The writer is an FT contributing editor and former chief economist at the Bank of England
Even economists are capable of love. And I love inflation targets, having been involved in their design and implementation in the UK, and across a number of other countries, for a period of more than 30 years.
Yet recent events have cast a long shadow over inflation targeting, with inflation in most countries rising to multiples of the targets adopted by their central banks.
The evidence of the past two years suggests two lessons for policymakers from two mini-monetary mistakes. The first is that central banks were initially too slow off the mark in tightening policy, misdiagnosing a large, lasting and broadly-based rise in prices as a modest, temporary and energy-specific one.
The second is that central banks then engaged in a game of catch-up, both with inflation and their own credibility. This came just as demand was stalling, making a bad growth situation worse. It has cast doubt on the wisdom and sustainability of monetary tightening.
This leaves many central banks struggling to communicate their intentions. Should monetary policy stick (to curb further harm to the economy) or twist (to curb future inflationary pressures)? This uncertainty has caused financial markets to whipsaw, and inflation expectations to wobble.
What the world has experienced is an upward shift in the level of global prices. This has arisen from dislocations in global supply chains, buffeted by geopolitical crosswinds. As these supply chains have become both more fragmented and more fragile, prices have been pushed higher.
Nowhere are these pressures more acute than in the supply of people and their skills. This has put acute upward pressure on pay as well as prices, resulting in stickier as well as higher global prices. High and sticky rates of underlying or core inflation attest to that.
This shift upward in the equilibrium global price level is the mirror image of the golden age of globalisation that occurred after the second world war, when global supply chains lengthened and deepened, contributing to inflation persistently undershooting its target in many countries, including Japan, the US and eurozone.
That golden era is now over, because supply chains take time to repair and reconfigure, particularly for people and their skills. The resulting reflation seems set to persist for a period measured in years not quarters.
Large and lasting global supply shocks of this type put monetary policymakers on the horns of a dilemma. Do they tolerate above-target inflation — in line with the initial (in)action of central banks recently? Or do they continue to raise rates to counter high and sticky prices — in line with their subsequent (hyper)activity?
The road so far has seen central banks run over in both directions, arguably first too soft on inflation and then too hard on the economy. The policy question, looking ahead, is how to prevent a recurrence of these mini-monetary mistakes in the event of persistent upward pressure on global prices.
One option would be to stick with current targets and explain inflation overshoots as a sequence of unexpected price surprises. But because further overshoots would be anything but a surprise, that approach risks a further knock to central banks’ already depleted credibility.
A second option, mooted recently on these pages, would be to shift up permanently the level of inflation targets, say to 3 per cent, reducing the scale of prospective inflation target misses. But whatever the substantive merits of a higher inflation target, this would be a misdiagnosis, as the problem at hand is a persistently higher level of global prices, not national inflation rates.
A third, and preferred, option would be to use the flexibility naturally built into inflation targeting. This could be done either by transparently lengthening the horizon over which inflation is returned to target, say, from one-to-two years to three-to-four. Or, more radically, given we cannot be sure exactly how long higher global prices will persist, by suspending inflation targets for a temporary period, with an accompanying promise to re-fix them at the earliest possible future date.
Flexing horizons, rather than the targets themselves, would protect the economy in the near term, while leaving inflation tethered to target over the medium term. It was for just such moments that inflation targeting was conceived as “constrained discretion”. Now is the time to exercise qualified discretion.
With inflation high and inflation expectations fragile, it could be argued that any tinkering with the monetary frameworks which have served us well is the worst possible response. It is in fact the second worst.
The worst would be to stick rigidly with existing targets and either continue missing them or inflict unnecessary damage on nascent growth. Far better a flexible third way that could steer a course between these rocks. If my love of inflation targets is to last and if these targets are to survive, that flexibility will be needed to prevent the mini-monetary mistakes of the recent past morphing into the maxi-monetary mistakes of the future.
