The Inflation Obsession: Flying in the Face of the Facts

Instead, deflation, not inflation, reared its head in much of the world last year as the financial crisis spun out of control. But adherents of the natural-rate theory were never able to see this threat. They were still arguing for an anti-inflation policy when the Asian crisis broke in 1997, and they were still clinging to it in the summer of 1998 when U.S. markets began to crack under the strain. As the case for urgent action grew evident to everyone else, including Federal Reserve Chairman Alan Greenspan, the diehard natural raters inside the Federal Reserve obstructed forceful action. The concrete result: interest rate cuts were at first too cautious to impress the financial markets and affect the economy, and so the crisis deepened.

Can a central bank pursue inflation targeting without adhering to the natural-rate doctrine? Although Bernanke and his coauthors make no effort to separate the two, it is possible to base inflation forecasts on something other than the unemployment rate. An inflation targeter could very well have argued at the Federal Reserve last August that the Asian crisis had eliminated inflation risk and that large cuts in interest rates were essential to ward off the threat of deflation.

This supply-side view may be an improvement over an employment-driven inflation obsession, but it is still less sensible than current Federal Reserve practice. Economists opposed to rate cuts could have countered, correctly, that deflation outside the United States will not depress prices inside the country because most wages and prices are unlikely to fall that quickly. However, the great danger of the Asian crisis is not falling price levels but rising unemployment, recession, and income inequality. A doctrine of inflation targeting, even if not tied to the natural-rate dogma, would have weakened the argument for the interest rate cuts needed to stabilize employment and output, not to mention the financial markets and the banking system.

A CASE FOR CUTS

In any case, events have already overtaken our authors. The only potentially effective response to the global slump has been for the Federal Reserve to sharply cut U.S. interest rates and ensure a depreciation of the dollar. These measures help slow the flight of capital to the United States, return confidence to Asian markets, and restore the balance sheets of otherwise insolvent Japanese banks. Inflation targeting would have delegitimized these policy goals. The argument for having our central bank exclusively address inflation not only ignores the reality of the crisis but assaults the urgent present priorities of the Federal Reserve itself.

What of the claim that inflation-targeting countries have enjoyed superior economic performance, even if employment and growth are omitted and inflation alone is considered? A fair evaluation of this claim would require a comparative perspective, which the authors do not provide. We are left then to review the historical record and ask, What kind of evidence do Bernanke and his colleagues actually present that inflation targeting succeeded?

This part of Inflation Targeting merits careful reading, for much of the story in detail is interesting and competently told. But what is striking is that even the authors admit that inflation targeting in practice has actually done little to fight inflation. In the case of New Zealand, they write, "the decision to announce inflation targets occurred after most of the disinflation . . . had already taken place." The same is true for Canada, and Britain also embraced inflation targets when "it was most likely to meet them." Sweden "was in deep recession" with inflation "down to a historically low rate of three percent per year" when its central bank adopted inflation targets.

In other words, the countries in question never introduced inflation targets when inflation posed a serious threat, nor did adopting targets reduce the cost of any ongoing inflation battle. In all cases, the declaration of war came after the fighting was over. So why did the central bankers do it? Bernanke and his colleagues are quite honest about the reasons. Inflation targeting in all cases coincided with high unemployment, and its main effect was to excuse central bankers from addressing this crisis. Second, inflation targeting could substitute for the messy practice of money supply targeting, an earlier misguided enthusiasm that Britain had once embraced and that Germany used until the launch of the euro. Third, and in sharp contradiction with the first motive, inflation targeting provided in a few cases some camouflage for central bankers who were actually planning to ease monetary policy in order to fight unemployment. They said one thing to placate conservatives and did another to accommodate the political and economic realities of the hour.

Central bankers, like generals, are often accused of refighting the last war. But as the motives above suggest, this case is somewhat different. First, inflation targeting commits itself in principle to fight the last war -- the war against inflation -- as a way to avoid addressing the present threat -- unemployment. Second, inflation targeting allows central bankers to change tactics of the last war even though it has already ended. And third, it permits central bankers to assert that the inflation war is still raging, even when they are really planning to fight unemployment. These mechanisms are useful from a narrow public relations standpoint, but it is hard to see how they actually relate to economic performance, including the pursuit of low inflation.