Inflation Targeting by Central Banks: Is it still appropriate?

Not many have escaped blame for causing the global financial crisis. Some more, some maybe less. Central Banks for one probably fit in the latter category. Martin Wolf of the Financial Times think they deserve more blame:

Just over five years ago, Ben Bernanke, now chairman of the Federal Reserve, gave a speech on the “Great Moderation” – the declining volatility of inflation and output over the previous two decades. In this he emphasised the beneficial role of improved monetary policy. Central bankers felt proud of themselves. Pride went before a fall. Today, they are struggling with the deepest recession since the 1930s, a banking system on government life-support and the danger of deflation. How can it have gone so wrong?

Over almost three decades, policymakers and academics became ever more confident that they had found, in inflation targeting, the holy grail of fiat (or man-made) money. It had been a long journey from the gold standard of the 19th century, via the restored gold-exchange standard of the 1920s, the monetary chaos of the 1930s, the Bretton Woods system of adjustable exchange rates of the 1950s and 1960s, the termination of dollar convertibility into gold in 1971, and the monetary targeting of the 1970s and 1980s.

Frederic Mishkin of Columbia University, a former governor of the Federal Reserve and strong proponent of inflation targeting, argued in a book that inflation targeting allows for all relevant variables – exchange rates, stock prices, housing prices and long-term bond prices – via their impact on activity and prospective inflation. Now that we are living with the implosion of the financial system, this view is no longer plausible.

No less discredited is the related view, that it is better to deal with the aftermath of asset price bubbles than prick them in advance.

Complacency about the Great Moderation led first to a Great Unravelling and then a Great Recession. The private sector was complacent about risk. But so, too, were policymakers.
What role then did monetary policy play? I can identify three related critiques of the central banks.

First, John Taylor of Stanford University, a former official in the Bush administration, argues that the Fed lost its way by keeping interest rates too low in the early 2000s and so ignoring his eponymous Taylor rule, which relates interest rates to inflation and output. This caused the housing boom and the subsequent destructive bust.

Prof Taylor has an additional point: by lowering rates too far, the Fed, he argues, also caused the rates offered by other central banks to be too low, thereby generating bubbles across a large part of the world. This induced a lowering of standards for granting credit and so a credit bubble.

Second, a number of critics argue that central banks ought to target asset prices because of the huge damage subsequent collapses cause. As Andrew Smithers of London-based Smithers & Co notes in a recent report (Inflation: Neither Inevitable Nor Helpful, 30 April 2009), “by allowing asset bubbles, central banks have lost control of their economies, so that the risks of both inflation and deflation have increased”.

Thus, when nominal asset prices and associated credit stocks go out of line with nominal income and prices of goods and services, one of two things is likely to happen: asset prices collapse, which threatens mass bankruptcy, depression and deflation; or prices of goods and services are pushed up to the level consistent with high asset prices, in which case there is inflation. In the short term, central banks also find themselves driven towards unconventional monetary policies that have unpredictable monetary effects.

Finally, economists in the “Austrian” tradition argue that the mistake was to set interest rates below the “natural rate”. This, argued Friedrich Hayek, also happened in the 1920s. The result is misallocation of resources. It also generates explosive growth of unsound credit. Then, in the downturn – as the American economist, Irving Fisher, argued in his Debt-Deflation Theory of Great Depressions, published in 1933 – balance-sheet deflation will set in, greatly aggravated by falling prices and shrinking incomes.

Whichever critique one accepts, it seems clear, in retrospect, that monetary policy was too loose. As a result, we now face two challenges: clearing up the mess and designing a new approach to monetary policy.

On the former, we have three alternatives: liquidation; inflation; or growth. A policy of liquidation would proceed via mass bankruptcy and the collapse of a large part of the existing credit. That is an insane choice. A deliberate policy of inflation would re-awaken inflationary expectations and lead, inevitably, to another recession, in order to re-establish monetary stability. This leaves us only with growth. It is essential to sustain demand and return to growth without stoking up another credit bubble. This is going to be hard. That is why we should not have fallen into the quagmire in the first place.

On the latter, the choice, in the short term, is certainly going to be “inflation targeting plus”. “Out” is likely to be the “risk management” approach of the Fed, which turned out to give an unduly asymmetric response to negative economic shocks. “In” is likely to be “leaning against the wind” whenever asset prices rise rapidly and to exceptionally high levels, along with a counter-cyclical “macro-prudential” approach to capital requirements in systemically significant financial institutions.

This unforeseen crisis is surely a disaster for monetary policy. Most of us – I was one – thought we had at last found the holy grail. Now we know it was a mirage. This may be the last chance for fiat money. If it is not made to work better than it has done, who knows what our children might decide? Perhaps, in despair, they will even embrace what I still consider to be the absurdity of gold.

Quoted from: "Central banks must target more than just inflation" by Martin Wolf, Financial Times, May 5, 2009.