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The Wrong War for Central Banking

BEIJING – Fixated on inflation targeting in a world without inflation, central banks have lost their way. With benchmark interest rates stuck at the dreaded zero bound, monetary policy has been transformed from an agent of price stability into an engine of financial instability. A new approach is desperately needed.

The US Federal Reserve exemplifies this policy dilemma. After the Federal Open Market Committee decided in September to defer yet again the start of its long-awaited normalization of monetary policy, its inflation doves are openly campaigning for another delay.

For the inflation-targeting purists, the argument seems impeccable. The headline consumer-price index (CPI) is near zero, and “core” or underlying inflation – the Fed’s favorite indicator – remains significantly below the seemingly sacrosanct 2% target. With a long-anemic recovery looking shaky again, the doves contend that there is no reason to rush ahead with interest-rate hikes.

Of course, there is more to it than that. Because monetary policy operates with lags, central banks must avoid fixating on the here and now, and instead use imperfect forecasts to anticipate the future effects of their decisions. In the Fed’s case, the presumption that the US will soon approach full employment has caused the so-called dual mandate to collapse into one target: getting inflation back to 2%.