Joseph Stiglitz Lambasts Inflation Targeting

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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.

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  1. a

    Well, the ECB uses a sort of inflation targeting, and they seem the grown-ups in the room at the moment, at least compared to the Fed. So maybe inflation targeting, whatever its faults, is better than the alternatives.

  2. Richard Kline

    Inflation is nature’s way of telling you your money isn’t worth what you think it is, that there’s too much of it, or both. Hiking interest rates can help with the first problem, but not the second.

    Announcing an inflation target (not that you can really tell a good number, but) is not such a bad idea; announcing _specifically_ what you are going to do about it isn’t so hot, though. Ever raise a kid?: they game known outcomes. Draw a line and keep it, but preserve your operational flexibility, not least because the problem will have different inputs at different times. Like now.

  3. Anonymous

    Joe maybe correct from a geopolitical stand point (avoid recession AND social unrest in poor countries)

    But does he ask himself what is it that causes sharply rising commodity prices? Isn’t it exactly overheating global aggregate demand partially responsible?

    And his proposal that rising commodity prices should not cause other falling prices is also dubious. Basically he proposes to inflate the prices of the non-commodity goods, so that they keep better up with rising commodities. So: inflate ?!? I don not think it is such a bright idea

  4. bobo7874

    Arguing about inflation targeting or other methodologies for controlling inflation is a side issue. The main contributor to the inflation mess in Asian and middle eastern countries is those countries’ central banks printing huge amounts of local currency to buy huge amounts of US treasuries/agencies in order to subsidize local employment in exports and/or as a quid pro quo for US military protection of their regimes. These countries have tried to control local inflation without moderating their currency pegs, but this level of printing can’t be “sterilized” to prevent inflation through increased reserve requirements and whotnot. The pegs are the real issue.

  5. Observer

    Volcker stayed with strict Friedmanite M management until one day in July 1982 when it didn’t suit his needs any more and he stopped.

    So much for theory. In practice, all it did was strangle the economy until stagflation was broken. But it labor power too, and so from 1982 to the present, aside from a short interlude in the late 1990s, productivity has run well ahead of wage earnings.

    And the way around -that- trap was the successive asset bubbles: first equities, then mortgages, and now, possibly, commodities.

    Meanwhile the Fed, which regulated and sometimes bothered to oversee most financial institution footings in 1982, now has direct control over nominally perhaps 20%. From too much to too little.

  6. Anonymous

    But isn’t the ECB essentially doing what Stiglitz argues? Instead of raising interest rates the ECB is currently holding steady, essentially betting on prices levelling out later this year.

  7. sk

    He’s discredited a lot by just casually stating that (price) inflation in the US is 3% when its 5.8% in India and 8% in China.

    Inflation in the US is NOT 3%. Its 7.x% or 11 % depending on whether you use a 90s standard or a 70s standard.

    This undermines the argument a great deal.

  8. Paul Deng

    I think the debate is not so much how about the merits of inflation targeting. Rather, it’s whether inflation targeting should be adopted by developing countries where food consumption accounts disproportionally a large chunk of personal disposable income.

  9. surfwalker

    I’ve been arguing exactly this point for a year now in Sweden. The central bank keeps raising rates in the face of a general economic slowdown. The greatest contributions to the CPI, besides the component representing rising interest costs, are all fuel-related (for example, food prices are rising, but largely due to increased transport costs). The central bank seems perfectly willing to inflict pain if that’s what the cookbook demands.

  10. Anonymous

    Stiglitz and surfwalker are right. We have an energy supply problem and it’s causing price increases that have nothing to do with interest rates or too much printing, so attempting to address the price increases with interest rate hikes will only shoot your economy in the foot.

    The price increases will be hard on almost everyone, but it will take a functioning economy to deal with the energy problem in a way that doesn’t consign the bottom 20% of our people to a permanent Lima-style slum hell.

    Bernanke’s job is to keep an economy alive through a painful and expensive transition to alternative energy and slow to non-existent growth. He has to try to contain genuine inflation (and he’s doing that by doing what he can to shrink money supply) without using unemployment to contain price increases that are not due to inflation.

    Moe Gamble

  11. Flow5

    It’s obvious that the author or those referenced in this article understand money & central banking because if they did they would know that monetarism has never been tried. That goes for nobel laureates too.

  12. Anantha

    These are my thoughts on this particular piece by Prof. Stiglitz:

    Beyond calling for abandoning inflation targeting and diversion of crops for biofuels, prof. Stiglitz has few concrete ideas in this article.

    I am not sure I entirely agree with his proposition. When it comes to food and energy prices, if supply cannot go up in the short-run, demand can be and should be restrained. This applies in particular to energy.

    Just as he questions the cost of fighting inflation (rising unemployment), i wonder if there is an implicit understatement of the costs of inflation itself.

    Central banks all over the world – with or without government pressure – are too reluctant to have a recession. In my view, for many reasons, we need one in the world. To cite just one reason, resources are too tight. Growth just cannot go on at the pace of last five years.

    Central banks can make that (recession) happen, if they wish to. But, they are scared that it would spiral out of control.

    This ties in neatly with the theme of the paper, “Mirage of fixed exchange rates” (1995) by Obstfeld and Rogoff: it is possible to have fixed exchange rates but sometimes it could be too costly.

    Similarly, if they believe in the need for a recession, central banks can have it but they wonder if they would pay too high a price for it.

    The price that they are paying and are willing to pay to keep growth up, is inflation either because they want growth at all costs or, are miscalculating that inflation costs won’t be too much.

    Methinks they are going to be very wrong on this one. In other words, it is going to be seriously unpleasant either way.

    Have a nice weekend!

  13. Flow5

    Monetarism hasn’t been discredited. Monetarism has never been tried. Monetarism involves controlling the volume of total reserves not just the volume of non-borrowed reserves as administered by Paul Volcker. One dollar of borrowed reserves has the same expansion coefficient as one dollar of non-borrowed reserves.

    Total legal reserves were inflated at a 15% annual rate in the last 6 months of 1980. When Volcker sent nominal gnp to 19.2%, he caused the FFR to hit 22.4% in the 1st qtr 1981. This particular 1970 event’s appellation was “time bomb” – forewarned. Thus Volcker laid the foundation for (the end of usury rates), i.e., payday loans and unrestricted credit card rates in 26 states.

    If Bernanke was using a non-borrowed reserve target today there would be no offsetting sales of Treasury securities, reverse repurchase agreements, Treasury redemptions, etc

    And Friedman: (1) no money figure standing alone is adequate as a guide post to monetary policy. (2) velocity isn’t a constant and his use of the income velocity figure isn’t valid. (3) The money supply is in constantly flux. (4) it should have been obvious that the DIDMCA would cause a shift from the narrow definition of money into interest bearing accounts – M2 (i.e., the elimination of Reg Q ceilings). Therefore the Fed would receive false signals using M1;

  14. Flow5

    (1)“Raising interest rates cannot bring inflation down to the targeted levels”
    (2)“need to abandon inflation targeting”

    Central banks cannot control interest rates, even in the short-end of the market, except temporarily. The effect of a series of temporary pegging operations is indirect, and varies widely over time, and in magnitude. The effect of tying open market policy to an interest rate target is to supply additional (and excessive) legal reserves to the banking system when loan demand increases….. I.e., inflation targeting should be abandoned for this reason.

    Stiglitz was quick to identify the problem, & quick to leave it begging (1) what is an acceptable inflation rate & (2) how should price indices be weighted?

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