A defence of inflation targeting as the best way to run monetary policy, written for the "Wall Street Journal" but not published
In recent months, there has been a chorus of voices attacking inflation targeting. The most recent that I have seen was one by Joseph Stiglitz headed "Inflation targeting shown to be a dismal failure". In that article, he claimed that "today, inflation targeting is being put to the test and it will almost certainly fail", and extended his sympathies "to the unfortunate citizens" of the 23 countries he listed as having adopted inflation targeting.
But it's often entirely unclear what the critics would put in place of inflation targeting. Surely nobody today wants to return monetary policy to the days when it was used in a vain attempt to increase economic growth or reduce unemployment. Of course monetary policy affects growth and employment in the short term, but we learnt the hard way back in the seventies that in the longer term monetary policy primarily affects inflation. Economic growth is driven by growth in the labor force and growth in the productivity of that labor force, with productivity likely to be enhanced if the price mechanism is sending useful signals about where to allocate capital rather than being distorted by generalized inflation. And in the longer term employment is a function of the level of wages, the generosity of the benefit system, the skill of the labor force, and the nature of employment law, not the level of inflation.
If the critics mean that monetary policy should ignore factors over which monetary policy has no influence - such as a sharp increase in the international price of oil - then most inflation targeting central banks already do that, though most also recognise that when those external factors start feeding into domestic wage- and price-setting behavior monetary policy needs to respond to those second-round effects. Attempts to compensate ourselves for higher international oil prices through demanding higher wages and salaries are futile - the importing country is made poorer by the higher oil import prices, and demanding higher money incomes runs the risk of generalizing the inflationary pressures.
If the critics mean that current inflationary pressures throughout much of the world economy have nothing to do with monetary policy they are clearly wrong. Certainly, higher oil prices are in part the product of structural changes in the international oil market, and the higher prices for many foodstuffs are the consequence of some unfortunate policies to subsidize the inefficient production of biofuels. But the huge escalation in the price of almost all commodities is also a result of the very loose monetary policies pursued in several of the world's leading economies. A small economy takes those prices as given, but can at least partially offset them by running monetary policy in such a way that their currency appreciates gradually against the currencies of countries which are running very loose monetary policy.
If the critics mean that monetary policy should focus on a broader definition of inflation than that measured by the Consumers Price Index, I would agree with them, though it is very difficult to do in a democracy where most people think an increasing CPI is inflation. I would argue that tolerating the CPI increasing at 3 per cent annually at a time of rapid growth in productivity is very likely to see a bubble in asset prices, as we've seen in several countries over many decades, but I'm the first to acknowledge the political difficulties of tightening monetary policy when CPI inflation seems moderate and the stock market, or the housing market, or the commodities market, is rising strongly.
But targeting monetary policy at inflation, with an explicit inflation target (with appropriate caveats to exclude totally external factors), has the huge benefit of making it clear to public and politicians alike what monetary policy can deliver and what it can not deliver, and of changing behavior through conditioning inflationary expectations. If the target is also agreed with the government, as it is now in New Zealand, Canada, Australia and the United Kingdom, the central bank can have a powerfully beneficial effect on fiscal policy by making it clear that a loosening of fiscal policy will under most circumstances lead to tighter monetary policy.
Pretending that monetary policy can bail out financial institutions which have made fools of themselves by lending to borrowers whose only hope of repaying the loan depends on a constantly rising real estate market - at the expense of higher inflation - is a very high risk strategy indeed.
Former Governor of the Reserve Bank of New Zealand, 1988 to 2002Adjunct Professor at the School of Law and Management at La Trobe University, Melbourne
3 June 2008
 The Independent Financial Review, New Zealand, 21 May 2008.
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