Is Monetary Policy Only About Expectations?

I have argued in the past that an explicit target for monetary policy is necessary for the central bank to accomplish its goals. For example, suppose that the central bank wants to increase the inflation rate by two percentage points. We know that they can do this by increasing money growth. But how much would they have to increase money growth in able to achieve their target? Well, one answer is that they can get out (I wish I could say dust off) one of their Old Keynesian forecasting models and recursively figure out the answer. In a lot of ways, it seems like this is what the Fed is doing. Whenever they announce asset purchases, they announce the nominal quantity of assets that they are going to purchase. An alternative strategy is to announce a target and to an intention to purchase as many assets as necessary to achieve the goal.

Now, of course, this doesn’t guarantee anything. If the Fed is targeting something that it cannot control or if policy doesn’t work in the way that the Fed believes, we might not get intended results.

But is announcing a strategy sufficient? According to what some in the blogosphere have referred to as the Chuck Norris strategy the answer is yes. And believe it or not, this is not the view that originated in the blogosphere. According to Benjamin Friedman and Kenneth Kuttner, for example:

Central banks no longer set the short-term interest rates that they use for monetary policy purposes by manipulating the supply of banking system reserves, as in conventional economics textbooks; today this process involves little or no variation in the supply of central bank liabilities. In effect, the announcement effect has displaced the liquidity effect as the fulcrum of monetary policy implementation.

The problem with the Chuck Norris strategy is that of commitment and credibility. The strong version of this Chuck Norris hypothesis is that an announcement is sufficient. The reference to Chuck Norris is due to (a version of) the following analogy. Suppose that Chuck Norris walks into a bar. He announces that he is going to beat everyone up if they don’t leave. Since he is Chuck Norris and everybody else is not, nobody bothers to fight him. They all leave. He doesn’t have to take action. Ironically, there is a flaw in this analogy that actually lends support to those of us who are skeptical about the Chuck Norris effect. Anybody who has ever been to a bar knows that not everybody will leave just because Chuck Norris makes the announcement. There will be somebody who challenges Chuck Norris — even if that challenge is futile. In other words, Chuck Norris cannot get by on credibility alone. He must follow up that strategy with commitment, i.e. he is going to have to beat a few people up.

Why do I bring this up? I bring this up because of the case of Switzerland. In order to prevent appreciation due to a flight to quality, the Swiss National Bank announced last year that they were pegging the Swiss franc at 1.20 per Euro. This is important because it seems to satisfy all the conditions for a Chuck Norris type policy. For example, a central bank has the resources and the means to buy and sell its own currency in foreign exchange markets to affect the exchange rate. Thus, it is targeting something that it can directly control and it is announcing its intended target. After announcing its intended target, this represents an explicit test as to whether or not the Chuck Norris effect is operational. Alas, Evan Soltas finds evidence that it is not:

I had implied in both posts that the floor was so credible that it did not require an active defense. Indeed, for several months after its establishment, the SNB did not have to conduct any trades. That is no longer true; I realize now that the correct conclusion to make was not that the Swiss currency floor would not require any currency purchases. Rather, the floor’s credibility eliminates the need for foreign currency purchases to the extent that those seeking to buy Swiss francs are speculating on exchange rates. To the extent, however, that Swiss franc buyers are seeking to park money in Swiss assets or deposit accounts, the SNB will have to purchase foreign currency to maintain the floor.

In other words, credibility is not enough. Central banks also need commitment. This is consistent with the view I described in the first paragraph. It is not consistent with the strong version of the Chuck Norris effect.