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Alan S. BlinderPrinceton University and the Brookings Institution

Critical Issues for Modern Major Central Bankers

directly in the loss function – wholly apartfrom any other reasons for doing so.

Issue No. 2 is whether the central bankshould be an inflation targetter. This, ofcourse, is a relatively new issue. A decadeago, it was not even on the radar screen;nowadays, no modern central banker canavoid it. I must admit that my initial reac-tions to inflation targeting, while ViceChairman of the Fed, were quite negative.That was because I wrongly associated infla-tion targeting with placing zero weight onoutput stabilization – what Mervyn Kinghas called “inflation nuttery” – at a timewhen I was arguing strongly for just thereverse (Blinder, 1994). But I have learnedsomething since then. As Lars Svensson(1997) and others have shown, the weightthe central bank places on output stabiliza-tion maps directly into the speed withwhich the inflation target should be appro-ached. A central bank that places a highweight on output stabilization can be a gra-dualist inflation targetter. A second piece ofresearch that has made me more sympathe-tic to inflation targeting is Orphanides’ fin-ding, mentioned earlier, that large errors inestimating the output gap can lead (andhave led) to egregious errors in monetarypolicy. If an inflation targeting central bankstarts out underestimating (overestimating)the economy’s potential, it will see inflationfalling (rising), and therefore be induced toease (tighten) policy. That is an importantvirtue. A yet-newer literature, spawned byJapan’s problems with deflation and thezero bound on nominal interest rates, callsinto question the previous professional con-

sensus that inflation targeting is superior toprice-level targeting. In fact, this literaturesuggests that a price-level target might bepreferred when deflation is a danger. Thereason is simple: to get real interest ratesnegative when the zero bound on nominalrates is binding, the central bank needs toengender expectations of positive inflationeven though prices are falling. A credibleprice level target accomplishes that by pled-ging the central bank to offset episodes ofdeflation with subsequent periods of inflati-on, to get the price level back on its prede-termined path. (The trick, of course, is tomake the pledge credible.)More generally, central bankers must nowpay attention to an issue that their older bre-thren (they were all men then!) could safelyignore: the costs of deflation, which mosteconomists reckon to be greater than thecosts of inflation. Just like modern majorgenerals, modern central bankers must pre-pare to fight the next war rather than conti-nue fighting the last one.

Issue No. 3 pertains to transparency:How open should a modern central bankbe, and about what? Qualitatively, theanswer is simple: A modern central bankmust be a good deal more transparent thanits ancestors.There seems now to be some-thing approaching a consensus on this point– the consensus itself signifies a sea changein central banking attitudes. Among thelogical candidates for greater transparencyare the bank's ultimate goals (Issue No. 1above), its basic model of the economy(even if only informally), and its internalforecasts.

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This conference is entitled “MonetaryPolicy-Making under Uncertainty.” But thattitle seems redundant to me – was thereever such a thing as monetary policymakingunder certainty? So I will adopt a differenttopic for this talk. With due apologies toGilbert and Sullivan, my focus is on what ittakes to be “the very model of a modernmajor central bank.” I will raise a host ofquestions, 15 in all, that would have to beanswered by a central bank starting do novoin the year 1999 – a situation that mayperhaps sound less than hypothetical here inFrankfurt. My emphasis is on how both thequestions and the answers differ from whatpeople might have thought ten or twentyyears ago – hence the adjective “modern.”The questions divide themselves into threecategories:1. issues of institutional design, or what mightbe called “setting up shop” (seven issues);2. tactics for operating in the markets (fourissues)3. issues pertaining to the bank's model of thetransmission mechanism (four issues).

I. Institutional DesignIssue No. 1, both literally and, I think,

figuratively, is the central bank's ultimategoal or goals for monetary policy – thearguments of its loss function. Almost allrecent academic research and thinking pre-sumes that the objective function of thecentral bank is some weighted average ofthe expected squared deviations of outputand inflation from their respective targets.But that raises several subsidiary questions:

(a) What are the weights? Just howmuch should the central bank care about

output (employment) deviations relative toinflation deviations? This choice is crucial,but underemphasized. It can exercise sub-stantial influence over actual policy decisi-ons. For example, it may be one of the keypoints of difference between the ECB andthe Fed today.

