The Present Monetary Policy Framework is Seriously Flawed

The current approach to monetary policy encapsulates the belief that the monetary policy stance can be measured by the level of the real policy rate (r) relative to a neutral rate (r*). We argue that this interest rate gap (r – r*) is a flawed concept. It would only be meaningful, if r* could be theoretically and empirically unambiguously identified as an essential variable for the establishment of equilibrium conditions in the economy. In this case, the central bank could generate temporary deviations of r from r* to restore equilibrium when an exogenous shock pushed the economy into disequilibrium. But r* is ambiguous in theory and unobservable empirically. The consequence is that we can only measure a monetary policy impulse generated by changes in r, but not its stance relative to an incomprehensible benchmark. Moreover, while short term changes in demand are driven by changes in interest rates, the difference of actual financial rates to a notional neutral rate does not translate into the real world by itself. The level of real interest rates, which affects investment in the medium term, has differed from financial rates, which are managed by the central bank with regard to its estimates of a neutral rate r*. Hence, we argue that the current monetary policy framework is seriously flawed.