Inflation Targeting: The Fed’s Excuse to Ignore Asset Bubbles?

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Kudos for an excellent post, “Inflation Targeting is Flawed,” by Michael Shedlock at Mish’s Global Economic Trend Analysis. Like many other observers, we’ve criticized the Fed’s failure to consider, or even acknowledge, asset price inflation in its monetary policy decisions. Instead, the Fed and other central bankers focus on traditional price inflation, and stick their head in the sand so as not to have to acknowledge the overwhelming evidence of excessive liquidity, which is undeniably a monetary phenomenon.

Inflation targeting is a dubious technique. It’s a finger-in-the-air approach, questionable due to the lack of good theoretical underpinnings and the uncertain, and sometimes variable, link between changes in interest rates and economic activity. Even though a monetarist approach is now out of fashion, it worked for Paul Volcker, and we keep wondering if all those smart young Fed economists had studied how to think about money supply in an era of proliferating near-money instruments, we’d have better policy frameworks.

Shedlock gives a thorough, rigorous but lively discussion of what is wrong with inflation targeting (example: defining what inflation measure to use is not trivial) and why the powers that be are missing the boat by acting as if asset bubbles aren’t the product of loose money.

The one failing in Shedlock’s otherwise solid piece is that he ignores the political hurdles to deflating asset bubbles. Strange as it may seem, the Fed and its counterparts don’t have a clear mandate to deal with runaway asset prices. As Australia’s former Reserve Bank chairman Ian MacFarlane pointed out, asset bubbles are quite popular. They make the community feel richer, and combating them is therefore controversial, since the decline in asset prices is measurable, whereas the systemic risk presented by inflated prices is (at least to most people) theoretical and hard to prove. As he explains:

So, if low inflation does not provide any insurance [against asset bubbles], what should a central bank do if it suspects that a potentially unsustainable asset price boom is forming, particularly when the boom is being financed by debt?…

Many people have pointed out that it is difficult to identify a bubble in its early stages, and this is true. But even if we can identify an emerging bubble, it may still be extremely difficult for a central bank to act against it for two reasons.

First, monetary policy is a very blunt instrument. When interest rates are raised to address an asset price boom in one sector, such as house prices, the whole economy is affected. If confidence is especially high in the booming sector, it may not be much affected at first by the higher interest rates, but the rest of the economy may be.

Second, there is a bigger issue which concerns the mandate that central banks have been given. There is now widespread acceptance that central banks have been delegated the task of preventing a resurgence in inflation, but nowhere, to my knowledge, have they been delegated the task of preventing large rises in asset prices, which many people would view as rises in the community’s wealth. Thus, if they were to take on this additional role, they would face a formidable task in convincing the public of the need.

Even if the central bank was confident that a destabilising bubble was forming, and that its bursting would be extremely damaging, the community would not necessarily know that this was in prospect, and could not know until the whole episode had been allowed to play itself out. If the central bank went ahead and raised interest rates, it would be accused of risking a recession to avoid something that it was worried about, but the community was not. If in the most favourable case, the central bank raised interest rates by a modest amount and prevented the bubble from expanding to a dangerous level, and it did so at a relatively small cost in terms of income and employment growth forgone, would it get any thanks? Almost certainly not…In all probability, the episode would be regarded by the public as an error of monetary policy because what might have happened could never be observed….

Note that MacFarlane did an effective job of reining in Australia’s housing bubble (far more pronounced than America’s) by talking frequently and loudly about how housing prices were out of line, and by making only a few interest rate increases.

One could argue that the Fed has enough influence to take on that role, but its very popularity and authority resulted from Greenspan enabling the overly-heady expansion of the 1990s. If he had acted in the style of his predecessor William McChesney Martin and had taken away the punchbowl just when the party started getting good, the Fed might not have as much perceived clout now (but if they had gotten the job done, would they need it now? And what good is power if you are not willing to exercise it?)

From Shedlock:

Bloomberg is reporting Bank of England’s Inflation-Targeting Loses Luster.

The Bank of England, confronting a record-breaking real-estate boom, is finding there’s more to monetary policy than just keeping consumer prices in check.

….surging U.K. property values are throwing into question the inflation-targeting approach of Governor Mervyn King and his colleagues, which focuses on consumer prices as the lodestar of policy and gives lower priority to asset values, money supply and credit growth.

The bank’s approach isn’t broad enough to tackle asset bubbles that can burst and lead to recessions, says Tim Drayson, an economist at ABN Amro Holding NV in London who formerly worked at the U.K. Treasury.

“In a few years’ time, people will find that inflation- targeting is flawed,” he says.”

Inflation Goal

The bank’s goal is inflation of 2 percent, and it has kept average gains in consumer prices at 1.5 percent since 1997, compared with 4.2 percent in the previous eight years.

While that allowed King, 59, to slash interest rates to the lowest levels since the 1950s, he now faces what Claudio Borio, head of policy analysis at the Bank for International Settlements in Basel, Switzerland, calls a “paradox of credibility”: The more a central bank succeeds in keeping prices stable, the more likely that signs of an overheating economy will show up first in asset bubbles.

As in the U.S., a combination of stable inflation and low interest rates triggered a real-estate boom in the U.K., where house prices have tripled in the past decade. In the last year alone, London values jumped 16 percent, reports HBOS Plc, the U.K.’s biggest mortgage lender.

