The End of Strict Inflation Targeting?

Wolfgang Munchau argues that strict inflation targeting is unlikely to persist as a monetary policy strategy:

End of inflation targeting in sight, by Wolfgang Munchau, Commentary, Financial Times: Since the late 1980s, increasing numbers of central banks have adopted the strategy of inflation targeting. The idea was to provide an anchor for expectations of future inflation and interest rates – both by means of the target itself and by means of an inflation forecast. While this strategy has worked well for some central banks – notably the Bank of England – it did not work out as well for others.

The Swedish Riksbank was one of the early adopters of inflation targeting. Yet, in Sweden, the strategy has come unstuck... Like many other central banks, the Riksbank defined price stability as an annual increase in consumer price inflation of 2 per cent, with a one percentage point margin on either side. Yet between January 2004 and February 2006 annual consumer price index inflation persistently undershot the lower band of the target, hitting a low point of minus 0.4 per cent in February 2004. Under its own definition, the Riksbank produced price instability...

In theory, inflation targeting is a relatively flexible monetary policy framework that gives central banks discretion to pursue particular strategies within the confines of the upper and lower tolerance levels. ... The bands act as the constraint. Going outside the bands would have required the Riksbank to take swift policy action to get inflation back towards 2 per cent – or at least above the lower band of 1 per cent. If it had taken its own strategy seriously, the Riksbank should have opted to pursue a Japanese or Swiss-style policy of zero nominal interest rates. But Swedish policy rates only came down to a low of 1.5 per cent in June 2005, at which level they stayed for only seven months.

Instead of cutting rates further to meet the target, the Riksbank subsequently raised interest rates. ... On the face of it, this is a perfectly sensible strategy for a central bank to adopt. The Riksbank had good reasons to deviate temporarily from its strict inflation target. At a time when inflation was close to zero, the country experienced high economic growth and a housing boom. The Riksbank concluded that a ... boom-bust development in the housing market could destabilise the economy and have negative effects on price stability. For that reason, the decision not to cut policy interest rates below 1.5 per cent was probably correct.

But while the Riksbank’s monetary policy was sensible, it was not consistent with its inflation target framework. ... The strategy as it is formulated now is simply not credible. Is the inconsistency of the Swedish central bank a sign of the beginning of the end of inflation targeting, or – at least – the end of the strictly banded version? It may well be. ...

The question here is whether strict inflation targeting is optimal. Consider a very simple version of a Taylor rule:

ff = a + b(y-y*) + c(π-π*),

Under strict inflation targeting this becomes:

ff = a + c(π-π*)

With this policy, keeping inflation within its target range is the sole goal of policy. Which of the two approaches is best? This can be reinterpreted as the question of "divine coincidence." From the archives:

Mankiw ... explains why pure inflation targeting ... is consistent with output and employment stabilization when there is what Olivier Blanchard calls “divine coincidence.”  In the end, however, Mankiw is not convinced that divine coincidence exists:

Comments on “Separating the Business Cycle from Other Economic Fluctuations,” by Robert E. Hall, N. Gregory Mankiw, Jackson Hole Conference, August 2005: In most academic studies of optimal monetary policy, a central bank is assumed to have two main objectives. ... keeping inflation low and stable ... [and] ... keeping the economy’s output of goods and services close to its potential... Optimal policy ... often takes the form of a Taylor rule. The central bank is supposed to set the short-term interest rate as a function of inflation and the deviation of output from potential.

Bob Hall’s paper takes aim at the practical application of this framework... The bottom line from these arguments is that central bankers should be wary when their staff of economists produces estimates of potential output and the output gap and that they should avoid relying on these estimates when setting monetary policy. The alternative is to focus almost exclusively on the other variable in their objective function—the rate of inflation. ...

This brings me to the policy question: If we cannot estimate potential output or the natural rate of unemployment, what are monetary policymakers to do? The obvious alternative is to focus exclusively on inflation, as some inflation-targeting central banks are now doing. Such a regime of pure inflation targeting would seem to be inconsistent with the Fed’s dual mandate of being concerned about both price stability and full employment. ... however, that this is not necessarily the case. In some modern theories of the business cycle, a monetary policy that aimed exclusively at stabilizing the price level would achieve, as a by-product, stabilization of output at its potential level. Olivier Blanchard has called this fact the “divine coincidence.” If the divine coincidence is actually true, it would conveniently solve the conundrum raised in this paper, for the central bank would not need to measure potential output in order to keep actual output at potential. It would only need to stabilize prices. ...

Is this coincidence true in the world, or just an artifact of some oversimplified macroeconomic theories? The literature on this topic not sufficiently developed to give a definitive answer, but my guess is that it is more likely an artifact... [If] supply shocks are not simply shifts in productivity but also represent shifts in how distorted the economy’s production process is ... then it turns out that the divine coincidence does not arise. In this case, monetary policymakers face a trade-off between stabilizing inflation and stabilizing the output gap. Whether this kind of supply shock is an important feature of the world is, I believe, a crucial unanswered question.

So what does all this mean for the practice of central banking? Unlike Bob, I am not ready to give up on concepts such as potential output and the natural rate of unemployment. But I agree with him that we measure these concepts poorly and that this fact suggests increased emphasis on measures of inflation. Some might argue for an exclusive focus on inflation, but I don’t see the current state of monetary theory as necessarily supporting such an extreme view...

So, if the conditions for divine coincidence do not hold, then it is optimal for Sweden to consider the housing driven output boom in addition to inflation in setting the target interest rate.