Time to rethink inflation targeting

March 19, 2009

John Kemp Great Debate– John Kemp is a Reuters columnist. The views expressed are his own –

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.

FLAWED THEORY

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.

PRACTICAL SHORTCOMINGS

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.

18 comments

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It appears that inflation was kept in check by mechanisms that in effect inventoried the inflationary outcomes. I have suspected this for years but do not know enough about economics to predict it. Now we will see the inflation index adjustment, we are going to experience that pent up inflation.

Posted by brad | Report as abusive

John Kemp correctly identifies that monetary policy narrowly targetted on CPI has failed. Hard to argue with that conclusion after the approach was tested to destruction under Greenspan.
But it is a non sequitur to then argue that financial and monetary policy should be run together and that there should be lots more discretion for central banks.

Under Greenspan, the Fed (as many other central banks) focussed on CPI. It ignored asset price inflation, debt build up and international capital flows. It’s interventions were lop-sided in that it loosened monetary conditions when a contraction threatened but did not tighten in the face of possible bubbles (on the basis that they could not be predicted).

All of those elements of Fed policy were in error. Instead, we needed and still need monetary policy that looks at asset prices, debt build up, and international capital flows and is not assymetric in its interventions. This is:
a) more complex than the old model, but
b) makes retaining independence from direct political control all the more important.
For both reasons, attempting to fold monetary policy into fiscal policy would be a deep mistake.
Incidentally, there is no third leg about the quantity of credit required. Tough minded monetary policy will tighten interest rates and the availability of cash in the face of debt build ups, deflating any credit bubble (which was, of course, just what Greenspan failed to do.)

A very interesting and enlightening article indeed.
Labor and business both wish real wages and prices respectively but they can only negotiate nominal wages and prices. The gap between the wishes of the two sides is bridged through inflation and/or unemployment. Fighting inflation central banks made sure that this bridging would happen only, or mainly, through unemployment. This was not a side-effect but the main purpose of the new monetary policy since 1980’s masqueraded as “independent” and “neutral”.
Moreover, inflation targeting (i.d. consumer prices inflation targeting) did not take into account soaring asset prices. But this was “saver prices inflation”. And normally one’s income is split to consumption and savings. As wages increased at a relatively slow pace, wage earners could buy less and less new assets although their stock of assets gained value. Strange as might sound the previous sentence, the picture is clarified when you consider house affordability measures; as house prices soared, one needed the wages/savings of many more years to buy the same house. If I didn’t buy some company A stocks this year, I would buy less stocks of the same company next year. This sounds to me for the definition of (saver prices) inflation, although nobody seems to consider it as such.
The above had as a result the voluntary surrender of any property the lower and lower middle class had to the upper class through accumulating debts. Inflation fighting and the independence of central banks was a central tool in this procedure.

Posted by Kostis Papadimitriou | Report as abusive

The phrase “But it also means freedom to raise them during a boom…” also sounds somewhat technocratic to me, since it’s not a freedom electorates are likely to allow their governments. At least, until a majority of the electorate are pensioners who always want higher interest rates! The opposition would simply need to accuse them of stifling growth by beng excessively cautious, regardless of whether they actually believed it or not.

Posted by Ian Kemmish | Report as abusive

“Inflation” as it is publicly discussed does not include one major household expense: the house related expenses where the household lives (rent or mortgage installments).
So, what is the real understanding for “inflation targeting”?
Is there any model where the real estate price (as a part of household expense) is considered fixed or marginally important? As far as I recall – NO.
So, I would say, the day-to-day discussions about “inflation” do not really match the whole story and the whole impact of prices on the household’s budget itself.
But I must say it’s really a good subject to discuss on or to listen about. :)

Posted by George O. | Report as abusive

Having an inflation target – ie, placing a life expectancy on money by gradually reducing its buying potential – I know for some people means getting money moving. There are folks who are fixated on the nominal flow of cash. I give John a dollar for raising his arm. John gives me a dollar for raising my arm. I give him $1.10 to lower his arm. He gives me $1.10 to lower my arm. Look at all of this economic movement. Give the laid off auto worker $100 because he will immediately spend it. Give him $1 million with instructions to spend it. Throw cash from the top of a building so people will spend it. I have a better idea. Literally just print the cash and burn it – like in a furnace. That’s the ticket. Just burn all of the cash. Print more cash. Burn that and so forth. Is that a whole lot different than some of the suggestions we are hearing.

Posted by Don | Report as abusive

Recommended reading for everyone: Flation by Abba Lerner. Easy to understand, well grounded, and logical without all the convoluted machinations typically associated with economic theory, and the contrived political implementations thereof.

Posted by J.O. Almist | Report as abusive

What is the role of the central banks? Is it to be super human and solve all problems before they arise, thereby preventing problems?