(b) Around what targets? The choice ofthe targets is probably more important thanthe choice of the weights.The inflation tar-get has been extensively examined both inacademic literature and in central bank dis-cussions. But what about the output target?Athanasios Orphanides' paper for this con-ference suggests that specifying an outputtarget in a sensible way can be quite difficultin real time.In addition, a deep question arises if theeconomy displays hysteresis: Does it theneven make sense to specify an output targeta priori, when doing so might lead the cen-tral bank to settle for a local optimum eventhough there may be a superior global opti-mum available? As a concrete example,think about how much worse off the UnitedStates (and, indeed, the entire world)would be today if the Fed had decided in1995 that the U.S. economy could notsustain an unemployment rate below 6% –and had acted on that belief.

(c) What about financial stability? Realcentral bankers care about more than justthe variances of inflation and output. Theyalso bear a responsibility for financial stabi-lity, which, while related to the other twogoals, is not entirely subsumed in them. Inmy view, concern over financial stability isthe best rationale there is for includingsomething like the change in interest rates

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central banks’ unwillingness to intervenewith large amounts of money.

Issue No. 6 is whether the monetaryauthority should also regulate and supervi-se banks. This issue is very much up in theair right now.The U.K. has explicitly sepa-rated monetary policy from bank supervisi-on, as you know, and the ECB is not a banksupervisor. (But several central banks wit-hin the ESCB are.) In the U.S., we have justconcluded a multi-year turf war betweenthe Federal Reserve and the TreasuryDepartment over the Fed's role in banksupervision.Throughout, the Fed has stead-fastly insisted that the information it routi-nely receives in its supervisory role, is vitalto the performance of its monetary-policyduties. Is that true?My personal view is that the Fed has taken agrain of truth and greatly exaggerated itsimportance. Proprietary information thatthe central bank receives in bank examina-tions is of some, limited use in formulatingmonetary policy – and is on rare occasionsvery important. So, on balance, it is proba-bly better to have it than not. On the otherhand, a bank supervisor may sometimeshave to be a protector of banks and someti-mes a stern disciplinarian – and either

stance may conflict with monetary policy.In the United States, there is yet anotherconflict of interest, which is currentlyunder study by the General AccountingOffice:The Federal Reserve not only super-vises banks, it also sells them priced servi-ces in competition with private vendors ofthe same services.Finally, two other questions are worth rai-sing in this context. First, as the lines sepa-rating banks from other financial instituti-ons blur and disappear in the modernworld, must central banks that serve asbank supervisors be morphed into general-purpose financial supervisors – and do theyhave the expertise to do this broader job?Second, even if we decide that central banksshould be bank supervisors, why shouldthey also be bank regulators, that is, rule-makers (as the Federal Reserve is)?Shouldn't that function remain in the politi-cal domain?

Issue No. 7 is genuinely novel – centralbankers of a generation ago certainly didnot think about it. The question is this: Dovarious (actual and incipient) forms of elec-tronic money pose a threat to central banks?Two distinct sorts of threats can be imagi-ned; both arise from the possible erosion of

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As many of you know, I have long been ahawk on transparency – on both economicand political grounds. Economically, I belie-ve greater transparency makes monetarypolicy easier by anchoring expectations bet-ter to the realities underlying policy.Financial markets that are better attuned tothe central bank's thinking are better able toanticipate its actions. And, anticipatorymovements in interest rates, if correct,shorten the lag in monetary policy – a lagthat has long bedeviled attempts to stabilizethe economy. Politically, democratic theorystrongly suggests that, in return for itsbroad grant of authority, the central bank isobliged to keep the public and their electedrepresentatives well informed.To do other-wise would be imperious. (Remember theetymology of that word!)

