Celebrating 30 years of inflation targeting?

Back in 1989, the Reserve Bank of New Zealand was the first central bank to formally introduce an inflation target. Many others adopted the policy in the subsequent decades, and it has largely been a success. 

Although central bank policy is just one of many factors driving down inflation, in developed economies inflation is now firmly anchored at moderate levels. In New Zealand, inflation declined from 7% in 1989 to an average of 1.6% since 2010. Similar averages have been seen in the US (1.8%), Canada (1.7%), UK (2.3%) and the Eurozone (1.4%) over the past decade. 

As inflation expectations have followed the decline in actual inflation levels, there is a risk of inflation becoming anchored at undesirably low levels.

The combination of low inflation and a low natural rate of interest has made it much more difficult for central banks to steer the economic cycle by controlling real interest rates. One has to wonder, therefore, whether a policy framework that was designed for the economic conditions of the late 1980s and early 1990s is still fitting for the economic reality of today. This can be seen in the table below.

The data on real rates illustrates the need for a review of the policy framework. In the low-rate, low-inflation recession environment of the 1950s and 1960s, the US central bank’s ability to bring down real rates was more limited than in the decades that followed, when core inflation and rates were higher. 

And in the arguably fierce recession of 2007-2009, lowering real yields by 4% was insufficient to trigger a recovery. With the Fed funds rate now much closer to the effective lower bound of zero and inflation at around 2.0%, bringing down real rates to stimulate the economy in the next recession will be a challenge. 

Needless to say, the Fed has responded by beefing up its monetary arsenal with forward guidance and quantitative easing (QE). Once dubbed ‘unconventional’, these instruments have been found by the Atlanta Fed to have yielded the equivalent of another 300 bps in interest rate cuts. 

However, more and more unconventional policy will be needed in the future, as the natural rate of interest has remained stubbornly low. Yet the Fed will not simply accept the erosion of traditional monetary policy, with good reason. It is one thing to have to support traditional policy instruments (rates) with non-traditional tools such as forward guidance and QE. 

But it is quite another to have to rely almost entirely on non-traditional instruments for monetary policy – which, arguably, is now the case in the Eurozone and Japan. Avoiding this ‘horror scenario’ should serve as a very powerful non-official motivation for the Fed to evaluate its current policy framework. 

So, what are the alternatives? Suggestions for a makeover, and some of their advantages or drawbacks, are:

• Raising the inflation target – pursue a policy aimed at higher inflation, such as 3%. While this would be a transparent approach, it would score low on credibility. The Fed quickly took this alternative off the list of possibilities.
• Introduce an inflation target range – the Bank of England and Bank of Canada aim for ranges of 1% to 3%. This would create flexibility in the policy objective itself, but it would add some uncertainty on the policy setting.
• Price level targeting – set a trajectory for the price index and manage monetary policy to make up for any past deviations from this path. This scores high on flexibility, but less so on transparency, as a moving index level just doesn’t have the same appeal as an inflation number.
• Nominal GDP level targeting – set a trajectory for nominal GDP growth and manage monetary policy to make up for any past deviations from it. While this has similar pros and cons to price level targeting, it would also be a more radical change from the Fed’s current policy objectives, and is probably a step too far.
• Forecast targeting – set monetary policy in such a way that the resulting forecasts for inflation and unemployment are in line with the Fed’s mandate. This would raise questions such as whose forecasts the Fed is targeting; in other words, who is in charge of the Fed.
• Average inflation targeting – an average level of inflation with a horizon of more than a year. While this would involve some loss of transparency, as the Fed would have to define the length of the averaging period, the objective would be more transparent than an index level.

The alternatives that achieve the highest scores are introducing a target range and inflation averaging. Both policies would allow the Fed to make up for past missed inflation targets and involve a limited loss of transparency. More importantly, neither would risk undermining the credibility of the Fed. Between the two, inflation averaging would probably be the preferred option.

In the current environment, inflation is below target. One thing, therefore, is clear: each of these options would allow for a more dovish monetary policy than would otherwise be the case. The four-percentage point miss on PCE inflation in the past five years likely implies that even on a medium-term horizon, monetary policy should be more expansionary than in the current setting. 

A dovish Fed policy would also allow other central banks to keep rates lower than would otherwise be the case. This is especially relevant for the central banks of emerging markets for which the exchange rate plays an important role in monetary policy setting. 

Some of the ideas put forward could, ultimately, be adopted by other central banks. Yet a broader rethinking of macroeconomic policy could also result in a different role for monetary policy. So, expect to see changes to both fiscal and monetary policy, with the Fed most likely leading the way.