Inflation Targeting Hits the Wall
Antony P. Mueller
Although the financial market crisis is not over but has grown into a vicious sovereign debt crisis, monetary authorities of the major economies continue to practice the same sort of policy that has brought about the crisis. According to the concept of inflation targeting, monetary policy may disregard the quantity of money and the amount and kind of credit creation. Central bankers are free to lower interest rates as much as it gets as long as the inflation rate is kept on target. In as much as nowadays central banks dominate the discourse about monetary policy, there is almost no debate going on about the indictment that inflation targeting is not only defective in guaranteeing monetary stability, but that it also provided the conditions for the current financial crisis to come about.
What is inflation targeting?
With the abandonment of the last remnants of the gold standard with the Smithsonian Agreement, monetary policy has no longer an anchor beyond a policy concept. By slashing what was left of a monetary anchor in 1971, the monetary base of the US dollar began to rise and swell into an avalanche of money.
Modern central banking began with the mission of providing monetary funding for governments in cases of emergency whereby the prime emergency has always been war. In modern times it was the Vietnam War which killed the Bretton Woods System. When the last obstacle against a full discretionary hold on money was instituted and the US central bank gained unrestricted power to produce as much money as it wanted a new chapter in monetary history began.
As soon as the US Federal Reserve System had gained full authority over money, the need arose to conceal this accomplishment under a specific monetary policy rule. In the search of such concepts, inflation targeting has superseded older concepts such as the monetarist rule which aimed at the control of the growth of certain money stocks.
A central bank that pursues an inflation targeting monetary policy model would tighten policy by raising the policy interest rate (which in the case of the United States is the federal funds rate) when the actual annual inflation rate tends to move beyond the target and to reduce the policy interest rate when price inflation tends to falls below the range. Operationally, the inflation rate is the target variable of this approach while the policy interest rate serves as the instrumental variable. Different from monetarism, the monetary aggregates play only a secondary or no role at all for inflation targeting.
The monetary policy model of inflation targeting can be expanded into the so-called Taylor rule to include the output gap and thus to encompass economic policy goals such as economic growth and employment.
The Taylor rule
In many parts of the world where monetary policy employs an inflation targeting framework, the tendency has shown up to systematically ignore the expansion of monetary aggregates and to install extremely low interest rates. Less so than being strictly guided by the original Taylor rule, monetary policy of inflation targeting has ignored the growth of money and credit and uniquely selected the current inflation rate as its foremost standard. Particularly in phases when the unemployment rate was found to be above the natural level, low rates of the consumer price index have served as a justification to bring down interest rates to excessively low levels. Inflation targeting has led monetary authorities to ignore not only money and credit growth, but also asset prices along with other variables such as the exchange rate. By the rational of inflation targeting, monetary policy has become blunt and ignorant on purpose, and in this respect a repetition of an earlier failure has occurred just at a time when the future head of the US central bank felt sure that he could promise that “we won’t do it again” to let the US economy fall into depression. Not different from other areas of policies, in monetary policy too, the only lessons which are learnt from history are the wrong lessons.
An earlier episode of inflation targeting
Inflation targeting is not new. Its basic idea was conceived by the American economist Irving Fisher (1867-1947). The US central bank implemented a rudimentary form of inflation targeting shortly after it became operative in 1914 and explicitly practiced a policy of “stabilizing the price level” in the 1920s, in the decade before the inception of the Great Depression.
The 1920s marked a period of rapid accumulation of debt which until 1929 was accompanied by a rise of wealth due to a stock market and housing boom. The collapse of the market ushered the economy into the Great Depression that lasted over a decade.
During the 1920s the US monetary authorities seemed little concerned with credit expansion because the main focus was the “price level” – a statistical construct that Fisher also promoted. Noticing that the price level was “stable”, the US central bank felt no need to change course or to become preoccupied with what was going on. The roaring twenties were in fact exuberant times and it was not just business and labor that celebrated the new era but most of all this decade was one more heyday for Wall Street after the financial bonanza that World War I had provided to the financial sector.
