Targeting inflation: Great moderation a great embarrassment

By Vatsal Srivastava,

In 2003, economist Robert Lucas, in his presidential address to the American Economic Association, declared that the “central problem of depression prevention has been solved, for all practical purposes”. Prior to the financial crisis of 2008, the mood prevailing among economists was that Macroeconomics had won. Finally, the business cycle could be tamed by a low and less volatile level of inflation. This was termed The Great Moderation.

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The primary focus of monetary policy to target only inflation is likely to lead to upheavals elsewhere. Currency Corner is raising questions over the pros and cons of “inflation targeting” as a monetary tool because as the global economy is finally showcasing a sustained recovery, inflationary expectations remain at the helm for the US Federal Reserve, the European Central Bank and the Bank of Japan. Despite the huge output (nominal GDP) losses of recent years, adherence to inflation targets appears to be stronger than ever. The Federal Reserve has started to taper its Quantitative Easing (QE) program and the market is expecting rates to move higher as we move ahead. However, monetary policy in Europe and Japan is primarily being guided by deflationary threats. Anticipation of further unconventional monetary policy tools which would also lead to devaluing their respective currencies are all answers to the threat posed by low inflation. Further, a long run of history reveals that the majority of recessions and financial setbacks have had nothing to do with high inflation.

Take the example of the United Kingdom. According to HSBC, UK GDP has contracted in 34 separate years since 1831 – yet only in the 1970s and early 1980s was there any kind of connection with rapid price increases. Inflation targeting may have helped deliver price stability but it appears to provide no guarantee of lasting economic or financial stability. Could it be possible that when central bankers tend to focus on just one key macro variable (in this case inflation), it may be the case that they are left unable or unwilling to spot increase in financial risk? It can be argued that prior to 2008, policymakers ignored rapid house price gains, excessive money supply growth and narrowing credit spreads even though, throughout history, these had provided good warning of future upheavals. Excessive risk taking was encouraged because as long as inflation was well-behaved, market participants could look forward to a stable and predictable monetary environment according to HSBC.

Another example is the booming Japan in the 1980s. Japanese inflation was well-behaved in the 1980s, but rapid asset price gains ultimately set the scene for the deleveraging and deflation of the 1990s and beyond. In hindsight, it would have been far better had monetary policy been kept a lot tighter in the 1980s: admittedly, inflation would have been far too low in the short-term but the bubble would probably have been smaller.

To be fair, some central banks, such as the US Federal Reserve, do incorporate the state of the labour market in their forward guidance. The latest ECB monetary policy announcements of targeted long term refinancing operations (TLTROs) and expectations of further QE from the Bank of Japan are all a function of expected inflation readings in the coming quarters. For the time being, deflation remains the biggest macro threat in these two regions. But as we start seeing an uptick in prices (Japan is moving in the right direction as per recent data), we should see a gradual shift away from inflation targeting to a more wide range of indicators which would guide monetary policy.

The Great Moderation might just have been a bit of good luck!

(18.06.2014. Vatsal Srivastava is consulting editor for currencies and commodities with IANS. The views expressed are personal. He can be reached at [email protected])