Blogs & Comment

The end of inflation targeting

For decades many central banks have been preoccupied with containing inflation. Are they now abandoning that strategy?

Something curious is happening in Britain. Its Office of National Statistics revealed that consumer prices in August were up 4.5% from the year before, meaning British consumers are suffering painful inflation. This was mainly due to rising prices for fuels, household heating, clothing and furniture. Britain has experienced annualized inflation of 4% or greater this entire year. There’s no need to panic: the British have experienced far worse. Far more interesting is the policy response, which may be summed up as follows: Nothing.

That’s remarkable once you understand that, at least in theory, Britain’s elevated inflation rate should already have triggered a response. The theory is called inflation targeting, and it has dominated the thinking of central banks in developed countries for two decades. Crudely put, the theory states that when inflation rises above a prescribed level (typically around 2%), central banks must respond by raising interest rates, which quells consumer demand and causes inflation to fall back to “acceptable” levels. Since New Zealand pioneered the idea in 1990, 14 members of the Organisation for Economic Co-operation and Development have adopted it, according to a 2006 paper by Andrew K. Rose, a professor at University of California’s Haas School of Business Administration. Canada was among the earliest adopters. The U.S. Federal Reserve and the European Central Bank have long been described as implicit inflation targeters. The idea has also gained currency among some developing countries.

Inflation targeting became fashionable for several reasons. Its rise following the rapid inflation of the 1970s and early 1980s was no mere coincidence. Inflation is universally felt, but particularly painful for citizens with low or fixed incomes. “Ordinary voters understand what inflation is,” wrote University of Western Ontario economics prof David Laidler in a 2007 paper, “and most of them don’t like it.” Central bankers may also favour inflation targeting because its execution demands a central bank free of political interference. To date no central bank that has adopted inflation targeting has been forced to abandon it later—a fact that lends considerable credibility to its adherents. And more importantly, for most of its history inflation targeting has simply worked.

The triumph of inflation targeting is significant, because monetary policy can be used to influence other things as well. For example, it can be used to manipulate exchange rates—which is particularly important if you’re trying to maintain competitive low prices for your exported goods. It can also be used to dissuade consumers from taking on too much debt—a compelling tool if you’re bent on preventing a household debt crisis. But if you listen to most modern central bankers, they remain slavishly subservient to inflation targeting. Here’s a recent example from Canada:

“The best contribution that monetary policy can make is to keep inflation low, stable and predictable. Monetary policy is guided by our 2 per cent target for total CPI inflation. This is a symmetric commitment. That is, the Bank cares as much about inflation being below target as above.”

     — Mark Carney, governor, Bank of Canada, Aug 19, 2011

The Bank of England also professes its adherence to inflation targeting. According to a brochure published for the benefit of the British public, “the Bank sets the official interest rate—Bank Rate—to keep inflation low.” In plain language, that brochure recalls the sky-high inflation of the 1970s (peaking at an eye-watering 27% in Britain in August 1975) and also how monetary policy can be used to contain it. Crucially, the Bank notes:

The Bank aims to keep the annual rate of inflation at 2%—the inflation target set by the Government. Some prices will rise by more, others by less. But, on average, the aim is that prices across the economy rise by 2% a year.

The BoE has pursued this 2% target since 2003. With inflation now consistently running above 4%, the BoE has some explaining to do.

The BoE’s explanation is that it believes inflation will return to 2% soon without intervention. “Given our target of 2%, the recent path of CPI inflation is uncomfortable to say the least,” acknowledged Paul Fisher, a member of its Monetary Policy Committee, in a speech in May. “Nevertheless, the nature of the price shocks were such that, in my view, there was little that monetary policy should or even could have done to offset them.” As the Bank’s brochure explains, interest rates sway inflation only after a lag. So the Bank therefore sets the Bank Rate today based on where it thinks inflation is headed, not where it’s trending today. According to the Bank’s official projections (see this chart) inflation should soon meander back to 2% of its own accord.

But if that sounds suspiciously convenient for you, it may be time to ponder a more momentous possibility: that the BoE has quietly become an inflation targeting apostate, and is now applying monetary policy to other problems instead. For example, it could be keeping rates low primarily to avoid pushing British’s debt-laden consumers to the brink, triggering another recession. Maybe inflation is no longer Public Enemy  No. 1.

This possibility is hardly far-fetched. Since the financial crisis (and arguably well before that), the central banks of developed countries have used draconian monetary measures as a means of staving off financial and economic collapse. Most have maintained rates at or near the lowest possible level (i.e. effectively zero). The Bank of Canada, for example, presently maintains its overnight rate at 1%, up marginally from a low of 0.25% during the worst moments of the recession. Maintaining such low rates has a stimulative effect on the economy, because it helps businesses and consumers borrow money cheaply, which in turn encourages them to buy things. It also punishes savers, who must consequently content themselves with pathetic returns on (theoretically) low-risk instruments like government bonds and bank deposits.

Low rates have serious side effects. Across the developed world, it’s contributed to record levels of household debt. With large segments of the population now deeply in hock, central bankers have far less latitude to raise rates to combat inflation. That’s because raising rates means sooner or later consumers will pay higher debt servicing costs. If they’re skating on the edge already, higher rates could force them to seriously curtail their spending on discretionary items, which could send the economy into a tailspin. You can be sure that if Canadians were paying 8% interest a year on their mortgages, Carney would be considerably less popular than he is today.

As noted above, interest rates can be used to manipulate exchange rates. Many countries are now locked in a conflict of competitive devaluation, and countries hoping to maintain relatively cheap currencies to attract foreign buyers may well feel compelled to use all available tools. This almost certainly has influenced the Bank of Canada, which clearly does not wish to see the Canadian dollar soar against the U.S. greenback. And it’s another reason why raising rates to combat inflation might prove a painful option.

There is now considerable circumstantial evidence suggesting that the primary goal of many central bankers, despite their continued professions of fealty to inflation targeting, has become avoiding recession at all cost.

More time must pass before we can be sure the BoE has abandoned inflation targeting. But it’s perhaps revealing that one of the few notable economies not practicing inflation targeting is Japan, which has suffered a stagnant economy for two decades. It’s now fashionable to claim that many Western countries face a similar bout of meagre growth. Should inflation targeting lose its appeal more broadly, this would not be surprising—the list of retired monetary theories is long.

But it would also serve as a warning that the contents of your wallet, RRSP and pension fund may soon buy a whole lot less.