Inflation targeting had induced the monetary authorities to ignore credit growth as well the productivity gains of the US economy in this period. The central bank felt vindicated to let the monetary aggregates expand as long as the price level remained relatively stable. No consideration was given to the notion that with productivity advances the price level should decline as it was the case before when the US was still on a full gold standard and thus the quantity of money was relatively stable. In the 1920s, fixed on the price level, the monetary authorities did not hold the quantity of money constant, which would have meant deflation, but instead allowed an expansion of the money supply because there seemed to be no reason to be concerned as long as the price level remained relatively constant.
Good deflation - bad inflation
In monetary history, the outbreak of World War I marks the end of deflation and the beginning of the inflationary age. The deflationary age was marked by the ascendancy of prosperity brought about by a financial environment of stable interest rates, moderate long-term declining prices and rising real wages . It is largely forgotten that the spectacular economic rise of Britain, of parts of the European continent and of the United States of America in the period of almost a century until the outbreak of World War I in 1914 was characterized by moderate deflation, particularly since the beginning of the latter half of the 19th century when productivity increases began to accelerate. In full concordance with the quantity theory of money the price level in an expanding economy would fall because the money supply was linked to the gold stock and the gold stock was relatively constant.
Letting “good deflation” happen would automatically put a break on excessive economic growth. A fixed stock of base money would prevent the excess on the upside, and thus it would automatically provide a safeguard against the excess on the downside.
A stable stock of base money would not mean inflexibility because a relatively stable but not fully constant velocity of money would automatically provide a certain degree of adaptability.
The current crisis
The latest episode of a mega boom occurred in the 1990s when, like in the 1920s, there was a stock market boom along with a massive increase of indebtedness. Central bankers no longer had paid much attention to the money supply and have remained sanguine throughout the period that led up to the current crisis pointing to moderate inflation rates as an indicator that monetary policy was sound. The mantra of monetary policy was that as long as the price level was relatively stable and only moderate inflation rates were registered, interest rates could fall as low as they can drop and the money supply could grow without restraint as large as demand of money seemed to warrant. In retrospect it is quite obvious that this policy did not produce the “great moderation” as was announced but rather was the time of the “great delusion”.
There were a series of severe crises in the 1990s as well as in the decade before and after. Yet up to the outbreak of the last crisis, all of the preceding calamities could easily be overcome, so it seemed, with the simple tool of bailing out the creditors and by an even larger expansion of the money supply. Inflation targeting consequently entailed a pervasive policy of bailouts and thus laid the basis for an ubiquitous financial culture of moral hazard.
In 2007 financial markets suddenly began to freeze, the flow of money in the interbank market came to a sudden standstill. It was as if a cardiac infarct had hit the heart of the financial markets. Albeit shocked, monetary policy makers demonstrated complete confidence that the appropriate amount of liquidity injection would make the markets move again and soon the economy would recover to full bloom again.
Doom set in when the old recipe didn’t work anymore. Despite massive injections of liquidity, markets only slightly recovered and in 2008 a wave of defaults of financial institutions occurred. In August 2011, the United States came close to bankruptcy when Congress was reluctant to raise the statutory debt limit. Shortly thereafter, the global financial crisis transformed into a severe sovereign debt crisis in Europe. Greece came close to bankruptcy and contagion hit Spain, Portugal and Italy.
Fear of deflation
Modern governments abhor deflation and embrace inflation. By making a definite national currency the single “legal tender”, governments force their citizens to pay tributes in an indirect way by paying an inflation tax, the so-called “seignorage”. By targeting a moderate amount of annual inflation central banks make sure that a steady stream of inflation tax can be secured. By keeping the inflation rate in its pre-defined range it is expected that the negative effect of inflation on the economy would be kept at bay and the receipt of seignorage be optimized in the long run.
The monetary policy of inflation targeting was adopted with the promise that “low and stable” inflation rates would serve as the recipe that “price level stability” would produce financial and economic stability. Reality has not confirmed this assurance. With the escalation of government debt to exorbitant heights and the unrelenting rise of consumer debt, deflation becomes a scare for governments and a nightmare for the indebted consumer. Quite different from a society where households and government are savers when the fear of inflation would be the dominant concern because only business would be the debtor while all the while business could cope well with deflation when the decrease of the price level is the result of productivity gains.
