Monetary policy games

FINALLY, the CBRT showed a clear opening that made sense to all. After all, monetary policy is a game, maybe like chess. As such it isn’t tightening per se because the effective funding was already at 14.80% the day the policy rate was raised to 15%, but a return to normalcy in the monetary policy mix. The signaling effect is more important than the magnitude of the hike. So is everything ‘normal’ now from the viewpoint of central bank independence, reputation, and credibility and suchlike? Not so fast. Here are a few seasoned thoughts about monetary policy games.


As demand picks up, inflation rises. This general phenomenon is further strengthened if the budget deficit soars and if the deficit is financed through monetization. Furthermore, if bank capitals are shored up by TRY injections, and TRY credit creation outpaces core funding growth rates, inflation rises. All of these are in place today. What is problematic is that the exchange rate blurs this closed economy view. Because corporates are FX-indebted, any exchange rate increase doesn’t trigger exports – it does but only afterwards and only if the real exchange rate remains low for a long period – but either deters imports and contracts the economy or curtails investments and contracts the economy, or both. The exchange rate – at whatever level it may stand – doesn’t equilibrate the sources of growth through reallocation of resources across sectors; it tips the economy off balance. Nevertheless, as no small open economy can simultaneously control both the interest and the exchange rates unless it closes itself to cross-border capital movements, willing that which can’t be willed won’t work in the interim term. One reason for this is inflation, obviously. As the exchange rate jumps, so does inflation. This invites all sorts of credibility problems: all that has happened is happening and will happen, will go by the book of monetary policy games.


Time inconsistency of optimal policies basically means that an optimal policy computed at the beginning of a planning horizon does not remain optimal at a later date. Ex ante – that is, prior to certain choices made by the private sector – an optimal policy induces a response from that sector. However, ex post responses may be very different from ex ante responses. This implies that the government’s ex post constraints are different from its ex ante constraints. Under the existence of a certain form of imperfection which makes the ex-ante optimal policy a second-best rather than a first-best, there is an ex post incentive to deviate from the ex-ante optimal policy. The incentive to deviate ex post vanishes if the government is able to make a binding pre-commitment to an ex ante optimal policy. It is difficult to envision the enforcement of such binding commitments since the government is by definition the dominant player and a sovereign decision-maker. Hence, those policies that would be optimal if binding commitments could be enforced do face a credibility problem due to the ex post incentives of the government not to perform as pretended. Forward-looking rational agents only believe a policy announcement that will be optimal to carry ex post. Nevertheless, imposing credibility in the sense of ex post optimality adds an additional constraint to the government’s policy problem, which in turn implies a welfare loss relative to the ex-ante optimal policy. The motive to push the economy towards the first-best drives the equilibrium away from the second to the third-best.


The primary focus is to design monetary policy to minimize these costs. The central presumption behind the modelling is that the policymaker has the possibility to influence output by engineering inflationary surprises. The government has an objective function V (I, i), increasing in employment (output) I to a certain target level I* and decreasing inflation i from some target level i*. The government controls i by setting either the money supply or the exchange rate in a small open economy. The private sector consists of firms with a neo-classical labor demand function and a number of forward-looking wage setters. The nominal wage is set for one period at a time so as to maximize some objective over the real wage and/or the employment. With a known government objective, equilibrium inflation and expected inflation must coincide and without any surprise, equilibrium employment must be at the privately desired level E. Before the wage has been declared, it is optimal to set inflation at i. If E* = E, this policy achieves a first-best outcome and there is no credibility problem. But if E* > E, due to a labor imperfection – arising from taxes or from union power – it can only achieve a second-best outcome and there is a credibility problem. Private employment, ex post – after the wage has been set – is a function of the real wage and differs from E only if there is surprise inflation. Then it is not credible to announce a policy i < i* because, for any nominal wage associated with expected inflation i(e) < i, there is an incentive to deviate from the announcement ex post – to increase employment by surprise inflation. Hence, the only credible policy is i = i. The smaller the weight the government puts on inflation, the higher is the credible inflation rate i relative to the desired rate i. This is clearly a one-shot game between the government and the private sector. Its basic insight is that, given the lack of pre-commitment, the economy is characterized by an inferior Nash equilibrium – having an inflationary bias – with unemployment remaining at its natural rate.


The above analysis can be extended to repeated games. The most fundamental characteristic of a repeated game is the presence of memory in the strategic behavior of players. Sustaining equilibrium between the government and the private sector is dictated by the reputational forces operating through threat strategies that punish a rival for bad behavior. Barro & Gordon elegantly analyzed this sort of a repeated monetary policy game back in the 1980s. They envisage a trigger mechanism in which inflationary expectations of the private sector are revised in response to the actual – ex post – inflationary strategy pursued by the policymaker. The initial low inflation target announcement of policymakers is recorded as viable. If actual inflation has been kept low, private agents would hold down their inflationary expectations. A reputational trade-off between the benefits of current surprise inflation and the costs of future expected inflation where “the policymaker must weigh up the current gains from cheating, with the subsequent loss of reputation reflected in higher expected inflation”. The degree of threat is obviously linked to the extent of reputation loss. The priority ascribed to inflation as a policy is also important.


Much more important is the fact that policy credibility is strongly associated with the design of institutions. The voluminous literature on this is centered on the presence or absence of binding rules or institutions represented by games. To overcome the aforementioned credibility problem by delegating monetary policy to an independent central banker mandated to pursue low inflation, smart people thought the appointment of a “conservative” central banker who alters societal preferences such that “society can make itself better-off by appointing a policy maker who places a greater weight on inflation prevention than itself does.” In other words, we posit an important weight on inflation in the personal loss function of the central banker. The more conservative the policymaker is, the closer the society comes to the pre- committed solution. On the other hand, such a solution can go too far. There is a flexibility/consistency trade-off in the presence of uncertainty. The need for flexibility makes it undesirable to have a lexicographically committed inflation-fighter at the central bank. The arguments for the Central Bank Independence (CBI) as a remedy for taming time inconsistency admit two strands of theory: the conservative central banker approach and the principal-agent approach. In the alternative approach, monetary policy is entrusted to a central banker by a contract that imposes costs on him when inflation deviates from the optimal level. The inflation penalty is linear in the basic model and thus, easy to design. Finally, a commitment to an institutional rule – representable by a principal-agent contract – can be more plausible than a commitment to a specific monetary policy action.


None of the above ever existed or put to use in Turkey. So, the Central Bank has never been truly independent in a sense. The institutional framework was only partially designed for that. Hence, policy rate hikes happen, although their occurrences are rare compared to cuts. But do they happen because of the right reasons and before the curve leaves the bank behind?

A very good move in the expected and right direction indeed: but we need to see more in the implementation of monetary policy. Any autonomous move that would render central banks credible are indeed warranted moves in this kind of game.

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