"The Urgent Need to Abandon Inflation Targeting"

Joseph Stiglitz doesn't like inflation targeting:

The urgent need to abandon inflation targeting Joseph Stiglitz, Project Syndicate: The world’s central bankers are a close-knit club, given to fads and fashions. In the early 1980s, they fell under the spell of monetarism, a simplistic economic theory promoted by Milton Friedman. After monetarism was discredited — at great cost to those countries that succumbed to it — the quest began for a new mantra.

The answer came in the form of “inflation targeting”... This crude recipe is based on little economic theory or empirical evidence... One hopes that most countries will have the good sense not to implement inflation targeting; my sympathies go to the unfortunate citizens of those that do. (Among ... those who have officially adopted inflation targeting are: Israel, the Czech Republic, Poland, Brazil, Chile, Colombia, SA, Thailand, Korea, Mexico, Hungary, Peru, the Philippines, Slovakia, Indonesia, Romania, New Zealand, Canada, the UK, Sweden, Australia, Iceland and Norway.)

Today, inflation targeting is being put to the test — and it will almost certainly fail. Developing countries currently face higher rates of inflation, not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries. In China, for example, inflation is approaching 8% or more. In Vietnam, it is expected to approach 18.2% this year, and in India it is 5.8% . By contrast, US inflation stands at 3%. Does that mean that these developing countries should raise their interest rates far more than the US?

Inflation in these countries is, for the most part, imported. Raising interest rates won’t have much effect on the international price of grains or fuel. ...

Raising interest rates can reduce aggregate demand, which can ... tame increases in prices of some goods and services... But, unless taken to an intolerable level, these measures by themselves cannot bring inflation down to the targeted levels. For example, even if global energy and food prices increase at a more moderate rate than now — for example, 20% per year — and get reflected in domestic prices, bringing the overall inflation rate to, say, 3% would require markedly falling prices elsewhere. That would almost surely entail a marked economic slowdown and high unemployment. The cure would be worse than the disease.

So, what should be done? First, politicians, or central bankers, should not be blamed for imported inflation...

Second, we must recognise that high prices can cause enormous stress, especially for poorer people . Riots and protests in some developing countries are just the worst manifestation of this.

Advocates of trade liberalisation touted its advantages; but they were never fully honest about its risks, against which markets typically fail to provide adequate insurance. When it comes to agriculture, developed countries ... insulate both consumers and farmers from these risks. But most developing countries do not have the institutional structures, or the resources, to do likewise. Many are imposing emergency measures like export taxes or bans...

If we are to avoid an even stronger backlash against globalisation, the west must respond quickly. Biofuel subsidies ... must be repealed. Some of the billions spent to subsidise western farmers should now be spent to help poorer developing countries meet their basic food and energy needs.

Most importantly, both developing and developed countries need to abandon inflation targeting. The struggle to meet rising food and energy prices is hard enough. The weaker economy and higher unemployment that inflation targeting brings won’t have much effect on inflation; it will only make the task of surviving in these conditions more difficult.

Contrary to the assertion above, there is quite a bit of theoretical and empirical work on this topic, and strict inflation targeting is not generally supported by what we know about optimal monetary policy (e.g. see the discussion of "divine coincidence"). So I agree with Stiglitz in the sense that strict inflation targeting, i.e. ignoring deviations of output from target and focusing exclusively on deviations of inflation from target, is the wrong approach. But I'm not sure he would support my view that using modified Taylor type rules, i.e. linking the federal funds rate to deviations price and output measures from target values, and allowing the target (natural) real interest rate to vary with real shocks (e.g. to food and energy), is the best way to stabilize output and employment.

Comments

[a]

"Contrary to the assertion above, there is quite a bit of theoretical and empirical work on this topic, and strict inflation targeting is not generally supported by what we know about optimal monetary policy..."

Doesn't the ECB beg to differ? Or is there baggage in "strict" which excludes the ECB's inflation targetting?

"Advocates of trade liberalisation touted its advantages; but they were never fully honest about its risks, against which markets typically fail to provide adequate insurance."

Exactly. Free trade tends to concentrate the production of foods and goods, which creates risks.

"If we are to avoid an even stronger backlash against globalisation, the west must respond quickly."

So the only reason the west must respond is to prevent a "backlash"? That makes it sound like the backlash is irrational, rather than well-founded.

