Wednesday, May 6, 2009

Inflation Targeting and Central Bank Independence

Recently a number of articles from economist regarding Inflation Targeting (IT) and Central Bank Independence (CBI) have put some thoughts out there that must be analyzed carefully. Those articles aim at causes of the current financial crisis and up-to-date policy efforts to tame it.

A quick review of the pre-dominance of IT and CBI should include that, the former is the result of taking inflation as a great monetary phenomena. This is, inflation is less related to the real economy, and the premise that the biggest contribution from any central bank to economic growth is keeping inflation rates low -thus interest rates low, thus increasing rates of investment thus increasing aggregate demand.

The IT scheme provides information about future policy decisions by the central bank, clearly, if observed inflation is above the targeted one, interest rates will go up, and if current inflation is below the targeted one, interest rates MIGHT go down.

CBI, as Becker explains is important because if any central bank finance treasury fiscal deficits, the medium term result is a high rate of inflation. So both IT and CBI contribute to low inflation. Indeed the world has seen a period of low inflation rates in the last twenty years. We all know that there are two direct causes of rising inflation: 1) If Aggregate Demand expands or 2) if Aggregate Supply retracts.

The key issue evaluating IT and CBI is finding how does monetary policy controls prices? Is it through Aggregate Demand or Aggregate Supply or both? Both is the most accurate answer. When a central bank increases the interest rate, aggregate demand diminish as credit and investment are relatively more expensive. However, aggregate supply can expand since as the interest rate increases, expectations on prices fall, thus increases in wages are moderate and thus firms can expand output lowering prices at the end by those two channels.

The latter example illustrates that monetary policy is important both for consumers and firms. This approach lacks an important feature, market bubbles. Evidence suggest that when output is considerably weak, central banks aim for a loose monetary policy, this is, low interest rates achieved by an increase in money supply. This loose monetary policy creates, fairly as a consistent result, an excess of money holdings. The latter in turn creates an excess of savings and thus a great probability of the rise of a market bubble. As financial firms compete for the excess of savings, and interest rates are low, managers have greater incentives to invest in riskier assets.

So there is a strong argument that blame central banks for the existence of market bubbles. This leads to a first direct conclusion, CBI is a key feature because it guarantees low inflation and can decide with the least political bias whether or not to sustain low interest rates when output is weak. If this were not the case, every time a political decision implied a monetary stimulus a bubble could arise. Is fairly straight to conclude that is better to have bubbles as an undesirable outcome, than every time the economy is weak and politicians need votes.

As for the IT case, it is true that its results in terms of inflation are rock solid. However, Martin Wolf argues that it should address market bubbles as well. This argument needs further analysis. Lets not forget that recent evidence suggest that, in the short-run, there is an undeniable positive relation between low interest rates and market bubbles. So how can a central bank achieve a dual objective involving market bubbles and inflation? The short-run Phillips curve suggests that this dual objective would have a negative impact in output growth. But why should the central bank look at the unemployment rate when making monetary policy decisions?

What if the central problem with IT is precisely that it has not stopped worrying about output? Even in Volker's Fed mantaining interest rates "too high for too long" did not represent a massive breakdown in any system, it did pushed the U.S. recession, but the economy grew more than eight years in a row after that. Today, the Fed mantained interest rate "too low for to long" stimulating bubbles in house markets and later in commodities. We can conclude that "too high for too long" addressed inflation and "too low for too long" addressed unemployment.

From the last argument a strong conclusion should state: IT will not be enough, central banks should address bubbles too. It remains out of the question to add to the central bank's responsabilities low unemployment.

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