The monetary policy experiment of inflation targeting has failed to produce a more stable macroeconomic environment. The failure doesn’t stem from the wrong objective, but from the poor structure of the framework. Arguments to raise the inflation target will only work if the structure is changed as well.
Inflation targeting
In recent years, central banks in several developed economies have adopted formal inflation targets. Proponents have claimed this would create greater transparency in the decision-making process and help central banks better communicate the reasons and rationales for any policy changes. The core reason behind this was that a low and stable inflation environment would anchor inflation expectations and also lead to greater macroeconomic stability.
Success for this type of monetary policy framework depends as much on selecting the appropriate basket as it does on the specific price target. US policymakers have selected the consumer price index (CPI) as the appropriate basket of items. At first glance, this traditional price index would seem to be the most appropriate measure of price change, since it captures the most dominant part of final demand.
However, the current structure of the CPI does not directly include the price of housing. Instead, the government statisticians create a proxy for house-price inflation based on trends in rents. This creates both a reality and a measurement problem because the rental market and the owner housing market are distinct markets.
Indeed, the current structure of the inflation-targeting framework sets a speed limit for a large chunk of the consumer basket—and no speed limit for housing. And policymakers only react to price changes in the housing market if the speed in housing prices creates a higher speed rate in the targeted basket of consumer items, or if house prices crash and burn and there is a potential spillover effect (negative) on the targeted basket.
Why this inflation-targeting framework is flawed
Housing, more than any other product or service in the economy, is highly influenced by the cost of borrowing, liquidity conditions and (at times) speculation. Directly and indirectly, all three of these conditions are influenced by the stance of monetary policy.
Also, the acquisition of housing involves the accumulation of debt. Consequently, by not formally monitoring prices and credit use, policymakers run the risk of creating macro imbalances in the economy that could become systemic.
Economic performance during the inflation-targeting regime
In the US, an informal and formal inflation-targeting regime has been in place for more than two decades. The resulting macroeconomic record is poor—if not worse than before.
First, the 2000s decade had two economic recessions; its performance matched the uneven economic performances of the 1950s, 1970s and 1980s. Moreover, the 2007–2009 economic downturn was the longest in duration (18 months) and deepest in terms of depressed gross domestic product (GDP) output (–4%), lost jobs (8.5 million) and shrinking household wealth ($12.7 trillion) in the postwar period.
Second, the economy spent 26 months in recession during the 2000s—a period marked by low and stable inflation. The only other decade that recorded as many months in recession was the 1970s—a decade marked by high and accelerating inflation.
Why isn’t the trade-off between low and well-anchored inflation and economic performance any better than it was during high and rising inflation? Is the inflation-targeting regime flawed or have policymakers selected the wrong basket?
Proposed changes to the inflation-targeting framework
Olivier Blanchard, the chief economist for the International Monetary Fund, argues that inflation targeting has not worked because the specific inflation target has been set too low. He and other policymakers and academics continue to debate and question what the optimal inflation target is. Some of them suggest that inflation targets be set as a high as 4%.
While the setting of a price target is important, it’s not as important as the specification of the price measure, in our opinion. That’s because central banks can influence the cost of borrowing and aggregate liquidity conditions, but they cannot direct the liquidity flows. Only the private sector will push the flows in the directions that fit its needs.
Formal price targeting can only work well if policymakers focus on actual prices and include prices that are most sensitive to monetary policy changes. Any attempt to add more monetary stimulus to the system, with the simple goal of trying to achieve a narrow price target, is likely to result in even greater price imbalances and potentially more economic instability.
By Joseph G. Carson, US Economist and Director, Global Economic Research, AB
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