King argues that asset values are inflated by many factors outside the bank’s control, and it’s better off focusing on a single gauge of consumer prices.

World Capital Markets

“What determines asset prices in the U.K. is very much a function of what’s going on in the world capital markets,” he told a parliamentary committee on April 24. “The impact of higher asset prices can’t just be linked solely and exclusively to U.K. monetary policy and credit growth.” Immigration and a property shortage caused by planning restrictions are also driving U.K. real-estate prices higher, policy makers say.

Still, King acknowledges that ignoring money supply and credit growth may lead policy makers into “tricky territory.”

In 2005, he became the first Bank of England governor to be outvoted by his committee when it decided to ignore the fastest money-supply expansion in eight years and cut rates to shore up economic growth.

“In retrospect, it was a mistake,” says Thomas Mayer, chief European economist at Deutsche Bank AG in London. The move reignited the housing market, sending the price of an average London home surging by a quarter. House-price inflation stood at 9.1 percent at the end of 2006, the London-based National Institute of Economic and Social Research said in a report today.

There is no question that inflation targeting is a mistake. For starters the Fed can not possibly know what neutral is if it were to bite them in the ass. After all, it is virtually impossible to define a representative basket of goods and services to measure prices.

For example: Gasoline is far more important to cab drivers than to someone living in a nursing home. Education is far more important to those with school aged children than those who are retired with no kids. Are home prices or rent more important and for who?

The measurement problem is made all the more difficult because new products and services come out all the time. Also compounding the problem (perhaps intentionally so) are hedonics and substitutions. No this does not all average out regardless of what anyone says (or if it does it is only by fleeting happenstance). Finally it should be noted that government has every reason to lie about prices to keep cost of living (COLAs) down for social security recipients.

But even if by some miracle the government was not distorting the data, measurements were accurate, etc etc, inflation targeting misses the boat because it excludes asset prices. Nonetheless, Bernanke is on the inflation targeting bandwagon.

Bernanke & Inflation Targeting

Back on October 17, 2003 Bernanke spoke about Inflation Targeting: Prospects and Problems.

Should the Federal Reserve announce a quantitative inflation objective? Those opposed to the idea have noted, correctly, that the Fed has built strong credibility as an inflation-fighter without taking that step, and that that credibility has allowed the Fed to be relatively flexible in responding to short-run disturbances to output and employment without destabilizing inflation expectations. So, the opponents argue, why reduce that flexibility unnecessarily by announcing an explicit target for inflation?

It would be foolish to deny that the Fed has been quite successful on the whole over the past two decades. Whether the U.S. central bank would have been even more successful, had it announced an explicit objective for inflation at some point, is impossible to say. We just don’t know. We can’t re-run history; and although empirical cross-country comparisons can be useful, they are far from being controlled experiments.

On the premise that effective communication is even more crucial near price stability, I will focus today on how an incremental move toward inflation targeting, in the form of the announcement of a long-run inflation objective, might help the Fed communicate better and perhaps improve policy decisions as well, without the costs feared by those concerned about potential loss of flexibility.

Given the bubbles in the stock market and housing, the implosion of subprime lending, consumer debt bubbles and an economy totally dependent on rising asset prices, Bernanke is showing more than a bit of misguided hubris when he states “It would be foolish to deny that the Fed has been quite successful on the whole over the past two decades“. Then again perhaps we need to understand where Bernanke is coming from.

Consider Roger Garrison’s article What Does Inflation Targeting Mean?

Although Ben Bernanke has pledged to ensure a continuity between the Greenspan policies and his own, he differs in several important respects, including his endorsement of “inflation targeting.” Greenspan has always been against it.

But Bernanke’s idea of “inflation targeting” is in need of some deconstruction.

First and foremost, it means that he actually wants some positive rate of inflation, a rate that is expected to persist and therefore gets factored into nominal interest rates. He wants nominal rates kept high enough to give the Fed some elbow room. That is, if the nominal fed-funds rate is, say, 5%, then the Fed has some scope for lowering that rate — in the event that it believes the economy is due for a monetary infusion.

Bernanke was most vocal about this view a year or so ago, when the fed-funds rate was 1% and Fed watchers began to worry about Greenspan “having no more arrows in his quiver.”

But can Bernanke actually pursue a policy of inflation targeting in the literal sense? In other words, can he increase the money supply whenever, say, the CPI begins to indicate an inflation rate below the target rate and decrease the money supply whenever the CPI begins to indicate an inflation rate above the target rate? I don’t think so.

The lag between changes in the money supply and corresponding changes in the CPI is somewhere between 18 and 30 months. This is the “long and variable lag” identified long ago by the monetarists. One of the lessons in Monetary Economics 101 is that a viable target must be one that yields timely feedback to the targeter.

Bernanke is an advocate of inflation targeting. We should understand this to mean that Bernanke is a deflation-scared inflationist.

For all his studies of the great depression, Bernanke still does not get it it. The fundamental cause of the great depression was the credit boom that preceded it. Inflation targeting that ignores asset prices is not targeting inflation at all. Inflation targeting must start with a proper definition of inflation: expansion of money and credit.

The current boom is a direct result of the greatest liquidity experiment the world has ever seen. Asset prices have been rising nearly everywhere as all central bankers have been in on it. It is now simply too late to do anything about it. All we can do sit sit back and wonder just how more insane things can get before they implode.

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