Time to rethink inflation targeting
It is time to add another victim to the ever-growing list of institutions (Bear Stearns, Lehman Brothers) and theories (value at risk, fair value accounting and originate to distribute) which have been tested by the financial crisis and found wanting. The central bank practice of inflation targeting — the jewel in the crown of modern monetary economics — has palpably failed.
Over the last two decades, inflation targeting has emerged as the most popular strategy for monetary policy among the world’s major central banks, and become something of a state-of-the-art choice among theorists and central bankers.
Even the Fed, long skeptical, considered announcing a formal target for inflation last year. Senior officials considered whether it would be a useful way to counter the threat of deflation by providing an “anchor” for expectations about future prices. In the end the central bank ducked the decision and decided to press ahead with long-term inflation forecasts instead, as a form of “soft” targets.
But the experience of major central banks over the last five years — both those pursuing formal targets and those like the Fed which have been employing “shadow” ones — suggests inflation targeting has failed and will need to be overhauled once the immediate crisis has passed.
CENTRAL BANK PERFORMANCE
Controlling inflation has been the central objective for monetary policy for the last 30 years. But using interest rates to target the inflation rate directly emerged only in the early 1990s. In many countries, it was something of a default choice after strategies targeting intermediate variables (such as the money supply and the exchange rate) had been tried and failed.
In its own (narrow) terms, inflation targeting has been successful. In the United Kingdom, consumer prices have increased broadly in line with the Bank of England’s target since the central bank was given operational independence to set interest rates in May 1997.
Evidence from the United States is more mixed. The Fed has long insisted it does not have a formal inflation target (preferring to retain flexibility for what it calls a “risk-management” approach). But senior officials have defined the “price stability” component of its dual mandate as an inflation rate of about 1.5-2.0 percent per annum.
Both the all-items consumer price index and the core index excluding food and energy have consistently risen faster than the Fed’s implied target since 1997. Access PDF here.
In fact, the performance of inflation and the Fed’s interest rate decisions suggest the Fed has actually been targeting a core inflation rate of about 2.25 percent per year, or an all-items rate of 2.50 percent.
While this is slightly faster than officials have been prepared to admit publicly, it is still respectable by historical standards.
The real problem is that a narrow obsession with hitting inflation targets blinded central bankers around the world to the build up of other problems, including bubbles in the bond and real-estate markets, as well as the build up of excessive levels of household and corporate debt.
Moderate growth in each month’s consumer price numbers provided false comfort even as distortions built up in other parts of the financial system (overvalued asset markets) and economy (a gaping trade imbalances and surging commodity prices).
If the ultimate purpose of inflation targeting was to provide a stable economic framework for long-term decision-making by households and businesses, it has failed. Bubbles and over-indebtedness have caused far greater output losses when they collapsed than any amount of moderate consumer price inflation.
The excessively narrow focus of inflation targeting reflects conceptual shortcomings.
In 1952, Professor Jan Tinbergen proved that to achieve two independent policy objectives simultaneously, policymakers must employ two independent policy instruments.
Tinbergen’s rule implies monetary and fiscal policy work best when coordinated to achieve the optimal joint outcome for inflation and growth, or between internal balance (inflation-growth-employment) and external balance (the trade deficit and exchange rate).
But in a curious inversion, modern economics has sought to separate them, assigning monetary policy the role of pursuing price stability, while leaving fiscal policy to worry about growth and employment.
It reflects the impact on the discipline of Milton Friedman’s famous comment about inflation being “always and everywhere a monetary phenomenon,” amplified by the impact of the rational expectations revolution, which seemed to indicate monetary policy could not have an enduring impact on the level of business activity and employment, only on prices.
From this stemmed the idea monetary policy should focus on choosing a desirable (low) rate of inflation, leaving other aspects of demand-management and employment policy to fiscal policy.
The discipline has gone further, and sought to implement an institutional separation between the fiscal and monetary authorities. Most theorists have supported establishment of “independent” central banks able to set monetary policy at arms length from the fiscal authorities.
This reflects a mistaken view that monetary policy is essentially a technical academic exercise that can and should be insulated from other aspects of the policymaking process.
Reflecting this technocratic approach, modern monetary economics has been dominated by a debate over rules versus discretion — with a rule-based system generally held up as superior.
The history of the discipline since the late 1970s can be summed up as the perfect monetary “rule,” specifying how much the central bank should adjust the instruments under its control (reserves and interest rates) to achieve some intermediate variable (money growth and the exchange rate) or direct target (consumer prices) and ensure the ultimate goal of price stability is met.
But focusing monetary policy on consumer prices encouraged central banks to ignore signs of growing instability in other parts of the financial system (such as asset prices and lending). The target was too narrow and needs to be broadened in future.
It was a mistake to separate monetary policy and fiscal policy and assume monetary policy could somehow operate in isolation from tax and spending decisions and other interventions in the economy. Macro management would be more effective if monetary policy and fiscal policy were coordinated.
Elsewhere, I have suggested the authorities might need to go further and supplement existing monetary and fiscal policies with a third, distinct policy to govern the quantity of credit and build up of debt to ensure that internal balance, external balance and financial balance can all be achieved simultaneously.
Finally, it was a mistake to pretend monetary policy is a technocratic exercise. Decisions about interest rates have distributional effects (between savers and borrowers, more and less growth, more and less employment) and are inherently political.
This is not an argument for interference. But it is an argument for greater honesty about the social trade offs involved.
It is also an argument for allowing discretion back in. Rather than mechanically applying rules targeting a single variable such as consumer prices, central banks need freedom to respond to changing circumstances. That means freedom to cut interest rates dramatically in response to a financial panic. But it also means freedom to raise them during a boom to prevent wider distortions in the financial system even when there are no obvious signs of consumer price inflation.
Inflation targeting needs to be reworked in favor of a more holistic approach that gives central bankers more discretion to pursue a complex set of goals (including financial stability. But they must also be held more accountable, and accept this not just a technical exercise but one which involves difficult choices for society as a whole.