With a fixed monetary stock, deflation happens when the economy expands either in absolute terms or on a per capita basis with productivity gains. In both cases business does do better on average while the wage earner automatically receives higher real wages because of the falling price level even if nominal wages remain constant. There would be no need for trade unions to drive up nominal wages because inflation erodes real wages. For business, the real debt burden would increase because of deflation yet this poses no threat because in as much as there is deflation, business activity would have expanded and likewise the debt capacity of the business sector as a whole.
ZIRP e TARP and other monsters
Once again, the monetary policy of inflation targeting with its tendency of benign neglect of most of the other important monetary variables, has produced ruinous consequences. By early 2012, monetary policy has reached a stage where it is almost completely paralyzed. With interest rates close to zero in the major economies of the world, it is only through gargantuan amounts of liquidity injections that the financial system is kept alive. By practicing a “policy of zero interest rate policy” (ZIRP) and buying assets of dubious quality from financial institutions through its “troubled assets relief program” (TARP) and by trying to pump ever more liquidity into the market through its policy of “quantitative easing” (QE), an expansion of unprecedented proportions of the American central bank’s balance sheet has occurred. The real or imagined assumption that the financial system was on the verge of complete collapse brought about massive government bailouts and stimulus programs which resulted in rising fiscal deficits and unsustainable public debt burdens.
As of now the additional liquidity which the major central banks have created, serves mainly for the banking sector to refinance itself. Monetary policy has become a vehicle for the bailout of a whole sector of the economy. In order to “save” the financial sector, central banks delivered even more monetary dynamite. The world is at a crossroads. The chance to get out of the mess without great pain is much smaller than of having a hyperinflation to be followed by economic depression or of crashing right away into the abyss of a deflationary depression. Monetary policy has hit the wall. It has reached the dead end. Like many times before, once again a magic formula of interventionist monetary policy bit the dust.
Conclusion
What was diagnosed as the great moderation was a great delusion, which has turned into the nightmare of a long stagnation. The current financial crisis can be directly attributed to the monetary policy of inflation targeting in so far as this policy rule has allowed for massive monetary expansion and extremely low interest rates. There is an urgent need for the return to stable money. The main barrier against establishing a sound monetary system is neither of an intellectual nor of a practical but of a political nature. All that it takes to establish a sound monetary system is to maintain a stable stock of the monetary base and to practice no bailouts of any kind. The consequence of a stable monetary system would be long-term moderate deflation, albeit the great loser of such as system would be the big spenders in government.
Footnotes:
Financial markets multiply the monetary base (MB) according to the reserve ratio (r) into money (M) for the public MB . m = M with m = 1/r
Taylor’s monetary policy rule focuses on the policy interest rate (it) as the main instrument of monetary policy which in the case of the United States would be the federal fund rate. In case that the current inflation rate is equal to the target rate, and the unemployment is equal to the natural rate of unemployment, the policy interest rate would be equal to an interest rate (i*) composed of the natural real rate (rn) and the chosen target inflation rate (π*).
This way one gets it = rn + π* = i*. The Taylor rule operates with two reaction coefficients α and β that denote the degree of reaction that the economic policy authorities attribute to the discrepancy between the current inflation rate and the target rate (πt - π*) and the output gap measured in terms of the discrepancy of the current unemployment and the natural rate of unemployment (ut – un).
Taken all together, the Taylor rule thus reads: it = i* + α (πt – π*) – β (ut – un).
Real wages are defined as the ratio between nominal wages (W) and the price level (P) as W/P. Such when P falls, the ratio W/P rises even with nominal wages remaining constant.
Given the caveat that a too mechanical application of the quantity theory of money should be avoided, the basic relationship which it contains is highly useful to structure monetary analysis As can be shown by the so-called equation of exchange, MV = Y = PQ, the monetary stock M multiplied by the number of its transaction, the velocity V, is identical to nominal national income Y, which in turn can be broken up into its real component Q and the price level P. With M and V relatively constant, and real output Q expanding, the price level must P must fall.
Writing the equation of exchange in dynamic form to denote changes over time gM + gV = π + gQ one gets the result that a fixed amount of money which would mean a growth rate of money of zero in combination with a constant rate of turnover (gV = 0) and thus π = gM - gQ, which shows the inflation rate (π) as the result of the difference between the growth rate of money (gM) and the growth rate of real production (gY).
