Inflation targeting is not dead yet
April 13, 2013 3:23 pm
by Gavyn Davies
Inflation targeting is dead, or so we are told with increasing frequency nowadays. Invented in the 1990s and widely propagated in the 2000s, targets for consumer price inflation failed to prevent the asset price bubble prior to 2008, or the subsequent financial collapse. Many investors now believe that inflation targets have been abandoned in all but name.
There is, however, a major problem with this line of argument. It does not tally with what the major central banks say they are actually trying to do, either in public or in private. Far from disappearing, inflation targets continue to gain prominence. Furthermore, they still play an essential role in ensuring good economic performance.
As recently as January 2012, the Federal Reserve formalised a 2 per cent inflation objective, while the Bank of Japan did the same for the first time only last month. The ECB continues to face heavy criticism because it pays such close attention to keeping inflation “below but close to” 2 per cent. Only the Bank of England can be seriously accused of downgrading its inflation objective in recent years, and even that may have changed in the past couple of MPC meetings.
The sceptics argue that the central banks are cynically saying one thing and doing another: publishing 2 per cent inflation targets while knowingly risking the long term stability of inflation by expanding their balance sheets with the real objective of reducing unemployment and public debt ratios.
Again, this shows a misunderstanding of how the central bankers think the economy currently works. Essentially, they have come to believe that they can adopt expansionary monetary policies without risking the stability of inflation. If they believed there was a choice between low inflation and low unemployment, they would (probably) choose the former, but they no longer recognise that this choice exists.
Important IMF Inflation Study
The IMF has just published an extremely clear economic explanation of why the central banks have reached this belief, written by John Simons and colleagues in the latest World Economic Outlook and prepared for the spring meetings in Washington next week. It is recommended reading for all dinosaurs who, like me, worry about inflation.
The IMF study shows that the inflation mechanism in the developed world has profoundly changed since the 1970s. Inflation has become far less responsive to changes in cyclical unemployment than it was prior to 2000, remaining stuck close to 2 per cent throughout the business cycle. Prices have continued rising since 2008, despite the large drop in output. The IMF authors argue that this is because wages do not decline in nominal terms however weak the labour market becomes, so inflation does not move into negative territory even in deep recessions.
The second reason why inflation has remained broadly stable since 2008 is that inflation expectations have remained anchored on the central banks’ 2 per cent target, in the face of large variations in import prices, indirect taxes and unemployment. This is in fact a strong validation of the inflation targeting approach. If inflation expectations had not remained well anchored at 2 per cent, then deflation would have taken hold in the wake of the financial crash.
What would have happened to US inflation after 2008 if the underlying mechanism had been unchanged from the 1970s? The IMF says that inflation would have turned negative after 2010 and would now be headed towards -3 per cent per annum instead of +2 per cent.
Imagine how much more difficult it would have been to cope with excess debt if real interest rates had been a full 5 percentage points higher than they are today. Critics of inflation targeting should bear this in mind.
If the IMF study is right about the new inflation mechanism, it does underpin and explain what the central bankers think they are doing at present. With inflation unresponsive to variations in unemployment, and inflation expectations well anchored, the impact on the economy of monetary expansion is likely to be benign.
It would show up in rising real output rather than higher inflation rates. Furthermore, the IMF authors argue that the consequences of a mistake, in the form of over expansionary policy, should not be too severe and should be relatively easy to reverse.
Lessons from the 1970s
To those of us who were active in economic policy in the 1970s, this sounds almost too good to be true, and even somewhat naive. After all, policymakers in that decade believed many of the same things that are believed today, and eventually inflation expectations were disanchored because central banks tried to target unemployment rates which were far too low to be sustainable. Two decades of painstaking attempts to establish a new and more credible inflation mechanism were the inevitable result.
The best protection against a repeat of these events is the maintenance of the social consensus which exists around current inflation targets. The IMF contrasts the differing experiences of the US and Germany in the 1970s. In America, there was no consensus in favour of low inflation, and the Fed followed the political culture of the day in accommodating inflation, until Paul Volcker heroically reversed strategy in 1980. In Germany, the social consensus in favour of low inflation enabled the Bundesbank to keep inflation much lower, even though the SPD government had much the same concerns about unemployment as those which were prevalent in the US under Jimmy Carter.
Conclusión
What are the implications? There are three.
First, investors who are worried about a near term rise in inflation, and who are seeking hedges against it, may well be too pessimistic. After all, these hedges are expensive.
Second, although policy mistakes may well be made in the determination to get unemployment down, these mistakes should prove less painful in countries which maintain a strong social consensus against inflation. This will protect the independence of central banks at a time when politicians may well want to monetize government deficits inappropriately.
