The Bank of Japan recently embraced inflation targeting – a decade and a half after academics recommended it (Krugman 2013). But this is not inflation targeting as conceived before the Global Crisis. Inflation targeting didn’t die, it evolved (as shown by the recent Vox eBook, Is inflation targeting dead? Central Banking After the Crisis.
Le roi est mort, vive le roi
The crisis threw up economic challenges of unprecedented size, intensity, complexity and frequency. In late 2008 and early 2009, something impossible happened every month; the improbable was a daily occurrence. Most governments reacted with denial, delay, prevarication, and obfuscation. Central bankers, by contrast, grasped the bull by the horns. For example, when global credit markets seized up, liquidity was immediately extended:
- While formally akin to a standard liquidity operation, the new liquidity was as much like responding to a bank run as breaking up a bar fight is like the Allied invasion of Normandy.
- And this was just the first foray; central bankers started getting creative in many other ways (see Eichengreen et al. 2011).
Augmented inflation targeting: New goals, new tools
Reacting to emergency after emergency, central banks broadened the meaning of ‘inflation targeting’ into what what might be called ‘augmented inflation targeting’, ‘ inflation targeting 2.0’, or ‘inflation targeting plus’.
Inflation targeting used to mean a committee meeting every few weeks to check the economy and consumer price index before bumping rates up or down by a quarter point. Today’s central banking is a distinctly more lively profession.
Augmented inflation targeting involves new goals and new tools. The key innovations correspond to two Crisis-linked problems:
- Financial instability threatens price stability via economic instability and by forcing central banks to approach the blurry line between fiscal and monetary policy.
- Conventional monetary tools lose traction at the zero lower bound.
The response to the first challenge has become received wisdom. Before Lehman’s collapse, financial stability was left to look after itself while central banks looked after inflation.1 Now, all central banks care about is financial stability. Macroprudential policies are the tools assigned to dealing with this new goal. These are tools designed to deal directly with financial sector imbalances and variations in risk. Importantly, most macroprudential tools are designed to prevent future crises rather than the disequilibria left by the Global Crisis. This is a work in progress (see Claessens and Valencia 2013, Perotti 2012).
Responses to monetary policy’s loss of traction at the zero lower bound have been far more diverse – and far more controversial. These include:
- ‘Balance-sheet’ tools, such as quantitative easing and market making (e.g. in mortgage-backed securities);
- Expectation tools, or ‘Jedi mind tricks’ as some financial-market commentators call them (see O’Brian 2012);
- Switching targets.
The balance-sheet tools have been widely discussed (Buiter 2009, Cochrane 2010, Banerjee et al. 2012) – the mind tricks less so. Mind-trick tools consist of manipulating expectations, triggering self-fulfilling expectations. If investors are convinced that real interest rates will remain low and growth will pick up, they might invest more and thus validate their expectations. The key is a credible communication strategy, or forward guidance. The high priest of these ideas – Michael Woodford – lays out the logic in crystal-clear terms (Woodford 2008a, 2008b). Paraphrasing Woodford:
- Make them believe by making them understand.
Mind tricks are simple in theory, but the practice is more involved.
The last set of new ‘tools’ is not really a tool but a change on emphasis – usually described as a switch of targets. The most obvious was the Fed’s recent switch to an explicit dual threshold. Its monetary policy will be guided by fighting unemployment as long as the inflation target is not at risk (Fed 2012). Many observers consider this nothing new. The Fed always had a dual mandate; this switch could thus be thought of as a more explicit form of forward guidance. Another, more radical, switch would be to raise the target (Blanchard et al. 2012).
Is it still inflation targeting?
Inflation targeting’s success rests on its ability to navigate the three tenets of monetary policy:
- Tenet 1: Low, stable inflation is critical to sustainable growth.
- Tenet 2: Expansionary monetary policy can stabilise output in the short run but has either no effects, or harmful effects, on growth and jobs in the medium to long run.
- Tenet 3: Unexpected inflation redistributes wealth from creditors to debtors.
Together these three elements shape today’s world of central banking:
- Tenet 1 explains why most nations embrace low and stable inflation as the strategic goal of monetary policy;
- Tenets 2 and 3 clarify the temptations to deviate – and thus the need for strong institutions to bolster monetary-policy credibility.
Pre-Crisis inflation targeting, what might be called ‘Inflation Targeting 1.0’, was the gold-medal arrangement. It locked in Tenet 1 by banishing fears of Tenet 3 and keeping Tenet 2 on tight reins.
‘Inflation targeting = target + trust’
Inflation targeting requires just two things -- a target and trust. The target is the easy part. The hard part is winning economic actors’ trust that the central bank will do whatever is necessary to attain the target in the medium run. When this trust exists – i.e. when inflation expectations are anchored –savers, investors and innovators can plan with confidence. Growth and job creation can flourish – provided there is also financial stability.
