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Thursday, May 08, 2008

"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.

    Posted by on Thursday, May 8, 2008 at 12:24 AM in Economics, Inflation, Monetary Policy | Permalink  TrackBack (0)  Comments (11)


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