Issue No. 4 is rarely discussed, butmust be considered at the design stage:Should monetary policy decisions be madeby an individual or by a committee? I amcurrently engaged in some experimentallaboratory research at Princeton to test twohypotheses: that, compared to individuals,H1: committees react more slowly to thesame stimulus.H2: committees nonetheless make betterdecisions.It is a bit too early for definitive results, butthe early returns dispute H1 while suppor-ting H2. More generally, I want to take noteof a small academic literature that is develo-ping around the question of whether, andhow, monetary policy decisions made bycommittee differ from monetary policydecisions made by individuals.

The Federal Reserve offers an interesting,and apparently highly successful, hybridmodel. The Federal Open MarketCommittee (FOMC) in a formal sensemakes decisions by majority rule with arecorded vote. But, in fact, it is dominatedby its chairman. Much of the outside worldis watching to see whether the ECB willdevelop into an FOMC-style faux commit-tee, or into a genuine committee organizedon the “one person, one vote” principle(like the Bank of England’s Monetary PolicyCommittee).

Issue No. 5 is whether a central bankoperating in a floating exchange rate regimeshould forsake foreign currency interventi-on as a policy tool – even though theexchange rate is an important part of themonetary transmission mechanism.The conventional wisdom nowadays seemsto be that central banks should forget aboutintervention, mainly on the grounds thatsterilized intervention doesn't work. But Iwonder if this is always right. Certainly, for-eign exchange interventions that opposemajor market trends stand little chance ofsuccess; the old market wisdom, “don’tstand in front of a freight train,” applies tocentral banks as well. But there are timeswhen markets have no particular convictionabout which way the exchange rate will gonext, or are thin, or have lots of nervousshort-sellers.At such times, the markets aresusceptible to being pushed around (withinlimits) by the central bank – if it is willing tocommit substantial sums to the effort. Itcould be that the current consensus againststerilized intervention stems, in part, from

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parent ways. Should monetary policy justproceed as if none of this had ever happen-ed? I think not. At a minimum, a moderncentral bank must make use of the informa-tion found in these new markets. For exam-ple, the Fed has for years used the Federalfunds futures market in Chicago as its pri-mary window into what the markets arethinking about future monetary policy. Inaddition, high-tech financial instrumentsalmost certainly affect the monetary trans-mission mechanism – especially the linka-ges from short rates to long rates and otherfinancial market prices.And, central bankersignore this at their peril. My own hunch –but it's just a hunch – is that derivatives haveshortened the lag in monetary policy.There are still more questions. Should amodern central bank operate in some ofthese more exotic markets, rather thanrestrict itself to conventional open-marketoperations in government securities? A con-servative central banker’s reflexive answeris no, and I must admit this is my own reac-tion to date. But perhaps the idea shouldnot be dismissed out of hand.After all, deri-vatives can enhance the power of the centralbank to push interest rates (or even exchan-ge rates) around, just as they do for privatemarket participants. A modern central ban-ker needs to give this issue serious thought.

Issue No. 10 pertains to what I call theBrainard (1967) conservatism principle: theidea that multiplier uncertainty should makethe central bank more conservative, in thesense of using its policy instrument lessvigorously. In Blinder (1998), I opinionedthat, while the conservatism principle is not

very robust mathematically, “My intuitiontells me that [it]... is more general – or atleast more wise – in the real world than themathematics will support.” (p. 12)This remark seems to have touched off a fairamount of quite interesting academic work,and I have been surprised at how little sup-port Brainard’s principle has received.There are, by now, a number of examples inwhich multiplier uncertainty, in conjunc-tion with something else, leads an optimi-zing central bank to vary its instrumentmore than it would under certainty. TheBrainard result is indeed fragile. Still, I findthese new anti-Brainard results both puzz-ling and troubling.Though my confidence inthe conclusion has been shaken by recentresearch, my gut still tells me that Brainardwas right in practice. In any case, it's cer-tainly an intellectual question that shouldengage modern central bankers.