Trust-building institutions differ, but the linchpin is always central-bank independence. ‘Inflation targeting 1.0’ was justified by 1970s and 1980s experiences. These showed that politicians with a short horizon tend to test Tenet 2 to destruction – pushing short run stimulus until the stabilisation benefits disappear. Today the problem is the inverse. Stimulus does not seem to work and deflation has become the main danger. But the challenge remains the same – maintenance of price stability.
From this perspective, augmented inflation target (or inflation targeting 2.0) is still inflation targeting – but augmented by a crucial factor:
- Inflation targeting now involves financial stability considerations – even when that means coordinating with other domestic institutions, regulators, and so on.
Avoiding or dampening financial crises helps central banks stay in their comfort zone where interest rate policies are useful.
- Unconventional stimulative policies such as quantitative easing can also be indirectly considered as helpful in meeting the strategic inflation goals.
If recessions last too long and get too harsh, political forces may take away the central bank’s independence. Just ask the former Japanese central-bank governor Masaaki Shirakawa.
A slippery road ahead
The challenges facing inflation targeting 2.0 are breath-taking. With all this experimentation, can we still be sure that central banks will be able to avoid both debilitating deflation and runaway inflation? The main worry is the vast accumulation of assets on their balance sheets.
When central banks buy assets to fix a liquidity problem, they are avoiding solvable problems. But if they buy assets to delay insolvency, they are creating unsolvable problems. The catch is that it is often impossible to distinguish liquidity problems with solvency problems in real time. With massive asset purchases, central banks have stepped onto the slippery slope that lies between monetary policy and fiscal policy.
The real fear is that all this unconventional policy will not be enough in the face of other impediments to growth. Debt overhang, stocks of useless housing, and lack of structural reform could hinder growth even in the face of negative expected real interest rates. As El-Erian (2013) puts it:
“It is therefore critical that the current phase of unusual central-bank activism give way to a more holistic policy response; and one that involves other policymakers with direct tools to enhance actual growth, increase growth capacity, overcome debt overhangs, improve labour-market functioning, and restore a proper system of housing finance”.
Yet, despite these worries, there really is no alternative. To paraphrase Churchill, inflation targeting is the worst of all monetary-policy regimes except all the others. Indeed we need anchored expectations now more than ever. Independent, inflation-targeting central banks are the battle-tested means of making sure printing presses are not used to avoid hard political choices. Augmented inflation targeting is here to stay.
Blanchard, Olivier, Giovanni Dell’Ariccia, and Paolo Mauro (2012), “Rethinking Macroeconomic Policy”, IMF Staff Position Note, SPN/10/03, 12 February.
Borio, C and P Lowe (2002), “Asset prices, financial and monetary stability: exploring the nexus”, working paper 114, Bank for International Settlements.
Claessens, Stijn and Fabian Valencia (2013), “The interaction between monetary and macroprudential policies”, VoxEU.org, 14 March.
Cukierman, Alex (2007), “The Revolution in Monetary Policymaking Institutions”, VoxEU.org, 27 September.
Eichengreen, Barry, Eswar Prasad, and Raghuram Rajan (2011), “Rethinking central banking”, Geneva Economic Report, 20 September.
El-Erian, Mohamed (2013), ”The evolution of modern central banking: What happens next?” in L Reichlin and R Baldwin (eds.) Is inflation targeting dead? Central banking after the crisis, VoxEU.org eBook, April.
US Federal Reserve (2012), press release, 12 December, Board of Governors of the Federal Reserve System.
Krugman, Paul (2013), “We Get Results, Japan Edition”, blog, The New York Times, 6 April.
O'Brien, Matthew (2012), “Save Us, Ben Bernanke, You're Our Only Hope”, The Atlantic, 5 June.
Perotti, Enrico (2012), “A blueprint for macroprudential policy in the banking union”, VoxEU.org, 16 December 2012
Woodford, Michael (2008a), “Forward guidance for monetary policy: Is it still possible?”, VoxEU.org, 17 January.
Woodford, Michael (2008b), “The Fed's enhanced communication strategy: stealth inflation targeting?”, VoxEU.org, 8 January.
1 The issue and tools, however, did come up the CEPR & ICMB Geneva Report of 2000 was entitled ‘Asset prices and central bank policy’; the abstract reads: How should central banks view movements in equity, housing and foreign exchange markets? Can policy-makers improve economic performance by paying attention to asset prices, as well as inflation and output forecasts? … Is it possible to use non-conventional policies to address asset price misalignments?