Inflation targets
Monetary conundrumsFeb 24th 2005
From The Economist print edition
SourceAmerica's monetary policy is off target“YOU are not here to tell me what to do. You are here to tell me why I have done what I have already decided to do,” Montagu Norman, the Bank of England's longest-serving governor (1920-44), is reputed to have once told his economic adviser. Today, thankfully, central banks aim to be more transparent in their decision making, as well as more rational. But achieving either of these things is not always easy. With the most laudable of intentions, the Federal Reserve, America's central bank, may be about to take a step that could backfire.
Unlike the Fed, many other central banks have long declared explicit inflation targets and then set interest rates to try to meet these. Some economists have argued that the Fed should do the same. With Alan Greenspan, the Fed's much-respected chairman, due to retire next year—after a mere 18 years in the job—some Fed officials want to adopt a target, presumably to maintain the central bank's credibility in the scary new post-Greenspan era. The Fed discussed such a target at its February meeting, according to minutes published this week. This sounds encouraging. However, the Fed is considering the idea just when some other central banks are beginning to question whether strict inflation targeting really works.
At present central banks focus almost exclusively on consumer-price indices. On this measure Mr Greenspan can boast that inflation remains under control. But some central bankers now argue that the prices of assets, such as houses and shares, should also somehow be taken into account. A broad price index for America which includes house prices is currently running at 5.5%, its fastest pace since 1982 (see article). Inflation has simply taken a different form.
Should central banks also try to curb increases in such asset prices? Mr Greenspan continues to insist that monetary policy should not be used to prick asset-price bubbles. Identifying bubbles is difficult, except in retrospect, he says, and interest rates are a blunt weapon: an increase big enough to halt rising prices could trigger a recession. It is better, he says, to wait for a housing or stockmarket bubble to burst and then to cushion the economy by cutting interest rates—as he did in 2001-02.
And yet the risk is not just that asset prices can go swiftly into reverse. As with traditional inflation, surging asset prices also distort price signals and so can cause a misallocation of resources—encouraging too little saving, for example, or too much investment in housing. Surging house prices may therefore argue for higher interest rates than conventional inflation would demand. In other words, strict inflation targeting—the fad of the 1990s—is too crude.
Oceans apart
In the past, asset prices were less of an issue. House prices took off at the same time as inflation, so both required the same monetary medicine. But in recent years inflation has remained modest, while share and house prices have surged. Thanks to low inflation, central banks have held real interest rates at historically low levels. But the extra liquidity created by low interest rates is now more likely to spill over into the prices of homes or excess credit-growth than into consumer prices. Inflation used to be described as too much money chasing too few goods. In a world where the supply of goods is more elastic—either because of technological advances or new sources of supply such as China—inflation becomes too much money chasing too few assets.
Some central bankers in Britain, continental Europe, Australia and New Zealand have said publicly that monetary policy needs to take more account of asset prices and that sometimes interest rates may need to rise by more than if the sole objective were to keep consumer-price inflation within target.
In a recent article, Otmar Issing, the chief economist of the European Central Bank (ECB), threw down the gauntlet to the Fed. He argued that it is hard, but not impossible, to identify when asset prices are overshooting; there are benchmarks against which valuations can be judged. If prices look frothy, central banks should signal their concern. And they should certainly avoid contributing to “unsustainable collective euphoria”. Central banks should also look out for the surge in money and credit which often accompanies a bubble.
In congressional testimony last week, Mr. Greenspan did not once mention the words “money” or “liquidity”. Yet America is overflowing with money. Partly as a result, global liquidity last year grew at one of the fastest rates on record. In contrast to the Fed, the ECB has been warning about excessive growth in liquidity in the euro area and the risk of unsustainable increases in house prices. This is how central banks should talk: threatening to take away the punch bowl just as the party gets going, rather than offering to serve an even stronger brew.
During the past century, every monetary rule has eventually broken down: the gold standard, the Bretton Woods system of fixed exchange rates, and monetary targeting. Now it seems that strict inflation targeting may not be a panacea either. It would be foolish for the Fed to sign up for crude inflation targeting just as it goes out of fashion.
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