naked capitalism

In Project Syndicate (hat tip Mark Thoma), Joseph Stiglitz takes on an increasingly common approach among central banks, namely, to announce a formal target for inflation and use interest rate policy to attempt to achieve it. Note the US does not use this approach, although one of the Fed’s responsibilities is to maintain price stability. One justification for inflation targets is greater transparency. Letting market participants know what deviations might trigger a policy response is thought to encourage a certain amount of restraint among private sector actors. It also means fewer surprises when monetary authorities raise and lower rates.

Despite the seeming logic of inflation targeting, I’ve never been comfortable with it. Bizarrely, it seems an offshoot of Friedman’s dictates, although it’s precisely the sort of thing the monetarist would have ridiculed. Friedman advocated setting strict monetary growth targets (although before his death he retreated somewhat):

Nothing that I have observed in recent decades has led me to change my mind about the desirability of a monetary rule which simply increased the quantity of money at a fixed rate month after month, year after year. That rule would get rid of the mistakes and that is probably about all you could expect to get from a monetary system.

By contrast, Friedman was critical of using interest rates as a guide, perhaps based on his study of the Depression, when the central bank mistakenly saw low rates as a sign of permissive monetary policy, when in fact real rates were high, and the tightening turned a downturn into a disaster.

My impression, from afar, is that the authorities, having used monetary targets for a bit (I recall how the everyone on Wall Street fixated on the money supply announcement every Thursday at 4:00 during Volcker’s tenure) came to find having a target of some sort useful and gravitated towards inflation targeting. I’ve never understood it, having never seen neither any compelling arguments in its favor nor any empirical support.

Stiglitz confirms my suspicions as to the lack of any sound basis for this practice. His article, “The urgent need to abandon inflation targeting.” focuses on the mistakes it can generate in a setting like ours, when many countries are experience inflation due to rising costs of imported commodities. Increasing interest rates in, say, Poland will have no impact on prices set in global markets. To achieve the desired inflation level will require having domestic goods greatly undershoot the target via an overly aggressive rate increase.

Tease Stiglitz’s logic out: if central banks stick to their targets, rather than yielding to domestic pressures, this means that the commodity price rise, which should dampen growth in and of itself, will lead to overly restrictive monetary policies in many countries and will worsen an international slowdown. That of course assumes that the authorities have the political will and clout to inflict that much pain, but the potential is clearly there.

From Project Syndicate:

The world’s central bankers are a close-knit club, given to fads and fashions. In the early 1980s, they fell under the spell of monetarism….After monetarism was discredited — at great cost to those countries that succumbed to it — the quest began for a new mantra.

The answer came in the form of “inflation targeting”, which says that whenever price growth exceeds a target level, interest rates should be raised. This crude recipe is based on little economic theory or empirical evidence; there is no reason to expect that regardless of the source of inflation, the best response is to increase interest rates….(Among the list of those who have officially adopted inflation targeting are: Israel, the Czech Republic, Poland, Brazil, Chile, Colombia, SA, Thailand, Korea, Mexico, Hungary, Peru, the Philippines, Slovakia, Indonesia, Romania, New Zealand, Canada, the UK, Sweden, Australia, Iceland and Norway.)

Today, inflation targeting is being put to the test — and it will almost certainly fail. Developing countries currently face higher rates of inflation, not because of poorer macro-management, but because oil and food prices are soaring, and these items represent a much larger share of the average household budget than in rich countries. In China, for example, inflation is approaching 8% or more. In Vietnam, it is expected to approach 18,2% this year, and in India it is 5,8% . By contrast, US inflation stands at 3%. Does that mean that these developing countries should raise their interest rates far more than the US?
Inflation in these countries is, for the most part, imported. Raising interest rates won’t have much effect on the international price of grains or fuel. Indeed, given the size of the US economy, a slowdown there might conceivably have a far bigger effect on global prices than a slowdown in any developing country, which suggests that, from a global perspective, US interest rates, and not those in developing countries, should be raised.

So long as developing countries remain integrated into the global economy — and do not take measures to restrain the impact of international prices on domestic prices — domestic prices of rice and other grains are bound to rise markedly when international prices do.

Raising interest rates can reduce aggregate demand, which can slow the economy and tame increases in prices of some goods and services, especially nontraded goods and services. But, unless taken to an intolerable level, these measures by themselves cannot bring inflation down to the targeted levels. For example, even if global energy and food prices increase at a more moderate rate than now — for example, 20% per year — and get reflected in domestic prices, bringing the overall inflation rate to, say, 3% would require markedly falling prices elsewhere. That would almost surely entail a marked economic slowdown and high unemployment. The cure would be worse than the disease.

So, what should be done? First, politicians, or central bankers, should not be blamed for imported inflation, just as we should not give them credit for low inflation when the global environment is benign.

Second, we must recognise that high prices can cause enormous stress, especially for poorer people . Riots and protests in some developing countries are just the worst manifestation of this.

Advocates of trade liberalisation touted its advantages; but they were never fully honest about its risks, against which markets typically fail to provide adequate insurance. When it comes to agriculture, developed countries, such as the US and European Union members, insulate both consumers and farmers from these risks….Many are imposing emergency measures like export taxes or bans, which help their own citizens, but at the expense of those elsewhere.

If we are to avoid an even stronger backlash against globalisation, the west must respond quickly. Biofuel subsidies, which have encouraged the shift of land from producing food into energy, must be repealed. Some of the billions spent to subsidise western farmers should now be spent to help poorer developing countries meet their basic food and energy needs.

Most importantly, both developing and developed countries need to abandon inflation targeting. The struggle to meet rising food and energy prices is hard enough. The weaker economy and higher unemployment that inflation targeting brings won’t have much effect on inflation; it will only make the task of surviving in these conditions more difficult.