Stark on pre-crisis reference model

Jürgen Stark, ECB’s chief economist looks at the pre-crisis economic thinking:

In discussing the current macroeconomic framework, I will focus on the institutional aspects that have proved successful, in particular, from the European perspective. These are central bank independence, the centrality of price stability for monetary policy and the need to adopt a medium-term, rules-based perspective in the conduct of monetary and fiscal policies. The financial crisis has not contested or discredited these three principles.

However, it is certainly true that other aspects of the international consensus framework merit some deep re-thinking. I will take this opportunity to share my thoughts on four such elements, namely inflation targeting, central banking as risk management, monetary policy and asset prices, and fiscal policy.

On inflation targeting he says (he reviews New Keynesian framework before this which has the same ideas):

The reference model has been at the heart of inflation targeting approaches. In brief, inflation targeting can be summed up as follows:

First, take inflation and output gap forecasts as summary statistics of the state of the economy. Second, ignore a host of variables, particularly money and credit. Assume that these adjust to the state of the economy, but do not influence it independently. Third, fine-tune the policy instrument so that inflation forecasts – whatever the nature of the shocks that might have caused them – are stabilised, and output volatility is minimised, at a pre-set horizon.

It has long been known that it is misleading to limit the information set to output gap and inflation forecasts. Output gaps are ill-defined and cannot be accurately measured. Furthermore, inflation forecasts are not summary statistics of the state of the economy. Different underlying shocks – even though they might lead to the same inflation forecast – can have vastly different implications for policy.

This paper pointed, IT countries fared batter than non-IT countries. But it is not because of IT countries alone.

On central bankers as risk managers he disapproves the IMF’s proposal to raise inflation targets to 4%.

It has frequently been argued that central banks should act as risk managers by organising their framework around events with a high deflationary impact. To minimise the likelihood of deflation, central banks should err on the lax side and aim at significantly higher inflation rates. With this in mind, the IMF asks whether a permanent inflation target of 4% is appropriate. The proposal is nothing less than asking whether in the pursuit of price stability central banks put macroeconomic stability at risk.

 I do see the temptation for governments to ask for higher inflation in order to monetise the dramatic build-up of public debt in nearly all advanced economies. This is why calling on central banks to raise inflation rates permanently is most unhelpful. It deflects from the most pressing problem that, currently, macroeconomic stability is threatened by the unsustainable position of public finances in nearly all advanced economies. I can only reject the idea of raising inflation rates permanently.

In sum, he says raising inflation targets could lead to a permanent rise in inflation trends. And this would do away with the  effort of so many years to lower inflation. Another interesting point is the reference to deflation. A friend just pointed how ECB is clueless when it came to managing a deflation situation in Eurozone. Perhaps it is because of the hyperinflation memories which persist in Europe. So their central banks are more hyperinflation conscious. So Stark does not like the idea. US/Japan have deflation memories and their central banks think about these issues.

For monetary policy and asset prices he says central banks cannot ignore asset prices anymore. A broader approach like ECB which looks at credit and monetary variables is one of the solutions.

On fiscal policy he says:

For many commentators, the financial crisis has underlined the need for a return of the State in managing macroeconomic developments. Of course, together with central bank liquidity support, discretionary government intervention has been key in forestalling a repeat of a 1930s-style depression. However, we are observing a drift in public liabilities that will prove hard to correct with the usual stabilisers. In some countries, this drift actually has nothing to do with the financial crisis. It is rooted in the policy hyper-activism that was already in place before the crisis. And this despite the obvious dangers of an overreactive fiscal stance, which cannot be decided and implemented without long lags.

Concluding lessons

The first lesson to be learned is that central banks need to broaden – not restrict – their overview of the economy. Monetary data are critical in warning against risks that are slow to appear in inflation forecasts. Monetary analysis at the ECB consistently sent early signals that risk was broadly under-priced, when inflation was quiescent and measures of slack were moderate.

The second lesson is that price stability is the only anchor which can pin down the economy in turbulent times. It is not sufficient to guarantee financial stability, but it is certainly necessary to prevent financial instability.


2 Responses to “Stark on pre-crisis reference model”

  1. Welcome Paulina Porizkova As The New Judge In ANTM | Onlymasti Funzone Says:

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  2. Easy Forex – Different Approaches to Forex Intervention | Says:

    […] Stark on pre-crisis reference model « Mostly Economics […]

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