In a conference held in 2014, John Williams, then president of the Federal Reserve Bank of San Francisco and presently the president of the Federal Reserve Bank of New York, summed up his assessment of twenty-five years of inflation targeting and the critical challenges (Williams, 2014).
My main conclusion is that inflation targeting and related approaches to monetary policy have been remarkably successful at providing a nominal anchor and keeping inflation low and relatively stable during a period of severe turbulence. Nonetheless, recent events have revealed some chinks in the armor of inflation targeting related to the zero lower bound on interest rates and financial instability.
Much water has flowed since then, with many central banks breaching the zero lower bound (ZLB) by instituting negative interest rates. Indeed, negative effective yields have now spread to corporate bonds in Europe and the value of negative-yielding debt worldwide recently climbed to a record $17 trillion. Yet, central banks appear to be losing the battle even in the one dimension that President Williams claimed was an unmitigated success—that is, meeting their respective inflation targets. Five years after his 2014 speech, President Williams acknowledged the shortfall (Williams, 2019).
Economic developments since this unprecedented monetary stimulus provide valuable insights into the efficacy and limitations of monetary policy. … And, despite the improvement in the real side of economies, inflation rates have persistently been below central banks’ goals. The fact that inflation has been running below target in most advanced countries—the United Kingdom being the most prominent outlier—suggests that this challenge is not due to factors specific to a single country. Instead, there are more systemic factors at play.
While there is greater recognition that monetary policy is inadequate to meet the economic challenges and there has been greater call for fiscal policy to play a bigger role, many mainstream economists and policymakers remain wedded to the idea that either an expanded set of monetary policy tools or tweaks to the inflation targeting framework can deliver price stability and full employment. For example, economists at the IMF have seriously contemplated mechanisms for instituting deeply negative interest rates to overcome the lower bound on interest rates (Assenmacher and Krogstrup, 2018). Meanwhile, Williams has argued for average inflation level targeting (Mertens and Williams, 2019), wherein the central bank makes up for past shortfalls in inflation. Former Fed Chair, Ben Bernanke, has argued for temporary price level targeting (Bernanke, 2017). Other proposals include price level targeting and the more ambitious nominal GDP targeting (Frankel, 2013).
Underlying the mainstream approach to monetary policy framework are two key assumptions. The first assumption is that low and stable inflation is vital for economic prosperity and that even moderately high inflation imposes enormous costs on society. Much of this is informed by the experience of the 1970s, even though recent empirical work has called into question the costs of high inflation (Nakamura et. al, 2018), and there is no evidence that inflation rates less than 40%, annual rate, matter at all for long-term growth (Bruno and Easterly, 1996). Indeed, the empirical literature is divided as to whether the so-called Great Moderation—the 1984-2007 period, which was characterized by low volatility in inflation and economic growth—was largely an artefact of luck or good policy (Bernanke, 2004).
The second assumption is that financial stability is not the remit of monetary policy but the domain of regulatory and other macroprudential policies. Long before the 2008-2009 financial crisis, economists at the Bank for International Settlements (BIS) argued that even inflation targeting central banks ought to take into account financial imbalances in setting policy.
In a monetary regime in which the central bank ís operational objective is expressed exclusively in terms of short-term inflation, there may be insufficient protection against the build up of financial imbalances that lies at the root of much of the financial instability we observe. This could be so if the focus on short-term inflation control meant that the authorities did not tighten monetary policy sufficiently pre-emptively to lean against excessive credit expansion and asset price increases. In jargon, if the monetary policy reaction function does not incorporate financial imbalances, the monetary anchor may fail to deliver financial stability. [Crockett, 2003]
However, the BIS line has been resisted by the mainstream economists and policymakers starting from Greenspan to Bernanke to Williams. In fact, Williams (2019) has argued that a single-minded pursuit of inflation targeting can actually reduce financial instability and that taking account of financial stability considerations in forming monetary policy could be detrimental to both objectives.
While the BIS view that financial imbalances matter and should be taken into account in policymaking is sound, it does not go far enough. The main argument of this paper is that inflation targeting, or for that matter any policy framework predicated on monetary policy dominance and overemphasizing low and stable inflation, will lead to build-up of leverage, and stoke asset price bubbles, thereby accentuating Minskian financial cycles. I argue that monetary policy works through balance sheets by encouraging leveraging and boosting asset prices rather than through conventional cost of capital channels. Moreover, a promise of low and stable inflation by central banks has the perverse consequence of inducing increasingly fragile balance sheet structures, thereby imperiling economic stability and eventually undermining price stability. Thus, the rise of leverage and the serial asset bubbles in the Great Moderation era was not a coincidence but intricately related to the monetary policy framework. Hitting the ZLB was but a natural culmination of the process.
The paper is laid out as follows. In the next section, I briefly review the history and logic of inflation targeting and evaluate its record. In the subsequent section, I sketch out the feedback loops of monetary policy and show how controlling inflation is often at conflict with financial stability. The next section deals with the guarantee implicit in inflation targeting and the financial incentives fostered by it. I conclude with some thoughts on the goals of macroeconomic policy and a framework for attaining those goals.
Srinivas Thiruvadanthai is Managing Director and Director of Research at the Jerome Levy Forecasting Center. Srinivas has a PhD in economics from Washington University in St. Louis, an MBA from the Indian Institute of Management, and holds the CFA designation.
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