The Futility of Inflation-Targeting

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has been much talk recently from some commentators of how the Fed
risks “going overboard” in its interest rate hike campaign, for
example in this
Marketwatch story

If by “going
overboard” they mean sending the U.S. economy into a recession,
I think they’re right. However, if by “going overboard” they mean
doing more than necessary to bring down price inflation, they are
not right.

But this reflects
a problem really inherent in the inflation-targeting dogma that
now most central banks have adopted. Even assuming for the sake
of the argument that successful stabilization of official
consumer price inflation really would stabilize the economy (a assumption
which can be challenged for several reasons), there is no reason
to believe that central banks can stabilize consumer price inflation.
The reason for that is that there is for several reasons a significant
time lag between monetary policy and its impact on consumer prices.

This reflects
in part a time lag between monetary policy decisions and monetary
inflation (a.k.a. money supply increases), in part it reflects the
time lag between monetary inflation and price inflation and in part
it reflects the distortions of price inflation that the two most
popular gauges of inflation, the CPI and the PCE deflator, contain.

The latter
factor means primarily the issue of how the cost of housing is measured.
When the Fed lowers interest rates this will in the short term lower
the actual cost of living in owner occupied housing, something which
will all other things being equal reduce demand for rented housing
something which in turn will depress rents and therefore by extension
will lower the “owner’s equivalent rent” component of official inflation
indices. In the long run, the interest rate cuts will however not
lower housing costs because either interest rates will be raised
again or if the cuts are permanent, housing prices will be adjusted
upwards. Indeed, because lower interest rates will raise credit
demand and because higher demand for credit will increase the money
supply, the long run effect of interest rate cuts will be to raise
housing costs.

But since the
short-term effect of the cuts is to lower the housing component
of official inflation indices this will cause central banks to
overreact to fight off what central bankers in general and Ben “Helicopter”
Bernanke in particular has depicted as the worst evil conceivable – price
deflation (a.k.a. falling cost of living). This was of course exactly
what happened in 2003, when the short-term effect of the previous
interest rate cuts had depressed rents so much that official “core”
inflation indices approached 1%, something which made the Fed lower
interest rates all the way down to 1%.

Now, we are
seeing the opposite situation. In part because of the lagged effect
of previous super-easy monetary policy have made housing prices
soar to unprecedented levels relative to both income and rents and
in part because interest rates have now returned to more normal
levels, owner-occupied housing has become increasingly unaffordable.
That has increased demand for rented housing something which in
turn has pushed up rents and by extension the “owner’s equivalent
rent” component of official inflation indices.

But this means
that central banks will in practice always aggravate – not reduce –
swings in actual housing costs, as during downturns we will experience
the lagged depressing effect on house prices from previous tight
policies and the lower mortgage interest rates from current easy
policies while during cyclical peaks (like now) we will face the
lagged boosting effect on house prices in combination with rising
mortgage interest rates.

Just how great
the total time lag between monetary policy decisions and official
price inflation numbers (taking into account all three aforementioned
time lags) are is unclear and will like most quantitative relations
vary somewhat between different countries and different time periods,
but most economists believe that it is generally about 1 to 2 years – or
more. For that reason, it really makes no sense from an inflation
targeting perspective to adjust policy according to the latest monthly

However, the
problem is that while the latest monthly data may be of little or
no relevance, it is really the only information central banks have.
No one – not even the best economists – can today say
whether the core PCE deflator in June 2008 will have increased 1.7%
or 2.7% compared to June 2007 – or even say whether the core
PCE deflator in June 2007 will have increased 1.7% or 2.7% compared
to June 2006. Central banks have simply no idea what will happen
in the future, meaning they cannot target future inflation either.

Central banks
who are guided by the fashionable dogma of inflation targeting thus
either face the choice of trying to target a number they know, but
cannot affect or trying to target a number they can affect but have
no knowledge about.

It is for this
reason it was even ironically the case that in recent years, Denmark
who pegs its currency to the euro have been more successful in achieving
a 2% inflation rate than Sweden who have a floating exchange rate
and who are guided by the inflation targeting dogma. This despite
the fact that Denmark haven’t even attempted to achieve a certain
inflation rate, illustrating the futility of inflation-targeting.

27, 2006

M.I. Karlsson [send
him mail
] is an economist working in Sweden. Visit his

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