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Rethinking Inflation Targeting

ZURICH – Over the last two decades, inflation targeting has become the predominant monetary-policy framework. It has been essentially (though not explicitly) adopted by major central banks, including the US Federal Reserve, the European Central Bank, and the Swiss National Bank. But the 2008 global economic crisis, from which the world has yet to recover fully, has cast serious doubt on this approach.

The Bank for International Settlements has long argued that pure inflation targeting is not compatible with financial stability. It does not take into account the financial cycle, and thus produces excessively expansionary and asymmetric monetary policy. Moreover, a major argument in favor of inflation targeting – that it has contributed to a decline in inflation since the early 1990s – is questionable, at best. Disinflation actually began in the early 1980s – well before inflation targeting was invented – thanks to the concerted efforts of then-US Federal Reserve Board Chair Paul Volcker. And, from the 1990s on, globalization – in particular, China’s integration into the world economy – has probably been the main reason for the decline in global inflationary pressure.

A more recent indication that inflation targeting has not caused the disinflation seen since the 1990s is the unsuccessful effort by a growing number of central banks to reflate their economies. If central banks are unable to increase inflation, it stands to reason that they may not have been instrumental in reducing it.

The fact is that the original objective of central banks was not consumer-price stability; consumer-price indices did not even exist when most of them were founded. Central banks were established to provide war financing to governments. Later, their mission was expanded to include the role of lender of last resort. It was not until the excessive inflation of the 1970s that central banks discovered – or, in a sense, rediscovered – the desirability of keeping the value of money stable.