If they are serious about their mandates, the Fed and ECB should consider other strategies
Megan Greene
Christine Lagarde, now ECB president, with Fed chairman Jay Powell during the G20 meeting in Buenos Aires in 2018, when she was IMF managing director © Eitan Abramovich/AFP/Getty
The policy framework reviews under way at the Federal Reserve and now the European Central Bank are the monetary equivalent of swimming upstream: a lot of energy will be expended, but they won’t really get anywhere. To the extent that these reviews continue to focus on tweaking inflation targets as a strategy, they will be largely pointless.
The Fed and the ECB have been clear that it is not their mandates that are in question, but how to fulfil them. The prevailing strategy has been to set an explicit target for inflation. The idea is that this builds credibility with markets and consumers, who will then know what inflation is likely to be over the medium to long term. This worked when inflation was high and variable.
But now we have the opposite problem. Since 2009, the Fed’s favourite measure of inflation, the personal consumption expenditures price index, has averaged 1.5 per cent, well below the 2 per cent target. The ECB has fared even worse, with its favourite measure, the Harmonised Index of Consumer Prices, averaging only 1.3 per cent over the decade. (The ECB target is “close to, but below, 2 per cent”).
Stubbornly low inflation pulls benchmark interest rates down, giving a central bank less ammunition to fight future recessions. And persistently failing to hit an inflation target undermines a central bank’s credibility.
Inflation targeting can also result in counterproductive monetary policy in the face of supply side shocks, such as oil price spikes or jumps in productivity. Nevertheless, both the Fed and the ECB seem determined to stick with some variation of inflation targeting. The Fed has said it will not change its 2 per cent target. The other options it is deliberating appear to be price-level targeting and average inflation targeting.
The ECB, which has only just started its review, has made no commitment to its target. But according to a Bloomberg survey of economists, nearly 90 per cent expect any new strategy to enable the central bank to under- and overshoot an inflation goal.
Obliging a central bank to overshoot on inflation after undershooting lacks credibility given that central banks have persistently failed to hit their targets for the past decade. If they are serious about achieving their mandates more effectively, the Fed and ECB should consider other strategies.
One has been circulating for decades: target the sum of inflation and total real output, or nominal gross domestic product. With NGDP targeting, a central bank automatically lowers rates as output falls, to push up inflation. That eases real debt burdens and lowers real interest rates, helping to generate growth. As output rises, rates adjust higher to bring inflation down and maintain the target.
A potential obstacle is that NGDP is reported quarterly, with a lag. But NGDP could be reported more frequently and accurately if the Fed treated it as a priority. The Fed could also target the forecast of NGDP instead, which is reported in the monthly blue-chip economic indicators survey of business economists.
Another strategy is yield curve control, employed by the Bank of Japan. If growth and inflation are weak, the central bank can peg rates low, reducing borrowing costs, raising stock prices and weakening the currency.
Consumption and investment rise, boosting growth and inflation. If investors believe the central bank is determined to maintain the peg, it can achieve this without buying up many assets. But if investors are sceptical, the central bank is forced to expand its balance sheet or lose credibility.
There are no silver bullets. And this shouldn’t be just a public relations exercise. The Fed and ECB should think boldly about alternative approaches.
The writer is a senior fellow at Harvard Kennedy School
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