If anything has survived more or less intact in the aftermath of the global financial crisis, it is inflation targeting. This is odd.
After all, pre-crisis, many economists and policymakers enthusiastically embraced the “Great Moderation” – the idea that wise monetary policies had not only helped bring inflation to heel but also, as a result, delivered more stable economic activity. “No more boom and bust” was not the boast of politicians alone: it became a core belief of the economics establishment.
Yet, the boast was clearly wrong. A narrow focus on price stability ultimately proved extremely damaging. Policymakers ignored other signs of incipient instability, most obviously rapid credit growth and, in the US at least, surging housing activity. Having done so, they gave the green light to excessive risk-taking: with inflation under control, there was no reason for investors to worry about nasty monetary shocks.
History shows, however, that economic and financial crises are more commonly associated with periods of low, not high, inflation. Low inflation may be desirable in many respects but it seems as though the obsession with hitting a precision-engineered inflation target simply reflected the fears of a generation of policymakers scarred by the monetary mistakes of the inflationary 1970s, a decidedly peculiar decade.
Post-crisis, central bankers were focusing a lot more on financial stability. But they have mostly been unwilling to admit, at least in public, the role of monetary policy in encouraging excessive risk-taking. Given the narrowing of bond spreads induced by quantitative easing and the associated resurrection of the “hunt for yield”, this is worrying.
Policymakers hope to tame excessive financial bets through macroprudential policies. Yet their success is hardly guaranteed: Spain’s experiments with “dynamic provisioning” – by which banks were required to hold more capital than they necessarily wanted to against possible future losses – did not prevent economic meltdown. The Bank of England is now contemplating macroprudential policies to tame the more bubbly aspects of UK behaviour – most obviously, an overheating London property market – knowing that the experience of other countries has been decidedly mixed.
Embracing macroprudential measures today offers unfortunate parallels with the enthusiasm for incomes policies in the 1970s. These microeconomic controls were designed to keep inflation in check even as macroeconomic policy was calibrated to boost growth and employment. It did not work.
Macroprudential measures are designed to limit risks within the financial system even though macroeconomic policy – monetary stimulus designed to lift economic activity – may actually be encouraging excessive risk-taking. As in the 1970s, this “push-me, pull-you” approach is unlikely to be sustainable.
Fortunately, there is a way forward. The blinkered focus on meeting a precision-engineered inflation target needs to be abandoned. Instead, monetary policy needs to address a number of potentially competing objectives, using what might be best described as “positive ambiguity”. Central banks should commit to a steady increase in the price level over the medium to long-term but they should also be willing to tolerate sustained departures of the inflation rate from target, depending on other macroeconomic variables.
To take just one example, Japanese monetary policy in the late 1980s looked just about right judged by inflation alone. It looked terribly wrong, however, once rapid money supply growth and surging asset prices were taken into account.
Had interest rates been higher, inflation in the near-term would have been exceptionally low but the bubble might have ended up a lot smaller. Ironically, a bigger near-term inflationary undershoot might have reduced the risk of persistent deflation longer-term.
Positive ambiguity would emphasise that interest rates might rise – or fall – for a whole host of reasons not necessarily connected with the near-term inflationary outlook: credit growth, the balance of payments, asset price inflation and so on. Central banks would inevitably be forced into making judgments, thereby removing the faux-certainty generated by a mechanistic approach to inflation targeting.
The cost would be an increase in monetary policy uncertainty. That, however, would also be the benefit: by making the world a little less certain, it might reduce some of the excessive risk-taking that has only been encouraged by the excessively narrow focus of central banks on inflation both before and after the financial crisis.
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