It may not be ideal but is still the best among various choices available of a monetary policy system aimed at macro stability
Is ‘flexible inflation targeting’ (FIT) ripe for a coup d’état that topples its almost three-decade grip on the ruling dispensations of central banks the world over? Pioneered by New Zealand as early as 1990, and soon emulated by Canada and the United Kingdom, FIT is now the de jure, or de facto, monetary policy of most major advanced and emerging market central banks, including the Reserve Bank of India (RBI).
Doubts about whether FIT was fit for the purpose began to grow after the global financial crisis of 2007-2009 and its aftermath. As this column has discussed several times, a monetary policy fixated solely on consumer price inflation (CPI), or some variant, failed to react to asset price bubbles that eventually burst and threatened to topple the entire global monetary and financial edifice.
As it happens, FIT largely survived that initial barrage. This was partly because, despite its limitations, no other monetary policy framework that might be a credible replacement was proposed by FIT’s legion of critics. It was a bit like disliking the government one had, but liking the alternative options even less. Plus, inflation stayed tame in the aftermath of that crisis, and attention was focused on unconventional policies such as ‘quantitative easing’ to pump liquidity into financial markets. This pushed debates on FIT largely onto the back burner.
There was also a sense that regulatory policies—so-called ‘macroprudential’ policies—would be better suited to the cause of keeping asset price bubbles in control, while the policy interest rate should remain focused on CPI, or another nominal anchor such as nominal gross domestic product.
Ironically, economic dislocations caused by the covid pandemic may end up having a more profound impact on the consensus around monetary policy alternatives to FIT than a financial crisis linked directly to monetary policy a little more than a decade earlier. Again, in the initial aftermath of this crisis, with a collapse in aggregate economic activity in all major economies, there was little fear of an uptick in inflation. Central banks across the world doubled down on unconventional policies, and governments began to roll out massive doses of fiscal stimulus in most advanced and emerging economies.
But, now that the world is on track toward vaccination, lockdowns are easing and green shoots of an economic recovery are becoming visible, alarm bells are starting to ring, at least dimly and distantly for now. In the United States, the stimulus proposal by President Joe Biden, which has a jaw-dropping price tag of $1.9 trillion, has caused even centre-left, Keynesian-oriented economists to take note and urge caution. Leading this charge is Lawrence Summers, a Harvard economics professor, former treasury secretary under president Bill Clinton and a key economic policy advisor to former president Barack Obama.
Meanwhile, Olivier Blanchard, a former chief economist of the International Monetary Fund, argues—as quoted in The Wall Street Journal—that the Biden stimulus is so large that it would represent “an increase in demand that I have not seen in my lifetime"; there is a danger that unemployment may be driven down to 1.5%, well below the ‘natural’ rate at which inflation would stay stable, and the stimulus is thus, in Blanchard’s view, potentially very inflationary. For his part, Summers calls the Biden stimulus an entry into “entirely unprecedented territory", again as cited by WSJ.
As it happens, fears of a return of inflation make the case for sticking with FIT more compelling. After all, the policy was designed to bring an end to the almost two decades of erratic monetary policy, which followed the collapse of the Bretton Woods system in 1971, when America’s then president Richard Nixon closed the “gold window", effectively killing the system of fixed exchange rates that had given the world much-needed monetary stability since its creation after World War II. The ‘stagflation’ fiasco of the 1970s—an era of economic recession and high inflation—and the failed experiment with monetary targeting in many advanced economies in the 1980s, which resulted in erratic inflation outcomes, propelled both academic economists and central bankers towards FIT in the 1990s.
In an important shift, the US Federal Reserve recently modified its inflation target to focus on average inflation. This means that periods of inflation below target could be compensated for with a phase of inflation above target, so that inflation hits an average target over a given span of time. This would eliminate the asymmetry caused by the fact that—once FIT was adopted and the public’s inflationary expectations got baked in around the Fed’s target—inflation has more often than not undershot rather than overshot its aim in the US.
Still, not all central bankers are equally sanguine. In an important recent speech, Andy Haldane, Bank of England’s chief economist, has warned that taming inflation, if it flares up again, may be akin to trying to catch a “tiger by the tail", borrowing an expression coined by libertarian economist, Friedrich von Hayek, who was always hawkish on inflation and sceptical of the government’s ability to fine-tune business cycles (and the wisdom of trying to do this).
At this juncture, it would be salutary to remind ourselves that the stagflation crisis of the 1970s occurred partly because of complacency over inflation heating up. FIT may not be ideal, but it is still the best among our current choices (many of which are significantly worse) of a monetary policy framework.