The death of Inflation Targeting..

A food for thought column by Jeff Frankel. The title is questionable though. We keep saying things like inflation is dead, business cycles are dead, beta is dead, etc. Most of the time  dead things to come back with a vengeance.

And now claims of Inflation targeting is dead.

He starts with how IT came up and has performed over the years. The real challenge came in 2008 crisis.

He says the major reasons for  IT death is its failure to focus on fin stability and inappropriate responses to trade shocks. What he says is very different. The usual response for central banks when imported inflation is rising is to raise interest rates. The idea is imported inflation leads to overall rise in inflation. To lower inflation, we need higher rates. But higher rates leads to appreciation of the currency (as flows come in) leading to worsening of exports and trade balances. As per Frankel it is better to lower rates which will lead to depreciation of the currency. This will lead to higher exports and lower imports (I am actually not sure whether I have read it correctly) :

While the lack of response to asset market bubbles was probably the biggest failing of Inflation Targeting, another major setback was inappropriate responses to supply shocks and terms of trade shocks.

An economy adjusts better if monetary policy responds to an increase in the world prices of its exported commodities by tightening enough to appreciate the currency. But CPI targeting instead tells the central bank to appreciate in response to an increase in the world price of the imported commodities – exactly the opposite of accommodating the adverse shift in the terms of trade. For example, it is widely suspected that the reason for the otherwise-puzzling decision of the European Central Bank to raise interest rates in July 2008, as the world was sliding into the worst recession since the 1930s, was that oil prices were just then reaching an all-time high. Oil prices get a substantial weight in the CPI, so stabilising the CPI when dollar oil prices go up requires appreciating versus the dollar.

IT is survived by the gold standard, an elderly distant relative. Although some eccentrics favour a return to gold as the monetary anchor, most would prefer to leave this relic of another age to its peaceful retirement, reminiscing over burnished fables of its long lost youth.

Hmm.. Very interesting. Does this apply to all? Take India’s case. Oil forms around 15% of WPI inflation basket. If world oil prices go up, this will lead to overall rise in inflation and further to inflation expectations. Should RBI be lowering rates seeing the rise in WPI inflation? Does it imply that currency depreciation via lower interest rates will be more effective compared to monetary transmission via higher interest rates? Those in rate cutting camp might want to look at this argument further…

What will take over from IT?

What will replace Inflation Targeting as preferred nominal anchor? A dark horse candidate, Product Price Targeting (PPT), is particularly relevant for small open economies that experience high terms of trade volatility (Frankel 2012). Product Price Targeting would stabilise an index of producer prices (which includes export commodities) rather than an index of consumer prices (which includes import commodities). Thus it would not, like IT, have the problem of responding perversely to terms of trade shocks (Frankel 2011). IT sometimes gave the public the misleading impression that it would stabilise the cost of living even in the face of supply shocks or terms of trade shocks, over which central banks in fact have no control.

The leading candidate to take the position of preferred nominal anchor is probably Nominal GDP Targeting. Even though it has gained popularity rather suddenly, over the last year, the idea is not new. It had been a candidate to succeed money targeting in the 1980s, because it did not share the latter’s vulnerability to velocity shocks (i.e., shifts in money demand) (Frankel 1990, 2007). Under certain conditions, it dominates not only a money target (due to velocity chocks) but also a price level target (if supply shocks are large) (Frankel and Chinn 1995, Frankel 1997, Frankel et al. 2008). First proposed by James Meade (1978), it attracted the interest in the 1980s of such eminent economists as Jim Tobin (1983), Charlie Bean (1983), Bob Gordon (1985), Ken West (1986), Martin Feldstein and Jim Stock (1994), Bob Hall and Greg Mankiw (1994), Ben McCallum and Edward Nelson (1998), among others.

Hmm. This PPT thing is interesting. Need to read more on PPT. NGDP has been on the radar for a while..

Meanwhile, here is RBNZ governor where IT started saying Inflation targeting is a robust framework..

Need to do lot of thinking on this. Exciting and trying times for C-bankers…

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