Monday, April 21, 2014
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The Death of Inflation Targeting

CAMBRIDGE – It is with regret that we announce the death of inflation targeting. The monetary-policy regime, known as IT to friends, evidently passed away in September 2008. The lack of an official announcement until now attests to the esteem in which it was held, its usefulness as an ornament of credibility for central banks, and fears that there might be no good candidates to succeed it as the preferred anchor for monetary policy.

Inflation targeting was born in New Zealand in March 1990. Admired for its transparency, and thus for facilitating accountability, it achieved success there, and soon in Canada, Australia, the United Kingdom, Sweden, and Israel. It subsequently became popular in Latin America (Brazil, Chile, Mexico, Colombia, and Peru) and among other developing countries (including South Africa, South Korea, Indonesia, Thailand, and Turkey).

One reason that IT gained such wide acceptance as the monetary-policy anchor of choice was the demise of its predecessor, exchange-rate targeting, in the currency crises of the 1990’s. Pegged exchange rates had come under fatal speculative attack in many of these countries, whose authorities thus needed something new to anchor the public’s expectations concerning monetary policy. Inflation targeting was in the right place at the right time.

In the early 1980’s, prior to the reign of exchange-rate targeting, the fashion was money-supply targeting, the brainchild of the monetarist Milton Friedman. But that rule succumbed rather quickly to violent money-demand shocks, though Friedman’s general argument – that a credible commitment to low inflation requires favoring rules over discretion – remains very influential.

Inflation targeting was best known as a rule that instructed central banks to set – and try their best to attain – a target range for the annual rate of change of the consumer price index (CPI). Close cousins included targeting the price level instead of the inflation rate, and targeting core inflation (the CPI minus volatile food and energy prices).

There were also proponents of flexible inflation targeting, who held that it was fine to put some weight on real GDP growth in the short run, so long as there was a clear longer-term target for CPI inflation. But some felt that if the definition of IT were stretched too far, it would lose its meaning.

Regardless of the form it took, IT began to receive some heavy blows a few years ago (analogous to the crises that hit exchange-rate targets in the 1990’s). Perhaps the biggest setback hit in September 2008, when it became clear that central banks that had been relying on IT had not paid enough attention to asset-price bubbles.

Central bankers had told themselves that they were giving asset markets all of the attention that they deserved, by specifying that housing prices and equity prices could be taken into account to the extent that they implied information regarding goods inflation. But this escape clause proved insufficient: when the global financial crisis hit (suggesting, at least in retrospect, that monetary policy had been too loose from 2003 to 2006), it was neither preceded nor followed by an upsurge in inflation.

That the boom-bust cycle could occur without inflation should not have come as a surprise. After all, the same thing happened when asset-price bubbles ended in crashes in the United States in 1929, Japan in 1990, and Thailand and Korea in 1997. And the hope of long-time US Federal Reserve Chairman Alan Greenspan that monetary easing could clean up the mess in the aftermath of such a crash proved wrong.

While the lack of response to asset bubbles was probably IT’s biggest failing, another major setback was inappropriate responses to supply shocks and terms-of-trade shocks. An economy is healthier if monetary policy responds to an increase in the world prices of its exported commodities by tightening enough to cause the currency to appreciate. But CPI targeting instead tells the central bank to tighten policy in response to an increase in the world price of imported commodities – exactly the opposite of accommodating the adverse shift in the terms of trade.

It is widely suspected, for example, that the reason for the European Central Bank’s otherwise puzzling decision to raise interest rates in July 2008, as the world was sliding into the worst recession since the 1930’s, was that oil prices were just then reaching an all-time high. Oil prices are given substantial weight in the CPI, so stabilizing the CPI when dollar-denominated oil prices go up requires euro appreciation vis-à-vis the dollar.

One candidate to succeed IT as the preferred nominal monetary-policy anchor has lately received some enthusiastic support in the economic blogosphere: nominal GDP targeting. The idea is not new. It had been a candidate to succeed money-supply targeting in the 1980’s, since it did not share the latter’s vulnerability to so-called velocity shocks.

Nominal GDP targeting was not adopted then, but now it is back. Its fans point out that, unlike IT, it would not cause excessive tightening in response to adverse supply shocks. Nominal GDP targeting stabilizes demand – the most that can be asked of monetary policy. An adverse supply shock is automatically divided equally between inflation and real GDP, which is pretty much what a central bank with discretion would do anyway.

A dark-horse candidate is product-price targeting, which would focus on stabilizing an index of producer prices rather than an index of consumer prices. Unlike IT, it would not dictate a perverse response to terms-of-trade shocks.

Supporters of both nominal GDP targeting and product-price targeting claim that IT sometimes gave the public the misleading impression that it would stabilize the cost of living, even in the face of supply shocks or terms-of trade-shocks, over which it had no control.

