Inflation Targeting Voodoo

Yves here. This article debunks yet another bad economic idee fixe, inflation targeting.

By Anis Chowdhury, Adjunct Professor at Western Sydney University and University of New South Wales (Australia), who held senior United Nations positions in New York and Bangkok and Jomo Kwame Sundaram, a former economics professor, who was United Nations Assistant Secretary-General for Economic Development, and received the Wassily Leontief Prize for Advancing the Frontiers of Economic Thought. Originally published at Jomo Kwame Sundaram’s website

All over the world, people expect policies by central bankers trained in economics to have a sound scientific base. But in fact, inflation targeting is an article of faith with neither theoretical nor empirical basis.

Policy Inspiration

The two per cent (2%) inflation target is now virtually an “economic religion”. US Federal Reserve chairman Jerome Powell noted it had become a “global norm”.

In 1989, New Zealand became the first country to adopt a 2% inflation target. “The figure was plucked out of the air”, acknowledged Don Brash, then Governor of the Reserve Bank of New Zealand (RBNZ), its central bank.

It was prompted by a “chance remark” of NZ Finance Minister Roger Douglas during “a television interview on April 1, 1988, that he was thinking of genuine price stability, ‘around 0, or 0 to 1 percent’.” Meanwhile, Brash seemed to think his role was to keep inflation positive, but under 2%.

In the RBNZ’s annual report to March 1989, Brash was “confident that inflation could be reduced below 2 percent by the year to March 1993”. The finance minister welcomed this, asking “whether it might be feasible to achieve that by the end of calendar year 1992 – he liked the sound of ‘0 to 2 by ’92’”!

Thus, “‘0 to 2 by ’92’ became the mantra, repeated endlessly”. Brash and his colleagues “devoted a huge amount of effort” preaching this new mantra “to everybody who would listen – and some who were reluctant to listen”.

This involved “many hundreds of informal speeches to Rotary Clubs, Chambers of Commerce, farmers’ groups, church groups, women’s groups, and schools”. A new cult – inspired by RBNZ’s inflation targeting – was thus born.

Parliamentary Mandate

When the bill setting the RBNZ inflation target between zero and 2% reached the legislature, parliamentarians were about to adjourn for Christmas. Also, “one of the bill’s strongest opponents was laid up in the hospital”.

Nevertheless, the debate over the legislation was robust. Labour unions were worried that an inflexibly narrow target would raise unemployment. The New Zealand Manufacturers’ Federation warned, “This is wrong in principle, undemocratic and inflexible”.

A real estate developer asked Brash to announce his body weight, for him to work out what rope would be needed to hang the RBNZ Governor from a lamppost in NZ’s capital, Wellington. But the bill passed as leaders of the ruling Labour Party brushed aside concerns.

Weak Evidence, Strong Conclusion

Since the RBNZ’s adoption of 2% inflation, “plucked out of the air” as a target, leading economists – some of whom have served as senior officials at the major international financial institutions and central banks – studied long time series for many countries.

However, none could find any strong evidence to justify a single digit inflation threshold beyond which inflation may negatively impact economic growth. Yet, they concurred with a single digit inflation target!

For example, Stanley Fischer concluded, “however weak the evidence, one strong conclusion can be drawn: inflation is not good for longer-term growth”. And Robert Barro asserted, “the magnitude of [negative] effects are not that large, but are more than enough to justify a keen interest in price stability”.

A Reserve Bank of Australia study found “Average inflation is…a fragile explanation of economic growth”. Yet, it concluded, “While the results are not as robust as one would like, the most obvious interpretation of the evidence … is that the negative correlation between inflation and growth arises from a causal relationship”.

Pierre Fortin – past President of the Canadian Economics Association – emphasized, “Strong claims that there are large macroeconomic benefits to be reaped … are not presently founded on robust quantitative evidence. They are premature”.

Cheerleaders claim inflation-targeting has delivered low inflation. But others have alternative explanations for the Great Moderation. The “one-size-fits-all” mantra has also effectively shut the door to alternative strategies for robust, sustainable and inclusive growth.

Harm’s Way

Inflation targeting can be harmful, especially as monetary authorities have little control over external sources of inflation. Current inflationary pressures are largely due to rising international food and fuel prices.

Targeting also harms the economy when inflation is caused by supply shocks, such as production and distribution disruptions, e.g., due to pandemic related lockdowns or other restrictions.

Raising interest rates or monetary tightening to achieve targets when inflation is largely due to external or supply shocks will exacerbate the debt burdens of households, businesses and governments, thus reducing economic growth and employment prospects.

