The big retreat from inflation targeting

Chastened by a failure to manage the great credit boom and bust of this decade, the world's major central banks are being forced to rethink the use of narrow inflation targets as the holy grail of monetary policy.

And if faith in strict inflation targeting with 1-2 year horizons has been mortally wounded, the search for a refined set of new monetary policy criteria will likely usher in a prolonged period of heightened policy uncertainty for global markets.

Conflicts will inevitably emerge; policy will become more complicated and almost certainly more difficult to predict.

Governments and politicians everywhere are already urging their central banks to take on greater responsibility for the supervision of mega banks and ensuring systemic stability -- the near collapse of which in 2007 monetary authorities either failed to adequately predict or felt powerless to head off.

The push to get central banks more involved in financial stability beyond control of a notional consumer price inflation level -- much the vogue for 20 years -- has gone up a gear.

U.S. President Barack Obama's financial reforms propose the Federal Reserve take control of supervising big financial firms.

Britain's opposition Conservative Party, which opinion polls predict will win next year's general election, said this week the Bank of England should be given back similar powers.

The European Commission too wants the European Central Bank to chair a powerful EU committee on averting systemic risks.

Successful or not, these plans will speed up moves within central banks to reassess narrow inflation targeting -- a policy blamed by many for facilitating, if not fuelling, the global credit explosion between 2003 and 2007.

As consumer prices were depressed over the past decade by rapid globalisation and technological leaps, central banks persisted in setting interest rates with reference to CPI targets and largely, often deliberately, ignored huge parallel bubbles in credit and housing markets.

Most central banks were eventually forced into unprecedented monetary policy remedies to cope with the fallout -- discarding explicit or implicit inflation targets in the process.

"Inflation targeting in the narrower sense is broken," said Deutsche Bank economist Thomas Mayer. "The strict inflation target turns a blind eye to the irrationality in asset markets."

"For sure, if there is to be a trade-off between strict inflation targeting and ensuring financial stability, which encompasses controlling asset price inflation, then it's better to internalise this conflict under one roof," said Mayer.

"But does that create a conflict for central banks who are wedded to narrow inflation targeting? Absolutely."

OPEN SEASON

So the debate about whether the goal of price stability should indeed include price of assets such as houses and stocks and even factors such as bank capital and leverage -- an argument seemingly won by strict inflation targeters over the past decade -- is wide open again.

Last week's annual Geneva Report on the World Economy -- written and reviewed by policy, academic and financial economists connected by the Centre for Economic Policy Research -- asked: "Are the golden years of central banking over?"

"Different aspects of policy cannot be conducted in isolation," said the report, referring to the linkages between monetary policy and regulation and supervision of markets.

If, it argued, there were any reflating of the credit bubble, central banks should tighten regulations via counter-cyclical capital ratios and forward-looking provisions in the event of monetary policy being too accommodative.

Yet it added: "Should such an arrangement not prove feasible or completely effective, the central bank ought to consider the risk of financial imbalances when setting interest rates."

The next few years, however, are likely to present policymakers with the reverse problem. If inflation rates creep higher, due to factors such as high commodity prices or low exchange rates, should central banks lift interest rates even if it risked destabilising the financial system again?

The answer may be they tolerate more inflation volatility in the short-term in exchange for meeting both inflation and stability goals on a horizon longer than 2 years.

Politicians may be happy with that if the end justifies the means and another financial implosion can be avoided.

But the price to pay may well be greater volatility of long-term borrowing rates as the policy outlook becomes murkier.

"One goal -- two targets? That is riddled with complications," said Jim O'Neill, chief global economist at Goldman Sachs, referring to supplementing inflation targets with regulatory/supervisory roles.

"I don't really see how policymakers have any other choice other than to try to achieve both objectives, but there are inherent contradictions here."

One risk is bond investors identify the policy uncertainty by building up higher compensation to long-term bond yields, so-called "term premia", and that this pushes up long-term borrowing costs for any given level of official rates.

Former Fed chief Alan Greenspan, among others, frequently cited an erosion of the term premium as one reason why more than 400 basis points of Fed tightening in the two years to summer 2006 had little or no impact on long-term borrowing rates.

And if that lack of traction in monetary policy was one of the reasons behind the credit bubble, was the "predictability" of inflation-targeting -- explicit or otherwise -- to blame?

Fed studies before the credit crunch are revealing. In 2005, one such study by Refet Gurkaynak, Brian Sack and Eric Swanson, showed how UK inflation expectations see were less volatile than in the U.S. after the BoE, unlike the Fed an explicit inflation targeter since 1992, became independent of government in 1997.

But this "success" in lowering inflation expectations may have sown the seeds of the downfall because it assumed financial market behaviour would remain rational and efficient. It didn't.

There is now a reasonable question whether an overly mechanistic and predictable monetary policy was dangerous.

"Key assumptions on which we ran the financial system were simply flawed," said Deutsche's Mayer. "Rational expectations and efficient markets is not dead as an hypothesis. What is dead that they are always rational and always efficient."

 

- Reuters