Monetary policy

Monetary policy refers to a change in the cost of borrowing (the rate of interest) or the quantity of money in circulation, in order to achieve the objective of low and stable inflation. 

Monetary policy is controlled by the central bank of a country, or regional monetary union, such as the Eurozone. While central banks are given the mandate to use monetary instruments to create price stability, the 'real' economy is usually taken into account through some form of 'dual mandate'. For example:

The US Federal Reserve has a dual mandate which involves:

1. Price stability - the Federal Reserve sets a symmetric target of 2% inflation (as measured by the Price Index for Personal Consumption Expenditures (PCE). A symmetrical target means possible intervention if the inflation rate rises above or below the 2% target.
2. Maximum sustainable employment - which means the highest level of employment or lowest level of unemployment that the economy can sustain while maintaining a stable inflation rate. A broad range of labour market indicators and estimates are used to inform policy decisions.

Other central banks refer and take into account the 'real economy' (growth and jobs) without operating an explicit dual mandate. For example:

The Bank of England's mission is to '..promote the good of the people of the United Kingdom by maintaining monetary and financial stability..". While the Bank has the achievement of low and stable inflation as its main goal, it also supports the Government’s other economic aims for growth and employment. 

The European Central Bank's (ECB's) primary objective is to '..maintain price stability, that is, to preserve the purchasing power of the euro..'. by making sure that inflation remains low, stable and predictable. Despite the popular view that the ECB has a single objective, it does have a legal obligation to '..support the [EU’s] general economic policies..' and contribute to the objectives laid down in Article 3 of the Treaty on European Union. (Secondary source: FT.com]

The Reserve Bank of India also operates a 'softer' mandate - to keep inflation within 2 percent points on either side of its 4% target [an upper limit of 6 per cent and the lower one of 2 percent], while 'keeping in mind the objective of growth'. The inflation target, which is set by central government, is reviewed every 5 years.

Monetary policy takes a long time to have an effect - taking up to 2 years to work its through through the 'monetary transmission mechanism' - hence decision making must take into account what the likely inflationary conditions will be 2 years in the future.

Margins of safety - avoiding deflation

The main reason why inflation targets are not set a zero is that a positive margin of safety is generally considered beneficial. This is largely to avoid deflation. It is commonly argued that there is a positive statistical bias in most price indices, meaning that the 'true' level of price inflation may be lower than the level shown by the official index.

Given the time lags in the system, it may be too late to avoid deflation if inflation falls to 1%. Hence, if the inflation rate has been moving steadily downwards, say in a 6-month sequence of 4.25%, 4.0%, 3.75%, 3.5%, 3.0%, 2.5% the trigger point of 3% or 2.5% allows a policy change (lower interest rate) to have an effect without generating deflation. [E.g., triggering at 2.5% would allow four 6-month periods of 0.25% reductions in inflation, so that, within a 2-year timeframe, officially 'measured' inflation would still be recorded, at 1.5%. If the positive bias in the official index is estimated at 1%, then actual inflation is 0.5%, with deflation avoided.] Clearly, this is a simplistic example, but it illustrates the problem of policy timing and the need to keep a margin of safety.