Central bankers trying to “cool” labour markets in their anti-inflation crusade hurt labour by raising unemployment and worsening working conditions. It is likely to be socially less costly to ‘accommodate’, i.e., accept supply or external shock inflation than mechanically achieving an arbitrary inflation target.

Inflation targeting has also privileged price stabilization at the expense of other central bank responsibilities, including maximizing employment, growth and progress.

Of course, central bankers should be monitoring prices of key goods and services (e.g., food, fuel, housing, healthcare) which weigh heavily on consumer spending. Policymakers must design alternative policy tools to address such essential price rises rather than relying solely on raising interest rates.

Targeting a specific inflation rate is against the International Monetary Fund (IMF)’s Articles of Agreement. Article IV states, “each member shall: (i) endeavor to direct its economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability, with due regard to its circumstances”.

Thus, IMF members are obliged to foster economic growth, and maintain “reasonable” price stability – not chasing a fixed inflation target, presuming that growth would follow. There is no ‘one-size-fits-all’ policy or universal target. And policy design depends on country specific circumstances.

Counter Revolution

Inflation targeting should never have become monetary policy. It should have been rejected long ago if policymaking was informed by theory and experience. But central banks have been targeting inflation, supposedly to enhance growth and employment!

Some assert money is “neutral”, insisting central bankers cannot affect real economy variables, e.g., output, employment, investment. Thus, they have “discounted the role of money in … monetary policy more than is justified”.

But money is far from neutral, impacting the real economy quite significantly. This was evident after the 2008-2009 global financial crisis and during the COVID-19 pandemic. Policymakers should instead be primarily concerned about the real economy – output, employment, sustainable development.

Unsurprisingly, inflation targeting has not accelerated growth, especially in developing countries. Even in developed countries, it seems to have exacerbated “secular stagnation”, i.e., anaemic growth.

Thus, instead of increasing growth, employment and structural transformation, the inflation obsession has slowed economic growth. Universal rejection of the inflation targeting hoax will thus advance human progress.

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  1. Ludus57

    In his book “The Worst Is Yet To Come”, the writer and academic Peter Fleming makes the observation that neoliberalism should be seen as a political, rather than economic project, because it does not lead to economic improvement (or efficiency).
    This can be seen in the UK, where, in the 1970s, a decade the neoliberals point to as home of all the problems they cured, annual growth generally exceeded clearly above 2%< yet in the sunny uplands of the Blessed Margaret (Thatcher) and her miraculous cure, growth generally struggled to rise above not much more than 1% growth. The idiocy inherent in Gordon Brown setting the Bank of England "free", but charged with an inflation target of 2%, made a major contribution to future developments such as his own brief premiership and Brexit, both lost on the back of anaemic economic growth for ordinary people during and after the New Labour years. It is now clear that Keir Starmer's Nu-Labour have not learned that lesson.

  2. RabidGandhi

    I do get where the Central Bankers are coming from, however. Sometimes I myself get into a traffic jam that will get me 20 km in an hour and announce stridently ‘I have just set a 20 km/h speed target’. Other times I set growth targets for my kids’ heights. Otherwise one feels completely powerless.

    That said, I can always pull a Central Banker and slam on the brakes in traffic or shave a few cm off my kids’ heads, if things get out of control.

    1. Larry Carlson

      Central bankers will admit that they can’t directly control inflation. Instead, they can do things that heat up or cool down the economy, and then hope those things eventually affect inflation more or less in the desired way. Given that economists don’t actually understand the mechanics of inflation in any detail (is it driven by the money supply, expectations, exogenous shocks, etc.), targeted intervention isn’t possible.

      In your case, pulling a central banker wouldn’t be shaving a few cm off of your kids’ heads if they exceed your arbitrary growth targets (since this is a straightforward, targeted intervention that directly affects the desired growth rate), but would be something more like putting unhealthy foods in the house and hoping that their growth eventually slows due to this lower-quality diet.

      1. Mike

        The inflation you are talking about is what hits the everyday man. Otherwise many would argue that the QE ops over the last decade-ish were deliberate policies to drive white paper asset inflation…

        The Fed keeping interest rates low seems like a deliberate policy to drive real estate inflation…

        The Fed knows what it can do and that is to drive inflation, but in such a way that the people closest to them get the money 1st, therefore the benefit. A central banker admitting they cant control inflation is a ploy or deflection from the inflation they really care about.


    Isn’t it a big thing to ignore that inflation destroys fixed income and people who have jobs with annualized wages?

