Pitfalls of Discretionary Monetary Policy
Starting in the 1970s, the economics profession began to recognize that the evolution of economic activity and inflation--and hence the design of optimal monetary policy--depends crucially on how households, firms, and financial market investors form their expectations regarding the future course of policy. This recognition of the central role of expectations in macroeconomic outcomes led to the discovery of the time-inconsistency problem, a concept that sounds highfalutin but is actually quite intuitive.
This problem arises whenever the possibility of short-run gains creates a temptation to renege on an existing plan, even though following that plan would produce a better outcome over the longer run. In essence, if a good long-run plan will not be followed consistently over time because the short-run gains of deviating from the plan are too tempting, then that plan is said to be time-inconsistent. In such a setting, the time-consistent policy is to reoptimize every period, whereas the preferable alternative would be to establish a firm commitment to the optimal long-run plan.
To take a common example that illustrates the time-inconsistency problem, someone may make a New Year’s resolution about starting a diet. At some point thereafter, however, it becomes hard to resist having a little bit of Rocky Road ice cream, and then a bit more, and pretty soon the weight begins to pile back on.The time-inconsistency problem arises in the context of monetary policy, because there is a temptation to give a short-run boost to economic output and employment by pursuing a course of policy that is more expansionary than firms or workers had initially expected. Nevertheless, if the economy is already at full employment, then this boost is merely transitory: As economic activity rises above its sustainable level, wages and prices begin to rise, and the private sector's inflation expectations start to pick up. Of course, the central bank must eventually remove the policy stimulus to avoid a continuous upward spiral of inflation. At that point, economic activity drops back to a sustainable level. However, inflation settles in at a permanently higher rate because prospects of future monetary expansions become embedded in expectations, and hence in wage and price adjustments, and the higher average inflation rate generates undesirable economic distortions. Thus, failing to address the time-inconsistency problem poses the risk of ending up with a higher average inflation rate, with detrimental long-run consequences for economic efficiency and the general standard of living.
As my mother often told me when I was growing up, "The road to hell is paved with good intentions." Similarly, discretionary monetary policy, even though well intended, can lead to poor economic outcomes.
For text of entire speech visit the Federal Reserve website.
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