Inflation targeting is survived by the gold standard, an elderly distant relative. Although some eccentrics favor a return to gold as the monetary anchor, most would prefer to leave this relic of another age to its peaceful retirement.

Read more from our "Imperfect Indicators?" Focal Point.

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  1. CommentedEdward C D Ingram

    Interesting history. Saw it all happening. Never liked Inflation targeting much.

    Advocate of a steady drip of new money into the system but first we have to stabilise wealth and debt as per my work on the subject.

    The value of money cannot be held steady but the value of savings and debts and the management of budgets can cope with that if done my way.

    This will end those asset price bubbles and leave us with sustainable economic growth regardless.


    The maths of lending etc is here:

    I will now write an essay on what I recommend on my own page.

  2. CommentedJonathan Lam

    Gamesmith94134: The death of inflation targeting

    It seems Mr. Jeffrey Frankel would had given a good insights monetary measures on the boom-bust cycle under the death of the inflation targeting, however, the term velocity shocks occurs after the money supply targeting as the aftermath of the non-circumvented crash made the economy vulnerable to reflation caused to break down the monetary system. Thus, reactions subjected to the exchange rates on currencies also created the flights of cash flow and credit crunch once the inflation or deflation is restrained and economical growth is compromised. Perhaps, it is how we criticize how ever-reacted the FED was if credit or investment were not responded sufficiently in case of disasters.

    As much of the CPI or GDP, they are just indexes to measure how vulnerable are we to the developments internally and externally. Perhaps, it is how Mr. Greensplan was proven to be wrong after the monetary easing, unfortunately, the coin is flipped in the death of inflation targeting. In term of the global financing or domestic growth, business cycle is under the pressure of the price and value, and the general public suits to the cost to the living. Since inflation and deflation is inclusively monitoring the sustainability in finance, the table turns when investments shift from macro-economical to micro-economical, and vice versa. Establishments abstains its vulnerability to profit, economy grows or falter, and we support the price through agreement of the value. Inflation or deflation became a mechanism for the protection in a way that price ameliorates to accommodate what we value. It is nature’s way or ecology of economics. Therefore, there is no miss in calculation. It is my belief that what is missing is only being substituted. Over-priced relatively to weaker income and under-valued relatively means strong dollar, they are just being replaced or displaced.

    I prefer if the FED or ECB can estimate both the margins of inflation and deflation under the currencies exchange rate or both long term and short term equitable creates the comfort zone for affordability for both of the debtors and creditors. Such zone becomes the margins of affordability which could affect how investors shift or retreat with their cash to advance their profitability, and how the public can support or defy on the value and expenditure in maintaining growth.

    But, each must be inbound with sustainable means or credit; eventually, there is lesser of surprise in the phrase of changing tables from micro-economic to its income earner, to macro-economic for the business cycle when credit or cash become the options to pivot point or velocity shock. Implosion and explosion are alike; they just shift as the coin is flipped.

    “Germany sold €4.56 billion in two year bonds at 0 coupon, suggesting investors are so afraid of the possible outcome of the sovereign debt crisis that they are willing to get no returns just for parking their cash in bunds.” By Forbes.

    Can inflation by 2% at the core for 30 years or two yea bonds at 0 coupon be guaranteed without consequence? It is not a question for disinflationary but Bundesbank.

    May the Buddha bless you?

  3. CommentedDarko Oracic

    "... when the global financial crisis hit (suggesting ... that monetary policy had been too lose from 2003 to 2006), it was neither preceded nor followed by an upsurge in inflation." The line is completely wrong. First, price change for domestic purchases excluding food and energy amounted to 3.3% in 2005 and 3.1% in 2006 - far above the (implicit) target. Reacting to that, the Fed raised the FF rate from 1.35% in 2004 to 4.97% in 2006. That caused the financial crisis, the housing bust and the recession. The Fed reacted to inflation too late and too much. In general, the problem with targeting is that it creates cycles of overshooting and undershooting. Central bankers tend to miss a target because they lack both knowledge and patience - rather common human shortcomings.

  4. CommentedMerijn Knibbe

    One of the problems of Inflation Targeting of the ECB is their rather limited definition of inflation, which by their definition is, short and simple, equal to changes in the 'Harmonized Index of Consumer Prices' (HICP) - as if there are no investments or asset prices! They've maintained this definition since 1998.

