When inflation targeting goes wrong

Critics of inflation targeting say it has blinded central banks and lulled everyone into a false sense of confidence, but the bigger problem is monetary policy as a whole and its limits when interest rates are close to zero.

Lowy Intepreter

Inflation targeting has been the lodestone for monetary policy in more than 25 central banks over the past couple of decades. But there are sceptics: can a policy which has the single objective of price stability cope with the threats to financial stability revealed by the 2008 global financial crisis?

Furthermore, can this narrow and rather simplistic focus allow monetary policy to provide appropriate support during the recession prevalent in most advanced countries in the aftermath of the global financial crisis?

Banks blind to imbalances

Inflation targeting clearly delivered on its central promise, and inflation (as well as its most pernicious manifestation, 'stagflation') has gone from being the principal macro-economic concern in the 1970s to background noise; not entirely absent, but not the malign distortion it seemed to be three decades ago.

But monetary policy's new critics claim that the single-minded focus on price stability blinkered central banks, blinding them to the growing imbalances that caused the financial crisis. Indeed, one version of the censure is that monetary policy was so successful in creating an environment of stable prices and growth that it lulled everyone into a false sense of confidence, leading borrowers to over-leverage and lenders to underestimate risk.

This criticism might be valid if central banks had treated inflation targeting with the nave simplicity envisaged when it was first proposed. In this rigorous form it was akin to a religious belief, with only one true objective (price stability) and just one way of achieving salvation: putting the interest rate instrument wherever necessary to maintaining low inflation.

But for most central banks the single-objective version of inflation targeting was a convenient heat shield to protect them from popular pressures for overly-accommodative policies. It was convenient for central banks to talk of 'doing whatever it takes', but they knew that their newly won independence could be taken away as easily as it was given. They might talk tough, but they weren’t going to be foolishly doctrinaire.

For most inflation-targeting central banks, there was always room for some flexibility to respond to cyclical fluctuations, supply-side price shocks and exchange rate irregularities.

In particular, there was no obvious conflict with financial stability, which had always been part of the central bank remit. In many countries the day-to-day micro job of prudential supervision had been given to a specialised agency. Once every generation, some financial institution would get into trouble and would have to be 'resolved' by a bailout or a forced merger. Central banks still had the powerful instrument of the 'lender of last resort'. All this could be held in readiness to be used in the rare times when it was needed. None of this conflicted with the inflation targeting framework.

Financial sector not properly supervised

There is no dispute that the 2008 global financial crisis was a major shock to the complacency that had developed during the two decades of the 'Great Moderation', when inflation was low and growth was good.

That said, what went wrong was not that inflation targeting prevented central banks from addressing the needs of financial stability, but that some of them (including the US, which has no formal inflation target) gave a low priority to the mundane task of ensuring that the financial sector was competently supervised.

The authorities mis-assessed how pro-cyclical the financial system can be, overestimated its self-righting properties and had too much faith in the 'magic of the market'.

But these mistakes were not forced on central bankers by the mono-dimensional inflation targeting framework. Fixing these deficiencies doesn't require winding up inflation targeting. It requires, instead, the creation of a competent supervisory structure in those countries where it didn't exist; higher capital requirements; some liquidity requirements; and limiting the degree to which banks can participate in high-risk market trading.

Macro-prudential instruments (cyclically varying capital requirements; loan/valuation limits) can be used as well. None of this requires abandoning inflation targeting.

Intentionally boost inflation?

And it should be acknowledged that an obsession with price stability may have led some policy makers astray. Two members of the Bank of England policy board clung too fixedly to the rhetoric of inflation targeting, advocating tighter policies in July 2011 to deal with temporary inflation, just as the UK was sinking deeper into recession. Fortunately, their appalling judgment was overridden by the rest of the policy committee. Across the channel, the European Central Bank pushed up interest rates as recently as July last year.

These mistakes were, however, errors of judgment rather than principle: in each case, the policy stance remained accommodative. The more fundamental problem is an old one: when interest rates are close to zero, monetary policy cannot be made still more accommodative.

In the US, UK and even in Europe, the interest rate instrument is up against the 'zero bound'. Thus the substantive debate is about whether 'unconventional policies' – quantitative easing, for example – should be taken further. This seems, at best, an uncertain policy tool.

Attacking from another direction, there are advocates of a higher inflation target (not only to get real interest rates lower and to speed balance sheet adjustment by eroding the real value of debt, but also to provide Greece with the opportunity to improve its competitiveness).

Of course the thought of intentionally creating higher inflation is shocking to some. But the real problem here is that no central bank has a policy instrument which can reliably boost inflation in a depressed economy. The Bank of Japan has been pushing on a string for decades. Not much point in blaming inflation targeting for the intrinsic nature of monetary policy.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.

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