Don't give up on inflation targeting just yet

The Money, Macro and Finance Research Group (MMF) annual policy conference is one of the best places to gain an overview of current issues in monetary policy and I was fortunate to attend this year’s event to hear presentations from the likes of St Louis Fed President Jim Bullard, former Fed Board member Frederic Mishkin and Riksbank governor Stefan Ingves (and not forgetting a useful contribution from the MPC’s ever-thought provoking Gertjan Vlieghe). Mishkin’s presentation won the prize for the most entertaining. In addition to being a very accomplished speaker, his was the first presentation I have heard which incorporated a reggae track, produced by the Bank of Jamaica to highlight its new inflation targeting regime (here – and it’s well worth a look).

There were a significant number of issues raised and I will undoubtedly come back to many of them in the course of future posts. If there was an overarching theme from the whole event, it was the general agreement that monetary policy has reached the limits of what it can do to support the economy without some additional fiscal support. Not that central bankers would ever admit they are out of bullets, but it seems obvious they cannot go on doing what they are doing in the expectation that things are going to change. There was also a lot of head-scratching as to why inflation continues to undershoot central banks’ 2% target and Mishkin’s presentation on inflation targeting is a good starting point to think about the inflation framework adopted by most central banks.

In my view, Mishkin started from the wrong place. He started by pointing out that inflation in the Anglo Saxon world started falling in the early-1990s at the same time as central banks began to directly target inflation. Although he did not say so in as many words (although it was explicitly stated by some in the audience), the underlying message was that central banks’ focus on reducing inflation was the key factor in quelling the rampant inflation of the 1970s and 1980s. This idea has been bandied around by numerous central bankers over the years, although it is heard less frequently today. And with good reason: it is far from the whole truth.

Inflation expectations took a battering following the early-1990s recession, the second in a decade, whilst intensified competition – itself the product of the 1980s deregulation regime – also acted to depress expectations. I heard nothing about the impact of the end of the Cold War or the rise of China, both of which increased the global economy’s productive capacity with consequent dampening effects on inflation. The reason why such denial may be a problem is that if central bankers really believe they have curbed inflation, when in fact it is largely the product of exogenous forces, they may not be best equipped to force it back towards target and may understand the inflation process less well than they think.

This raises another question. If inflation is persistently below target, what is the point of maintaining the target? In the case of the ECB, for example, CPI inflation has averaged 1.0% since 2013 which is well below the target rate of below, but close to, 2%. In order that the ECB’s inflation rate averages 1.9% over the ten-year period 2013 to 2022, it would have to average 3.9% between now and December 2022. Such arithmetic has prompted luminaries such as Olivier Blanchard, the IMF’s former chief economist, to suggest raising central bank inflation targets to 4%. But there are good arguments against such a strategy.

In the first place, it is more difficult to stabilise inflation at 4% than 2% because the former figure is not consistent with the definition of price stability in which inflation is not a big factor in economic decision-making. An inflation rate of 4% implies that the price level doubles every 17.5 years versus 35 years in the case of 2% inflation. If you are making long-term calculations, such as investment or pension planning, there is a big difference between these two figures. Moreover, once we start to deviate from a 2% inflation target, why stop at 4%? Why not raise the target to 6% or 8%? Before too long, we could very easily get back towards 1970s territory.

But there is an argument suggesting that central banks could allow temporary deviations from the 2% target. Rather than target the inflation rate, an alternative would be to target the price level on (say) a two-year horizon. One of the disadvantages of targeting inflation (i.e. the rate of change of prices) is that shocks which impact on prices – and therefore temporarily raise the inflation rate – become fully embedded in the price level. But in a price level targeting regime, they are not.

We can illustrate this graphically (below). Consider the case where there is a shock to prices which causes them to fall by 1.5%. If the central bank does not attempt to compensate for this, in the knowledge that this is a one off impact, the price level is permanently lower and the rate of change eventually rises back to the 2% target (grey line). But if the central bank attempts to restore the price level to its steady state path on a 2-year horizon, it can tolerate much higher inflation and it is only three years after the initial shock that the inflation rate returns to the steady state rate of 2% (black line). One clear advantage of this regime is that it acts as an anchor for long-term price levels, and thus provides more certainty for inflation rates used as a basis for long-term wage and pricing contracts.

This sounds good in theory but does it work in practice? Much of the literature is based on the assumption that inflation expectations adjust relatively quickly and in a pre-defined manner. However, the experience of the last decade suggests that expectations adjust much more slowly than is often assumed. Nor do we know the functional form of the expectations formation process. This means that central banks may have to allow inflation to run further ahead of target for longer than they would like in order to give time for expectations to normalise. This in turn runs the risk that central banks may be perceived as having made a permanent adjustment to their inflation target.

Much as we may be critical of central banks which bang on about their target even though inflation continues to deviate from it, the constant repetition serves a purpose of reminding us that this target exists. If they stop talking about it, we might start to pay less attention to it and eventually forget about it altogether. And if we get to this point, there is a real fear that expectations could become unanchored and move around wildly as economic conditions change.

You might argue that in a world of exceptionally low inflation, there is no need to worry about any pick up in the pace of price growth. But central bankers can counter, with some justification, that just as the exceptionally high inflation of the 1980s quickly gave way to lower inflation within the space of five years, so the process could just as quickly run the other way. It is thus important to try and ensure that expectations remain anchored and it may be too soon to call for radical changes to the inflation framework.