Inflation Targeting Is Dead, Long Live Inflation Targeting

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Inflation targeting is dead. Harvard’s Kennedy School professor Jeffrey Frankel, a former economic advisor to Bill Clinton, is now trying to write its obituary, in an article for Project Syndicate. According to Prof. Frankel, the system that was born in New Zealand in 1990 and exported successfully to several other countries passed away in September 2008, when most of the world’s central banks cut interest rates to record lows in an attempt to curb the effects of a major liquidity squeeze and avoid the prospects of long term deflation. Since then, the central banks that used to adopt the system did not formally abandon it and the Federal Reserve released an explicit inflation target, but it is clear that price stability is either taken for granted or became less important than other economic policy goals. Inflation targeting may not make much sense in a world where inflation, to paraphrase the FOMC communicates, is to remain subdued for a long period of time.

If inflation is no longer a problem, central banks could use their increased discretionary power to pursue new and more ambitious goals. In a world of difficult political coordination and little consensus about what must be done to put the economy back on the growth and development track, central banks are the ultimate instruments of economic policy implementation. Over the past few years, they have become responsible not only for price and financial stability, but also for a substantial part of government funding in the developed world. The consequences of this huge experiment are still to be totally understood and felt; meanwhile, a group of countries rely heavily on central banks to keep their debt cost at sustainable levels.

One of the many challenges of this new economic order will be dealing with collateral effects of ultra loose monetary policy. Using a single instrument to pursue several and sometimes conflicting goals cannot be seen as a definitive solution. In the near future, governments will be pushed to come up with an answer to the problems masked by unprecedented amounts of central bank intervention. The trigger can be a negative response from voting ballots, or, in a global scale, a return of rising prices. History shows that periods of inflation and deflation always come to an end. Then either the responsibility of economic policy will be transferred back to democratic elected leaders, or central banks will have to reevaluate their priorities and occasionally rediscover inflation targeting as an effective and useful nominal anchor. Reports of the demise of inflation targeting may prove, eventually, to be greatly exaggerated.