At the same time, I do not favor total discretion in which the monetary policy strategy is determined in an ad hoc fashion as we go along. For monetary policy to be most effective, market participants, households and businesses need to be able to anticipate how the Federal Reserve is likely to respond to evolving conditions. That is because the transmission of monetary policy to the real economy depends not only on what policymakers decide to do today, but also on what the public anticipates that the FOMC is likely to do in the future as the economic outlook changes and evolves. Our experience at the zero lower bound in recent years underscores how important expectations are in influencing the effectiveness of monetary policy. Policymakers thus need to act in a systematic and consistent manner so that expectations are formed accurately and economic behavior can respond consistently with those expectations. In my view, this consideration rules out a totally discretionary monetary policy. Before I critique the use of prescriptive rules in monetary policy-making, I’d like to make it clear at the start that the Taylor Rule (by which I mean the formulation based on John’s 1993 and 1999 papers) has a number of positive attributes that make it a useful reference for policymakers. First, it has two parameters – the long-term inflation objective and the level of potential output – that map directly to the Federal Reserve’s dual mandate objectives.
Subject to the caveat that the equilibrium exchange rate of a currency cannot be estimated very precisely, there is common agreement that the exchange rate of the Maltese lira does not appear to be significantly misaligned and that the reasons for the economy’s slow growth lie elsewhere and should be addressed directly. Indeed, I cannot detect an economic rationale for the sudden attention being given to the exchange rate. The exporting community, the sector most directly concerned, has not to my knowledge made a formal proposal through the FOI. It is also significant that a change in the exchange rate did not feature among the 55 MCESD recommendations for the restoration of competitiveness. Devaluation to improve competitiveness does not work. Unless it is accompanied by a cut in real wages, it serves only to raise inflation. This is borne out by the experience of several countries, including Malta’s after 1992. As for the concept of a “gradual depreciation”, which has not been clearly defined, the nearest instrument known to economic theory is a crawling peg. Since this involves a change in the exchange rate regime, it requires an announcement that the currency will be depreciated at given intervals dictated by movements in some anchor, such as the retail price index. This method creates uncertainty and offers speculators a one-way bet. Experience has indeed shown that crawling peg regimes have often ended in crisis. The lessons of recent economic history should not be ignored.