Inflation targeting under fire

In recent years, central banks have succeeded in keeping inflation low. Now, as economies slow, that goal is proving hard to reverse, leaving policy makers to wonder whether the inflation targets adopted a generation ago are still relevant.

Inflation targeting is simply a monetary policy that explicitly aims to meet a defined annual rate of inflation. By anchoring expectations for prices, the policy reasons that central banks can encourage consumers to spend while promoting stability in financial markets and the broader economy. Its effectiveness depends on central banks clearly (and believably) signalling the direction of future interest rate movements.

Inflation targeting’s supporters say that it contributes to economic stability by fixing expectations. “Over time,” International Monetary Fund economist Sarwat Jahan has written, “inflation targeting has proved to be a flexible framework that has been resilient in changing circumstances, including the recent financial crisis.”

However, central banks including the European Central Bank and Federal Reserve have consistently fallen short of their inflation targets, undermining their credibility (see chart). In times of strong economic expansion, including through 2016 and 2017, markets more or less ignored that failing. Now that growth has slowed, investors and central bankers themselves are questioning the paradigm.

European Central Bank President Mario Draghi last week said that “basically there is no 2% cap” on inflation and suggested that he backs ‘symmetry’ that would, for example, let the central bank keep inflation slightly above 2% after an economic downturn to stimulate growth. Formally, the ECB defines price stability as inflation “below, but close to, 2% over the medium term.”

We should not forget that decades of targeting inflation has been politically convenient in ageing populations where limiting price increases kept savings from being eroded. On the other hand, Japan illustrates the dangers of persistently low inflation and an economy that even suffered prolonged deflationary periods when consumers did not spend and firms froze salaries.

The policy’s opponents argue that inflation is no longer a meaningful target metric for central banks, and it remains debateable whether consumers are sensitive to inflation at low single-digit levels. Critics argue that, looking forward, the modern economy’s logistics are more streamlined, as stable prices and inflation undermine any value the approach offered.

Locating the target

Historically, central banks used currency pegs as the ‘nominal anchor’ for public expectations of prices and monetary policy. The disadvantage was that anchoring monetary policy to another currency limited central bankers’ ability to respond to the domestic economy. As countries looked for a new anchor, they shifted to money supply or adopted flexible exchange rates, and when those rates then came under attack in the 1990s, or proved unstable, they turned instead to targeting inflation.

The origins of inflation targeting are visible in the collapse of the Bretton Woods system at the end of the 1970s. As the value of the US dollar declined, other currencies gained, and Switzerland and Germany started to pursue disinflationary policies. Switzerland’s economy faces the additional challenge of a strong franc, which makes euro-denominated imports cheaper and lowers inflation even further.

The real paradigm shift came almost 30 years ago. Inflation targeting began in earnest in 1990 at the Reserve Bank of New Zealand, and was quickly copied by central banks including Canada, Australia, the UK, Sweden, Brazil, Chile, Mexico, South Africa, South Korea, Thailand, and Turkey (where political interference has replaced monetary policy). In the wake of the financial crisis, the Fed explicitly adopted a 2% target for Personal Consumption Expenditure inflation in 2012. The Fed is now in the process of reviewing its joint employment and price stability mandates. Officially, it does not plan to change its inflation target (which it has undershot since 2012).

Nevertheless, inflation expectations in the US have continued to decline and as the US/China trade dispute endures, the business cycle continues to mature and fiscal stimulus fades, the Fed has shifted its stance towards easing.

In the eurozone, inflation remains weak despite rising wages and high employment, as companies prefer to keep prices on hold and absorb a hit on margins. If inflation is stubbornly flat in a period of prosperity, it is unlikely to rise as the world’s economies slow. Growth in the eurozone is forecast to increase by 1.2% in 2019, and last week the ECB said it expects to keep key rates on hold, or lower, at least through the first six months of 2020.

As recent promises of additional stimulus from the Fed and ECB show, normalising monetary policy is getting more difficult.

Shooting for alternatives

After a protracted period of low inflation, the Bank of Japan has significantly changed its policy framework since Haruhiko Kuroda's appointment as governor in 2013, with limited signs of success. Having hit a low of -1.7% in 2010, Japanese core inflation crossed above zero in 2013 and now stands at 0.5%. Starting in 2016, the framework has included "yield curve control" as well as an "inflation-overshooting commitment", which commits the BoJ to monetary expansion until inflation exceeds its 2 percent target, and then stays above the target "in a stable manner".

In April this year, the Reserve Bank of New Zealand changed its mandate to a dual target of maximising employment and price stability. Hungary’s central bank gave its policy makers more flexibility in 2015, letting them aim for one percentage point either side of a 3% target, and last week Reserve Bank of Australia governor Philip Lowe said that he expects his country’s re-elected government to maintain its 2-3% long-term inflation target unchanged.

In reality, no central bank has rigidly targeted inflation, but rather they have taken a flexible approach with targets measured over a period of years.

An alternative would be to shift to an average target over time, aiming to stabilise prices around a constant growth path (see a recent speech by Fed vice chair Richard Clarida for a discussion on this). Another alternative would be to combine an inflation target with a nominal GDP (NGDP) target that takes into account the rate of economic expansion needed for full employment.

Adopted at a time when central banks could bring inflation under control by raising interest rates, in today’s economic climate inflation targeting looks like an answer to yesterday’s question. Having successfully fought high inflation, policy makers now need more tools that give them the flexibility to raise inflation. Given these evolving challenges, it is logical that central bankers should debate their consistently missed targets. Even if it is not yet clear what their new targets will look like, history shows that paradigms eventually change.