Monetary Policy Under Uncertainty, Regime Change and High Volatility

Economic policy usually faces a number of risks and uncertainties, as a byproduct of the changing nature of signals, the economic structure, the interaction of aggregate variables, the mutations in the behavior of economic agents and their reaction to policy decisions. It is generally acknowledged that uncertainty poses a challenge to monetary policy making. In the recent years, a growing body of literature addresses the effect of a variety of sources of uncertainty in the design of monetary policy. However, this literature has mainly focused in developed economies albeit that the uncertainty phenomena is generally more severe in emerging countries. We overview recent progress in economic literature that emphasizes the influences of uncertainty over the design of monetary policy. This literature has its main focus on developed economies but, a fortiori, those considerations seem particularly appropriate for economies that are characterized by the presence of deep uncertainty about the “correct” model that governs economic interactions, the value of structural parameters, the main transmission mechanisms of monetary policy and the nature of the significant and recurrent shocks which affect them. Economies like Argentina, have shown a clear propensity to the gestation of macroeconomic instability and a high frequency of regime changes. In the paper we show that in this environment, the uncertainty that surrounds the decision making process can undermine the efficacy, margins, and hence, the credibility of monetary policy. Experience shows that under such environment, uncertainty is particularly deep-rooted. On the one hand, the magnitude and persistence of the shocks which these economies typically face and the absence of appropriate mechanisms to restore macroeconomic equilibrium have made the job of the policymaker particularly tough. On the other hand, the source of these shocks and uncertainty for economic agents can often be attributed to the own policy decisions. Thus, the instability and inconsistency of policies, together with the difficulties to meet intertemporal budget constraints have been a source of uncertainty in their own right. We discuss the macroeconomic functioning of these economies and intend to define the relation between aggregate volatility, macroeconomic disequilibrium, regime changes and uncertainty. With this in mind, we illustrate the empirical relevance of many of these arguments for the Argentine experience. The analysis focuses on the distinction between conventional aggregate instability episodes, and two types of crisis that, from our point of view, have mainly characterized our economies in the near past. Moreover, we emphasize the differential characteristics and consequences of episodes of deep nominal uncertainty and the shortening of planning horizons, on the one hand, and plan inconsistency and generalized breaks of contracts, on the other. Agents that face this adverse context are naturally involved in adaptive behavior, and have frequently exacerbated aggregate disequilibrium forces. This is partly because recurrent past policy failures have yielded very low credibility on current and future policies, implying well-grounded inquiries about the possibility of policy regime change. Hence, agents display a high demand for a visible anchor for expectations to reduce the uncertainty surrounding the conjectures about macroeconomic sustainability. In such conditions, usual monetary policy tradeoffs become much stronger, as deep uncertainty seems to call for predetermined rules to coordinate expectations, while on the other side, the engagement in unconditional monetary arrangements can complicate the absorption of shocks. Thus, it appears to be a reasonable strategy for monetary policy in emerging economies to preserve flexibility, while at the same time, meeting the objective of a stable nominal environment, helping to reduce volatility and crisis probability. The uncertainty and low credibility of policies have shown a tendency to mutually reinforce by mechanisms of negative interaction: the uncertainty of the environment has made the job of the policymakers tougher, but at the same time, uncertainty has been increased endogenously by the own policy decisions and actions. In this paper we emphasize that in the literature about uncertainty for developed economies, this feedback mechanism has usually been neglected or held under the ceteris paribus clause. Finally, we analyze the most relevant sources of dominance -fiscal, external and financial- that have characterized the formulation of monetary policy in our countries. Dominances are relevant because if agents perceive that the actions of the monetary authority are dominated its ability to achieve monetary policy goals could be severely undermined. In other words, the resurgence of solvency problems in the financial front, in the fiscal front, or a low demand for domestic assets under the perception of lack of external sustainability can create renewed pressures in the management of monetary policy. We conclude that although monetary policy should take into account potential sources of dominance, this should not generate doubts about the compromise of the authorities in providing a nominal anchor for expectations and contracts. If this is not the case, perverse interactions that magnify factors of potential dominance and intensify the already eroded state of credibility on monetary policy can emerge. In the presence of dominances, the best way to widen the action margins and increase the efficiency and power of monetary actions is to attack the origin of dominances and to design monetary schemes that specifically take into account its consistency with the rest of the macroeconomic policy. In a context of uncertainty, regime changes and in those situations where agents and authorities are involved in a learning process about the environment, it seems reasonable to keep policy options open avoiding irreversible courses of action. However, this attitude should not be interpreted as a synonym of full discretion. It is essential then, to have a clear and transparent communication strategy, associated to a monetary scheme whose institutionality gives high priority to the objective of price stability. If this is not the case, to resort to the notion of uncertainty would be a perfect excuse to reintroduce the absence of course in the conduction of policy, going against the possibility of recovering lost credibility.