Consider that the current crisis erupted only after oil hit $140 plus per barrel with fears of even higher prices due to “Peak Oil” production. Literally, one morning the world woke up and saw that the old way of economics, especially real property pricing and debt, was not going to work in an oil constrained economy. A new paradigm is the outcome.

Most observers will agree that under the new paradigm, all the present debt can not be repaid (in equal exchange value) because fundamental relationships have changed permanently. That raises the political question of “Who gets stuck with the losses that are sure to come?”. The corollary question is “Where do we go from here?”.

The central banks and governments of the world seem to have a goal of restoring past conditions. That is probably impossible under the new paradigm.

Posted by Roger | Report as abusive

Why is it that I get the feeling that economics is a failure because it believes its own spin/hype.

Inflation is a tax that is levied by people who are not voted into office. This is is simply unconstitutional (and I am not a libertarian). The American Revolution was mounted on a platform of no taxation without representation.

Inflation devalues everything including money and forces business, workers, investors, savers, real estate owners, etc. to deal with the complete skewing of the market economy.

Why do bubbles build up? Because distortion caused by inflation and preferential treatment to some vested interest prevents the market from working rationally. This idea that central banks with the power to create money is somehow beneficial to society is a complete joke. Central banks are simply a way for the financial elite to relieve everyone else of their wealth, gradually, almost imperceptibly through printing money and other non-productive initiatives.

We would be better off to turn these powers back to the Congress and make them publicly debate how much they are going to decrease everybody’s net worth in order to run their unproductive government initiatives.

We could do away with the IRS and taxes and simply devalue the currency every year by printing more in order to pay for government. At least this would be honest. It would really put a laser beam of attention on this subject which would mean that only the most beneficial government programs would be enacted.

As a side benefit, you wold probably get a completely different class of citizen politicians instead of the corrupt, greedy, sold-out hypocrites that we now suffer under.

Posted by Jonathan Cole | Report as abusive

John, it seems to me that you did not expand your analyses on 2 vital points.

1.You provide the notion that fiscal and monetary policy needs to be coordinated. With the central banks exercising control over monetary policy and the government exercising control over fiscal policy, how do you propose to get these two supposedly “independent” decision making groups to coordinate policy?

2. You mention that by focussing monetary policy on consumer prices insufficient attention was given to asset inflation. Seriously John, glossing over this will not do.
Inflation targetting, EXCLUDING asset prices, is part of the heart of the debacle of the crisis in the financial system. A large proportion of the income of banking and financial services businesses is derived from asset related lending (mortgages and CDS) and targetting this area of the economy would have put a dampener on the ever growing income revenue and Capital “expansion” (since it has proven to be illusiory).

The assumptions of your argument is its downfall. The assumption that the central banks are independent and operate autonomously when in fact they are the central clearing house of the private banking system and therefore will act in the interest of that industry and formulate policy based on ensuring the continuation of that industry.
You may say, well what is the problem with that? Simple, are the objectives and policies that are required to maintain the continuity of the present structure of the banking/financial services industry in synchronicity with what is required by the real economy?

See: inflation targetting is directed at the real economy but excludes the economy which is the heartland of banking, asset prices. Why? Because monetising and collaterlising of the assets economy is the bee hive and money pot of the economic and financial system.

The financial crisis has brought to the surface the survival needs of the real economy and this terrain of what is good for the real economy versus what is good for the financial economy may turn out to be more complex than “you suckers need to bail us out otherwise if we go down you go down with us.”

When the real economy is being squeezed who benefits to extend them the “lifeline” of more debt? The banks, obviously.

Summary: What the financial industry would like to see is the bail out the financial system (the Master) with tax revenues from the economy (the Servant) and then the Master can continue to provide for the Servant.

It remains to be seen to what level the Servant imposes conditions and attachments to provide this relief to the Master.

Posted by Gregory | Report as abusive

There is only one real solution: valuable money.

Worthless money has had it’s day. The Federal Reserve has now caused two depressions in a century (it turns 100 in 2013). The one which started in 1929, just 16 years after the creation of the Fed, was longer and more severe than any in history. It remains to be seen whether the coming one will be worse, but all indications are that it will, and that it will be an inflationary, not a deflationary depression.

So what do we need? Valuable money. Money which has a direct relationship to one commodity. I prefer gold, since in the case of gold, the commodity *is* the money. One can carry a coin which is much like a silver dollar, and is worth over $1000. For those who don’t remember, this means it’s worth as much as $20, on the day the Federal Reserve started it’s orgy of destruction.

Only a commodity standard makes it impossible to artificially expand the money supply. And only a natural money supply will stop the American economy from sliding into the ash heap of history.

I don’t agree that the management of inflation was entirely flawed, but when you load the model up with the wrong factors it was destined to fail (particularly when the Chinese slave labour camp was keeping it artificially low). I’ve long thought that house prices should have represented a very major slice of the inflation calculation basket. Had they done so, rates would have gone up at the right time to prick the house price bubble when it was needed, and the also the subsequent debt overload. At the end of the day, if you influence house prices in the UK (with rates that’s so easy to do) you effectively control the health of the economy. They chose not to and now we’re going to have to pay the price – yet again!

