A test of strategic interaction in monetary policy.

• Author: Briggs, Hugh C., III

Beginning with an example provided by Kydland and Prescott [29], a large literature has evolved concerning strategic interaction between the public and a monetary authority in the conduct of monetary policy. We undertake a direct test of a fundamental assumption of the strategic monetary policy literature. Monetary policy games suppose that the monetary authority and the public are aware of the strategic interdependence between them. That is, these models suppose that the monetary authority chooses an inflation rate that is a function of the public's expected inflation rate and that the public is sophisticated enough to realize that the inflation rate chosen by the monetary authority is a function of its beliefs. Below we extend Cukierman and Meltzer's [18] model of ambiguity and credibility in monetary policy to nest other models. We then use a novel data set that permits a test of the assumption of strategic awareness for agents in the U.S. We find support for our extension of the Cukierman and Meltzer model.

The new data brought to bear is the Federal Reserve's forecast of inflation conditional on the monetary policy it chose. Throughout the sample period, the Federal Open Market Committee (FOMC) met from eight to twelve times per year to consider various short term monetary policies. Data on the forecasted paths for the inflation rate, growth rate in output, and unemployment rate associated with the different monetary policies under consideration is available for some of their meetings; it seems reasonable to suppose that the chosen monetary policy satisfies revealed preference in the forecasts of these variables that it and the rejected monetary policies imply. Therefore, in referring to the data, we use the terms "inflation rate forecast by the Federal Reserve" and "inflation rate chosen by the Federal Reserve" interchangeably. Since theories of time consistent monetary policy have always been cast in the latter terminology, the data are especially well-suited to a direct test of the theory.

Section I briefly reviews the theoretical literature on monetary policy games and empirical literature relevant to the present paper.(1) The econometric tests are generated by a version of the monetary policy game advanced by Cukierman and Meltzer [18] which is explicated in section II. Section III presents and discusses empirical results. Section IV concludes with suggestions for further research.

1. Monetary Policy Games: Theory and Evidence

   Burro and Gordon [7] provide a formal model of Kydland and Prescott's example and show the difference between the optimal policy, given by a monetary rule, and the time consistent or discretionary policy. Their model explains the persistence of positive inflation rates as an equilibrium phenomenon in the context of a model embodying the natural rate hypothesis but, because it is a single period model, does not explore how the monetary authority's concern for its reputation can affect policy. Burro and Gordon [6] examine the effects of reputation in infinitely repeated play of their one-shot game. They show that if the creation of surprise inflation by the monetary authority would be followed by a loss of credibility with the public and consequently higher expected inflation in the future, then the monetary authority's desire to avoid the future high inflation caused by a current inflation surprise will cause it to choose a lower inflation rate than is implied by the single period model.(2) They also discuss the implications of including asymmetric information via a taste parameter of the monetary authority that follows a white noise process that is unobserved by the public. Because the public forms expectations using the mean of the taste parameter, from period to period the economy moves along an expectational Phillips curve as the monetary authority's tastes between inflation and unemployment change.

   Another set of models with asymmetric information has wage setters contract a nominal wage in advance of the observation of a real or nominal shock to the economy. An early example is Rogoff's [30] analysis of stabilization policy, which among other results, concludes that the selection of a Federal Reserve chair with a strong aversion to inflation can mitigate the inflationary bias of discretionary policy. Another example is Canzoneri's [13] model, in which information is private as well as asymmetric.(3) In his model, the Fed possesses private information on money demand. The public cannot distinguish between an increase in the money supply in response to an increase in money demand from an increase in the money supply intended to come as a surprise and lower unemployment. Canzoneri's model predicts inflation shifts between high and low regimes that mimic the inflation experience of the U.S. better than a single stable regime.(4)

   A second approach in the literature on dynamic monetary policy games posits private information with respect to different types of monetary authorities to focus on reputational considerations explicitly. In contrast to the models discussed above, these games have a known, finite horizon that represents the regime of a monetary authority; the preferences of the monetary authority are assumed constant. Backus and Driffill [3; 4] provide the earliest example of this literature.(5) Their finite-horizon model can explain why a disinflationary policy would gain credibility only slowly as the public updates its beliefs in response to unexpectedly low inflation after a change in the monetary regime.

   Cukierman and Meltzer [18] use an infinite horizon model to combine aspects of the approaches outlined above and incorporate several additional features of the monetary policy milieu that can be verified with casual empiricism. Rather than treating the monetary authority's objective function as a social welfare function, Cukierman and Meltzer argue that the objective function of the Fed reflects constantly evolving preferences over inflation and unemployment of the changing membership of the FOMC and political pressures sporadically applied to the Fed by Congress and the President. Formally, they represent the changing objective function with a stochastic taste parameter that follows an AR(1) process. Because the Fed's past behavior provides probabilistic information to the public about its current objectives and thus its current and future behavior, the Fed's optimization problem will have an intertemporal linkage. Thus, in the Cukierman and Meltzer model as the Fed chooses the current money supply it must be aware that its current choice will affect the public's future perceptions of what the Fed is seeking to accomplish. Their approach sheds light on what is meant by a change in the regime of the monetary authority. As Cukierman [17, 191-94] observes, if the distribution of the stochastic taste parameter has thin tails, large changes in the money supply regime will occur infrequently in response to infrequent, large draws of the taste parameter. These in turn might reasonably be expected to follow changes in the occupancy of the White House, the Fed chair, or other sources of change in political pressure.(6) The behavior of the public in the Cukierman and Meltzer model rationalizes "Fed watching," the existence of which is verified by casual empiricism. Fed watching is complicated by the fact that the instrument of monetary policy (e.g., M1, M2, the monetary base) is subject to only imperfect control by the Fed. Hence the public cannot precisely infer the Fed's objectives by monitoring the money supply growth rate. Cukierman and Meltzer explicitly define the Fed's credibility at a given point in time as the difference between the most recent money supply growth rate the Fed chose and the money supply growth rate the public expected the Fed to choose.(7) Because the public cannot disentangle a temporary monetary control error from a change in the Fed's tastes, after a large change in the Fed's stochastic taste parameter generates a large absolute value for credibility, credibility will adjust slowly over time. Although their analysis is not couched in terms of unemployment (or some other measure of real activity) and inflation, their model clearly has a rationale for a short run trade-off between real activity and inflation based on the value of credibility.

   Extant empirical papers that are relevant to strategic monetary policy issues focus on the public's reaction to announced changes in monetary policy rather than time consistency issues. One strategy common to several papers is the "prediction error" technique [10; 14; 15; 33]. Analysts using this method estimate a Phillips curve relationship and/or an interest rate term-structure equation from a sample drawn immediately before the announced change and then investigate the prediction errors of the model after the announced change. In the case of Phillips curve estimation, if the policy change is credible then private-sector inflation expectations change and inflation prediction errors after the change should be negative; that is, for a given level of unemployment, inflation should be over-predicted. For term-structure equations, Blanchard [10] argues that if the policy change is credible in financial and labor markets and if prices and wages are not predetermined, then since agents will have lower real balances in the short run but will anticipate less inflation in the future, long term and short term rates will move in opposite directions and the term structure equation will over-predict the long rates after a policy change. Blanchard (for the U.S. following the Fed's announced procedural changes in 1979), Christensen [14; 15], and Slow [33] all find that announced policy changes gain credibility only gradually with the passage of time. In particular, Blanchard's Phillips curve estimates imply that it took approximately nine quarters for the 1979 policy change to gain credibility.

   A second...