Before the Crisis, inflation targeting had become the de facto standard framework for monetary policy. Even non-inflation targeters like the ECB and the Federal Reserve built their monetary policy around the idea of commitment to a quantitative objective for medium-term inflation.
The financial Crisis of 2008 and the recession which ensued challenged this consensus on best practice on monetary policy. In early 2013, we asked 14 world-renowned scholars, practitioners and market participants to share their wisdom on "Is inflation targeting dead? Central banking after the Crisis". Writing in a personal capacity, they explain how central banks experimented with new tools to deal with a wide range of problems related to the difficulty of stimulating the economy when the policy interest rate is near zero and when the economy is deleveraging as well as problems of financial stability and of liquidity shortage.
As Former ECB Executive Board members Lorenzo Bini Smaghi writes in his chapter: “Inflation targeting did not prevent the financial Crisis or provide sufficient stimulus to get the economy out from the Crisis.”
But what caused what? Inflation targeting is cast alternatively as perpetrator, innocent bystander, or saviour.
- Perpetrator: Inflation targeting made monetary policy too easy before the Crisis and insufficiently so since. It helped build the Crisis in the 2000s and today hinders the clean-up.
- Bystander: The regime was like a coastal schooner finding itself in the path of Hurricane Sandy. Inflation targeting was developed during ‘the Great Moderation’. No one ever claimed it was robust enough to deal with a five-year sequence of once-in-a-lifetime crises.
- Saviour: Things would have been much worse without inflation targeting’s anchoring of expectations. “While the shock to the financial system has been more complex than that which led to the Great Depression, the decline in output has been far less marked”, as Stefan Gerlach writes in his chapter.
Can inflation targeting deal with today’s Crisis?
Are the policy tools used recently such as quantitative easing, credit easing, and liquidity provision – or even helicopter money – compatible with inflation targeting, or should we scrap it? Should we keep some of its essential elements and put more content into the notion of flexible inflation targeting which many central banks had identified as their approach before the Crisis but many of whose details remained undefined?
The Bank of Japan’s recent bold departure is a timely demonstration of how urgent and radical this debate has become. On a more speculative basis, Adair Turner has recently suggested that permanent creation of money (helicopter money) should be considered as one of the options for monetary policy. In a recent CEPR event, Adair Turner and Michael Woodford discussed this view and compared it with other forms of coordinated monetary and fiscal policy interventions.
There was no coordination among the authors – and they certainly cover a wide range of views. Nevertheless a surprising degree of consensus emerged:
- Crisis-linked innovations have challenged inflation targeting narrowly defined, but flexible inflation targeting is not to be discarded.
- Large asset positions have been taken by central banks in the course of their Crisis-linked innovations. These open enormous pitfalls. Blurring the distinction between monetary and fiscal policy presents a real risk to central-bank independence.
- Inflation targeting has a key role to play in avoiding these pitfalls. Inflation targeting is a well understood means of keeping the printing presses out of politicians’ hands. Further inflation-targeting refinements, however, may be required.
While not all authors would ascribe to all these points, there was enough agreement to think that inflation targeting is far from dead. It has evolved to survive and its discipline and credibility seem to be needed now more than ever.
Editors' note: Download "Is inflation targeting dead? Central banking after the Crisis", edited by Lucrezia Reichlin and Richard Baldwin, here.