Monday, April 22, 2013

Is Inflation Targeting Dead?

Not that long ago, it seemed as if there was an emerging consensus among economists and central bankers that the goal of monetary policy should be "inflation targeting"--that is, aiming at a low and steady inflation rate in range of about 2% per year. In the aftermath of the Great Recession, this consensus has, if not shattered, at least taken a severe hit. In an e-book  Lucrezia Reichlin and Richard Baldwin have just edited an e-book called "Is inflation targeting dead? Central Banking After the Crisis," published by VoxEU, with 14 short and readable essays on the question. 

In their introduction, Reichlin and Baldwin point out that when it comes to talking about the Great Recession, "inflation targeting is cast alternatively as perpetrator, innocent bystander, or saviour.
• Perpetrator: Inflation targeting made monetary policy too easy before the Crisis and
insufficiently so since. It helped build the Crisis in the 2000s and today hinders the
• Bystander: The regime was like a coastal schooner finding itself in the path of Hurricane
Sandy. Inflation targeting was developed during ‘the Great Moderation’. No
one ever claimed it was robust enough to deal with a five-year sequence of once-in-a-
lifetime crises.
• Saviour: Things would have been much worse without inflation targeting’s anchoring
of expectations."

They argue that while inflation targeting in a narrow sense was clearly abandoned in 2008, a broader notion of inflation targeting  has an important role to play going forward, because it offers a clear framework for limiting the temptation of politicians to print money. They write:

"Inflation targeting is alive and well. It is needed now more than ever. Inflation expectations will need to be kept anchored while the advanced economies work the debt-laden economic malaise. The debt creates temptations for governments to bail out debtors with unexpected inflation. Inflation targets and central-bank independence are the conventional ways of keeping politicians away from the printing presses. Central banks’ balance-sheet expansion and even permanent money creation are all options that can be used and considered but if there is any chance they will succeed, the credibility
of the commitment to a medium-run inflation target should not be lost. The questions remain on the effectiveness of such policies and, given their quasi-fiscal nature, on how to deal with the challenge they represent to central bank independence."

The eminent Michael Woodford contributes an essay called: "Inflation targeting: Fix it, don’t scrap it." He writes:
"It is important, first of all, to recognise that proponents of inflation targeting do not actually have in mind a commitment by the central bank to base policy decisions purely on their consequences for inflation, and to act so as to keep the inflation rate as close as possible to the target rate at all times. Mervyn King (1997) memorably referred to this as the ‘inflation nutter’ position, and distinguished the ‘flexible’ inflation targeting that he advocated from it ...  And the theoretical case for inflation targeting has never rested on an assertion that a single-minded focus on inflation stabilisation would achieve the best outcome ... Quantitative investigations of optimal monetary policy in a variety of structural models and under varying assumptions about parameters and shocks have instead found as a much more robust conclusion that optimal monetary policies involve a low long-run average rate of inflation, and fluctuations in the inflation rate that are not too persistent ...

And indeed, there are important advantages for real stabilisation objectives of maintaining confidence that the medium-run inflation outlook is not changed much when shocks occur. For example, ...if changes in the rate of inflation were expected to be highly persistent, it would be much more difficult for monetary policy to have an effect on real variables as opposed to simply affecting inflation. ...

I thus believe that it would be possible to avoid the problems with inflation targeting as currently practised, that have been the focus of recent criticism of inflation targeting as such, while retaining the essential features of an inflation targeting regime: not only a public commitment to a fixed numerical target for the medium-run rate of inflation, and a commitment to regularly explain how policy decisions are consistent with that commitment, but the use of a forecast-targeting procedure as the basis both for monetary-policy deliberations and for communication with the public about the bank’s decisions and their justification. And I believe that it would be desirable to retain these
features of inflation targeting as it has developed over the past two decades."

I can't do justice to the volume in a blog post, but one theme that comes up in several of the papers is that some of the arguments for  inflation-targeting seem to assume that it has slowed down and limited the responses of central banks, and that an alternative monetary framework like targeting nominal GDP would have justified an even more aggressive monetary policy with more powerful results. Several of the authors are skeptical of this claim. Adam Posen makes the point that if the nontraditional tools of monetary policy (like quantitative easing and a "forward guidance" policy of announcing that interest rates will remain low for several years) are not effective, then it doesn't matter what framework you claim to be using. Posen writes:
"Talk about alternatives to inflation targeting is, to me, a result of frustration – the lack of recovery despite massive monetary-policy shifts. But to my mind, the frustration is misdirected. Sifting a central bank’s target from inflation to nominal GDP in no way changes the effectiveness of policy instruments. Either quantitative easing works through the channel of promoting confidence, promoting asset prices, promoting aggregate demand and reallocation of the riskier assets, like all monetary policy, or it does not. If it does not do that, then it does not do that for nominal GDP any more than it does for inflation. The fact is we could have pursued more aggressive monetary policy, achieved better goals and been totally consistent with the current inflation target. There is no need to incur all the risks, dangers, and confusion of switching regimes – especially not to a regime like nominal-GDP targeting, which lacks inflation targeting’s robustness."
To me, one of the biggest surprises about the policies of the Federal Reserve since 2008 or so is how little effect they have had in stimulating nominal GDP growth--whether inflationary or real.