse. The reasons why rates were unduly high prior to the EMS collapse vary among countries, but two factors stand out: First, German monetary policy was unusually tight because of the pressure of unification. Second, the business cycles were not "in sync" with Germany, particularly for the United Kingdom and France. To the extent there is a threat to the system, it will come from asynchronization of economic conditions across the member countries.