Australia’s central bank governor is now appearing in the world press as something of a hero for putting interest rates up recently in defiance of world trends. Today he is featured in many finance home pages for his statement that the RBA cannot afford to be timid in putting rates up in the current months. This has raised expectations that we are in a race to get the target rate up towards their so-called neutral rate sometime soon. So almost rock star status for our central bank governor. Pity, the whole paradigm he is representing is destructive and helped get us into this mess in the first place. This blog explains why inflation targeting per se is not the issue. The problem is that fiscal policy becomes subjugated to the monetary policy dominance. This passivity manifests as the obsessive pursuit of budget surpluses which allegedly support the inflation-first stance. But this policy strategy is extremely damaging in real terms and will provoke another debt-bust cycle sometime in the future.
Today, the RBA governor gave a speech on the The conduct of monetary policy in crisis and recovery in Perth. He started by describing the medium-term targeting framework that the RBA uses.
He rehearsed the standard NAIRU rhetoric that:
… in the long run, monetary policy is about the value of money – that is, prices … [but] … in the short term, monetary policy changes do affect the real economy, because they affect aggregate demand.
This is the famous classical dichotomy that ruled economic theory prior to the Great Depression. It refers to the assertion that the real side of the economy (output and employment) are completely separable from the nominal (money) side. The latter only determines prices (via the Quantity Theory) and the former is driven by the supply side.
So nominal spending growth will only influence prices because the economy is always assumed to be at full employment. The other way of expressing this is via the neutrality rule – that money is neutral with respect to real variables and only drives the the price level.
The policy prescription is simple – government attempts to increase aggregate demand will be inflationary and will not reduce unemployment. The less extreme versions of the theory say that short-run growth can be influenced by macroeconomic policy changes (because they claim there are sticky prices) but once prices adjust, neutrality sets in and renders policy futile.
The RBA has been significantly influenced by the NAIRU concept. It conducts monetary policy in Australia to meet an openly published inflation target. It uses its control of the cash rate (market rate on overnight funds) to influence short-term interest rates. To what extent is the RBA working within its legal charter, which includes the maintenance of full employment?
In September 1996, the Treasurer and Reserve Bank Governor issued the Statement on the Conduct of Monetary Policy, which set out how the RBA was approaching the attainment of its three identified policy goals. It elaborated the adoption of inflation targeting as the primary policy target. The 1996 Statement said the RBA:
… adopted the objective of keeping underlying inflation between 2 and 3 percent, on average, over the cycle … These objectives allow the Reserve Bank to focus on price (currency) stability while taking account of the implications of monetary policy for activity and, therefore, employment in the short term. Price stability is a crucial precondition for sustained growth in economic activity and employment.
The rest of the text emphasised the need to target inflation and inflationary expectations and the complementary role that “disciplined fiscal policy” had to play. There was no discussion about the links between full employment and price stability except that price stability in some way generated full employment even though the former required disciplined monetary and fiscal policy to achieve it. In a stagflation environment if price spirals reflect cost-push and distributional conflict factors, such an approach can surely never work. So the RBA will always control inflation by imposing unemployment.
How does the RBA answer this apparent contradiction? The RBA says that it only has to meet an average inflation target over a business cycle. The Head of Economic Analysis at the RBA argued in 1999 said that the Bank is sensitive to the state of capacity in the economy when it pursues a change of interest rates aiming at the inflation target (I cannot link to this document anymore – it is Malcolm Edey (1999) Monetary Policy in Australia, published by the RBA).
Consider, for example, a situation in which inflation is regarded as likely to be too high. A rise in interest rates may will help to reduce inflation but can also be expected to reduce growth. How far and how quickly interest rates should be raised will depend partly on how the economy is performing at the time. If the economy is operating with very little surplus capacity or is overheating, a fairly rapid rise in interest rates might be called for; if, on the other hand, there is significant surplus capacity in the economy, the appropriate increase in rates might be more gradual. Thus it makes sense for policy to take account of short-run cyclical developments in pursuing the inflation target.
But in the next paragraph, Edey (1999) says that the trade-off between inflation and unemployment is not a long-run concern because, following NAIRU logic, it simply doesn’t exist.
Ultimately the growth performance of the economy is determined by the economy’s innate productive capacity, and it cannot be permanently stimulated by an expansionary monetary policy stance. Any attempt to do so simply results in rising inflation. The Bank’s policy target recognises this point. It allows policy to take a role in stabilising the business cycle but, beyond the length of a cycle, the aim is to limit inflation to the target of 2-3 per cent. In this way, policy can provide a favourable climate for growth in productive capacity, but it does not seek to engineer growth in the longer run by artificially stimulating demand.
