Why Central Bank Inflation Targeting Didn't Work

Martin Wolf, one of the best economics commenters, notes that the widespread idea that central banks, over the past 30 years, had found the holy grail of policy in inflation targeting, was clearly wrong. That's good as far as it goes, and he's right. But it's worth taking farther--the problems with inflation targeting included the definition of inflation, the inflation target and the uncontrolled flow of money

Inflation as measured during this period did not take into account asset bubbles. Wolf almost notices this, when he notes that the Fed didn't see it as its job to stop asset bubbles. But he doesn't go quite far enough: asset price increases are a type of inflation. If it costs more to buy a dollar of future income, a house, or a share in a company, that's inflation. To manage inflation properly, as a central bank, requires first to know what inflation is, and that means adding asset inflation into an inflation index. This would be the opposite of the current "core inflation" index, which is non-asset inflation minus food and energy prices, ostensibly to remove volatility (which is not the way to remove volatility, the way to remove volatility is to use a moving average.) Of course, in the real world, increases in fuel prices and energy prices are, well, inflation. Add in credit price increases as well, and you'd have a measure which actually measures inflation. Target that, and you'd be targeting something real.

The second issue is simpler, the inflation target was too low. It seems like inflation being low is nothing but good, but in fact the lower it is, the more sectors of the economy are actually in deflation at any given time. If inflation is 5% and consumer goods, say, are 4% less than that, they aren't in deflation. If inflation is at 3% and consumer goods are at 4% less, they're at -1% and are deflating. As the last little while (and the Great Depression) have taught us, deflation is not a good thing, and yet for a long time large parts of the economy have been in and out of deflation fairly constantly. In addition, a higher rate of inflation discounts past economic activity, which isn't an entirely bad thing, as it means people have to be agressive with their money. In a world where fraud and financial speculation wasn't the best way to make returns, that is a good thing. (In our world, perhaps not, admittedly.)

Finally, open financial flows turn bank policies into something of a joke. As Wolf himself notes, foreign central bank independence from the Fed was largely chimerical: other central banks had to lower interest rates along with the Fed, and if they didn't, then hot money would pour in from the US, or for that matter, from Japan, which was running its interest at zero or near zero for much of the past 20 years.

As a result, the effective interest rate was whatever the lowest interest rate of a large credible central bank with relatively stable currency was. (If you're borrowing from a country with an unstable currency, and the currency appreciates suddenly, your apparent low interest rate can turn into a trap which costs you greatly.)

This meant that even if central banks wanted money to be expensive, for those people and corprorations able to borrow from foreign sources, it wasn't, and the asset bubbles, inflation and so on which came from that came even if the bank was trying to be conservative. Real independent monetary policy is greatly damaged by free money flows between countries, which is even before you get to its damaging effect on real free trade and comparative advantage.

And old management maxim is that you get what you measure. Central banks weren't measuring all inflation, and so they weren't managing asset inflation, which is one main reason we got asset bubbles. Add to that that even where they were targetting inflation, they were targetting it at too low a level and that international money flows made it difficult to run an independent bank policy even in countries which might have wanted to, and you had a very flawed central banking system in virtually every country in the world.

So it's not clear to me that inflation targeting is necessarily a bad policy. It seems more likely that it might have been a good policy, implemented in a very bad way. It disciplined the small actors in the economy, small businesses and ordinary workers--restricting their wages and their goods inflation, while allowing rampant inflation in securities and real-estate and (in the 90s) stocks.

The people who weren't disciplined, then, drove a truck through the hole created and caused a disaster. The lesson isn't "we shouldn't target inflation", the lesson is "we need to target all inflation" not just inflation which effects some people.

Comments

[Kirk Kinder]

1. You are absolutely right that buying a home that has increased in value is inflation. However, asset price inflation is not part of the CPI. They use a version of owner equivalent rent so many asset bubbles are conveniently left out of the inflation equation. They do this to ensure the inflation number is lower than it actually is.

2. We should want low to no inflation. Why would anyone want real inflation. It hurts savers and the average American. The savers find their savings don't buy as many goods and services, and the same holds for the Average American as well. We want to have as stable of prices as possible. It is the only way for regular Americans to get ahead. Inflation actually benefits the government as they can repay their massive debt with devalued dollars.

The real lesson is we shouldn't target any inflation rate. We need to get rid of the Fed. Should we really trust a cartel of bankers to look out for our best interests? They are the reason we are over-leveraged.

[vagabondvet]

Agreed: the Federal Reserve has failed on all its goals.

If you look http://oregonstate.edu/cla/polisci/faculty-research/sahr/sumprice.pdff) at table 1 and compare it to tables 5 and 6, it's really easy to see the effect of long term sustained year-to-year inflation on the long term price level. A dollar buried in 1800 was almost as valuable in 1900, but a dollar buried in 1913 would be worth 95% less!

[lightningbolt]

Currency inflation is just a way of stealing money from those who own dollars. The Fed's member banks have grown quite wealthy and powerful using this method. The Fed is not designed to control inflation, it is designed to create inflation. The Fed is an unconstitutional criminal organization that must be stopped. The power of creating money should belong only to the government, where the Constitution says it belongs.

[TennesseeCatfish]

You miss what I believe to be the biggest point regarding inflation targeting. The Fed targets wage inflation above all things. When economies rebound, profits grow as employment and wages lag. Profits go to dividends and corporate officers who are disproportionately wealthy. At some point, the economy does well enough that employment increases. Then it does well enough that real wages increase for the bottom 80%. Soon after, the Fed tightens credit in the name controlling inflation. But workers have not had time to recoup losses from unemployment and drops in real wages.

Repeat that for about 30 or 35 years and you have recent economic history.

I believe that this gaming of the system accounts for the stagnation of the middle class even more than globalization.

[Ian Welsh - Huffpost Blogger]

Yes, targetting wage push inflation was a big deal, agreed. Especially in the 80s and 90s, it became a non factor in the 00's because there were essentially no wage increases (for ordinary people).