Inflation Targeting Gets a Black Eye, But It Had It Coming

Inflation targeting has been taking a beating across the Atlantic. In the United Kingdom, where there is an explicit inflation target, it appears the Bank of England is getting ready to tighten monetary policy despite ongoing economic weakness. The reason for the expected tightening is rising inflation, even though the recent increases may be a one-off event. Nonetheless, because of its inflation target the Bank of England seems set to reign in aggregate demand regardless of the consequences for the economy.

This makes little sense. Nick Rowe notes that this experience raises tough questions for those who believe that monetary policy that stabilizes inflation will also tend to stabilize economic activity. Scott Sumner goes says this experience shows the failure of inflation targeting. I say it definitely gives inflation targeting a black eye, but it had it coming. Inflation targeting is an imperfect approach to monetary policy that only works when certain conditions hold. It was inevitable that at some point those conditions would not hold. That seems to be the case in United Kingdom.

So why is inflation targeting an imperfect approach to monetary policy? First, it treats all changes to the inflation rate the same. Inflation targeting fails to distinguish between inflation rate movements arising from aggregate demand (AD) shocks and those coming from aggregate supply (AS) shocks. This can be destabilizing because monetary policy should ignore AS shocks but respond to AD shocks. Too see this, assume Y2K actually turned out to be hugely disruptive for a prolonged period. This negative AS shock would reduce output and increase prices. An inflation-targeting central bank would have to respond to this negative AS shock by tightening monetary policy, further constricting the economy. Conversely, say there is a new technology that makes computers super fast so that productivity soars. This would tend to lower the inflation rate and increase the neutral interest rate. Here, an inflation-targeting central bank would ease monetary conditions to maintain its inflation target. This, however, would require lowering the policy interest rate even though the neutral rate was increasing. Monetary policy would be too loose and a boom could ensue.

Now if all shocks were AD shocks then all inflation movements would be AD-driven and inflation targeting would make more sense. For example, if inflation rose above target because AD was growing too fast then the central bank could respond appropriately with inflation targeting. In the real world, however, there are both AD and AS shocks. Inflation targeting’s failure to distinguish between the two sources of inflation makes it bound to have problems.

A second problem with inflation is that even if it were responding to an AD shock, it has “no memory.” That is, if a central bank targets inflation and the economy actually undergoes several periods of deflation there is no making up the inflation shortfall once inflation returns to its target. It is as if the decline in the price level was “forgotten” by the monetary authorities. Such a decline causes problems because households and firms prior to the deflation entered into nominal contracts with expected inflation that was based on the inflation target holding. The absence of any catch-up inflation means there will be an permanent transfer of wealth that was unexpected.

The obvious answer to my second critique of inflation targeting is to adopt a price level target that does take into account past misses. While this would be an improvement over inflation targeting it too fails to distinguish between AD and AS shocks. So while a price level target might improve our current plight it is bound to get a black eye in the future too. What is needed, then, is a monetary policy rule that (1) ignores AS shocks but responds to AD shocks and (2) does so with “memory.” Is there anything out there that fits this billing? The answer is nominal GDP level targeting. This approach aims to stabilize total current dollar spending (i.e. nominal spending) around some targeted growth path. If nominal spending falls below trend growth there is catch up growth in the subsequent periods and vice versa. This is not a new idea and was even discussed by the FOMC in its September, 2010 meeting. See here, here, here, and here for some of my past writings on this idea. If Congress wants to really narrow the mandate of the Fed in a constructive way it should consider nominal GDP level targeting.

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