The death of inflation targeting

Jeffrey Frankel

The current economic crisis has called into question the role of monetary policy, particularly inflation targeting and its oversight of asset bubbles and supply side shocks. This column is an obituary to inflation targeting and call for nominal GDP targeting to replace it.

It is with regret that we announce the death of inflation targeting. The monetary regime, known affectionately as “IT” to its friends, evidently passed away in September 2009. That the demise of IT has not been officially announced until now testifies to the esteem in which it was widely held, its usefulness as a figurehead for central banks, and fears that there might be no good candidates to assume its position as preferred anchor for monetary policy.

Inflation targeting was born in New Zealand in March 1990. Admired for its transparency and accountability, it achieved success there, and soon in Canada, Australia, the UK, Sweden and Israel. It subsequently became popular as well in Latin America (Brazil, Chile, Mexico, Colombia, and Peru) and in other developing countries (South Africa, South Korea, Indonesia, Thailand and Turkey, among others).

One reason that IT gained such wide acceptance as the champion nominal anchor was the failure of its predecessor, exchange-rate targeting, in the currency crises of the 1990s. Pegged exchange rates had succumbed to fatal speculative attacks in many of these countries. The authorities needed something new to anchor the public’s expectations of monetary policy. IT was in the right place at the right time.

Earlier, before the reign of exchange-rate targeting, the fashion in the early 1980s had been money supply targeting, the brainchild of monetarist Milton Friedman. The money supply rule succumbed to violent money demand shocks rather quickly, although Friedman’s general argument for rules over discretion, to make a commitment to low inflation credible, is still very influential.

Inflation targeting was best known as a rule that told central banks to set a target range for the yearly rate of change of the Consumer Price Index (CPI) and to try their best to attain it. Close cousins included targeting the price level instead of the inflation rate and targeting the core inflation rate (that is, excluding the volatile food and energy components of prices) instead of the headline number.

There were also proponents of flexible inflation targeting, who held that it was fine to put some weight on real GDP growth in the short run, so long as there was a clear target for CPI inflation in the longer term (Svensson 2009). But some felt that if the definition of IT were stretched too far, it would lose its meaning.

Regardless, inflation targeting began to take some heavy blows several years ago (analogous to the crises that hit exchange rate targets in the 1990s). The biggest setback hit in September 2008, when it became clear that central banks that had been relying on IT had not paid enough attention to asset bubbles and that the consequences for the economy were severe.

Central bankers had told themselves that they were giving asset markets all the attention they deserved, by specifying that housing prices and equity prices could be taken into account to the extent that they carried information regarding goods inflation. But this escape clause proved insufficient: When the global financial crisis hit, suggesting at least in retrospect that monetary policy had been too loose during the years 2003-2006, it was neither preceded nor followed by an upsurge in inflation.

That the boom-bust cycle could take place without inflation should not have come as a surprise (White and Borio 2004). The same thing had happened when asset market bubbles ended in crashes in the United States in 1929, Japan in 1990, and Thailand and Korea in 1997. And the Greenspan hope that monetary easing could clean up the mess in the aftermath of such a crash proved to be wrong.

While the lack of response to asset market bubbles was probably the biggest failing of inflation targeting, another major setback was inappropriate responses to supply shocks and terms of trade shocks. An economy adjusts better if monetary policy responds to an increase in the world prices of its exported commodities by tightening enough to appreciate the currency. But CPI targeting instead tells the central bank to appreciate in response to an increase in the world price of the imported commodities – exactly the opposite of accommodating the adverse shift in the terms of trade. For example, it is widely suspected that the reason for the otherwise-puzzling decision of the European Central Bank to raise interest rates in July 2008, as the world was sliding into the worst recession since the 1930s, was that oil prices were just then reaching an all-time high. Oil prices get a substantial weight in the CPI, so stabilising the CPI when dollar oil prices go up requires appreciating versus the dollar.

IT is survived by the gold standard, an elderly distant relative. Although some eccentrics favour a return to gold as the monetary anchor, most would prefer to leave this relic of another age to its peaceful retirement, reminiscing over burnished fables of its long lost youth.

What will replace inflation targeting as preferred nominal anchor? A dark horse candidate, product price targeting (PPT), is particularly relevant for small open economies that experience high terms of trade volatility (Frankel 2012). Product price targeting would stabilise an index of producer prices (which includes export commodities) rather than an index of consumer prices (which includes import commodities). Thus it would not, like IT, have the problem of responding perversely to terms of trade shocks (Frankel 2011). IT sometimes gave the public the misleading impression that it would stabilise the cost of living even in the face of supply shocks or terms of trade shocks, over which central banks in fact have no control.

The leading candidate to take the position of preferred nominal anchor is probably nominal GDP targeting. Even though it has gained popularity rather suddenly, over the last year, the idea is not new. It had been a candidate to succeed money targeting in the 1980s, because it did not share the latter’s vulnerability to velocity shocks (i.e., shifts in money demand) (Frankel 1990, 2007). Under certain conditions, it dominates not only a money target (due to velocity chocks) but also a price level target (if supply shocks are large) (Frankel and Chinn 1995, Frankel 1997, Frankel et al. 2008). First proposed by James Meade (1978), it attracted the interest in the 1980s of such eminent economists as Jim Tobin (1983), Charlie Bean (1983), Bob Gordon (1985), Ken West (1986), Martin Feldstein and Jim Stock (1994), Bob Hall and Greg Mankiw (1994), Ben McCallum and Edward Nelson (1998), among others.

