Daniel L. Thornton of St Louis Fed in a short paper makes a case for inflation first monetary policy. There is a big discussion post-crisis on what should a central bank target – inflation, growth, financial stability etc.
He says monetary policymakers must pursue a hierarchical target with price stability at tops
I argue that there are several reasons central banks might want to operate under what Laurence Meyer calls a “hierarchical mandate,” that is, where the principal objective is price stability and policymakers do not pursue economic stabilization policy unless their price stability objective has been achieved.
The first reason monetary policymakers might be well served to operate under a hierarchical mandate is that changes in the money supply have no long-run effects on the economy.
The second reason is that the policy option faced by policymakers is a function of the structure of the economy, the source of the shock, and whether the shock is temporary When faced with a supply shock, an attempt to mitigate its effect on prices exacerbates the effect on output and an attempt to mitigate its effect on output exacerbates the effect on prices. A hierarchical mandate would alleviate concerns that policymakers might jeopardize their long-run price stability objective for some short-run gain in economic stability because of political pressure or for other reasons.
Finally, policymakers might prefer a hierarchical mandate because the more firmly anchored are inflation expectations, the more aggressively policymakers will be able to pursue economic stability.
Though am not sure whether there will be many takers for this inflation first idea.Before crisis, the basic idea was that price stability is a necessary condition (some even thought it as sufficient condition as well) for financial stability. Hence focus was on price stability and pre crisis inflation levels were really stable and non-volatile. Hence, it was thought that financial markets are stable as well. Central Bankers either just practiced price stability or asked others to follow it.
We all know what followed was anything but stable.
What is also ironical is how quickly price stability became a vogue. Just after Volcker showed in late 1970s that inflation could be tamed by monetary policy all central banks jumped onto it. But think about financial instability. It has been there since ages but nobody wants to do something meaningful in this area.
This does not imply price instability can be tolerated. Price Stability is a very important goal. But financial stability is a very important objective as well. You cannot ignore it anymore.
Whether central banks like it or not they will always be responsible for financial stability. One major reason is central banks act as lender of last resort. So in case of any problem in fin markets the attention is always going to be on central banks. So, it is always better to give them proper responsibility. They should be given more tools apart from interest rates to manage financial stability. The tools should be sharper and not just involve writing financial stability reports (or issuing sermons as Mervyn King calls it).
I don’t think hierarchical mandates would work. Price Stability and Financial Stability would go hand in hand. This makes things complicated but that is reality for you. We were thinking monetary policy is so simple (again boring as Mervyn King called it)- just look at price stability. Economics is pretty complicated and policymaking is also going to be complicated.
It is useful to simplify things but not oversell it. I think everything was oversold before this crisis – inflation targeting, price stability, monetary policy only, efficient financial markets etc.