An earlier post on Unbalanced Central Bankers made the point that most inflation-targeting central bankers have consistently undershot their inflation targets in the wake of the global financial crisis. As a result, rather than the symmetry that should mark deviations around target inflation, with above-target observations interspersed with below-target “misses,” the pattern has been a series of consistent under-shooting. The New York Times recently pointed out, here, that the Federal Reserve is failing to meet its own targets on inflation and unemployment.
The NYT article helpfully notes that the Fed has a dual mandate — it is expected to achieve low inflation and low unemployment. Monetary policy purists are likely to note that this creates potential tensions in the conduct of monetary policy, since the Fed has one instrument with which to hit two targets. The problem is akin to an archer that is told to hit two separate bull eyes with one arrow: hard to do unless the two targets are aligned. In some situations, such as the inflationary episode of the 1970s, when it became increasingly difficult for monetary policy to deliver on both policy objectives, it was well near impossible. Efforts to use expansionary monetary policy to lower unemployment led to progressively higher inflation. In the context of the past six years or so, however, the two targets (inflation and unemployment) have more or less been aligned: policy to raise inflation to target would be consistent with reaching the target of lower unemployment.
As noted previously, central bankers have not been oblivious to all of this. Many central banks adopted extraordinary measures in the wake of the global financial crisis; some continue with such policies today. And central bankers can be forgiven for complaining that their economies are not behaving as they should! Nevertheless, the persistence of below-target inflation begs the question of why central banks haven’t done more to ensure greater symmetry with respect to target outcomes. Two key factors loom large in this respect:
- First, the concern that “doing more” or maintaining extraordinary policies for “too long” risks unleashing the inflationary dragon and, rather than a gradual increase to target or slightly above target, triggering a hyperinflation reminiscent, say, of the Weimer republic.
- Second, there is a concern that extraordinary monetary responses threaten to distort risk-taking behavior and could, in effect, sow the seeds of another financial crisis.
Early proponents of the first risk were proven decisively wrong; as Paul Krugman has argued time and time again. Moreover, if concerns of possible above-target risks do explain a reluctance to do more, it would illustrate a curious case of asymmetric behavior: fear of a possible risk that has not materialized preventing further action to address a clear and present risk. And, make no mistake, there have been real costs of not moving to full employment in a timely manner. The longer that workers remain idle, the greater the loss of human capital, attachment to the labour market and so on — not to mention social costs of greater unemployment. These effects would be harmful to the productive capacity of the economy, which is not helpful in terms of reducing debt burdens. That being said, hyperinflation would have large negative effects as well. But, if central bankers are holding back because of that fear, they should be prepared to demonstrate clearly where that risk lies; as Krugman might say: “show me the model.”
I am more sympathetic to the second concern. Yet, if there are increased risks associated with irresponsible risk taking, there is increased need for macro-prudential policies (adding another instrument to the Fed’s quiver). Isn’t that the point of all the post-crisis work on financial regulation? And, if the concern of fueling another bubble is justified, what does it say about effectiveness of all those meetings and all those regulations?