The RBA is silent, however, about the stock of long-term unemployed that exists beyond the cycle. The empirical evidence is clear that the economy has not provided enough jobs since the mid-1970s and the conduct of monetary policy has contributed to the malaise. The RBA has forced the unemployed to engage in an involuntary fight against inflation and the fiscal authorities have further worsened the situation with complementary austerity.
After explaining why the RBA cut rates quickly from 7.5 per cent to 3 per cent from September 2007 into early 2009, the Governor said it was time to think of monetary policy in the recovery.
Now that the risks of really serious economic weakness have abated, however, the question arises as to how to configure monetary policy for the recovery. We have said that, over time, interest rates will need to be adjusted towards a more normal setting as the economy recovers. A step in that direction was taken last week … If we were prepared to cut rates rapidly, to a very low level, in response to a threat but then were too timid to lessen that stimulus in a timely way when the threat had passed, we would have a bias in our monetary policy framework. Experience here and elsewhere counsels against that approach … In conducting monetary policy during this expansion, our objectives will be the same as they were in the previous one: to keep inflation low …
While market commentators are “pricing in” (horrible jargon) at least a 50 basis points rise over the next two months, there is now a feeling around (today) that the RBA might hike more substantially. This is in contrast to comments made last week by US Federal Reserve chairman Bernanke who said that low interest rates “will likely be warranted for an extended period.”
Anyway, how did we get into this ridiculous policy situation where central bankers are like rock stars even though their policy decisions hurt the most disadvantaged workers in our communities?
In Chapter 6 of my recent book with Joan Muysken – Full employment abandoned, we consider the inflation first approach of central banking in detail. We call it the new mantra of macroeconomics.
The approach emerged out of the policy vacuum that was left as most OECD governments abandoned their commitment to full employment, variously in the 1970s. The new policy framework took some time to emerge and its manifestation was not uniform across all countries. But essential common elements can be identified that have defined macroeconomic policy making, especially since the 1990s.
The rise of Monetarism occurred as the world economies were struggling to absorb the consequences of the OPEC oil price shock in 1973. The cost shocks posed the problem of how the real income losses were to be shared between labour, capital and government. Many economies failed to accomplish this absorption in a consensual way and the distributional struggles that ensued further fuelled the inflation process.
The 1970s was the battle of mark-ups period par excellence. However, neoclassical macroeconomists opportunistically seized the serendipitous moment and elevated the forecasts of the NAIRU (dumb) gurus Edmund Phelps and Milton Friedman to centre stage. In doing so they were able to resurrect into the policy domain the pre-Keynesian natural rate approaches that had been discredited during the Great Depression.
In this momentous policy shift, it was overlooked that the Phelps- Friedman account of the dangers of continued full employment, inasmuch as they had any relevance, rested on demand side shocks feeding into an expectations spiral rather than a supply side shock provoking distributional conflict and incompatible claims.
Despite this clear anomaly, the Keynesian economists gave in with barely a whimper and thus allowed the Monetarists to reinstate their faulty logic as the new mainstream approach to economic policy making.
By the late 1970s, many economists within this new orthodoxy considered that inflation had become the number one economic problem. With labour markets slack after the stagflation period, they focused their attention on the persistence of inflationary expectations as the on-going source of the inflation.
The misadventure in the 1980s started with the Monetarist doctrine of monetary control, which was a direct application of the discredited Quantity Theory of Money, being interpreted literally by policy makers.
The aim was to automate monetary policy by forcing the money supply to follow some long-run real output growth path. If this trend growth rate was 4 per cent per annum, and a 2 per cent inflation rate was desired, then the monetary growth target would be set at 6 per cent per annum. Maintenance of that growth volume would result in stable macroeconomic conditions.
The erroneous assumptions underlying this experiment were that the monetary authorities actually had control over the money supply and that there was a solid connection between the volume of money and nominal gross domestic product (that is, velocity was stable and predictable). These assumptions were simply assertions derived from the Quantity Theory of Money. Velocity was constructed as being a stable trending variable moving over time in response to technology changes in banking and elsewhere (for example, payments methods).
Many OECD countries explicitly adopted monetary targeting as their monetary policy framework, including the US, Australia, Canada and the UK. The monetary targeting experiment during the 1980s failed everywhere as measured velocity proved to be highly volatile, as different measures of money moved in different ways and as commercial banks and other financial intermediaries innovated around regulations imposed by the monetary authorities.
As a consequence of the failure of monetary targeting, monetary authorities in many OECD countries reconstructed their approach to monetary policy during the 1990s by introducing regimes that targeted the inflation rate directly – or, similarly, regimes that placed a large and explicit emphasis on inflation. In this chapter we will evaluate this development.
