The issue of inflation targeting has once again come to the forefront, though for reasons and in a way policymakers had never anticipated. That speaks volumes already. The recent introduction of this (flexible) average inflation targeting is merely the latest tweak to a process that’s already more than thirty years old. Not exactly new thinking.
While the US Federal Reserve wouldn’t adopt an explicit target until 2012, central banks in New Zealand, Canada, and the United Kingdom had shifted their own framework back in the early nineties. This immediately ignited controversy and debate in worldwide official circles, a continuation of evolving circumstances ever since the end of the Great Inflation the decade before.
At the January 1995 FOMC meeting, for example, Chairman Alan Greenspan put the matter up for argument. On the one side he asked Janet Yellen, at the time a member of the Federal Reserve’s Board of Governors, to reason against Al Broaddus, the influential President of the Richmond branch. According to the transcript, the rest of the members were “split down the middle” and unable to reach a consensus.
The matter would come up, obviously, from time to time throughout the following seventeen years until Ben Bernanke’s post-QE2 FOMC finally agreed to an explicit inflation target in January 2012. They did so out of the belief controlling inflation (after so much “money printing” in the common perception and financial press) would be the central bank’s greatest challenge – even after, at that time, an unusually lagging “recovery” which was then heading into another year of “unexpected” but still massive economic uncertainty (as well as, importantly, two more QE’s).
This had been the common view throughout each of those prior decades since the topic was first broached in the eighties. It was the unchallenged position that central banks needed to emphasize their inflation fighting capacities at every opportunity. Hindsight was laser focused on the effects from an imperfect and incomplete understanding of the seventies all the while trying to prevent only its repeat.
No one seems to have asked whether the increasingly unmeasurable monetary system which had gone haywire back then might go haywire in the future – in the other direction. Instead, this was chalked up to nothing more than random good luck.
[Correction: the original version of this article incorrectly cited Richmond Fed President Al Broaddus as the FOMC official who delivered the speech quoted below. It was instead given by FOMC Governor Edward Gramlich; though both Broaddus and Gramlich were each involved in the years of debates on inflation targeting, including the 1995 FOMC discussion noted above, the quotes used below were all taken from Gramlich’s speech. This article has been changed from the original to reflect this correction.]
At the dawn of the 21st century, in mid-January 2000, FOMC Governor Edward Gramlich was in Charlotte, North Carolina where he gave an important speech on the subject of inflation targeting. There were a number of issues standing in the way of the Fed’s moving in the direction of New Zealand and Canada; not the least of which were arguments about whether the FOMC had the authority to do so.
Did the Fed need Congress’ approval?
In 2005, at his hearing before the legislature, just-nominated future Fed Chairman Ben Bernanke argued that an inflation target of any kind needn’t require statutory changes at all. Bernanke instead claimed such a measure would amount to little more than a “modest bit of additional transparency.”
As Gramlich had stated five years before, that’s really how inflation targeting works. There’s no money supply or monetary involvement whatsoever; the central bank is merely stating very clearly what it intends to accomplish; that much becomes very transparent.
How it intends to accomplish its goals, well, throughout the subsequent three decades no one seems to have cared much about those details – even after Japan. Instead, according to the FOMC’s Gramlich:
To the extent that monetary authorities can hit their target, central banks would also gain credibility, which many need after years of inflation. The ideals of transparency and credibility certainly have democratic value in their own right, but they may also pay off in narrower economic terms.
Again, two things: inflation fighting and no specifics about how the fight might be conducted. Everyone assumes first that any risks on the inflation front will always be toward “too much”, while at the same time the answer to “too much” is easily “rate hikes.” And the reason rate hikes are the easy answer, according to this thinking, is credibility.
This is the pay off Edward was talking about. The whole debate, such that there ever was one, centered around how best to make these assumptions clear to the public so that credibility might be best enhanced.
But wouldn’t it be simpler to just intervene directly in the monetary system? Why go through all the bother with such emphasis on expectations, the inherently dirty and unstable business of emotion and manipulation of interpretations? It sure doesn’t seem all that scientific nor more helpfully straightforward.
Gramlich admitted, however, no, they can’t do that:
One can also rationalize inflation targeting through another form of economic reasoning. Some years ago many believed, along with Milton Friedman, that stabilizing the growth of the money supply would lead to stable prices. But this approach is now generally discredited because shocks in the demand for money and an unstable transmission mechanism imply that stable growth of monetary aggregates could lead to quite unstable behavior for prices and real incomes.
I particularly like his bit about “unstable transmission mechanism” which, taken from the post-seventies view of especially money demand, is an important but never discussed omission from the conventional monetary policy lexicon. I’ll translate it for you: we just don’t know how all that money stuff works.
In the absence of direct knowledge of the monetary condition, demand or supply, expectations is what’s left. Monetary policy, therefore, totally dependent upon credibility – again, which officials thought all along would only mean finding new ways to bolster their own inflation fighting credibility.
And it puts enormous pressure on authorities to become good to great forecasters using good to great econometric models.
