In general, economists have made considerable progress towards understanding the role of central banks in addressing inflation. Until at least the early 1970s, the majority of the economists felt the central banks were able to do little to control inflation. However, such skepticism about the central banks’ abilitiy to control inflation has somewhat disappeared. This actually happened even though there was no change to the views about how monetary policy affects the economy.

But inflation targeting may not work well in today’s scenario. It is because the current framework is more likely to make it tough for central banks to address the next recession. What has happened today is that central banks which adopted the 2% target are finding themselves following the Japanese predicament. So, it it time to look at nominal GDP targeting?

• In general, economists have made considerable progress towards understanding the role of central banks in addressing inflation. Until at least the early 1970s, the majority of the economists felt the central banks were able to do little to control inflation. Conventional wisdom indicated that monetary policy was relatively ineffective to control inflation or even to stabilize economy. It was the fiscal policy which principally stabilizes the economy and keeps inflation low by filling the gaps between actual and potential output.

• However, such skepticism about the central banks’ abilitiy to control inflation has somewhat disappeared. This actually happened even though there was no change to the views about how monetary policy affects the economy. Hence, “inflation targeting” moved in first in 1988 by the central banks of New Zealand and Canada, where their inflation target was set at 2%. It was followed by the Bank of England in 1992 while the European Central Bank also embarked on the inflation targeting in 1998.

• In the case of the US Federal Reserve, the policymakers somewhat privately agreed to adopt the inflation targeting process by setting inflation at 2% in 1996. But the US Federal Reserve did not make any official statement or made it known publicly until 2012. At that point in time, targeting inflation around 2% worked reasonably well for a while. It was easy to communicate and provided a yardstick against which to measure central bank performance.

What caused the shift towards inflation targeting?

• One of the salient factors that led to the sharp change towards inflation targeting by the central banks was the believe that they can address inflation by focusing on their monetary aggregates. At the same time, it is of the view that for countries that have been operating in large and persistent deficits, such fiscal policy should be sidelined as the monetary policy will be able to do well in addressing inflation. Besides, if such countercyclical fiscal policy remains, it will blur the relative importance of the monetary and fiscal policy in addressing inflation and also in acting as an economic stabilizer.

• Finally, by shifting towards inflation targeting, it will help reduce inflation permanently by lowering the cost and raise credibility. The rise in central banks’ credibility in addressing inflation successfully through the use of its monetary policy plays an important role. More so, if it is carried out and done with no change taking place in understanding as to how the monetary policy worked. It worked by focusing on the Phillips curve framework despite the view that any change in short-term rates is likely to have a relatively small impact on aggregate demand.

Inflation targeting may not work well in today’s scenario

• For a start, with so much invested in the 2% inflation targeting by the central banks, it is unlikely to see them move quickly to alter or replace it. However, it is important for the central banks to rethink their “inflation targeting”. It is because the current framework is more likely to make it tough for central banks to address the next recession.

• What has happened today is that central banks which adopted the 2% target are finding themselves following the Japanese predicament. If one looks at Japan, this economy fell into an inflationary trough for an extended period. And until today, Japan is still struggling to lift its inflation reading to 2%. As a result, it now threatens the Japanese regime’s credibility.

• Besides, the 2008 global financial crisis should act as a reminder for everyone. By focusing exclusively on price inflation, it became insufficient to keep the overall health of the economy sustainable. This can be seen in Europe. The European Central Bank raised rates in June 2007 and was reluctant to cut rates until the fall 2008. This was a clear evidence of policy mistake.

• Another point that needs close attention is on the real or inflation-adjusted neutral rate of interest. In the early 2000s, estimates by the several major central banks showed the real or inflation-adjusted neutral rate of interest was 3%. Inflation was said to be at 2% with a 5% nominal rates. Under such circumstances, it allows the central banks to cut rates to address economic slowdown or recession.

