Inflation target tyranny
That’s the title of my piece in the Fin last week. As with my previous column, Catallaxy was out with a comment long before I got around to posting here, but it seemed to me to miss the point fairly comprehensively.
Ever since the first signs of the global financial crisis emerged back in 2007, the central bankers of the developed world (most importantly the US Federal Reserve, the European Central Bank and the Bank of England) having been making policy on the run, trying one expedient after another, even while insisting that nothing has really changed.
Our own Reserve Bank, buoyed by the successful management of the crisis here, is even clearer in the view that the current policy regime needs no real change. They are supported by the government, which has repeatedly rejected calls for an inquiry into the financial system, to examine whether our escape from the impact of the Global Financial Crisis was in fact the result of good management, or whether luck played an important role. Given the near-collapse of financial systems with broadly similar regulatory frameworks, such an inquiry might uncover vulnerabilities that need to be addressed before the next crisis.
The central banks of the leading developed countries failed spectacularly in the lead-up to GFC. Their failure was centred on what most central bankers still regard as the great achievement of the 1990s, the shift to a system of ‘inflation targeting’, in which the sole objective of monetary policy was to keep the rate of inflation in a target range, typically close to 2 per cent.
Inflation targeting led central bankers, most notably Alan Greenspan of the US Fed, to ignore or even applaud the unsustainable bubbles in speculative real estate that produced the crisis, and to react too slowly as the evidence emerged.
Worse still, in the post-crisis environment, achievement of inflation targets has no longer promoted stable economic growth. Rather, low inflation has been a drag on growth. But with inflation clearly under control, central bankers like former European Central Bank President Jean-Claude Trichet have been able to describe their own performance as ‘impeccable’, even as the economies and currencies they manage appear headed for collapse.
This system is clearly unsustainable. But what is the alternative? The most popular idea begins with a change of target, from the rate of inflation, to the level of nominal GDP (the most commonly used measure of national output, valued at current prices).
The idea would be to combine a target rate of inflation (say 2-3 per cent) with an estimate of the medium-term rate of real economic growth required to maintain full employment (again 2-3 per cent is a plausible estimate). The aim would then be to keep the value of GDP, expressed in current dollars, on a growth path consistent with these targets (that is, at an average annual rate somewhere between 4 and 6 per cent).
This change would have several effects. First, it would restore the balance that used to prevail in monetary policy before the 1990s, when central banks were explicitly required to pursue full employment as well as price stability.
Second, because the target would apply to the level of nominal GDP, its adoption would require central banks to catch up the ground lost over the last few years of depressed growth and generally low inflation. That would permit a temporary increase in inflation, which is necessary if growth is to be restarted against a crushing burden of debt.
Third, the adoption of a nominal GDP target, by committing central banks to an expansionary policy would have self-fulfilling effects on expectations. By contrast, the effectiveness of past measures to expand credit has been undermined by the expectation (justified by events) that they would be wound back as soon as the immediate crisis was over.
Last but not least, a nominal GDP target would create room for fiscal policy as well as monetary policy. What is needed now is the abandonment of counterproductive austerity policies as a response to the slump in Europe and the US. Austerity should be replaced by a combination of short-term fiscal stimulus and long-run measures aimed at a sustainable budget balance. That can only be achieved if central banks co-operate with pro-growth fiscal policy, instead of seeking to counteract it in the name of inflation targets.
The abandonment of inflation targeting would, of course, be an admission of failure. But central banks have failed, disastrously, and admitting this would be the first step towards a sustainable recovery.
A system of nominal GDP targeting would maintain or enhance the transparency associated with a system based on stated targets, while restoring the balance missing from a monetary policy based solely on the goal of price stability.