Is inflation targeting – the rule that most of the world’smajor central banks (though not the United States Federal Reserve) use to setinterest rates – in its death throes? Manyanalysts seem to think so.
Mark Carney, currently Governor of the Bank of Canada, hasnot even taken over his new job at the helm ofthe Bank of England, yet he has already announced that he might change theBoE’s policy anchor. In Japan, the Liberal Democrats won December’s generalelection after having promised a more expansionarymonetary policy. And in the US, the Fed has announced that it will keepinterest rates low until unemployment reaches 6.5%.
None of this is as new as it seems. Among rich countries,inflation targeting has been on its way outsince the 2008-2009 financial crisis. The large-scale asset purchases carriedout by the European Central Bank, for example, have little to do with any definitionof inflation targeting.
But inflation targeting has also been losing its hold onpolicymakers in emerging-market economies. Starting in the 1990’s, centralbanks in Brazil, Chile, Mexico, Colombia, Peru, South Africa, South Korea,Indonesia, Thailand, and Turkey adopted varieties of the scheme. But thingschanged with the global financial crisis. In joint researchwith Roberto Chang and Luis Felipe Céspedes, we show that all inflation-targetingcentral banks in Latin America have used a range of non-conventional policytools, including currency-market interventions and changes in reserverequirements. Again, this is a far cry from thetextbook version of inflation targeting.
What comes next? In the developed world, the leading contender to replace inflation targeting isnominal-GDP targeting. This seems to be what Carney has in store for Britain.Under the proposed new system, if the BoE would like to keep inflation around,say, 2%, and expects the trend rate of GDP growth to be 3%, it should announcea target for nominal GDP growth of 5%.
This new regime might help rich-country central banks tokeep their economies suitably stimulated. But, from the point of view ofemerging countries, changing the monetary-policy regime in this way makeslittle sense. Central banks in Asia and Latin America have had three problemswith inflation targeting from the outset, butmoving to nominal-GDP targeting solves none of them.
The first problem concerns capital inflows andexchange-rate appreciation. When rich-country central banks cut interest rates,capital moves south and east. Some inflows are always welcome. But when theflow becomes a flood, the currency strengthens sharply. Commodity exportstypically continue to grow, but industrial and non-traditional exports suffer.
Increasing interest rates only attracts more capital, whilecutting rates can cause the economy, already stimulated by the foreign inflows,to overheat. Faced with this dilemma, many emerging-market countries haveturned to exchange-rate intervention, and then to raising banks’ reserverequirements, in order to make foreign borrowing less attractive.
This is a problem that concerns the composition of output(traditional versus non-traditional exports), not just its level. Moving tonominal-GDP targeting would not make a difference.
The second problem is shared by rich and middle-incomecountries’ central banks: how to ensure that monetary policy addresses the needto maintain financial stability. Inflation targeting concerns itself with theprices of goods and services, not the prices of financial assets. If“irrational exuberance” set in and a bubble developedin real-estate or equities markets, well, so be it, the standard theorymaintains.
After the devastation wroughtby the boom-and-bust cycle of recent years, notmany economists are comfortable with the “so be it”attitude anymore. Nor are many emerging-market countries’ central banks, whichare adopting changes in reserve requirements and loan-to-value ratios, amongother measures, to prick asset-price bubbles intheir early stages.
Advocates of nominal-GDP targeting claim that theseprudential measures could be added to create an extended version of theirpreferred regime. Perhaps, but they could be added to the standardinflation-targeting regime as well. Moving from one system to the other helpslittle in this regard.
The final problem concerns central banks’ role as lenders of last resort in a crisis. This job isespecially important – and difficult – in emerging markets, because asignificant share of debt, both public and private, is typically in foreigncurrency. As a result, lending in crisis situations implies using internationalreserves and providing foreign-currency liquidity. This, too, is alien to the standardtarget-inflation-and-float-the-currency regime. But it would be just as aliento a system in which the central bank targeted nominal GDP and the currencyfloated.
These considerations suggest that the way out does not liein moving from one simple, one-size-fits-all rule toanother. Emerging markets need a monetary-policy regime that takes explicitaccount of capital-flow volatility, asset-price misalignments (including the exchange rate, which isthe price of foreign currency), and the resulting financial instability.
The feedback from these factors to interest rates probablyshould not be the same in tranquil and turbulent times. A comprehensive regime shouldencompass two rules – one for crisis situations and one for “the rest of thetime” – plus explicit guidelines for moving from one to the other and back.
We are far away from beingable to formulate and apply such a rule. But at least the debate has now begun.The floor is open.