Has inflation targeting reached its sell-by date? Given the Federal Reserve’s formal adoption of an inflation target only last week, the answer is presumably No. There is, nevertheless, something odd about the enduring enthusiasm among central bankers for inflation targeting. The pursuit of price stability, after all, was supposed to be the best way of delivering overall economic stability. Yet, despite the widespread adoption of inflation targets, the developed world succumbed in 2008 to the biggest economic and financial crisis in generations.
This terrible performance surely should have led to a period of introspection, a desire to examine the role of inflation targeting in contributing to the crisis. Central bankers, however, have mostly brushed objections to one side, preferring to lay the blame on regulatory and supervisory failures or the misdemeanours of individual titans of finance.
Inflation today is determined increasingly by factors beyond an individual central bank’s control. In the early years of the new millennium, many countries in the developed world benefited from rapid declines in import prices, thanks to the growing role of China and other low-cost producers in the global supply chain. As a result, inflation had a tendency to undershoot target. Central bankers were faced with a choice: allow inflation to drop to unusually low rates or keep interest rates low in order to boost domestic demand and, hence, lift domestically-generated inflation.
They mostly did the latter. Real interest rates – nominal rates minus inflation – were left at unusually low levels, contributing to the bubble in house prices and the boom in credit growth. Inflation targets were met, but only at enormous cost.
Meeting an inflation target in any one year increases the risk of instability in the medium term. It’s one reason, perhaps, why the Fed’s two per cent inflation target is an ambition only “over the longer run”. This, however, seems remarkably imprecise, leading Lorenzo Bini Smaghi, a former member of the European Central Bank, to argue in the Financial Times earlier this week that “the long-run is not a ‘policy-relevant’ time horizon and has little value for those attempting to understand the central bank’s next moves”.
That might be so, but shorter-term horizons have their own problems. Mr Bini Smaghi says that “central banks should be held accountable” over a one to three-year period. On that metric, the Bank of Japan was right to have set interest rates at very low levels between 1986 and 1988 – consumer prices initially fell but Japanese inflation returned to about two per cent by 1989. However, low rates also contributed to Japan’s extraordinary late-1980s financial bubble that paved the way for deflation. Conversely, the Bank of England was apparently wrong to have cut interest rates so aggressively in 2008 given elevated inflation rates in 2010 and 2011, even though the UK was, at the end of 2008, on the verge of economic collapse.
One of the most important lessons from the crisis is that inflation targeting has not delivered the lasting economic stability we all crave. Low inflation creates the aura of stability, but too often allows central bankers to take their eyes off the ball. The rapid expansion of credit pre-2008 was, after all, mostly ignored simply because inflation itself was so well-behaved. Unfortunately, US inflation was also well-behaved in the roaring 1920s yet it prevented neither the Wall Street crash nor the Great Depression that followed.
Price stability is, of course, desirable but inflation targeting itself is in danger of turning into a fetish. It’s time for a thorough re-examination of its contribution to our economic welfare.
The writer is HSBC Group’s chief economist and the bank’s global head of economics and asset allocation research. He is a member of the Financial Times Economists’ Forum