Posted by Paul B | Report as abusive

It is easy to sit back, armchair quarterbacking economic policy with the benefit of hindsight.
There is a knee-jerk mentality being cultivated by fear of the unknown and an urgent feeling that we should immediately throw out the baby with the bath water. Bottom line, free market princaples don’t work with out meaningful compitition, excessive speculation on mortgages, dirivatives, insurance, etc, is and was a ticking timebomb with out oversight, meaningful risk mitagation, and reasonable leverage.
To allow purchaes on credit, based on colateral that you can’t hope to cover, to buy things you could and can’t afford??? Did anyone really think that this was a good idea, oh yeah, it’s all hedged, no sweat, and why own something you hedge against, should I go on? How the hell can you buy insurance against the failure of something that you don’t have any interest in.
My point is that the whole financial system is so perverted by the mice running the cheece factory for the last eight years that sound a meaningful theory does not work because sound princaples of money management and risk management have been thrown out.

Posted by Andy W | Report as abusive

Take a step back from the frey. Look at the frey. Look at the movements that arise from the frey. Understand the competition that exists between well placed competitors. Recognize the genius of the overall schematic of domestic evolution.

Regulation is always countered with cries of Socialism. Mob rule is always countered with a rally around the republic. Deregulation is always countered with a cry for justice. Until you understand this you will always turn on the mouse wheel of everyday events.

At the end of the day one can feel confident in the application of freedom upon the tendency of tyranny.

You have been smacked.

It is time to end the Fed and return to to consitutional money. Greenspan on page 481 of his book speels it out congress wanted inflation as hidden tax to allow for expansion of government without actually having to raise taxes and as long as things chugged along everyone was happy.

Return to gold and silver as money per the constitution. Gold reguires no elaborate regulatory policies since it has real value. And forget all that BS about there not being enough gold in the world. The value of gold is tied to supply and demand so ever smaller pieces will have ever greater value and thuis purchasing power.

As for loans allowing for greater economic expansion, business models that reguire loans to keep the doors open in perpetuity are failures. LET THEM FAIL!!!

There will be no confidence in the USD until it is backed with something another than hot air and pipe dreams.

End the Fed

Posted by katwoman | Report as abusive

The Federal Reserve Bank was the first act of Congress giving up the one of it’s many Constitutional duties in the twentieth century. Subsequent Congress’ enacted the War Powers Act, Patriot Act, Homeland Security Act… ad nauseum. We have a group of leaders unwilling to make tough decisions because they are more concerned with getting reelected. So they legislated the powers away and created an Emperial Presidency.

I believe we have never as a a nation lived up to the principals or laws the Constitution set forth. I would have hoped we would be a little closer by now. If we expect to endure as nation and a society, we must bring our elected officials to fulfill their constitutional duties, by any means necessary.

Posted by Anubis | Report as abusive

These arguments are over thinking the problem. If the Fed would have done its job without political influence then monetary policy would have been effective. Two reasons:

First, the Fed dropped rates to near zero after 911 to stave off the recession. The trillions of dollars out there started looking for place that paid better than the 1.0%. Mr Greenspan was offerring so Mortgage backed securities were the investment of choice. Unfortunately there were not enough 30yr fixed pools to satisfy demand so Wall St came up with newer riskier pools. They bought them straight from the originators bypassing FNMA and Freddie. You know the rest.

Secondly, all Greenspan had to do was look at consumer debt as a percentage of GDP. It went from 50-60% in 2002,straight up to 100% by 2008. Somewhere a bell should have been ringing loudly in the Fed’s ear!

If the Fed is paying 5% risk free why would there be a need to invest in riskier products. The higher rates would have deterred home buyers as well.

Bubbles are easy to spot. Even if you dismiss that notion then debt to GDP is published every month. Any Fed chairman should have noticed the dangerous levels of consumer debt and acted accordingly. The system is in place, the people running it failed in their duty.

It might be better if we let a computer run monetary policy instead of humans IMO. Thanks

Posted by Billy Cope | Report as abusive

The overwhelming cause of inflation is the government printing money that they haven’t taken in. For an irrefutable example just look at Zimbabwe, Weimar Germany or the any other failing government who prints money to pay their debts without taxation. World renowned Economists, Presidents, Congressmen, and world leaders and financial journalists will write and analyze endlessly trying to say otherwise. Various groups (labor unions, and consumers) or industries (oil companies, or wall street)will be blamed by uninformed journalists and self appointed pundits but they are all powerless and blameless to either cause or cure inflation. Inflation = (Total Money Supply)/(Total Goods and Services) I know nothing about economics, but I also know more than you do. Logsplitter

Posted by Joe Logsplitter | Report as abusive