What are the main arguments made by the proponents of inflation targeting and the alleged benefits of the monetary policy framework? In our book we characterise the shift to inflation targeting as the triumph of the NAIRU ideology.
Once the monetary targeting experiment of the 1970s and 1980s was abandoned as a failure, the monetary authorities in many OECD countries reconstructed the conduct of monetary policy during the 1990s by introducing regimes that targeted the inflation rate directly. The emphasis became one of directly maintaining price stability.
Several countries formally adopted inflation targeting. The Reserve Bank of New Zealand adopted inflation targeting first in 1990. This is no surprise given the country had been undergoing a vast neo-liberal unwinding of its Keynesian Welfare State since the mid-1980s. Canada was next to formally announce inflation targeting guidelines in February 1991 then Israel in December 1991, followed by the United Kingdom in 1992, Sweden and Finland in 1993. Australia and Spain followed in 1994.
Inflation targeting refers to a monetary policy framework where the central bank explicitly and publicly declares a target inflation (or price) quantum and changes short term interest rates to manipulate economic activity (and inflationary expectations) in order to maintain actual inflation within the pre announced target, which may be represented by an acceptable range.
Inflation targeting as described is differentiated from the use of a quantitative definition of price stability as in the case of the European Central Bank (ECB). The latter approach may require medium term compliance but cannot be construed as something the ECB targets given that the ECB does not act in a rule driven way if the inflation rate exceeds some threshold.
Hence, although the practice of monetary policy may differ somewhat between countries, they all share a strong focus on maintaining a low and stable inflation. This is consistent with the belief in a NAIRU view of the world, whereby there is some unique real level of activity (summarised in either output or employment) that the economy gravitates to, and any episodes of price disinflation will only temporarily push the real economy below these levels.
The move to inflation targeting, be it formally announced or more pragmatically implemented, reflecting an overwhelming faith in NAIRU ideology, marked the final stages in the abandonment of full employment in OECD countries. The modern policy framework is in contradistinction to the practice of governments in the Post World War II period to 1975 which sought to maintain levels of demand using a range of fiscal and monetary measures that were sufficient to ensure that full employment was achieved.
Over this period – the Keynesian era of full employment, unemployment rates were usually below 2 per cent. Since the mid-1980s unemployment rates in most OECD countries were usually above 6 per cent. In the current crisis, they have sky-rocketed in most countries as has underemployment.
Inflation targeting proponents claim that it has several advantages over previous monetary policy approaches. Many of the gains are attributed to the fact that inflation targeting allegedly provides the central bank with the independence it needs to be credible, transparent and accountable – essential conditions for an effective policy regime.
The enhanced policy credibility allegedly allows a higher sustainable growth rate. The enhanced central bank independence overcomes the time inconsistency problem whereby an inflation bias is generated by the pressure the elected government places (implicitly or explicitly) on non elected officials in the central banks to achieve popular outcomes. Thus inflation targeting can allegedly lock in a low inflation environment.
Current Swedish central bank boss (Svensson) has often argued that inflation targeting not only reduces inflation variability but also reduces the variance of output growth. If certainty in monetary policy generates more stable nominal values, it is argued that lower interest rates and reduced risk premiums follows. This allegedly stimulates higher real growth rates via an enhanced investment climate.
Further, inflation persistence is allegedly reduced because one time shocks to the inflation rate are quickly eliminated by the policy coherence. The reduced inflation variability allows more certainty in nominal contracting with less need for frequent wage and price adjustments. This in turn means less need for indexation and short-term contracts.
However, the implications of this are a flatter short-run Phillips curve. In other words, higher disinflation costs – more unemployment and real GDP losses.
While some extreme elements of the profession, who still consider rational expectations to be a reasonable assumption, will deny any real output effects, most economists acknowledge that any disinflation engendered by this approach will be accompanied by a period of reduced output and increased unemployment (and related social costs) because a period of (temporary) slack is required to break inflationary expectations.
How large are the output losses following discretionary disinflation? Can these output losses be attenuated by the design of the monetary policy? The conservatives argue that the losses are minimised if the disinflation is rapid. But the credible research literature (see, for example, Larry Ball’s work) shows that the losses are inversely related to the speed of disinflation.
There is also no credible empirical research which shows that a more politically independent central bank can engineer disinflations with attenuated real output losses.
The evidence is that while inflation targeting does not generate significant improvements in the real performance of the economy, the ideology that accompanies inflation targeting does damage the real economy because it embraces a bias towards passive fiscal policy which in our view locks in persistently high levels of labour underutilisation.
Disinflationary monetary policy and tight fiscal policy can bring inflation down and stabilise it but it does so at the expense of creating and maintaining a buffer stock of unemployment. The policy approach is seemingly incapable of achieving both price stability and full employment. I constantly write about these failings.
