Brief history of time spent inflation targeting

This pulls together tweets that I sent on the history of inflation targeting, having read this article in the New York Times.  Warning:  this is a highly subjective, UK-centric and stream-of-consciousness, and still very brief ‘history’.

A key thing to recall about inflation targeting was that it was about targeting the only thing that central banks had not yet tried targeting and failed.  It came after broken promises to target the relative price of money and gold;  the exchange rate;  and the growth rate of money aggregates;  even after periods when, confused about the difference between an instrument and a target, central banks ‘targeted’ the interest rate.

That statement leaves out nominal GDP targeting.  Despite elegant works by Meade and others, this never seemed to be a runner at the time.

Another feature of inflation targeting, remembering the haste with which it was embarked on, particularly in the UK, was ‘we have to target something, inflation is something, so we have to target inflation’.

At the outset, what seemed scary about doing it was the notion that you can just promise to target the thing that policy really cares about, rather than specifying a value for an intermediate target like money or the exchange rate.

One way of interpreting this new ‘promise’ was:  ‘we won’t tie our hands, because we’ve tried that before, and found that we always have to untie them again;  so instead we will just do it.’  That borrows from Bennet McCallum’s use of the Nike advertising campaign back in the day:  instead of making a commitment, just do good policy.

Naturally, there were sceptics.  Why would markets believe a promise just to get inflation down, when promises to keep intermediate targets had been broken?  The answer was that the lack of resolve that had led to those past failures had their ultimate cause in the variable link between intermediate targets and the ultimate goal, meaning that there were times when, with respect to the ultimate goal, the intermediate target would be better broken.  There was no better demonstration of that than the UK’s exit from the ERM in 1992 which precipitated inflation targeting.

These flaws with intermediate targeting were known at the time, but the dominant view was that the credibility benefits of sticking to a verifiable intermediate target trumped the credibility costs of promising to do something that was occasionally harmful.

I wonder too if part of the reason for pre-inflation targeting strategies was the lack of understanding about what caused inflation.  Money growth and exchanges rates were a monetary policy phenomenon, but inflation was to do with costs, trade unions, oil prices, and lots of stuff that wasn’t monetary policy.  So how could a promise be framed in terms of a variable so little under central bank control?

Subsequently, inflation targeting central bankers enjoying the good times of macro stability would crow about the optimality of their regime, but the benefits of final goal targeting were not at all universally subscribed to at the outset.

Another aspect of the history not mentioned in that NYT piece is the shift from lexical mandates that stressed the primacy of the inflation goal, using ‘subject to’ texts to mention other goals associated with the real economy, towards mandates that emphasised the trade-offs that existed between inflation and other goals.

In my opinion the ‘subject to’ language was always nonsense.  In responding to shocks that did not generate a trade-off, the ‘subject to’ clause was redundant.  Stabilising inflation would stabilise other goals automatically.  In circumstances when there was a trade-off, the ‘subject to’ clause was simply wrong, directing policy, essentially, to ignore the trade-off to the detriment of the economy.

But ‘subject to’ probably seemed necessary at the outset given the worries about our monetary policy misbehaviour in the past, the sense that simply promising to hit your final goal sounded a bit like magic, and the need to sound like you had engaged conservative central bankers, and not lily-livered ones worried about unemployment.  Who, in the aftermath of our ejection from the ERM, could imagine a Chancellor declaring that ‘we will henceforth target a weighted sum of the variance of inflation and resource utilisation’?  Though that is precisely where the logic of giving up on intermediate targets leads, ultimately.

Central bankers did slowly become bolder and less confusing about the trade-off language.  Two reasons:  1) They were emboldened by the apparent taming of inflation, and perhaps felt that there was a credibility dividend that could be spent.  2) There was a torrent of applied monetary policy work on evaluating regimes articulating why even in the simplest models dual goals were warranted [culminating in Woodford’s Interest and Prices].

But initially – and still occasionally – multiple goal pursuit was hidden in tricksy language about there being only one target, just variations in the horizon at which it was optimal to meet it.

The most recent chapter in inflation targeting history has been the great financial crisis, which has had many consequences.

The first is that it retroactively boosted a line of thought that held that inflation targeting had led to a neglect of asset prices, and this had brought about financial instability.  The second is that it thrust interest rates at the zero bound, essentially handing back to fiscal authorities the job of hitting the inflation target.  The third was a bursting of the bubble of thought that had clearly greatly exaggerated the contribution of inflation targeting and central bank independence to macroeconomic stability.  A fourth is the unprecedented level of political controversy generated by persistently low interest rates, and quantitative easing, both of which are resented in some quarters as conspiracies to aid the rich, borrowers, or both.

