Mark Carney, the Governor of the Bank of Canada and chairman of the Financial Stability Board, has an interesting contribution on the role of monetary policy in the Financial Times. In it, he argues that this is not the time to abandon the inflation-targeting framework that has served Canada so well. I agree. During the crisis, the Bank of Canada adopted extraordinary measures to relieve stresses in the financial system and to preserve the flow of credit to the economy. Despite these extraordinary measures for extraordinary times, however, inflation expectations remained firmly anchored.
But some of the comments on Governor Carney’s contribution lead me to ask: To what extent is the Canadian experience from inflation targeting in the crisis transferable to other countries? Thanks to better management or perhaps a culture of less risk-taking, Canada did not suffer the syndrome of collapsing financial institutions that, say, the U.S. and the U.K. experienced. As a result, the informational and relationship capital in Canadian banking was preserved and, with assistance from a series of measures to support credit markets adopted by the Government, financial markets pretty much returned to normal once the crisis passed. Growth returned, employment recovered and – most important for monetary policy making – actual output moved back closer in line with potential output.
As the latest version of the IMF’s World Economic Outlook notes, the same can be said for most emerging market economies in Asian and Latin America, where output is growing above pre-crisis trends. Yet many of these economies, which adopted inflation targeting before the crisis, are now temporizing with inflationary pressures and potential asset price bubbles because they are conflicted: they recognize the importance of controlling inflation; yet they want to resist upward pressure on their currencies, fearing the internal adjustment challenges and the loss of current account surpluses.1 Their dilemma is that, in trying to limit appreciation, they could end up with much higher inflation. This underscores the simple fact that, while it is a powerful instrument for macroeconomic management, monetary policy has its limits: it cannot be used to both control inflation and manage the exchange rate. For them, Governor’s admonition is entirely warranted.
It can be argued, however, that the situation is different in a number of countries, particularly the U.S., the U.K. and the euro zone – the economies at the very core of the global economy and the epicentre of the global financial crisis. The financial systems in these three key economies remain “challenged” by the legacies of the crisis, namely, the deleveraging associated with previous excessive risk-taking and under-capitalized banks. And, while it can be debated, in some respects conditions resemble the canonical Keynesian liquidity trap of intermediate macro textbooks.
For the sake of argument, assume that the U.S. has followed Japan into the liquidity trap as Paul Krugman has repeatedly argued. What are the implications for monetary policy? This is where monetary policy making gets very interesting indeed. This is because “normal” monetary policy instruments – which textbooks typically equate with a temporary expansion of the money supply – are ineffective in a liquidity trap.
The intuition here is fairly straightforward: because nominal interest rates are already at the effective zero lower bound, additional monetary easing to reduce interest rates and stimulate the economy doesn’t work. In 1932, at the height of the Great Depression, Keynes likened this to “magneto problems” in an automobile in a famous passage in the Atlantic Monthly. If the economy is below full employment with deflationary pressures at play, this scenario implies that real interest rates (nominal, or market, interest rates less the expected rate of inflation) are rising as unemployment worsens, output gaps increase and the rate of deflation rises. The outcome is the kind of secular stagnation that Japan has experienced for much of the past two decades. Eventually, nominal wages will be driven sufficiently to restore full employment
The textbooks say there are two possible policy-based exits from the liquidity trap. The first is large scale fiscal stimulus that drives output back to full employment, relieving the downward pressure on prices and stabilizes prices and output. That option is off the table in the U.S. (And, indeed, given the political polarization in the U.S., the immediate prospects are for the withdrawal of fiscal stimulus!)
This implies that the full burden of adjustment is on monetary policy. In this regard, the textbooks say that monetary policy can pave an exit from the liquidity trap if central bankers successfully raise expectations of inflation. These expectations of higher inflation will reduce real interest rates and start the process economic recovery. But here’s the rub: to raise inflation expectations, central bankers have to commit to permanent monetary expansions that would be consistent with higher inflation.
Needless to say, this is an anathema for central bankers steeped in the game-theoretic literature of credibility, reputation and rules versus discretion. They fear un-anchoring inflation expectations and possibility unleashing hyperinflation – that was certainly the concern voiced by successive governors of the Bank of Japan. Inflation is certainly undesirable. It represents a tax on money balances and introduces myriad distortions. At some point, however, those costs have to be balanced against the risks of protracted economic stagnation and the economic and social losses associated with unemployment. As the Nobel laureate James Tobin observed years ago: “it takes a heap of Harberger triangles to fill an Okun gap.” That is the dilemma confronting Ben Bernanke.
Some commentary on the Governor’s article makes the point that inflation targeting could be useful in this regard. The Fed, it is argued, could announce a higher inflation target; it is possible that the Fed’s credibility would allow it to raise inflation expectations without unleashing a Weimerian hyperinflation. (It should be recalled that the hyperinflation that destroyed the Weimer Republic was self-induced and not the unintended by-product of well-meaning, but inept stabilization policy: not to put too fine a point on it, the goal was to punish the allied powers for their reoccupation of the Ruhr).
The constrained-discretion approach to monetary policy followed by inflation-targeting central banks allows central bankers to acquire reputations and credibility. Building reputations is costly and takes considerable time; it takes only one bad decision to lose that credibility. This creates a status quo bias in decision making: better to stick with what you know, even if it uncomfortable, then to jump to a policy option of uncertain effects that could lead to the loss of a well-deserved, hard-earned reputation for sagacity. But some are now asking: what is the purpose of accumulating credibility, if it is not put to work?
1In addition, efforts to limit appreciation risk introducing a deflationary bias and the threat of insufficient global aggregate demand, reminiscent of the 1930s – the subject of future post for another day.