Guest post by Kevin English
In the two previous posts, I sketched out the broad contours of inflation targeting (IT), and discussed the historical evolution of the Bank of Canada’s monetary policy framework, as laid out in Ted Carmichael’s presentation at CEA 2014.
In this post we turn to Professor Paul Beaudry’s contribution to the session. Beaudry began his presentation by posing the provocative question of whether “our current flexible inflation targeting regime is still viable/stable?” - in the sense that there are additional policy instruments and communication tools that can be added to still achieve the desired objectives.
His tentative answer was “yes.” However, he qualified the statement with two reasons we should question the current situation in which central banks find themselves.
The first point is that, in some regards, IT has not been functioning as was previously believed – or rather it has been even more “successful” than previously thought possible. Despite nearly a half decade of several major central banks’ policy rates being hamstrung by the effective zero lower bound (ZLB), inflation has remained remarkably stable and within the target range.
The original theoretical underpinning of IT assumed a “divine coincidence” between inflation stability and output stability. This condition appears to have been violated by the experience of recent years – during which numerous major economies have experienced persistent output gaps with little historical precedent[1].
This, Beaudry argued, should make us at least question the presumed mechanisms behind the success of IT. For example, he reflected that inflation targeting may have induced private actors to develop an extreme form of anchored inflation expectations, where even large changes in aggregate demand are not enough to translate into material changes in price and wage setting dynamics.
Indeed, this possibility is supported by the continued flattening of the Phillips Curve over the past decades[2].
Second, there are increasingly convincing reasons to believe that the equilibrium real rate (the rate that clears the market for savings and investment when an economy is operating at potential) is now lower than in previous decades[3].
In particular, as Beaudry’s presentation documented, when residential investment is stripped out, investment levels in advanced economies have been trending downward for close to a decade and half. The housing booms in many advanced economies that occurred between 2002 and 2007 – and continued even longer in Canada – simply glossed over what may have be a structural change in the demand for loanable funds.
In making this observation, Beaudry was mirroring some of the arguments Larry Summers has been using to make his case for the risk of ‘secular stagnation’.
Critically, under such conditions the zero lower bound (ZLB) on policy rates binds faster. That the ZLB would only rarely be encountered was another of the original theoretical assumptions underpinning IT. With a lower natural real rate this may no longer be the case.
Beaudry ended his presentation on a cautionary note, stressing that if the ingredients behind the success of inflation targeting are different than previously presumed, then the possibility exists the current situation is far less stable than often believed. As such, inflation (and broader macroeconomic) dynamics could develop in un-predicable, non-liner, ways.
These risks point to the need to formulate contingency plans and accompanying communications strategies, which may entail publically expressing concerns over such potential eventualities.
Above all, Beaudry’s presentation was a call for humility. As the professor stressed, “our understanding is not what we thought.”
[2] On this issue, see the BIS’s recent Annual Report (pg. 51)
[3] For further elaboration on Beaudry’s analysis of potential changes in the neutral real rate, see his recent CD Howe Policy Brief with Philippe Bergevin.