[robertdfeinman]

I think one of the ways to get a handle on inflation expectations is to look at what market professionals are thinking. What they are thinking is reflected in what they are doing.

The preferred stock GED issued by General Electric is now selling above the call price for the first time in nearly two years. Since GE is a company with unparalleled financial stability the rise in price can only be due to expectations about future interest rates, rather than the prospects of the firm surviving.

So it would seem that some group of investors thinks interest rates will remain low for some time in the future and that inflation will remain moderate as well. Unlike the pundits they are apparently willing to back their evaluations with cash.

Perhaps someone can explain the divergence of viewpoints. I can't.

[David Pearson]

A better idea for Central Bankers:

Abandon fine-tuning.

[kharris]

My impression is that "This crude recipe is based on little economic theory or empirical evidence..." was not intended to mean this there is not "quite a bit of theoretical and empirical work on this topic" but rather that "strict inflation targeting is not generally supported by what we know about optimal monetary policy". That is to say, I think you and Stiglitz agree on more than you seem to think you do. Perhaps you know more about his views than is reflected in this piece.

David P,

At least in the Fed's case, there is far less short-term, back-and-forth adjustment of rates since the late 1980s than prior periods. What do you have in mind by "fine tuning"?

[bakho]

Should the cause of the inflation be important to the Fed decision? If the cause of inflation is energy prices is the solution to curbing high energy prices to raise interest rates? Some monetarists like to argue that high interest rates in the early 1980s cured inflation.

However, inflation in the late 70s was being driven by high energy prices. The energy prices were addressed by conservation measures such as CAFE standards and investments in fuel switching. Inflation was "cured" when demand for oil dropped over 20% between 1978 and 1983. It has been argued that the high interest rates actually impeded needed investment in energy savings measures (new cars, new equipment, etc.)

Energy cannot be fixed by monetary policy alone.

[johnchx]

I think the problem is terminology. Consumer price changes (measured by things like CPI and the PCE deflator) are not at all the same thing as the theoretical abstraction called "inflation." Joe and Mark are arguing against CPI targeting. (And, unfortunately, some central banks may be engaged in CPI targeting, which they confuse with inflation targeting.)

What's needed, of course, is a better measure of "true" inflation, from which changes in relative prices (e.g. a sweatshirt is worth fewer gallons of gas than it was two years ago) have been purged. I seem to remember an NBER working paper on just that topic being discussed here earlier this year.

[don]

"By contrast, US inflation stands at 3%."

By what definition, the fed's 'core' inflation? The BLS says the CPI is at 4% as of March (April numbers won't be out until May 14.) The rest of this piece is equally flawed.

I side with David Pearson (as modified by the presumed response to Kharris). Greenspan's legacy was bad enough. Wait until we see what comes from Ben's policies, trying to keep up U.S. borrowing. When it goes beyond targeting inflation, the fed probably does more harm than good.

I think it more likely that the stock of 'inflation targeting' will wax rather than wane in the future. If it survives the upcoming ECB experience, it will prove remarkably robust. I'm just afraid that experience may give it an undeserved bad name, because it may expose the weakness of the euro - it's not an optimal currency area.

Bakho is also right. The source of the inflation matters. For example, the initial response to the oil price hike of the '70s may have been reasonable. But the ensuing result was not. When we finally got someone with the necessary integrity (Volcker), the medicine was harsh, indeed, and not only for the U.S., but for the LDC debtors as well.

[don]

"If we are to avoid an even stronger backlash against globalisation, the west must respond quickly."

If a backlash comes, it will be in response to the old "keep your currency undervalued to export your unemployment or to keep up growth" strategy that Asia seems to have become enamored of. In a world of deficient aggregate demand, such policies won't go over so big in importing countries.

[Dan]

Thanks for posting...

Henry Liu wrote an excellent essay about inflation targeting and the risk of hyperinflation: http://www.henryckliu.com/page153.html

Highly rec'd!

[Conundrum]

The problem with constant inflation is that it prevents many people from responding to supply/demand price signals efficiently. When a plethora of import supply increases potential domestic supply, prices do not fall to increase consumption. When a paucity of import supply decreases potential domestic supply, prices rise at about the same pace as they did when there was an abundance of import supply. Consumption attempts to stay the same, but fewer consumer goods are available. Thus the conundrum, and unintended consequences.