Inflation targeting must be modified. But how?
Mojmír Hampl (The Wall Street Journal, 2.2.2011)
What exactly caused the recent financial crisis? This question will be the subject of heated debate for years to come. In time, Nobel prizes will be awarded for convincing answers and ensuing recommendations. Some central banks have already intuited that they are going to have to make some changes in at least two areas: monetary policy making and the currently little-researched area of so-called financial stability. These two subjects may have more in common than first appears.
Central banks in many advanced countries operate under the well-established inflation-targeting system. Before the financial crisis, these inflation targeters had reached a simple consensus supported by studies and experience that said that monetary policy would be most beneficial (or least damaging) to the economy if it focused on delivering stable and negligible growth in consumer prices.
This objective was successfully pursued for many years in Western countries before the crisis. It looked like we had won the game. We began to refer to the entire period with pride as the “Great Moderation.” But as so often, pride came before the fall. True, there had been a moderation, but it was also something of an optical illusion. The focus on consumer prices meant, for example, that rapid credit growth and soaring prices of property and of many financial assets slipped under central banks’ radar. Stabilizing this growth was outside of central banks’ defined objective. The subsequent crisis demonstrated yet again that the schools of economic thought that emphasize just how important it is to keep track of these variables were right on the money.
ack in 1978, the U.S. economic historian Charles Kindleberger, in his now classic book “Manias, Panics, and Crashes: A History of Financial Crises,” pointed out that financial upheavals had almost always been preceded by credit and property price booms. The bad news for monetary policy, however, is that credit booms have not always led to crisis. In other words, we still lack a rule of thumb for the future.
The basic proposition about the importance of credit, asset prices and the extent of financial intermediation in the economy, is slowly establishing itself in central bankers’ post-crisis thoughts—although so far only at the general intuitive level described above. As soon as we start to ask when exactly, and at what level, the rate of growth of credit aggregates or asset prices start to become risky, or how large a leverage ratio and how high a risk mark-up are sustainable, we have no clear answers.
Moreover, we are frequently asking fundamental questions that we thought we had already answered: What prices should we actually target? How should we define new price indexes? Hacking at the foundations like this is painful in any field of study. Try asking a monetary expert for a precise definition of money. Where does money start and end? The layman may be surprised to learn that the answer is not necessarily clear cut.
If this line of thinking is correct, it will require central bankers to change their view of the world. They will have to accept the previously rejected view that home purchases are normal consumer expenditures and therefore we should stop drawing a dividing line between property (and perhaps certain other) prices, and the prices of consumer goods and services.
Revolution, though, is not on the cards. We are not turning all the existing knowledge on its head. No one is saying, for example, that high or higher inflation would be a good thing. Mercifully, IMF chief economist Oliver Blanchard’s suggestion in that direction quickly disappeared. Inflation targeting, it seems, will be modified rather than abandoned.
Similarly important questions with no clear answers are arising in the currently fashionable area of so-called financial stability. Again, the public may be surprised to hear that we still have no fixed definition of exactly what financial stability is. We know all too well what financial instability is not, but we don’t know how to define the opposite in elegant and understandable terms. And we are even less able to define the tools for achieving this coveted goal of financial stability.
This new thinking will be much more relevant in the long term than the torrent of malignant ideas for regulatory micromanagement of specific markets and financial institutions that has been pouring out since the crisis erupted. It is unfortunately far easier to get people excited about bankers’ pay or hedge fund regulation than how to recalibrate monetary policy.
In the language of economics, the market for these ideas is unsaturated, hungry and full of promise. It offers good long-term returns on both the national and international level, as no one has so far established a clear lead in answering them. If any revolutionary papers come out in this area, I’d be grateful if you could forward them to my central bank.