The criticism that inflation targeting ignored asset prices – the BIS were the most persistent advocates of this – was always wrong.  It was sometimes based on a misunderstanding of the capability and inclination of inflation targeters to respond to multiple goals, to things not defined in their headline quantified index.  It also exaggerated the power of monetary policy to do anything about what, in essence, was a ‘real’ and not a ‘monetary policy’ phenomenon, whose root cause lay in inadequate regulation, not loose monetary policy.  This critique therefore misconstrued symptoms as causes.  The focus on fine tuning the details of inflation targeting practice, and lack of focus on regulation were both caused by a failure to see the risks building up in the system.

The accidental return of the job of hitting the inflation target to the fiscal authorities [who had delegated it in the first place] was unfortunate, and came at a time when those authorities faced their own credibility issues attempting it and when fiscal policy was so politicised that fiscal branding took precedence over confronting the technical problem of assisting monetary policy.

A highlight of the bubble bursting on the contribution of monetary policy frameworks to stability was of course the UK Bank of England conference on the ‘Great Stability’, which took place in September 2007, and was punctuated by the senior attendees leaving to follow up the breaking news they had seen on their Blackberries.

This broad brush history misses out some of the details that transfixed central bank economists.  The developments in communication towards increased, but still incomplete transparency.  The use and abuse of measures of ‘core inflation’.  Discussion of point versus range targets;  of price level versus inflation targets.  Developments in the method of estimating price increases and biases that remained.  The spread of DSGE models in central banks.  The curious phenomenon of the ECB and Fed inflation targeting quietly while saying that they weren’t.

It also begs questions about the future:  how inflation targeting should be reformed to better weather future macroeconomic storms.  Much ink has been spilled on that, so I won’t repeat here.




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6 Responses to Brief history of time spent inflation targeting

  1. Spencer says:

    All economists are really, really, STUPID. And stupid is just the name for those who are ignorant and arrogant, or deaf, dumb, and blind. Rates-of-change in money flows = aggregate monetary purchasing power (were N-gDp is just a proxy).


  2. Spencer says:

    POSTED: Dec 13 2007 06:55 PM |
    The Commerce Department said retail sales in Oct 2007 increased by 1.2% over Oct 2006, & up a huge 6.3% from Nov 2006.
    10/1/2007,,,,,,,-0.47,… -0.22 * temporary bottom
    11/1/2007,,,,,,, 0.14,,,,,,, -0.18
    12/1/2007,,,,,,, 0.44,,,,,,,-0.23
    1/1/2008,,,,,,, 0.59,,,,,,, 0.06
    2/1/2008,,,,,,, 0.45,,,,,,, 0.10
    3/1/2008,,,,,,, 0.06,,,,,,, 0.04
    4/1/2008,,,,,,, 0.04,,,,,,, 0.02
    5/1/2008,,,,,,, 0.09,,,,,,, 0.04
    6/1/2008,,,,,,, 0.20,,,,,,, 0.05
    7/1/2008,,,,,,, 0.32,,,,,,, 0.10
    8/1/2008,,,,,,, 0.15,,,,,,, 0.05
    9/1/2008,,,,,,, 0.00,,,,,,, 0.13
    10/1/2008,,,,,,, -0.20,,,,,,, 0.10 * possible recession
    11/1/2008,,,,,,, -0.10,,,,,,, 0.00 * possible recession
    12/1/2008,,,,,,, 0.10,,,,,,, -0.06 * possible recession
    Trajectory as predicted:
    Bankrupt u Bernanke SHOULD HAVE SEEN THIS COMING. IN DEC. 2007 I COULD.

  3. Spencer says:

    I not only forecasted the recession, but when it would occur. Every boom/bust since 1941 is entirely the Fed’s fault.

    Bankrupt u Bernanke was the sole cause of the Great Recession. He should be in prison along with some other flim-flam men.

    At the height of the stock market bubble, Federal Reserve Chairman Alan Greenspan initiated a “tight” monetary policy (for 31 out of 34 months).

    Note: A “tight” money policy is defined as one where the rate-of-change in monetary flows (our means-of-payment money times its transactions rate of turnover) is no greater than 2-3% above the rate-of-change in the real output of goods & services.

    Greenspan then wildly reversed his “tight” money policy (at that point Greenspan was well behind the employment curve), & reverted to a very “easy” monetary policy — for 20 consecutive months (i.e., despite 14 raises in the FFR (June 30, 2004 until January 31, 2006), -every single rate hike was “behind the inflationary curve”). I.e., Greenspan NEVER tightened monetary policy.

    And as soon as Bernanke was appointed to the Chairman of the Federal Reserve, he immediately initiated, his first “contractionary” money policy for 29 consecutive months (coinciding both with the end of the housing bubble, & the peak in the Case-Shiller’s National Housing Index in the 2nd qtr of 2006 @ 189.93), or at first, sufficient to wring inflation out of the economy, but persisting until the economy plunged into a depression).