Third, inflation targets are still important institutional props which will help to keep that social consensus in place.
Formal and transparent objectives for inflation may not be sufficient for good macro-economic policy making, but they are still necessary. There is life in the old dog yet.
There is, however, a major problem with this line of argument. It does not tally with what the major central banks say they are actually trying to do, either in public or in private. Far from disappearing, inflation targets continue to gain prominence. Furthermore, they still play an essential role in ensuring good economic performance.
As recently as January 2012, the Federal Reserve formalised a 2 per cent inflation objective, while the Bank of Japan did the same for the first time only last month. The ECB continues to face heavy criticism because it pays such close attention to keeping inflation “below but close to” 2 per cent. Only the Bank of England can be seriously accused of downgrading its inflation objective in recent years, and even that may have changed in the past couple of MPC meetings.
The sceptics argue that the central banks are cynically saying one thing and doing another: publishing 2 per cent inflation targets while knowingly risking the long term stability of inflation by expanding their balance sheets with the real objective of reducing unemployment and public debt ratios.
Again, this shows a misunderstanding of how the central bankers think the economy currently works. Essentially, they have come to believe that they can adopt expansionary monetary policies without risking the stability of inflation. If they believed there was a choice between low inflation and low unemployment, they would (probably) choose the former, but they no longer recognise that this choice exists.
Important IMF Inflation Study
The IMF has just published an extremely clear economic explanation of why the central banks have reached this belief, written by John Simons and colleagues in the latest World Economic Outlook and prepared for the spring meetings in Washington next week. It is recommended reading for all dinosaurs who, like me, worry about inflation.
The IMF study shows that the inflation mechanism in the developed world has profoundly changed since the 1970s. Inflation has become far less responsive to changes in cyclical unemployment than it was prior to 2000, remaining stuck close to 2 per cent throughout the business cycle. Prices have continued rising since 2008, despite the large drop in output. The IMF authors argue that this is because wages do not decline in nominal terms however weak the labour market becomes, so inflation does not move into negative territory even in deep recessions.
The second reason why inflation has remained broadly stable since 2008 is that inflation expectations have remained anchored on the central banks’ 2 per cent target, in the face of large variations in import prices, indirect taxes and unemployment. This is in fact a strong validation of the inflation targeting approach. If inflation expectations had not remained well anchored at 2 per cent, then deflation would have taken hold in the wake of the financial crash.
What would have happened to US inflation after 2008 if the underlying mechanism had been unchanged from the 1970s? The IMF says that inflation would have turned negative after 2010 and would now be headed towards -3 per cent per annum instead of +2 per cent.
Imagine how much more difficult it would have been to cope with excess debt if real interest rates had been a full 5 percentage points higher than they are today. Critics of inflation targeting should bear this in mind.
If the IMF study is right about the new inflation mechanism, it does underpin and explain what the central bankers think they are doing at present. With inflation unresponsive to variations in unemployment, and inflation expectations well anchored, the impact on the economy of monetary expansion is likely to be benign.
It would show up in rising real output rather than higher inflation rates. Furthermore, the IMF authors argue that the consequences of a mistake, in the form of over expansionary policy, should not be too severe and should be relatively easy to reverse.
Lessons from the 1970s
To those of us who were active in economic policy in the 1970s, this sounds almost too good to be true, and even somewhat naive. After all, policymakers in that decade believed many of the same things that are believed today, and eventually inflation expectations were disanchored because central banks tried to target unemployment rates which were far too low to be sustainable. Two decades of painstaking attempts to establish a new and more credible inflation mechanism were the inevitable result.
The best protection against a repeat of these events is the maintenance of the social consensus which exists around current inflation targets. The IMF contrasts the differing experiences of the US and Germany in the 1970s. In America, there was no consensus in favour of low inflation, and the Fed followed the political culture of the day in accommodating inflation, until Paul Volcker heroically reversed strategy in 1980. In Germany, the social consensus in favour of low inflation enabled the Bundesbank to keep inflation much lower, even though the SPD government had much the same concerns about unemployment as those which were prevalent in the US under Jimmy Carter.
Conclusión
What are the implications? There are three.
First, investors who are worried about a near term rise in inflation, and who are seeking hedges against it, may well be too pessimistic. After all, these hedges are expensive.
Second, although policy mistakes may well be made in the determination to get unemployment down, these mistakes should prove less painful in countries which maintain a strong social consensus against inflation. This will protect the independence of central banks at a time when politicians may well want to monetize government deficits inappropriately.
Third, inflation targets are still important institutional props which will help to keep that social consensus in place.
Formal and transparent objectives for inflation may not be sufficient for good macro-economic policy making, but they are still necessary. There is life in the old dog yet.
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