Are central banks dealing with inflation as if they were hunting bears with a howitzer?
The simple answer is no, though a growing number of academics would say otherwise.
Six industrialized nations and at least 20 developing ones use inflation targeting as the cornerstone of their monetary policies. Eight others, including the Federal Reserve, the European Central Bank and Bank of Japan, unofficially target inflation, according to Morgan Stanley.
Yet, the strategy is too restrictive, bordering on mechanistic, critics say. And by rigidly focusing on inflation, it ignores other central bank responsibilities, such as growth, employment and financial market stability.
“The struggle to meet rising food and energy prices is hard enough,” Joseph Stiglitz, a professor at Columbia University and winner of the 2001 Nobel Prize in Economics, had said in a recent paper.
“The weaker economy and higher unemployment that inflation targeting brings won’t have much effect on inflation; it will only make the task of surviving in these conditions more difficult.”
Bottom line: Developing and developed countries should abandon inflation targeting, he said.
Not so fast.
With a target, a government or a central bank identifies a specific inflation level or range it wishes to achieve and explicitly acknowledges that low and stable inflation is the paramount goal of monetary policy, said Fed chairman Ben Bernanke and Fed governor Frederic Mishkin in a 1997 paper they co-wrote.
Anchoring monetary policy around a well-thought-out inflation target is better than none at all, which may leave markets confused and guessing. It helps to insulate a central bank from political interference, while enhancing its credibility. A target also provides explicit criteria against which to measure monetary policy and a central bank’s performance.
That hasn’t silenced the critics. “Inflation targeting could promote damaging mechanical policy-making, as happened with money supply targeting in the late 1970s,” Thomas Palley, Washington-based head of the Economics for Democratic and Open Societies Project, wrote in a Web posting last year.
Inflation targeting central banks have tended to select a low target, when a slightly higher one may lead to “higher real wages, lower unemployment and possibly faster growth”.
Inflation, particularly in developing countries, is the imported product of surging food and energy prices, not policy mismanagement, Stiglitz said, adding that the cure—markedly slower growth and high unemployment—“would be worse than the disease”.
Stiglitz is wrong in suggesting that the inflation infecting developing countries is an external phenomenon. That ignores the subsidies that emerging market nations grant their populations, their inefficient use of energy and the practice of many central banks in Asia and West Asia of pegging currencies to the dollar, importing the Fed’s monetary policy.
Nor must targeting be as inflexible as academics contend.
An inflation target should be realistic. Central banks using one must be disciplined and free of political influence, and their policies ought to reflect a citizenry willing to withstand the pain associated with enforcing the target.
There’s only one thing to do with today’s accelerating inflation: Fight it.
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