Nominal GDP targeting was not adopted by any country in the 1980s. Amazingly, the founders of the European Central Bank in the 1990s never even considered it on their list of possible anchors for euro monetary policy. (They ended up with a “two pillar approach,” of which one pillar was supposedly the money supply.)

But now Nominal GDP Targeting is back, thanks to enthusiastic blogging by Scott Sumner (at Money Illusion), Lars Christensen (at Market Monetarist), David Beckworth (at Macromarket Musings), Marcus Nunes (at Historinhas) and others. Indeed, The Economist has held up the successful revival of this idea as an example of the benefits to society of the blogosphere. Economists at Goldman Sachs have also come out in favour (see Business Insider, Weisenthal 2011).

Fans of nominal GDP targeting point out that it would not, like inflation targeting, have the problem of excessive tightening in response to adverse supply shocks. Nominal GDP targeting stabilises demand, which is really all that can be asked of monetary policy. An adverse supply shock is automatically divided between inflation and real GDP, equally, which is pretty much what a central bank with discretion would do anyway.

In the long term, the advantage of a regime that targets nominal GDP is that it is more robust with respect to shocks than the competitors (gold standard, money target, exchange rate target, or CPI target). But why has it suddenly gained popularity at this point in history, after two decades of living in obscurity? Nominal GDP targeting might also have another advantage in the current unfortunate economic situation that afflicts much of the world: Its proponents see it as a way of achieving a monetary expansion that is much-needed at the current juncture.

Monetary easing in advanced countries since 2008, though strong, has not been strong enough to bring unemployment down rapidly nor to restore output to potential. It is hard to get the real interest rate down when the nominal interest rate is already close to zero. This has led some, such as Olivier Blanchard and Paul Krugman, to recommend that central banks announce a higher inflation target: around 4% or 5% (Blanchard et al. 2010 and Krugman 2012a). (This is what Krugman and Ben Bernanke advised the Bank of Japan to do in the 1990s, to get out of its deflationary trap, see Krugman 2012b.) But most economists, and an even higher percentage of central bankers, are loath to give up the anchoring of expected inflation at 2% which they fought so long and hard to achieve in the 1980s and 1990s. Of course one could declare that the shift from a 2% target to 4% would be temporary. But it is hard to deny that this would damage the long-run credibility of the sacrosanct 2% number. An attraction of nominal GDP targeting is that one could set a target for nominal GDP that constituted 4 or 5% increase over the coming year – which for a country teetering on the fence between recovery and recession is in effect a 4% inflation target – and yet one would not have be giving up the hard-won emphasis on 2% inflation as the long-run anchor. Thus nominal GDP targeting could help address our current problems as well as a durable monetary regime for the future.

References

Bean, Charlie (1983), “Targeting nominal income: An appraisal”, The Economic Journal, 93:806-819.

Blanchard, Olivier, Giovanni Dell’Ariccia, and Paolo Mauro (2010), “Rethinking macroeconomic policy”, IMF Staff Position Note, 12 February.

Frankel, Jeffrey (1990), “International Nominal Targeting (INT): A proposal for overcoming obstacles to policy coordination”, For presentation at the Fall Academic Conference, Federal Reserve Bank of San Francisco, 15 November.

Frankel, Jeffrey (1997), Financial Markets and Monetary Policy, MIT Press.

Frankel, Jeffrey (2007), “International Nominal Targeting (INT): A Proposal for Monetary Policy Coordination in the 1990s”, The World Economy, 13(2):263–273.

Frankel, Jeffrey (2011), “A Comparison of Product Price Targeting and Other Monetary Anchor Options, for Commodity Exporters in Latin America”, forthcoming Economia.

Frankel, Jeffrey (2012), “Product Price Targeting – A New Improved Way of Inflation Targeting”, Macroeconomic Review, April.

Frankel, Jeffrey, Ben Smit, and Federico Sturzenegger (2008), “Fiscal and monetary policy in a commodity-based economy”, Havard University, Working Paper.

Feldstein, Martin and Jim Stock (1994), “The Use of a Monetary Aggregate to Target Nominal GDP”, NBER Working Paper.

Gordon, Bob (1985), “The conduct of domestic monetary policy”, NBER Working Paper.

Hall, Robert E and N Gregory Mankiw (1994), Nominal inflation targeting.

Krugman, Paul (2012a), “Two per cent is not enough”, The New York Times, 26 January.

Krugman, Paul (2012b), “Earth to Bernanke”, The New York Times, 24 April.

McCallum, Bennett T and Edward Nelson (1998), “Nominal Income Targeting in an Open-Economy Optimizing Model”, Journal of Monetary Economics, 43(3):553-578.

Meade, James (1978), “The meaning of internal balance”, The Economic Journal, 88:423-435.

Svensson, Lars EO (2009), “Flexible inflation targeting – lessons from the financial crisis”, speech at BIS, 21 September.