Moving beyond the monetary policy rule of thumb

Central banks around the world tend to use historical, fixed “rule of thumb” models to predict how changes in exchange rates will affect prices. These effects are key for deciding whether to raise or lower interest rates, or adjust quantitative easing.

The existing models work well to capture differences among countries, but they don’t necessarily take into account what is happening inside a country to affect currency values in the first place. Changes in supply and demand, or other “shocks,” impact import prices and consumer prices differently, which means they require different reactions from a central bank.

Now a new framework takes into account six different shocks that cause exchange rate fluctuations and “pass-through” to ultimately affect prices. The framework should help central bankers around the world develop more accurate economic forecasts — and therefore improve monetary policy. It has already been used by the Bank of England and is part of the current discussion by the European Central Bank on how to adjust quantitative easing.

The framework was created by Kristin J. Forbes, a professor of management and global economics at MIT Sloan, along with Ida Hjortsoe and Tsvetelina Nenova, who were all at the Bank of England when they started work on this project. Forbes served as an external member of the Bank of England’s Monetary Policy Committee from 2014 to 2017.

“With the benefit of hindsight, this framework sounds obvious, but it was something no one was thinking about at the time,” Forbes said.

Even if people had wanted to use this framework, policymakers lacked the technical tools to identify shocks in real time. Academics had been developing models that focused on differences in pass-through across countries over long periods, but had not focused on a framework useful for the shorter time periods that matter for policy. Academics had also paid little attention to why pass-through changed in a single country over short periods.

“Our modeling is bringing research techniques and theoretical work from academia and applying it to a real-world problem,” Forbes said.

Different causes, different effects

In a working paper, Forbes and her co-authors present a structural vector autoregression framework to model the impact of six types of shocks: domestic productivity, domestic demand, domestic monetary policy, exchange rate risk premia, global productivity, and global demand.

The framework emphasizes the need to model the shock behind the exchange rate movement, Forbes said, rather than simply apply a “rule of thumb” to predict exchange rate pass-through to consumer prices. (For the Bank of England, the rule of thumb estimate is a 20 percent to 30 percent impact.)

For example, the depreciation in sterling’s value from 2007 to 2009 led to a sharper increase in prices (more exchange rate pass-through) than the rule of thumb forecast was predicting at the time. This led to a period of higher inflation than the Bank of England expected.

The new analysis suggests that this should not have been a surprise, because sterling’s depreciation was driven by large negative global and domestic supply shocks. These shocks tend to cause a sharper increase in import prices, allowing British producers to safely raise prices for their own goods as overall costs go up.

The framework was important when the Bank of England considered how to respond to the Brexit vote for the UK to leave the European Union. Even though sterling’s value dropped by about 20 percent — similar to in the 2007-2009 period — this new framework suggested that there would be a more muted impact on inflation. Even though the price of many imported goods would increase (including for popular UK items such as marmite) the “shocks” behind sterling’s fall suggested these price increases would be more limited.

Forbes said this framework helped reduce concerns about a sharp pickup in inflation, allowing the Bank of England to ease its monetary policy after the June 2016 Brexit vote.

“This analysis made me more comfortable that we could lower interest rates if the economy slowed, even if prices were going up,” Forbes said. “So far, we are seeing the lower levels of pass-through predicted by the model. It’s nice to have some validation that the predictions from this framework are playing out.”

Academic work, real-world implications

In addition to the Bank of England, central banks in other countries — such as Iceland, the euro area, and Switzerland, have discussed this framework, Forbes said. The United States has also discussed this approach but the impact of exchange rate fluctuations on prices tends to be less important, as the U.S. is such a large market with fewer imports. For the European Central Bank, estimating exchange rate pass-through is important for predicting when inflation will return to the 2 percent target — and therefore when to end its policy of quantitative easing.

For Forbes, the process of creating the framework in her dual role at MIT Sloan and the Bank of England reinforces the MIT motto of “mens et manus,” or mind and hand.

“At MIT, we think about technical ways to approach a question, and having the chance to serve in senior policy roles forces you to focus on questions that apply to the real world,” she said. “It’s been very rewarding to see these two worlds meet.”

The framework will also give Forbes an opportunity to help central banks answer a key question: Has globalization changed the inflation process? This will be a focus in summer conferences held by institutions such as the Bank of International Settlements and European Central Bank, events where Forbes will present new research.

In both the United States and Japan, unemployment is low and growth continues to be strong — but inflation is low. Does a more integrated global economy mean that global shocks matter more than domestic demand and supply shocks? How will that affect inflation?

“We’re going to take the analysis and apply it to a whole new set of questions that are front-and-center for central banks today,” Forbes said.