Breaking the shackles of inflation targets

WHEN it comes to containing prices and inflicting the least damage to the global economy, pragmatism is better than purity. Worries about encouraging risky behavior didn’t prevent a rescue of depositors at Silicon Valley Bank (SVB) or the rollout of a further US backstop to the banking system. The same is true of a totem of monetary policy the past few decades: inflation targeting.

Being above your target — for many central banks it’s somewhere around 2% — isn’t an argument to keep going with interest-rate hikes regardless of the cost to either growth or the financial health. Even in New Zealand, the country credited with pioneering the use of numerical objectives, flexibility has been key. While the relentlessly hawkish tone of the Reserve Bank of New Zealand (RBNZ) may obscure it, the target has evolved and was only ever intended as means to an end. It’s been diluted and widened over the years. There’s a lesson there: No need to charge full speed ahead given this bout of volatility. It isn’t necessarily a betrayal of principle.

The idea that big central banks could take a pass on further hikes seemed a stretch just a week ago. Federal Reserve Chair Jerome Powell weighed the prospect of picking up the pace while the European Central Bank (ECB) seemed sure to embark on at least one more increase of 50 basis points in its main rate. In Japan, people speculated that Kazuo Ueda would dismantle the ultra-easy framework fairly soon after he arrives at the central bank next month. Some traders even bet Haruhiko Kuroda would take the plunge last Friday at his final board meeting. The Reserve Bank of Australia said the time was approaching for a pause but was careful to not commit to a particular timetable. The epic retreat in bond yields suggests a range of outcomes is plausible, if not necessarily desired.

Stepping away is tricky because inflation is well above the goals central banks have set for themselves or been handed to them. But SVB’s failure and the subsequent market tumult has many economists thinking the Fed will now recoil from the 50-basis-point step that Powell himself laid on the table March 7. Some big names, including Goldman Sachs Group, Inc., now see the Fed pausing when policymakers meet next week. Nomura Securities went so far as to predict a rate cut. Investors are skeptical of the ECB’s commitment to hikes beyond its council meeting on Thursday. A rush by Ueda to take apart Kuroda’s legacy — never remotely a sure thing — looks even less attractive now.

Such a radical rethink is understandable. Through the global financial crisis, rate cuts were an important part of the central bank response. When credit markets seized up in mid-2007 — more than a year before Lehman Brothers Holdings, Inc. collapsed — the Fed began reducing borrowing costs, and did so throughout 2008 before embarking on quantitative easing. But the Fed had ended its previous hiking cycle quite some time before the subprime drama began. The situation today isn’t quite analogous.

Inflation being too high for comfort clearly complicates the picture. But how did 2% come to be so important and is that relatively low pace of price increases really a hill to die on? New Zealand certainly didn’t set out to reinvent the world. Just to establish credibility at a time — the mid-1980s — when it was lacking. For decades, its inflation performance had been woeful. The idea was just to hit upon a number that would send a signal about the country’s seriousness. 

It caught on globally and 2% has become a reference point for monetary authorities everywhere. It figures in ranges or average targets for almost everyone from South Korea to the US, Australia, Indonesia, the euro zone and a host of others. This is a little number with great weight. But what has got lost is that this was always intended to be malleable and never a sacrament. “The evolution of the inflation-targeting framework in New Zealand can be characterized as one of increasing flexibility,” John McDermott and Rebecca Williams, senior officials at the RBNZ, wrote in a paper for a 2018  conference devoted to the practice. “As our tree grew taller and its roots grew deeper — as we gained credibility by actually meeting our target, and anchored inflation expectations — we could be more confident that our tree could bend in the wind, without being uprooted.”

The idea of surrendering targets or raising them is heresy when inflation is so far above the existing objectives. But there is scope to relax a little about how long you take to get there and be mindful of the damage of racing too quickly to the finish line. Andy Haldane, once the most hawkish member of the Bank of England (BoE)’s rate-setting committee, suggested a less-zealous approach last week. The former BoE chief economist warned that policymakers now face the “hardest yards” in reducing inflation to 2% and suggested they view the goal far more flexibly and even consider taking longer to return there. Given the drama unleashed by SVB, his remarks look prescient.

Targets ought not be a substitute for discretion. Alan Greenspan worried about the loss of the freedom to pivot quickly. When the Federal Open Market Committee considered the arguments for targeting 2% in mid 1996, he warned his colleagues of the grave consequences if the discussion leaked, according a transcript of the meeting. As long as the initiative was secret, it was reversible, wrote Sebastian Mallaby in The Man Who Knew: The Life and Times of Alan Greenspan. (It took until 2012, under Ben Bernanke, for the Fed to formally commit in writing to targeting 2% inflation.)   

If nothing else, the SVB fiasco has crystalized the choices facing central banks. This isn’t the time to blindly demonstrate their fealty to something that was never truly fixed to begin with. Whichever way Powell, Lagarde & Co. jump, the press conferences that follow will be dominated by a three-letter acronym few people had heard of at the start of March. As if PCE and NFP weren’t enough!


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