But if models are not working well and there are not many reliable leading indicators, it is not clear how much information is contained in these other forecasts. Without models or leading indicators, even forward-looking inflation targeting strategies may not work as well as advertised.
You’ve probably already noticed how even Ed Gramlich’s argument leaves open the opposite possibility from the one suspected; “unstable behavior for prices and real incomes” is a pretty broad term that also encompasses the possibility of the other condition of “too little” money, economic growth, and therefore inflation (as expressed against a hard target).
As such, “not work as well as advertised” could become a two-pronged dilemma.
Which brings us up to Jay Powell’s 2020 inflation and bond market conundrum where everything has aligned against the common understanding of what central banks would end up facing. Always fear of the seventies. Suddenly, an inflation puzzle where the central bank consistently undershoots its target, growth concurrently anemic (at best), and no answer readily available in the current central bank format.
We never once planned for this!
One big reason why is that where there is evidence and there are warnings, such as “reliable leading indicators”, these are simply dismissed out of hand as inconvenient to these decades of established thinking. From persistent, stubborn low bond yields (interest rate fallacy) to specifically market-based prices for inflation expectations, central bankers worldwide refuse to admit that markets can identify the problem for them.
Why do they refuse? Because in identifying the problem these markets are pointing the finger back at them!
Not only do markets tell them what they don’t want to hear, the increasingly explicit unreliability of their own models backs up that very contention. Implicit in what Jay Powell said at the end of August in unveiling the Fed’s grand strategy review, the one settling on average inflation targeting, is that the central bank’s econometric models must’ve been exactly unreliable all this time.
To the absurd, extreme point officials now won’t even consider full employment which used to be the very central focus of all these things.
From 2008 onward, the Federal Reserve (as its central bank compatriots around the world) has done everything Edward Gramlich had told them not to do; the very things Al had warned would undermine the Fed’s key method to such an extent officials are now painted into the very smallest corner. They’ve become everything he argued would weaken the very fundamental framework that underpins the modern central bank (as, again, explicitly divorced from the modern monetary system).
This backward proposition is deeply engrained in the very fabric of the central bank. In January 2009, on one of those far-too-common emergency conference calls the FOMC held because they could never once get their heads around a crisis no policy of theirs could seem to solve, Ben Bernanke looked at these two polar opposites, inflation fighting in the longer run versus current deflationary problems right in his face, you can just guess which way he would come down.
CHAIRMAN BERNANKE. There are a number of considerations, but the two I would mention are, first, that we do face, if not deflation, certainly some disinflation; and disinflation, if it proceeds too quickly, can be counterproductive because it raises real interest rates.… At the same time that we are using every power we have to try to fight this incredible crisis, there are concerns on the other side that, by expanding our balance sheet and the like, we risk inflation increasing in the medium term. It is important for us to communicate that we will be effective and timely in removing that stimulus, so that we will not have an inflation problem during the exit from our current policies. [emphasis added]
During the worst of GFC1, while the global economy was being devastated not by subprime mortgages but by a global dollar shortage that showed up in each and every financial and market indication as well as price, they still assumed monetary policy would easily handle the downside, the entire system being at more risk of an inflationary upside over time. And when time stretched out year after year after year, no recovery nor inflation, they still looked at it this way anyway.
These are not serious people. They do play them on TV, however.
In trying to explain what’s happened over the intervening eleven and a half years since then, the persistent inflationary undershooting as a start (not to mention the lack of actual economic recovery also implicit in this new way of thinking), average inflation targeting is the Fed saying the problem hasn’t been downside money and deflation, no, no, no, the problem all this time is that the Fed has done too good a job positioning itself as this epic inflation fighter.
In a world conspicuously devoid of any such inflation (and growth) upside, with all signs pointing in the direction of “too little” money supply, whatever it is, we’re now supposed to believe this latest thing is likewise a serious effort. Not just serious, but this average inflation targeting will work; definitely, 100%.
They couldn’t hit the inflation target from the very moment it was introduced a decade ago so now they’re going to let inflation go over that target they couldn’t hit all because for a decade they couldn’t hit this target they had been preparing to hit for even more decades before it.
This just isn’t serious. It’s not. It just sounds like it is because that’s the whole point.
What was it that Ed said twenty years ago? “To the extent that monetary authorities can hit their target, central banks would also gain credibility, which many need after years of inflation.” To any extent that monetary authorities can’t hit their target, central banks would not gain credibility, which all of them even more desperately need after more than a decade of not being able to register inflation.
Good for Gramlich; this much, at least, makes sense when you put it in the inverse. And in the absence of credibility, what’s really left? Lie your damn ass off.
This isn’t really about consumer prices, either.
After all, there’s the overwhelming mountain of evidence for the dreaded “unstable transmission mechanism” which has been surely coupled with the even worse (see: Keynes) “quite unstable behavior for prices and real incomes.”
We can’t even keep workers in this persistently deflated economy.
You see, the bond market isn’t that complicated at all. It’s actually monetary policy, this supposed modest bit of transparency, which becomes ever more complicated and detached from straightforward sense because of it.