An examination of the research literature suggests that inflation targeting has not been effective in achieving its aims. This is despite the constant claims by the proponents to the contrary. Only a minority of the research literature supports the contrary view.
The most comprehensive and rigorous work on the impact of inflation targeting is the 2003 study by Ball and Sheridan who aimed to measure the effects of inflation targeting on macroeconomic performance in 20 OECD economies, of which seven adopted inflation targeting in the 1990s.
They used special econometric techniques (which are widely accepted) to compare nations that had adopted targeting to those that had not. Overall, Ball and Sheridan found that inflation targeting does not deliver superior economic outcomes (mean inflation, inflation variability, real output variability, long-term interest rates).
One of the claims made for inflation targeting is that central bank independence and the alleged credibility bonus that this brings should encourage faster adjustment of inflationary expectations to the policy announcements. Ball and Sheridan found that there is no evidence that targeting affects inflation behaviour in this regard.
Work I have done in Australia (here is a link to the 2004 Working Paper version which you can get for free – subsequently published elsewhere) found similar results for Australia with the degree of persistence in the inflation rate being unaffected by the transition to inflation targeting in 1994.
A related perceived benefit of inflation targeting is that it expunges inflationary expectations from the economy. There is virtually no research in this area which uses survey data on expectations from consumers, and only little research which uses forecaster’s data. In our 2004 study we found that, among other things, the major mean-shift in inflation and inflationary expectations occurred during the 1991-2 recession and had nothing at all to do with the onset of inflation targeting (1994).
In fact, there were no inflationary pressures in the economy (apart from a brief period in early 2000 when a 10 per cent value added tax was introduced for the first time) after the 1991-2 recession. For Australia, at least, it is hard to attribute the improved inflationary performance to the conduct of inflation targeting at all. The decline in the inflation juggernaut occurred around the 1991 recession in most countries.
So there is no hard evidence available at this point in time that can support the rhetoric of the proponents of inflation targeting. Considered in isolation, inflation targeting does not appear to make much difference. It is certainly hard to distinguish it from non-inflation targeting countries, especially those which have adopted the broader fight inflation first monetary stance, such as the US.
But the real damage comes from the discretionary fiscal drag which is the ideological partner to inflation targeting.
Economists use a concept called the sacrifice ratio as a standard measure of the costs of disinflation. The sacrifice ratio shows the percentage cumulative loss of real output divided by the cumulative reduction in the inflation rate over the disinflation period. Thus, a sacrifice ratio of three implies that a one-point reduction in the trend inflation rate is associated with a loss equivalent to 3 per cent of initial output.
There is a vast literature on the estimation of sacrifice ratios which typically find that disinflations are not costless and, are in fact, significant. Our 2004 study calculated three measures of the sacrifice ratio for eight countries over country-specific episodes. The findings were consistent with other research.
Of note, is the finding that the average estimated GDP sacrifice ratios have increased over time in Australia, from 0.6 in the 1970s to 1.9 in the 1980s and to 3.4 in the 1990’s. That is, on average reducing trend inflation by one percentage point results in a 3.4 per cent cumulative loss in real GDP in the 1990s.
Taken together the evidence is clear – inflation targeting countries have failed to achieve superior outcomes in terms of output growth, inflation variability and output variability; moreover there is no evidence that inflation targeting has reduced persistence.
Other factors have been more important than targeting per se in reducing inflation. Most governments adopted fiscal austerity in the 1990s in the mistaken belief that budget surpluses were the exemplar of prudent economic management and provided the supportive environment for monetary policy.
The fiscal cutbacks had adverse consequences for unemployment and generally created conditions of labour market slackness even though in many countries the official unemployment fell. However labour underutilisation defined more broadly to include, among other things, underemployment, rose in the same countries.
Further, the comprehensive shift to active labour market programs, welfare-to-work reform, dismantling of unions and privatisation of public enterprises also helped to keep wage pressures down. It is clear from statements made by various central bankers that a belief in the long run trade off between inflation and employment embodied in the NAIRU has led them to pursue an inflation-first strategy at the expense of unemployment, even though the existence of long term unemployment itself, beyond the cycle, cannot be explained in this context.
Disinflations are not costless irrespective of whether targeting is used or not and sacrifice ratios have risen over the last 15 years. The point is clear. The real costs of inflation targeting lie in the ideology that accompanies it such that fiscal policy has to be passive (that is, the pursuit of surpluses given the logic adhered to).
The failure of economies to eliminate persistently high rates of labour underutilisation despite having achieved low inflation is directly a consequence of this fiscal passivity. We thus need to move towards a new paradigm where inflation control can coincide with full employment.
This is where I argue for a Job Guarantee but that has been dealt with elsewhere – and it is getting late in the day!