Issue No. 11 is related:When a centralbank decides to change monetary policy,should it move its interest rate by large orsmall amounts? Under Alan Greenspan’sstewardship, the Federal Reserve has showna clear preference for frequent, small moves– usually 25 basis points. And who wouldargue that the Greenspan Fed has not beensuccessful? Yet, I suspect that this style ofpolicy is not what dynamic optimizationcalls for.Why not? The argument for largermoves is predicated, in part, on the unitroot in the inflation process: If inflation canrandom-walk away from you, the centralbank will want to make sure to step on thebrakes hard enough. But what if the unitroot in the inflation time series is a bypro-

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the bank's monopoly over the issuance of themedium of exchange. The first threat is tocentral bank independence: If seignoragerevenue shrinks enough, the central bankwill become beholden to the legislature forits annual budget, and that could make itmore susceptible to political influence. Lossof seignorage revenue is probably not muchof a threat to the big three (Fed, ECB,BOJ), but it could be a more serious matterfor smaller central banks whose expensesmore nearly exhaust their revenue. Thesecond threat is to monetary policy itself: IfMicrosoft-money and the like come to beused for settlements on a grand scale, bankswill no longer need reserves at the centralbank for clearing purposes. Indeed, thebanking system might be bypassed entirelyif buyers and sellers settle accounts directlywith e-cash. Similarly, electronic transfersof all sorts make it increasingly easy forbanks to avoid the implicit tax on requiredreserves – as sweep accounts have beendoing in the U.S. for years. In combination,these two developments will weaken – andmay eventually even destroy – the mainlever that central banks have traditionallyused to manage their economies: controlover base money.What's a central banker todo? For now, I think, the answer is: nothing.But sometime, in the near future, thesehypothetical questions may become realones which modern central bankers will beforced to confront.

II. Tactics for Operating in theMoney Market

My next four questions relate to how thecentral bank operates in the financial markets.

Issue No. 8 is a broad question of stra-tegy rather than a narrow tactical one. If Imay be forgiven for indulging in stereoty-pes for a moment, some years ago, centralbankers saw their proper role as surprisingand bullying the markets. Central bankerswere (they thought) in control; marketswere meant to be pushed around. No lon-ger. Nowadays, a thoroughly modern cen-tral banker is more likely to respect marketsand keep them well informed. That is ahealthy development, but it can be takentoo far.As I emphasized in my Robbins Lectures(Blinder, 1998), central bankers are oftentempted to “follow the markets” – that is, todeliver the monetary policy the markets areexpecting or, indeed, demanding. At times,that might be precisely the right thing to do– especially if the bank has conditionedmarket expectations properly. But notalways. Many of us believe that marketstend to go to extremes, to overreact to sti-muli, and to be stunningly shortsighted. Agood monetary policymaker must succumbto none of these temptations.

Issue No. 9 concerns the implicationsof high-tech finance for the conduct ofmonetary policy. A host of questions formodern central bankers arise here. Howshould monetary policy adapt to the explo-sion of derivatives and financial exotica ofall kinds – instruments that central bankersnever dreamed of a decade or two ago?Some of these markets are extremely deepand liquid; some contain a great deal ofinformation; many of them create extreme-ly high leverage – sometimes in non-trans-

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Issue No. 14 is a closely-related para-dox in the international arena. Uncoveredinterest parity is supposed to tie currentand expected future exchange rates to theinterest-rate differential between any twocountries. Yet it fails miserably as a foreca-ster of future exchange rates. Once again,everybody knows this, but no one (myselfincluded) seems to know what to do aboutit. Since interest parity is an essential link inthe monetary transmission mechanism foropen economies, and since all economies areopen, this is not only an intellectual embar-rassment but a major impediment to success-ful monetary policy. It must rank high onthe work list for modern central bankers.

Last, but certainly not least, I come toIssue No. 15: How does a central bank con-duct monetary policy in the absence of aPhillips curve it can trust? For years, I usedto gloat that the Federal Reserve had animportant advantage over the other G7central banks: We had a reliable statisticalPhillips curve to use, they did not. Butnowadays we all seem to be in the sameboat. As is well-known, the traditional U.S.Phillips curve, which worked so well fordecades, has been malfunctioning of late.Today the Fed finds itself up the creek with-out a Phillips-curve paddle, just like othercentral banks. This is a serious handicap.Given the long lags in monetary policy, it isgenerally agreed that the authorities needto conduct a “preemptive” monetary policy.That means moving on the basis of inflationforecasts. But, the collapse of the Phillipscurve leaves us without a reliable way toanticipate the impacts of economic activity

on inflation. And that, in turn, raises aserious intellectual question:When is it bet-ter to wait for an actual upturn in inflationrather to act preemptively, on the basis of aforecast? Both Orphanides’ paper and theBrainard uncertainty principle suggest thatthe current preference for preemption mayneed reexamination.

