Is Inflation Targeting Dead?

It is with regret that we announce the death of Inflation Targeting. The monetary regime, known affectionately as “IT” to its friends, evidently passed away in September 2008. That the demise of IT has not been officially announced until now testifies to the esteem in which it was widely held, its usefulness as a figurehead for central banks, and fears that there might be no good candidates to assume its position as preferred anchor for monetary policy.

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

One reason that IT gained such wide acceptance as the champion nominal anchor was the failure of its predecessor, exchange rate targeting, in the currency crises of the 1990s. Pegged exchange rates had succumbed to fatal speculative attacks in many of these countries. The authorities needed something new to anchor the public’s expectations of monetary policy. IT was in the right place at the right time.

Before the reign of exchange rate targeting, in turn, the fashion in the early 1980s had been money supply targeting, the brainchild of monetarist Milton Friedman. The money supply rule had succumbed to violent money demand shocks rather quickly. Friedman’s general argument for rules over discretion, in order to make a commitment to low inflation credible, however, is still very influential.

Inflation Targeting was best known as a rule that told central banks to set a target range for the yearly rate of change of the Consumer Price Index (CPI) and to try their best to attain it. Close cousins included targeting the price level (instead of the inflation rate) and targeting the core inflation rate (that is, excluding the volatile food and energy components of prices) instead of the headline number.

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 target for CPI inflation in the longer term. But some felt that if the definition of IT were stretched too far, it would lose its meaning.

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Regardless, Inflation Targeting has taken some heavy blows over the last four years, analogous to the crises that hit exchange rate targets in the 1990s. Perhaps the biggest setback came in September 2008, when it became clear that central banks that had been relying on IT had not paid enough attention to asset bubbles.

Central bankers had told themselves that they were giving asset markets all the attention they deserved, by specifying that housing prices and equity prices could be taken into account to the extent that they carried 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 during the years 2003-06, it was neither preceded nor followed by an upsurge in inflation.

That the boom-bust cycle could take place without inflation should not have come as a surprise. The same thing had happened when asset market bubbles ended in crashes in the United States in 1929, Japan in 1990, and Thailand and Korea in 1997. And the Greenspan hope that monetary easing could clean up the mess in the aftermath of such a crash proved wrong in the great recession of 2008-09.

While the lack of response to asset market bubbles was probably the biggest failing of Inflation Targeting, 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 appreciate the currency. But CPI targeting instead tells the central bank to appreciate in response to an increase in the world price of the imported commodities — exactly the opposite of accommodating the adverse shift in the terms of trade. For example, it is widely suspected that the reason for the otherwise-puzzling decision of the European Central Bank to raise interest rates in July 2008, as the world was sliding into the worst recession since the 1930s, was that oil prices were just then reaching an all-time high. Oil prices get a substantial weight in the CPI, so stabilizing the CPI when dollar oil prices go up requires appreciating versus the dollar.

One promising candidate to take the position of preferred nominal anchor has lately received some enthusiastic support in the blogs: Nominal GDP Targeting. The idea is not new. It had been acandidate to succeed money targeting in the 1980s, since it did not share the latter’s vulnerability to velocity shocks.

Nominal GDP Targeting was never adopted at that time. But now it is back. Its fans point that it would not, like Inflation Targeting, have the problem of excessive tightening in response to adverse supply shocks. Nominal GDP targeting stabilizes demand, which is really all that can be asked of monetary policy. (An adverse supply shock is automatically divided between inflation and real GDP, equally, which is pretty much what a central bank with discretion would do anyway.)

A dark horse candidate is Product Price Targeting. It would focus on stabilizing an index of producer prices rather than an index of consumer prices, and so would not like IT have the problem of responding perversely to terms of trade shocks. The 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 central banks have no control.

IT 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, reminiscing over burnished fables of its long lost youth.

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