    Note: A “contractionary” money policy is defined as one where the rate-of-change (roc’s) in monetary flows (our means-of-payment money times its transactions rate of turnover) is less than 2% above the rate-of-change in the real output of goods & services (for this entire 2 year period roc’s in MVt, proxy for inflation, were NEGATIVE (less than zero!).

    Money market & bank liquidity continued to evaporate despite the FOMC’s 7 reductions in the target FFR (which began on 9/18/07 until 4/30/08). Bernanke didn’t initiate an “easy” money policy, and continued to drain liquidity despite Bear Sterns two hedge funds that collapsed on July 16, 2007, & immediately thereafter filed for bankruptcy protection on July 31, 2007 — as they had lost nearly all of their value.

    BuB didn’t ease until Lehman Brothers later filed for bankruptcy protection (& it was one the Federal Reserve Bank of New York’s primary dealers in the Treasury Market), on September 15, 2008. The next day AIG’s stock dropped 60%. I.e., BuB maintained his “tight” money policy [i.e., credit easing or mix of assets, not quantitative easing –injecting new money & reserves].

    The FOMC’s “tight” money policy was due to flawed Keynesian dogma (using interest rate manipulation as a monetary transmission mechanism), rather than by using open market operations of the buying type to expand legal reserves & the money stock — and thus AD.

    On January 10, 2008 Federal Reserve Chairman Ben Bernanke pontificated: “The Federal Reserve is not forecasting a recession”.

    Bernanke subsequently initiated the economy’s coup de grâce during July 2008 (his second ultra-contractionary money policy). The 3rd contractionary policy was the introduction of the payment of interest on excess reserves, which destroyed non-bank lending/investing (the 1966 S&L credit crunch is the economic paradigm and precursor).

    Note aside: the 2 year rate-of-change (roc) in MVt (which the FED can control – i.e., the roc in nominal-gDp), peaked in the 2nd qtr of 2006 @ 12%. Bernanke let it fall to 8% by the 4th qtr of 2007 (or by 33%). N-gDp fell to 6% in the 3rd qtr of 2008 (another 25%). N-gDp then plummeted to a -2% in the 2nd qtr of 2009 (another – 133%).

    By withdrawing liquidity from the financial markets, risk aversion was amplified, haircuts were increased, additional and/or a higher quality of collateral was required, liquidity mis-matches were multiplied, funding sources dried up, long-term illiquid assets went on fire-sale, non-bank deposit runs developed, withdrawal restrictions were imposed, forced liquidations lowered asset values, counterparties’ credit default risks were magnified– all of which contributed a general crisis of confidence & frozen financial markets (regulatory malfeasance was a subordinate factor).

    I.e., Alan Greenspan didn’t start “easing” on January 3, 2000, when the FFR was first lowered by 1/2, to 6%. Greenspan didn’t change from a “tight” monetary policy, to an “easier” monetary policy, until after 11 reductions in the FFR, ending just before the reduction on November 6, 2002 @ 1 & 1/4% (approximately coinciding with the bottom in equity prices).

    I.e., Greenspan was responsible for both high employment (June 2003, @ 6.3%), & high inflation (rampant real-estate and commodity speculation).

    And BuB NEVER eased. BuB then relentlessly drove the economy into the ground, creating a protracted un-employment, & under-employment rate, nightmare.

  4. Spencer says:

    As I said one year ago (after the experience with the 1st rate hike): “The economy is behaving exactly as it is programed to act. Raise the remuneration rate and in a twinkling the economy subsequently suffers. The Fed’s 300 Ph.Ds. in economics don’t know the differences between money and liquid assets.”
    Apr 28, 2016. 11:25 AMLink

    – Michel de Nostredame

  5. Spencer says:

    In “The General Theory of Employment, Interest and Money”, John Maynard Keynes’ opus “, pg. 81 (New York: Harcourt, Brace and Co.), gives the impression that a commercial bank is an intermediary type of financial institution (non-bank), serving to join the saver with the borrower when he states that it is an “optical illusion” to assume that “a depositor & his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.”

    In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term non-bank in order to make Keynes’ statement correct.

  6. Spencer says:

    Never are the commercial banks, DFIs, financial intermediaries (conduits between savers and borrowers), in the savings-investment process. From an accounting belvedere, commercial banks do not loan out existing deposits, saved or otherwise. All domestic bank-held savings, $10T +, are un-used and un-spent, lost to both investment and consumption, indeed to any type of payment or expenditure. I.e., unlike the non-banks, the commercial banks pay for their new earning assets with new money.

    Unless pooled savings are expeditiously activated, and put back to work via non-bank conduits, a dampening economic force is continually exerted. It is not benign, it matastizes.

    There was a monetary offset – up until 1981 (the saturation of DD Vt). No longer. Secular strangulation (chronically deficient AD), and Alfred Marshall’s cash-balances theories, result in an excess of savings over investment, which will accelerate. Transfer payments (more leakages), will ultimately consume us.

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