IV. in Conclusion So, that is my highly-selective list of 15 cri-tical issues. Rather than try to sum up, I willagain beg the indulgence of Gilbert andSullivan, and conclude in verse:

I am the very model of a modern centralbank for all.I’ve information national, financial, interna-tional.I know the Bank of England, and I quote theminutes of the Fed.I mimic every syllable that Alan Greenspanever said.I’m very well acquainted, too, with mattersmathematical.I understand equations, both the simple andquadratical.Of standard deviations, I am teeming with alot o’news,With many useful facts about the square ofthe hypotenuse.I’m very good at integral and differentialcalculus.My staff provides me models that are reallyquite miraculousIn short, in matters national, financial,international,I am the very model of a modern centralbank for all.

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duct of a particular policy regime that letinflation ratchet up from the 1950s to the1960s to the 1970s? As more recent data areadded to the sample, the evidence for a unitroot weakens. In other words, an appro-priate monetary policy – one that approxi-mates a Taylor rule, say – can remove theunit root from the inflation process. In thatcase, a more gradualist approach to mone-tary policy might make sense. It's some-thing for a modern central banker to thinkabout.The ECB, according to current marketlore, prefers larger, less frequent moves –say, 50 basis points. But I caution you thatsuch a deduction is based on a rather thindata base – precisely two observations!

III. Questions about the MonetaryTransmission MechanismMy final four questions pertain to the cen-tral bank's model of the economy.

Issue No. 12 should be an easy one,although the ECB seems not to agree. Inthis case, I will state an answer rather thanpose a question: A modern central bankshould think of its overnight interest rate,not any monetary aggregate, as its principalpolicy instrument. My reason is simple andwell known. As Gerry Bouey, a formerGovernor of the Bank of Canada, aptly putit, “We didn’t abandon the monetary aggre-gates, they abandoned us.” With financialinnovation virtually certain to continue,and with the lines between banks and othertypes of financial institutions blurry andgetting blurrier, I see no reason to suspectthat this abandonment will end soon.A cen-

tral bank that relies on a monetary aggrega-te may trap itself in vestigial thinking – andmay therefore put its economy in harm’sway. Indeed, modern financial arrange-ments are rapidly eroding the primacy ofbanks, which are the source of the moneysupply as conventionally defined. Suchdevelopments scream out to central banksto stop focussing on the textbook link frombank reserves to bank lending to aggregatedemand. Instead, a modern central bankshould think of the main linkages in thetransmission mechanism as running from itspolicy rate to other interest rates and finan-cial prices (such as longer-term interestrates, exchange rates, and stock marketvalues), and then on to aggregate demand.The Ms are byproducts of this process, butof no great intrinsic interest.The next two issues follow directly fromthis point of view, and are vexing ones. Butsince they are also familiar, I will deal withthem briefly.

Issue No. 13 observes that the stan-dard model linking short- and long-terminterest rates – the so-called expectationstheory of the term structure – is deadwrong, in the sense that long rates are ter-rible predictors of future short rates. Thisfact seems to be well-known in academia, inthe markets, and in central banking circles.But, its resolution remains a mystery. Giventhe importance of long-term interest ratesto the monetary transmission mechanism,this may be the single most importantintellectual issue with which modern cen-tral bankers must grapple. I wish I could tellyou the answer, but I can't.

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I know central banking history fromLombard Street to ECB.I speak in cryptic phrases whose intent israther hard to see.With repos, I can push the rates from floorto ceiling flawlessly.And seignorage enables me to prosper rat-her nice-a-lyMy monetary knowledge is extensive andadventury.It’s based on all the wisdom handed downacross the centuries.And so, in matters national, financial, inter-national,I am the very model of a modern centralbank for all.

