Ingves: Flexible inflation targeting in theory and practice
Governor Stefan Ingves presented a speech on Thursday at the Swedish Economic Association. The topic of the speech was the relationship between theory and practice in monetary policy. Mr Ingves noted that the theoretical framework often used to describe monetary policy is a useful tool. It captures in an illustrative and relatively simple way the essence of inflation targeting and it has helped to structure thinking with regard to the practical implementation of monetary policy.
However, Mr Ingves said that the step from theory to practice is not entirely simple. In his speech he highlights a number of circumstances that complicate this step in various ways. For example, the variables the central bank is expected to stabilise – inflation and resource utilisation – are unambiguous and clearly specified in theory, but in practice it is far from clear how these variable should be measured. Nor is it entirely clear from the simple theoretical framework how the central bank should manage the fact that in certain situations there may be a risk of a very poor outcome. Another complicating circumstance is that the monetary policy decisions are made by six people who can have differing views on these questions.
The picture will probably be complicated even further by the increased focus on systemic risk that arose in the wake of the financial crisis. The macroprudential policies that may be used to a greater degree can have effects that are in many ways similar to the effects of changes in the interest rate. This increased interaction between monetary policy and macroprudential policies means that the connections between the theoretical framework and practical monetary policy may become even more twisted.
Despite Mr Ingves highlighting a number of complications in translating the theoretical analysis into practical policy, he said that theory, when used wisely, could provide important support in explaining and evaluating monetary policy. Essentially it is a balancing act: On the one hand, one wants to retain in the step from theory to practice enough of the clarity and structure given by the theoretical framework. But on the other hand, one does not want to provide an overly simple and thereby perhaps misleading picture of monetary policy and the deliberations that a central bank has to make in practice. Each central bank has to try to determine where the optimal balance lies and how the theories can be best used in the practical work.
Read the speech in full in the PDF below.
