Por Frederic Mishkin
Inflation targeting is now facing its greatest challenge from a series of fundamental shocks. High energy and other commodity prices have led to inflation rates well above the inflation target – nearly 5 per cent in the UK versus the 2 per cent inflation target, for example – at the same time that the financial markets are reeling from the worst financial crisis since the Great Depression. Some critics of inflation targeting have argued that under the present circumstances, such targeting should be abandoned.
Is inflation targeting an idea that worked well in the past, but cannot cope with the stress of the present environment? How can monetary policy respond to the negative shock to the economy from the financial crisis, when inflation targeting requires a commitment to reduce inflation back to its target? Would the need to hit the inflation target not require tighter monetary policy that will just kick the economy when it is down?
To the contrary. I believe that inflation targeting, with some flexibility built in, is exactly what is needed right now. Inflation targeting establishes a transparent and credible commitment to a specific numerical inflation objective that provides a firm anchor for long-run inflation expectations, thereby directly contributing to the objective of low and stable inflation.
Additionally, the presence of a firm nominal anchor gives the central bank greater flexibility to respond decisively to adverse demand shocks. Such a commitment helps ensure that an aggressive policy easing – which might be needed to counteract the blow to the economy from the current financial crisis – is not misinterpreted as signalling a shift in the central bank’s inflation objective and thereby minimises the possibility that inflation expectations could move upward. A continuing, strong commitment to retain the same inflation target is exactly what is needed at the current juncture.
But how can an inflation target remain credible if monetary policy responds to adverse demand shocks when inflation is well above the target, as has happened recently? This is where flexibility comes in.
The modern science of monetary policy argues that it should not try to get inflation to within a tight range over short time horizons. To do so would only result in excessive fluctuations in economic activity. It argues, instead, that when shocks to the economy are sufficiently large, inflation might have to approach the target gradually over time and this could be longer than the two years that is usually assumed as a reasonable time horizon for monetary policy to have its intended effect on inflation.
Trying to get inflation down to the target too quickly will impose an unnecessary cost on the economy, and is actually likely to weaken the credibility of the central bank. Both the public and the central bank know that the central bank is unable to sustain an overly tough policy stance because if it did so the government might very well take steps to weaken its independence. An overly tough policy stance could then undermine the support for the inflation targeting policy and unhinge longer-run inflation expectations, actually leading to worse outcomes, both on economic activity and inflation. Instead, the central bank should articulate a desired path for inflation that gets to the target over a reasonable time horizon, thereby promoting the joint objectives of price stability and maximum sustainable employment. This kind of public communication can build the support that makes this policy sustainable.
The approach outlined here is actually representative of where best practice in inflation targeting is heading. The Norges Bank and Riksbank, the central banks of Norway and Sweden, have moved exactly in this direction. They have both made clear that they are pursuing more flexible inflation targeting regimes in which the horizon over which inflation returns to its target might have to vary, depending on the shocks to the economy.
Inflation targeting has been a significant step forward in improving the conduct of monetary policy. The challenging environment that central banks are facing today, however, suggests that inflation targeting practice needs to keep evolving in a more flexible direction, with a focus on what should be the best path for inflation that moves it towards a longer-run inflation objective, but not necessarily over a fixed time period.
Indeed, a more flexible approach to inflation targeting might make it more attractive to countries that have not adopted this monetary policy strategy, such as the US, where there is a fear that inflation targeting might promote too much of a focus on controlling inflation in the short run and not enough on financial stability or the dual objectives of promoting stability and maximum sustainable employment.
The author is a professor of finance and economics at the Graduate School of Business, Columbia University, a former member (governor) of the Board of Governors of the Federal Reserve and the author of ‘A Monetary Policy Strategy’ (MIT Press, 2007)