Rethinking Inflation Targeting

Farewell to Inflation Targeting?

The Failure of Inflation Targeting

Moreover, the US Federal Reserve is targeting a 4 annual inflation rate.

Most importantly, both developing and developed countries need to abandon inflation targeting.

So did inflation targeting the excessive focus on inflation had diverted attention from the more fundamental question of financial stability.

This, by itself, calls for a review of the overall efficacy of inflation targeting.

Today, inflation targeting is being put to the test and it will almost certainly fail.

Critics identify this crisis straitjacket syndrome as the main problem with single minded inflation targeting.

But inflation targeting was never an obvious concept, and the financial crisis has discredited it.

While this proposal shares some features with inflation targeting, it may actually achieve its goals more effectively.

The main anchor of central banks monetary policy over the past 20 years was an inflation targeting framework that developed from academic interpretation of the problems involved in targeting monetary aggregates.

Moreover, those who warn that the Fed might fail to raise interest rates if inflation picks up don t understand that the Fed s culture of inflation targeting is deeply ingrained.

The weaker economy and higher unemployment that inflation targeting brings won t have much impact on inflation it will only make the task of surviving in these conditions more difficult.

For his part, Bernanke led the intellectual charge toward inflation targeting by central banks, arguing that setting a target for annual inflation was a full and sufficient framework for monetary policy.

This is the strategy pursued by countries such as Turkey and South Africa, which have adopted more conventional inflation targeting regimes.

Thus, monetary authorities should simply focus on price stability by targeting the rate of unemployment at which inflation does not increase, referred to as the non accelerating inflation rate of unemployment (NAIRU).

In the 1980s, major advanced countries tried the money supply. After the monetarist approach failed, some switched to targeting the inflation rate.

Coming from different experiences, most countries converged on the adoption of a floating exchange rate, many in the context of inflation targeting.

Out goes the fusty old inflation targeting regime, with its fixation on the consumer price index and disregard for financial sector imbalances.

In that regard, Governments may wish to consider inflation targeting as a possible option, as well as acting to eliminate fuel subsidies.

Inflation in 1950 1973 and 1980 2007 was about the same just over 3 while inflation targeting has failed to prevent a succession of asset bubbles that have brought recessions in their wake.

For the past 25 years, the mantra of inflation targeting (introduced in my 1985 paper) has served as a mechanism for containing inflation expectations by reassuring the public of the central bank s intentions.

Indeed, some countries are ditching their inflation targeting regime and moving into uncharted territory, where there may be no anchor for price expectations.

During the first part of the decade, intervention was motivated by the desire to avoid devaluation, and therefore to support the inflation targeting objectives.

The answer came in the form of inflation targeting, which says that whenever price growth exceeds a target level, interest rates should be raised.

This focus supported the ascendancy of inflation targeting as the favored monetary policy framework and, in turn, led to operational independence for central banks.

In most countries, at most times, inflation should be kept very low and central banks should anchor inflation expectations with a stable long term target, although the alternative of targeting nominal GDP deserves to be discussed.

What about inflation targeting? Here, too, the record since 1980 has been patchy, despite the huge deflationary pressure exerted by low wage competition from Asia.

New Zealand led the way for much of the world s central banks with inflation targeting, along with many liberalizing reforms in the late 1980 s.

The main change was a large reduction in interest rates, in line with an inflation targeting framework, which has led to a more competitive exchange rate policy.

That is why you need an independent fiscal council to administer it, just as you need an independent central bank to pursue an inflation targeting monetary rule.

In 2003, Ben Bernanke, then a Governor of the US Federal Reserve, stated in a speech that many Americans considered inflation targeting foreign, impenetrable, and possibly slightly subversive.

Even countries that practice inflation targeting and have otherwise vowed to let their exchange rates float Brazil, Colombia, Peru, and Chile, for example have done it, and in large quantities.

Haruhiko Kuroda, the Bank of Japan s new governor, has sent a clear signal to markets that the BOJ is targeting 2 annual inflation, after years of near zero price growth.

The low inflation objective need not involve the formalities of an inflation targeting regime, such as that practiced by the European Central Bank and the Bank of England, and is similar in approach to that recommended for the United States by US Federal Reserve Chairman Ben Bernanke.

Weary with crisis, Ecevit s administration embarked on a comprehensive reform package spearheaded by Minister for the Economy Kemal Dervis that included a flexible exchange rate system with a dedicated inflation targeting regime.

The dominant policy blueprint looked roughly as follows the monetary authorities focus on inflation targeting in setting interest rates should suffice to maintain price stability and economic growth near its potential rate.

Legal advice on targeting

Japan faces a different conundrum. Haruhiko Kuroda, the Bank of Japan s new governor, has sent a clear signal to markets that the BOJ is targeting 2 annual inflation, after years of near zero price growth.

For example, the inflation targeting regime implemented by the Central Bank of Turkey has been revised to incorporate financial stability, and a new monetary policy framework has been in effect since the end of 2010.

Targeting of sectors will decline.

Moreover, after the financial crisis erupted, central banks were increasingly compelled to depart from inflation targeting, and to implement myriad unconventional monetary policies in order to ameliorate the consequences of the crash and facilitate economic recovery.

In particular, central banks behavior during the crisis has called into question whether inflation targeting is an effective framework in the presence of systemic shocks, and, more broadly, whether it can be sustained throughout economic cycles.

This prideful interpretation amounted to the siren song of an extremely accommodative monetary policy. Unable to disentangle the global and domestic pressures suppressing inflation, a price targeting Fed has erred consistently on the side of easy money.