Inflation targeting: It's even worse than you thought
Wolfgang Munchau has a nice article in the Financial Times on inflation targeting. I agree with much of what he has to say, but will offer mild criticism of two points. Here’s how Munchau begins:
Back in the 1990s inflation targeting was all the rage. I was a sceptic. I recall asking a senior central banker at the time what he would do if faced with stagflation – high inflation, low growth. Would he raise interest rates and force the economy into recession just to meet the target? He said the situation would never arise.
He was right. It did not. Inflation targeting became an improbable success. But it is failing now for reasons different from those I feared.
I believe Munchau is wrong in believing he was wrong. In fact, as far as I can tell his 1990s fears have proven accurate. Consider the following facts:
1. In July 2008 the ECB tightened monetary policy because inflation was running above target. This was done despite very sluggish growth in the eurozone.
2. In mid-2011 the ECB tightened monetary policy because inflation was slightly above target. This was done despite the fact that the inflation mostly represented VAT increases for austerity purposes, as well as rising prices of imported commodities due to fast growth in places like China. The prices received by European producers were not rising rapidly.
Surely Munchau is aware of these facts, which makes me wonder why he did not cite them. Perhaps when he worried about “stagflation” he was thinking about the very high rates of inflation experienced in the 1970s. Yes, that has not occurred. But unless I’m mistaken the policy errors of 2008 and 2011 are pretty clear examples of exactly the sort of scenario that inflation targeting (IT) foes feared. The first almost certainly worsened the 2008-09 recession, and the second helped abort a recovery, and led to a double dip recession.
Munchau goes on to provide a lucid explanation of why a policy of targeting the path of prices is better than an IT regime that lets “bygones be bygones.”
My only other quibble with the article is this comment about NGDP targeting:
Another option would be to target nominal output growth – which is best thought of as the sum of real economic growth and inflation. The trouble is that nominal output growth is so slow that, if you started this regime today, hitting the target would entail a larger stimulus programme than anyone would have the nerve to implement. If you are looking for a new policy, targeting the price level is a better choice.
This is an argument I see all the time, but it doesn’t really hold up. Although both price level and NGDP targeting are completely rules-based once established, there is inevitable discretion in setting up the original trend line. While some NGDP proponents have recommended going back to the pre-2008 trend line (indeed that was originally my view), so much time has now passed that it seems far more likely that any NGDP targeting regime would set a new trend line along a track considerably below the pre-2008 trend. Thus adoption of NGDP targeting need not involve excessive monetary stimulus and inflation, it entirely depends on where you set the trend line, and also which growth rate is chosen. For instance, Bill Woolsey has proposed a 3% NGDP target path, which would almost certainly lead to a very low rate of inflation in the long run, even accounting for the modest reduction in trend growth in recent years.
HT: Nicolas Goetzmann