BibliographyBall, Laurence, “Efficient Rules for Monetary

Policy,” NBER Working Paper No. 3952 (1997).

Blinder, Alan S., Central Banking in Theory and

Practice, Cambridge, MA: MIT Press (1998).

Blinder, Alan S., in Reducing unemployment:

Current issues and policy options: A symposium

sponsored by the Federal Reserve Bank of Kansas

City (1994).

Brainard, William, “Uncertainty and the

Effectiveness of Policy,” American Economic

Review 57 (May 1967), pp. 411-425.

Brayton, Flint, John M. Roberts, and John C.

Williams, “What’s Happened to the Phillips

Curve?,” Division of Research and Statistics,

Federal Reserve Board (1999).

Faust, Jon.“Whom Can We Trust to Run the Fed?

Theoretical Support for the Founders’ Views,”

Journal of Monetary Economics 37 (April

1996), pp.267-283.

Fischer, Stanley, “Modern Central Banking,” in

Forrest Capie, Charles Goodhart, Stanley Fischer

and Norbert Schnadt, The Future of Central

Banking, Cambridge, UK: Cambridge University

Press (1994).

Sibert, Anne, “Monetary Policy Committees:

Individual and Collective Reputations,” Birbeck

College (1999).

Svensson, Lars E.O.,“Inflation Forecast Targeting:

Implementing and Monitoring Inflation Targets,”

European Economic Review 41 (1997), pp.

1111-1146.

Svensson, Lars E.O., “Price Level Targeting vs.

Inflation Targeting,” Journal of Money,Credit and

Banking (1999).

Wolman, Alexander L., “Real Implications of the

Zero Bound on Nominal Interest Rates,”Working

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Session Summaries

Monetary Policy-Making under Uncertainty

Conference organised jointly by the

European Central Bank (ECB)

and the Center for Financial Studies

of the University of Frankfurt

on 3 December 1999

in Frankfurt am Main

Impressum

Monetary Policy-Making under Uncertainty

EditorsEuropean Central Bank,Center for Financial Studies

PublishersIgnazio AngeloniFrank SmetsProf. Dr. Axel Weber

Typeset & EditingRoberta Ruben

DesignStählingdesign, Darmstadt

PrintWerbedruck PetzoldJune 2000

ProgrammeFriday, December 3, 1999

Editors Introduction

Introduction by W. Duisenberg (European Central Bank)

Policy Panel

Introduction by J.B.Taylor, (Stanford University), Chair

Otmar Issing (European Central Bank)

Steven Cecchetti (Ohio State University)

Charles Freedman (Bank of Canada)

Leo Leiderman (Bank of Israel)

Lucas Papademos (Bank of Greece)

Dinner Speech

Alan Blinder (Princeton University)

Session Summaries

L.E.O. Svensson (Stockholm University and Princeton University) and M.Woodford (Princeton University): „Indicator Variables for Optimal Policy“

T. Sargent (Stanford University and Hoover Institution) andIn-Koo Cho (University of Illinois, Urbana Champaign): „Escaping Nash Inflation“

A. Levine,V.Wieland and J.Williams (Federal Reserve Board): „The Performance of Forecast-Based Monetary Policy Rules under Model Uncertainty”

A. Orphanides (Federal Reserve Board): „The Quest for Prosperity without Inflation“

Saturday, December 4, 1999

G. Rudebusch (Federal Reserve Bank of San Francisco): „Assessing Nominal Income Rules for Monetary Policy with Model and Data Uncertainty“

Shorter Presentations

M. Ellison and N.Valla (European University Institute):„Learning, Uncertaintyand Central Bank Activism in an Economy with Strategic Interactions“

P. Geraats (University of California, Berkeley):„Transparency and Reputation:Should the ECB publish its Inflation Forecast?“

B.Winkler (European Central Bank):

„On the Need for Clarity in Monetary Policy-Making“

P. Schellekens (Harvard University, London School of Economics and UFSIA):

„Caution and Conservatism in the Making of Monetary Policy“

U. Söderström (Sveriges Riksbank):

„Monetary Policy with Uncertain Parameters“

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