Some thoughs on inflation targeting

By: Wolfgang Münchau

I always suspected –perhaps unfairly- that many of the advocates of direct inflation targeting would change their mind once global inflation would be rising again. Over the last fifteen years,  many soft-money advocates were able to jump on the inflation targeting bandwaggon. No longer did they need to declare: I’d rather have 10% inflation than 10% unemployment. They could have their cake and eat at the same time. Inflation targeting allowed them to pretend that they really did care about inflation. Of course, there are academics who derived at that position as a result of their own research, and I know many genuine advocates of that system. But my underlying suspecion had always been that direct inflation targeting has more followers than it deserves.

 

As inflation is now rising again worldwide, and inflation targeting strategies are become more difficult to implement, I would assume that this episode in monetary history has surpassed its peak.

While I am aware that the Fed is not pursuing a policy of direct inflation targeting, we know that Ben Bernanke and some of his colleagues have long favoured such an approach. If the Fed was an inflation targeter, and if the target had been 1-2% core inflation – as Fed official tend to describe their “comfort zone” – the Fed would probably have raised interest rates to above 5.25% back in 2006. Under such a framework it would also have been difficult to justify the Fed’s 50bp cut in September, even though some governors desperately tried to make the point that inflationary pressures had somewhat subsided. If you look at those wonderful general equilibrium models, which Mr Bernanke and his colleagues had been staring at profusely before, you just do not see a clear image of an economic downturn with a fall in price pressures. That recession that everyone is now predicting with confidence was not supposed to have happened. It was not in the model, and still is not, ergo it cannot be. So if you were as serious about inflation targeting today than you were in 2003, you would not have cut interest rates in September.

 

Of course, US central bankers have the convenient excuse of the dual mandate. They can now focus on economic growth rather than inflation. In doing so, they have already had a profound effect on financial markets. The markets are clearly expecting a re-run of 2001-2004 episode. While the markets are probably assessing the Fed’s mindset correctly, they are misjudging the Fed’s room for manoevre. My own guess is that the Fed has another 50bp headroom for rate cuts this year, and maybe another 50bp next year in view of continued price pressures affecting all economies, and especially the US with a weaker dollar. Another 100bp in rate cuts, to be spread over six months, is not going to be enough to stop the recession, but it may be just enough to shift long-term inflationary expectations upwards.

 

The latter is not supposed to happen under an inflation targeting framework. My guess is that the Fed will ultimately try to establish a de facto target, but one that is in line with its policy, not in line with its old comfort zone for core inflation, which I suspect already crept up to 1.5%-2.5% some time ago. The sheer panic about deflation back in 2003 and 2004 shows clearly that the Fed fears an inflation rate of 1% more than an inflation rate of 3%, so it is probably even higher today. As we entering into the next downcycle, we may find that that range will shift to 2-3%. This was also my reading of Fredrick Mishkin’s commments some months ago that it would be too painful to push core inflation to below 2%. But the whole point about inflation targeting is to do precisely that: when the inflation rates moves out of their bounds, you try to push it back in to ensure that expectations remain unaltered. To do so you would have to willing to incur a short-term cost in terms of lost output. The Fed is clearly not willing to make that trade-off voluntarily, but may be forced to make that trade off by the bond and foreign exchange markets in due course. A pure inflation targeter should, however, volunteer to make such a trade off. This is surely the real test of the inflation targeting framework.

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