• But in more recent projections, the real or inflation-adjusted neutral rate of interest is seen to be well below historical levels. It is projected to be around 1% or even less. As a result, it will limit the central banks from cutting rates to address economic slowdown or recession. Of course, central bankers can apply other unconventional policy tools to help keep interest rates low. But it remains unclear how willing they will be in using them again or how effective these will be.

Is it time to look at nominal GDP targeting?

• Inflation targeting is a core guiding principle for central banks to maintain the credibility of monetary policy and anchor expectations about policies. It is an important driver of growth during the last two decades. Having an independent central bank with a clear mandate and quantifiable target diminished the problem of using monetary policy for political purposes that so many governments had done over many decades. So, the key benefit of inflation targeting is not just looking at inflation per se, but as a measurable target that the central bank could aim for and could influence.

• Hence, should central banks move away from inflation targeting or exchange rate targeting to nominal GDP targeting after taking into account of the predicament of struggling to meet the 2% inflation target? Looking further into the details, it shows that flaws on inflation targeting come from productivity, supply shocks and countries with excessive levels of government debt.

• Inflation targeting does work well in addressing the demand shock. The mismatch between the speed at which demand rises compared with supply will apply inflationary pressure upwards through demand shocks. This can be addressed by raising interest rates which in turn will dampen inflation by reducing the excess demand in the economy. It will also reduce volatilities from output and inflation over the cycle.

• However, there is a problem with inflation targeting when upward inflationary pressure comes from supply shocks. Under such circumstances, it becomes uncertain as to whether the inflation targeting policy will work well or otherwise to address inflation. It can also heighten output volatility. For instance, a fall in productivity growth is a negative supply shock that will increase input costs and drag output. Under such circumstances, an inflation targeting central bank will likely tighten its monetary policy to address inflation driven by higher input costs. Such a move will reduce economic growth. Hence, the monetary policy under these circumstances would worsen the impact on the real economy than that caused by the shock alone.

• This is important as it has always been a problem for emerging economies where they tend to experience more extreme supply shocks (e.g. weather events, political instability, etc.) than demand shocks (excessively exuberant consumers). Should the mantra of the central banks in emerging countries is inflation targeting, then it will cause problems for their real economy in many cases. What happens is that the benefits they would have enjoyed from monetary policy credibility will be offset by real output losses from an overly tight policy. Interestingly, it is also becoming more relevant today for advanced economies, especially those facing falling productivity and rising risk.

• So, inflation targeting is not the best framework for central banks in these circumstances. This problem can be addressed by shifting away from inflation targeting to nominal GDP growth targeting. Nominal GDP growth is the sum of inflation and real GDP growth.

• To understand why nominal GDP targets works well, consider the case of a fall in productivity (equivalent to a rise in input costs). An inflation targeting central bank will tighten its monetary policy in response to rising inflation. A central bank following a nominal GDP target would combine the rise in inflation with the fall in real GDP. It will not tighten the monetary policy but may loosen the monetary policy if the expected fall in real GDP is a larger-than-the expected rise in inflation. The outcome for the real economy would be better but expectations from having a clear policy rule would not be undermined.

• Another issue where policy will need to be adjusted is because of the prevalence of countries in the global economy with high ratios of nominal debt to nominal GDP. While fiscal policies will ultimately need to be tightened to bring down the level of debt, it is also important that the rate of nominal GDP growth is maintained. Falling debt levels combined with falling nominal GDP growth implies the ratio of nominal debt to GDP will rise, even as countries attempt to get their fiscal deficits under control. This is a recipe for bad economic outcomes, as southern European governments are discovering.

• In summary, on the face of current realities, it is clear that central banks many need to shift their focus away from inflation targeting or exchange rate targeting to nominal GDP targeting. The sooner this happens, the better it will be for the world economy. The management of monetary policy in the next five years will likely be very different to current conventional wisdom.

Source: AmInvest Research - 1 Apr 2019