    Even if people were able to magically get inflation adjusted wages updated every year (which they don’t bc of low ball inflation measures and most companies wages being fixed without a promotion) – they’d still get crushed for the next 12 months until the wages updated again.

    1. Starry Gordon

      No one who matters seems to care about people with fixed incomes or crap jobs, the wages whereof are hard to raise. Their inconvenience would be therefore unimportant, but for the fact that they are still allowed to vote. True, they often vote against their interests, but one can’t count on it. And many of them hate inflation. So that’s one of the problems.

    2. Susan the other

      Chowdhury and Sundaram specifically point this out, saying that “… we need alternative policy tools to address price increases of key goods and services other than raising the interest rate.” The fact that “inflation targeting” was totally bogus but nobody bothered to address it, to my thinking, clearly puts the practice in the political arena. When a national currency gets out over its skis, like the British Pound did when it began to lose value as the empire melted away, the people who once enjoyed all that purchasing power don’t want to lose it and the only trick they had was to impose interest rates that maintained its value; like the Fed making sure asset prices (stocks and real estate) didn’t crash, etc. That’s totally political. It serves to maintain the status quo and prevent a progressive transitional economy. Ergo, Maggie Thatcher. And Ronald Reagan. And every other clown we delegate authority to.

  4. philnnc

    Hence the importance of universal, free, programs for health care, and given recent trends, the need to now be looking at food and food assistance that may have to include actual housing and food instead of worthless (in a time of sharply declining supply) vouchers. Even a national jobs program would fall far short under current circumstances. A $15 minimum wage is now clearly too little, too late. The oligarchs and still above water PMC won’t consider the possibility, but the if the tens of millions thrown out of their homes and made to watch their kids starve ever get organized…

    1. Amateur Socialist

      I keep thinking a General Strike will be required. Or maybe more than one. But then when I consider how difficult it would be to organize one in this omni surveillance world I get discouraged.

      1. drumlin woodchuckles

        Well . . . . the semi-general Great Resignation is the closest we will get to any General Strike.

        ” Go ahead and have your General Strike. We’ll just move all the rest of the jobs to China.”

        ” I can get ten interns who will pay ME to LET them do your job. So go ahead and strike.”

        But maybe not so much as before . . .

        The Great Resignation should be matched with a Great Consumer Slowdown and also a Great Consumer Re-Targetting. Those who care will buy from Nomazon. And those who don’t care will still buy from Amazon. Let those who don’t care . . . . have no jobs in their future ever again except Amazon warehouse jobs. Just as . . . . those who ride in Ubers deserve to have no job ever again except driving an Uber.

  5. chuck roast

    If inflation targeting is voodoo then that is simply one pin in the doll of the true believers. Similar pins would include the non-accelerating rate of unemployment (NAIRU) which was proved completely wrong a generation ago. However, high priests regularly turn a blind eye to real world conditions, so this is nothing new. I can see their colleagues in the Arts & Sciences snickering as they pass these pseudo-scientists.

  6. Mike

    “ Raising interest rates or monetary tightening to achieve targets when inflation is largely due to external or supply shocks will exacerbate the debt burdens”

    Did this author miss the last two years? How is the Fed monetizing the federal debt tightening? Sure covid supply chain issues are inflationary but so is PPP, Covid checks, fed buying bonds, federal deficits, etc. I know a few people on here aren’t the biggest fans of Friedman but the whole inflation is a monetary phenomenon still applies in our current case.

    1. Skippy

      Those purchases or swaps are not effecting money supply or VoM to the unwashed and in case you have not noticed in the U.S. most of it is flowing into the digital economy e.g. Milton like Keynes would not have a clue to this reality and as such might not be a good source for observation.

      You might want to have a peek at the fintech shadowsector 2.0 link e.g. another mutation of Plaza and EMH IMO.

      1. Mike

        I think the authors approach to inflation is very narrow minded. You are helping with that argument by saying how much has flowed into the digital economy. Paper assets are directly impacted by the central banks and many legitimate economists view that as as a form of inflation.

        IMO you also can’t write an article like this without mentioning that questionable methods for calculating inflation even more delegitimize the 2% target. So essentially they have applied an arbitrary target to a questionable calculus, but to me that is intention-able on their part.

  7. skippy

    File under when you blend moral monetarism of hard currency with sovereign fiat and quasi monetarism pops out the other side, per se the anguish some feel when they worry about which side their bread is buttered on hitting the floor, so a ritual is enacted to stave off such unhappy thoughts …. you know capital would not invest in productive stuff otherwize[tm] ….

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