Before the global financial crisis, central bankers thought the pursuit of price stability would deliver low and stable inflation plus steady and sustained economic growth. However, too many policymakers failed to recognise that low inflation on its own provides no guarantee of lasting economic progress.
Yet despite the huge output losses of recent years, adherence to inflation targeting seems stronger than ever. The US and Japan have more formally embraced it and others, including Russia, are set to follow, even though most financial setbacks have nothing to do with high inflation. In 34 separate years since 1831, UK GDP has contracted, yet only in the 1970s and early 1980s was there any connection with rapid price increases.
Inflation targeting may have helped deliver price stability but it provides no guarantee of lasting economic or financial stability. Worse, narrowly defined targeting may have contributed to recent upheavals.
Policymakers should expect long periods when inflation is either well above or well below target
Before the financial crisis, an almost pathological commitment to low and stable inflation left policymakers unable or unwilling to spot the increase in financial risk. They ignored rapid house-price gains, excessive money-supply growth and narrowing credit spreads even though, throughout history, these had provided good warning of future upheavals.
Not all central banks rigidly adhered to a strict inflation target. Some allowed inflation to rise and fall in a bid to hit other objectives. ‘Forward guidance’ emphasises both price stability and the labour market, though as yet, only limited attention has been paid to monetary policy’s role in delivering financial stability.
One reason is the increased emphasis on macroprudential policies to stabilise the financial system. Unfortunately, there are uncomfortable parallels with the incomes policies of the 1970s – designed to stop wage-price spirals at the microeconomic level even though, at the macroeconomic level, persistent stimulus aimed at lowering unemployment only added to inflationary pressures.
Relying on macroprudential policies to deliver financial stability in a world of zero interest rates and central-bank asset purchases offers similar problems: loose monetary policy designed to lift real economic activity and lower unemployment again leads to excessive financial risk-taking.
The lesson from earlier financial bubbles – most obviously Japan in the 1980s and 1990s – is that a failure to tame financial excess ultimately undermines a central bank’s ability to control longer-term inflation.
In the years preceding the global financial crisis, monetary policy would have been better directed at taming excessive leverage than delivering a precision-engineered inflation rate.
The aim of monetary policy now should not be to deliver price perfection or optimum output because excessive risk taking will quickly follow. Central bankers who promise too much end up fostering the kind of behaviour that leads to financial instability. Instead, they should aim for ‘positive ambiguity’ – using monetary policy to deliver a combination of price stability, high output and, importantly, a heightened sense of financial stability.
No single policy instrument can achieve all three objectives simultaneously, of course. But there will be occasions when a central bank should downplay the inflation objective in the pursuit of financial stability. Policymakers should expect long periods when inflation is either well above or well below target. Macroprudential policies alone are unlikely to succeed.
‘Positive ambiguity’ reduces the chances of one-way bets and herd-behaviour dominating financial markets. And given recent experience, that can only be a good thing.
This article was first published on 9 June 2014.