Central Banks Seen Keeping Devil They Know: Inflation Targeting

  • Australia, Canada have upcoming chance to review CPI targets
  • In Europe and Japan, inflation goals appear a long way off

When Don Brash introduced a zero-to-2 percent inflation target in New Zealand in 1990, it was viewed as “wildly implausible.” 

“You’ve got to be joking,” Brash remembers was the reaction. Even his central bank colleagues were incredulous, saying: “Pull my other leg. Get it under 5? Yeah probably. But under 2? Not a chance.” 

Inflation had peaked at almost 19 percent in 1987 and was at 7.2 percent in the final quarter of 1989, when the law was passed -- some years after the historic victory over inflation achieved by Paul Volcker at the U.S. Federal Reserve. Gains in the consumer price index have averaged 2.2 percent since then, so there’s little wonder the targeting idea caught on.

How times change. In a world struggling with disinflation or outright deflation, targets now seem too high rather than too low, fueling calls to shift or even ditch the yardstick.

Central bank watchers including Bill Evans at Westpac Banking Corp. are urging incoming Reserve Bank of Australia Governor Philip Lowe to use the signing of a new Statement on the Conduct of Monetary Policy with the government to lower or widen the current 2 percent to 3 percent range. A similar debate is bubbling away in Canada, where a five-year agreement on policy between the government and central bank is due for renewal.

The worry is the two central banks will follow their peers elsewhere and burn through the remainder of their limited conventional monetary firepower to hit targets that are no longer feasible, fueling asset bubbles in the process.

There is precedent for change: the Bank of Korea set its inflation target for 2016 to 2018 to 2 percent -- down from 2.5 percent to 3.5 percent for 2013-2015 -- citing weaker demand, aging, and intensified price competition in global and local markets.

Credibility Stretch

Meanwhile, Japan’s central bank appears to be bowing to reality on its commitment to a two-year time frame for meeting its 2 percent inflation target. Announced three years ago, it was intended to underscore a determination to drive prices higher. Instead, the repeated failure to meet forecasts for hitting the goal has eroded its credibility.

The European Central Bank has missed its target of inflation just under 2 percent for more than three years and updated projections last week showed it doesn’t foresee reaching the goal before at least late 2018.  The current rate is 0.2 percent and even Germany -- with record-low unemployment and interest rates that are probably too low for its economy -- posted data on Tuesday showing consumer-price gains at just 0.3 percent.

U.S. prices also remain tame, belying strength in other areas such as housing and clouding the policy outlook. Federal Reserve Governor Lael Brainard said on Monday that with little need to lean against an overshoot of inflation or employment, there’s no reason to rush to raise interest rates at this month’s meeting.

So with CPI undershooting, the flexibility in time frames that typically accompany inflation targets is being stretched.

Higher Targets?

Before inflation goals came along, most central banks had tried to ensure price stability via intermediate factors such as money aggregates or exchange rates. Specific targeting of inflation was meant to improve transparency and accountability, and remove the inflationary bias of frameworks that prioritized growth or employment. In today’s low-growth, low-inflation world, those benefits are less compelling.

The call for altered targets run both ways, with some suggesting that higher levels would be a safer way of ensuring against deflationary threats. At a Federal Reserve symposium in Jackson Hole, Wyoming, last month, Chair Janet Yellen raised the possibility that future policy makers might increase their inflation target and broaden the types of assets they can buy to enhance their ability to counteract a severe recession.

Nobel laureate Paul Krugman has been among those to advocate a higher inflation target of 4 percent or more. He argues that targets aren’t as defensible as they used to be, that lower consumer-price gains make it tougher for relative wages to adjust, and that higher goals would insure against slipping into the feedback loop between low inflation and economic weakness.

For a look at the discussion around inflation targeting, click here

A key argument for change is that disinflationary pressures appear entrenched in many advanced economies, driven by technological and demographic shifts rather than anything central banks can directly control. Improved efficiencies, advances in robotics, and Chinese competition are keeping a lid on factory wages and prices, while aging populations typically have weaker spending power.

GDP Targeting?

Federal Reserve Bank of San Francisco President John Williams raised potential alternatives to inflation targeting last month. These include flexible price-level targeting or aiming for particular levels of nominal gross domestic product.

The U.K. government considered, and rejected, nominal GDP targeting and other options in 2013 when Mark Carney was preparing to come in as governor. Carney backed flexible inflation targeting, telling lawmakers that officials “can vary the horizon” over which they meet their goal if there is a threat to the stability of the economy or financial markets.

Financial Metrics

The Bank for International Settlements -- the central bankers’ bank -- has noted that “low and stable inflation doesn’t guarantee financial, and thus macroeconomic, stability." It advanced a hypothesis where policy incorporates financial-stability considerations.

Australia’s Lowe -- scheduled to replace Glenn Stevens as governor on Sept. 18 -- cited the research in a speech to a Sydney forum last week, suggesting he has an open mind on the subject. Lowe’s assessment was that, while the hypothesis needs to be tested, if found valid “it would have implications for policy makers in a number of spheres, including monetary policy, prudential policy and even fiscal policy.”

Yet inflation targeting retains the default for many central bankers, based on the old maxim that it’s better the devil you know.

Emerging Economies

Indeed, for developing economies, inflation targeting still holds allure.

A single objective based on prices is "an enviable arrangement,” People’s Bank of China Governor Zhou Xiaochuan said in a June speech in Washington. He currently has to juggle a four-pronged mandate of maintaining price stability, boosting economic growth, promoting employment and keeping the balance of payments steady, all while taking instruction from the State Council, China’s version of a cabinet.

India formalized its inflation target last month, mandating the central bank to keep consumer-price gains at 4 percent through 2021 while allowing the rate to fluctuate in a 2 percent to 6 percent band.

Brash, now 75 and retired, has an open-minded solution to the question of whether to scrap inflation targets in developed countries: Keep them, but don’t strain too hard to meet them.

“The paranoia of low measured inflation rates is a bit overdone,” he said. "I think there is some logic in saying to the central bank: we are relaxed about inflation being below target, don’t cut rates simply, mechanically, to crank up the inflation rate.”

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