    Compare this with the inflation definition of the Fed: “Inflation occurs when the prices of goods and services increase over time. Inflation cannot be measured by an increase in the cost of one product or service, or even several products or services. Rather, inflation is a general increase in the overall price level of the goods and services in the economy. Federal Reserve policymakers evaluate changes in inflation by monitoring several different price indexes. A price index measures changes in the price of a group of goods and services. The Fed considers several price indexes because different indexes track different products and services, and because indexes are calculated differently. Therefore, various indexes can send diverse signals about inflation. The Fed often emphasizes the price inflation measure for personal consumption expenditures (PCE), produced by the Department of Commerce, largely because the PCE index covers a wide range of household spending. However, the Fed closely tracks other inflation measures as well, including the consumer price indexes and producer price indexes issued by the Department of Labor. When evaluating the rate of inflation, Federal Reserve policymakers also take the following steps:

    •First, because inflation numbers can vary erratically from month to month, policymakers generally consider average inflation over longer periods of time, ranging from a few months to a year or longer.
    •Second, policymakers routinely examine the subcategories that make up a broad price index to help determine if a rise in inflation can be attributed to price changes that are likely to be temporary or unique events. Since the Fed’s policy works with a lag, it must make policy based on its best forecast of inflation. Therefore, the Fed must try to determine if an inflation development is likely to persist or not.
    •Finally, policymakers examine a variety of “core” inflation measures to help identify inflation trends"

    No, that's not short or simple. But not everything in life is short and simple. Even then, house prices are however still not mentioned. Or the fact that higher wages (which in a number of cases almost directly measured as a price entering the consumer price index) might sometimes be higher as productivy has increased, i.e. a quality increase in stead of a price increase. Though the consumer price index (contrary to the HICP!) is a very usefull rod to measure putchasing power of wages, it should not be abused as a rod to estimate inflation. And using the HICP to the exclusion of other metrics did contribute to the present troubles - the dogmatism of the ECB still makes its policies in incredulous.

  5. Commenteddw b

    great article - the only thing that I would add is that nominal gdp targeting has "risk sharing" component that other frameworks do not provide. That is, when asset price bubbles do deflate (and they will) nominal gdp targeting prevents a caustic Fisher-type debt deflationary spiral by taming cyclical unemployment and promising to maintain the ngdp path (employers would not have cut so far so fast if they had expected demand to come back). debt deflation and those those pesky velocity shocks!

    The 2008 Fed was very focused on oil prices at the Sept 16th 2008 meeting in spite of the obviously tight credit conditions. If they had been ngdp targeting, i think the world would look a lot different.

    I think its better to think of the housing price bubble as a "mortgage finance" bubble that made owner/occupied / rental prices out of whack. Hence it was really a relative-price supply shock.

    And how does one optimally respond to a supply shock (and more importantly, a supply shock with deep implications for the banking system)?

    yep, you guessed it.

    Legend has it, Greenspan was softly targeting ngdp. IMO thats why the real estate bubble in the early 1990s did not devolve into a mess.

  6. CommentedMichael Nikolaou

    Very interesting and quite convincing.

    Now, for my own understanding of the subject, isn't it the case that both inflation and GDP are targeted by central banks in their macroeconomic policies? For example, the widely known Taylor rule suggests central bank interest rate adjustment as a simple linear combination of interest rate and GDP.

    Clarifications would be welcome.

  7. CommentedSarchis Dolmanian

    Interesting development.
    Gold standard, exchange-rate targeting and now inflation targeting are dead.
    Nominal GDP targeting, whatever that may be, is supposed to take its place.
    Now let's take a look back.
    First we 'invented' democracy. Not only because autocrats may sometimes act selfishly but because we, as a group, discovered that one person, or a group of persons, cannot manage as much information as the entire community because any individual has a limited amount of time and his ability to act rationally is also limited, by his innate characteristics, the influences under which he grew up and by the way he feels about things.
    Then we invented the free market, basically for the same reasons as for the democracy. A really free market sees to it that the blunders of a single economic agent don't topple the entire market and in order to be sure of this we passed anti-trust legislation.
    But we still entrust a small bunch of basically unelected people with the job of fine-tuning the economy. Don't get me wrong, I'm not in favor of completely deregulating the economy or against the idea of a Central Bank, the problem is that these institutions should follow instead of leading.
    The regulators should keep the playing field level and make sure that the bullies are brought back to measure instead of telling the players what sport to play or how to do it. At the same time the Central Bank should act as a lender of last resort, do it in certain transparent conditions and at a rate based on an average of those at which money change hands in the free-market instead of imposing one 'from above'.

  8. CommentedProcyon Mukherjee

    The central bankers have in their arsenal a range of instruments that would take care of a range of challenges, starting from inflation to asset price bubbles, and in doing so they would need to optimize a range of sensitive parameters that impact the lives of people. In any optimization one has to work with one parameter while changing the others so that the optimization leads us to the best possible scenario. The question here is that inflation targeting has not led us to the best denouement that a range of stakeholders would be satisfied with. But in choosing the next best option, we need to be clear which side of the problem we are fixing, the supply side or the demand side. Is the polity clear on this direction is the question.

    Procyon Mukherjee