Stephen King: Inflation targeting simply has not worked and now is the time to let go
The new behemoths bend, twist and warp prices in ways that make the control of inflation more difficult
Monday 11 April 2011
Perhaps it's time to write the obituary for inflation targeting. After all, it hasn't been working very well. It was supposed to foster lasting economic stability. The financial crisis and the recession put paid to that. It was supposed to provide a clear framework within which policy decisions would be transparent, predictable and, to steal a favourite word of Mervyn King's, a little bit "boring". Yet members of the Bank of England's MPC still find room to fundamentally disagree on the appropriate direction of interest rates in the months ahead.
And it was supposed to enable central banks around the world to react in unambiguous fashion to external shocks such as higher oil prices. Yet while the European Central Bank (ECB) last week chose to raise interest rates, Ben Bernanke's Federal Reserve remains resolutely opposed to a rate increase and the Bank of England, sitting on the fence, is in danger of doing itself a mischief: it has been unable or unwilling to provide any kind of clear message on interest rates to the people of Britain, preferring instead to hold a public version of a senior common room debate.
So what has gone wrong? First on the list must be the increased influence on inflation in the Western world coming from emerging nations. Twenty years ago, when inflation targeting first became fashionable, the emerging nations had little influence on inflationary trends in the Western world. True, the OPEC nations caused havoc from time to time but China and India were largely irrelevant: their gravitational pull was tiny.
That's now all changed. The new economic behemoths bend, twist and warp prices in ways that make the control of inflation more difficult. Their influence can be seen in a range of different areas: they were partly responsible for the rapid declines in manufacturing goods prices that hit UK shores 10 years ago, they've more recently been a big influence on the price of energy while their success also helps to explain why food prices have headed upwards.
But these effects hit us in unpredictable ways. Five years ago we seemed to be importing deflation from the emerging world. Outsourcing of manufacturing production to China and other low-cost producers contributed to dramatic declines in the price of flat screen televisions, computers and iPods. With all this imported deflation, Western central banks were faced with the prospect of undershooting their inflation targets. They responded in the only way they knew – keeping interest rates low to push domestically-generated inflation higher to counteract the lower inflation coming from elsewhere.
This resulted in a boom in domestic credit. Although inflation wasn't high, credit growth was extraordinarily rapid. Most central bankers dismissed the fast pace of money supply growth, explaining this was merely the result of innovations within the financial system which were beyond the understanding of mere mortals and irrelevant for the functioning of the economy more broadly. They were partly right but yet also completely wrong. Overall inflation may have been well-behaved, but that wasn't good enough to prevent economies from completely collapsing.
Now we are faced with the opposite circumstances. Rapid increases in commodity prices – mostly pre-dating the effects of the recent turmoil in the Middle East and North Africa on the price of oil – have stemmed from extraordinarily rapid growth in China, India and elsewhere. They – and not higher wages – are responsible for the increases in inflation now being witnessed in the Western world. If central bankers are to be consistent, they should be endeavouring to drive down domestically generated inflation to ensure that the overall inflation target is being met. In the UK's case, that might mean a substantial increase in interest rates – and the inevitable deep recession – given that inflation, currently, is more than double the Bank of England's target.
And the consequence of this single-minded devotion to an inflation target? It must, surely, be a big increase in the volatility of output. If a big chunk of our inflation is made in the emerging world and is neither controllable nor predictable, the only way to reduce the volatility of inflation on a year-to-year basis is to allow output to go up and down to allow the domestic bits of inflation to counteract the inflation which stems from foreign climes. Far from offering economic stability, a rigid adherence to an inflation target actually increases instability. That was never part of the plan.
Of course, it might be argued that the strength of the emerging nations and the impact of that strength on commodity prices is indirectly a consequence of loose monetary conditions in the Western world. I happen to have a lot of sympathy with that view. But, from an inflation targeting perspective, it just makes a central banker's job a lot more difficult. Remember, the whole idea of low interest rates and so-called quantitative easing was to stimulate domestic economic activity, not to lift imported inflation.
This reveals another unfortunate feature of inflation targeting. Should a central bank be responding to current inflation, taking the view that today's undershoot or overshoot will influence expectations regarding tomorrow's inflation? Or should today's deviation be regarded as no more than an aberration which carries no implications for future inflation?
Central bankers have sometimes gone about their inflation targeting duties with unhealthy precision, encouraging a view which says that deviations from target are signs of failure. Many of them wanted to bask in the reflected glory of earlier successes with price stability, preferring to believe that they stemmed from wise policy decisions and not, as it now seems, from a dose of good luck imported from China, India and elsewhere. Given that price stability is so much more difficult to deliver, perhaps we need to revisit both the extent to which central bankers really were responsible for earlier inflation successes and also the degree to which they can foresee future inflationary dangers. On both counts, the recent record has not been encouraging.
The lesson from the economic crisis is that inflation targeting has not lived up to its billing. It hasn't delivered the economic stability we all crave, its earlier successes were more a result of luck than of good judgement and it led central bankers to ignore other economic signals which, in hindsight, told us more about the dangers of financial instability. Chief among those was credit growth. Credit growth in the eurozone today remains very weak suggesting that the ECB has still not learnt the lessons from the past, remaining fixated on inflation when indicators suggest a recovery is far from secure.
Mr King used to say we were living in a decade of "non-inflationary consistent expansion". All jolly NICE, as he might put it. The single-minded devotion to inflation targeting has, unfortunately, helped take us a long way away from that world. We now live in an economy best described as "serious headwinds, inflationary trauma". I'll leave you to work out the appropriate acronym.
Stephen King's book, Losing Control: The Emerging Threats to Western Prosperity (Yale University Press) is out in paperback
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