By John McHaleThursday, May 31st, 2012
I have previously referred to the dangers of a new “impossible trinity” for the euro zone: avoiding its disintegration; avoiding a significant move towards fiscal integration; and avoiding any relaxation of the current definition of price stability. In Wednesday’s post, I held out hope that stronger mutual insurance mechanisms could follow credible mutual assurances of disciplined policies. Here I want to revisit the possibility of relaxing current definitions of price stability. I realise this is taboo – but one I believe has to challenged given the nature and extent of the challenge facing the euro zone.
The move to formal inflation targeting in the euro zone, Canada and the UK (as well as informal inflation targeting in the US) followed the traumas of the stagflation of the 1970s, not least the expensive efforts in terms of lost growth and employment to bring inflation down in the 1980s and 1990s. However, while it is understandable that governments would not want to squander such expensively bought gains, the danger is that policymakers end up fighting the last war.
The particular constellation of problems in the weaker euro zone economies means that it will be very difficult – maybe impossible – to pull through the crisis under current arrangements. The boom-bust cycle in capital inflows have left a number of countries with current account deficits that cannot be financed. There is no alternative to adjustment. Given nominal rigidities, internal devaluation is a slow and costly process, requiring deep recessions to curb the demand for imports and induce the necessary wage/non-traded price cuts. Slow growth further undermines the creditworthiness of States and banking systems, creating damaging negative feedback loops. The euro zone may not survive the trauma under current policies. A higher inflation target could lower the costs of adjustment.
The danger is that the protection of hard-won low inflation becomes a mantra, preventing a broader reconsideration of the appropriate macroeconomic regime for the euro zone that properly reflects the full range of challenges being faced. Good macroeconomic management could become a victim of its own past success in institutionalising a low inflation-targeting regime. The question is whether it is possible to maintain much of the achievement of inflation targeting, while putting in place a macroeconomic regime that is consistent with a path through the crisis that avoids a disintegration of the euro zone.
It is important not to lose sight of the strong case for inflation targeting. The benefits are not limited to low and stable inflation. (See, for example, this account from the Bank of Canada.) By anchoring inflation expectations, a credible inflation targeting regime allows central banks the freedom not to have to respond to temporary supply-driven jumps in prices – due, say, to oil price or other commodity price shocks. If inflation expectations are not well anchored, central banks may have to tighten policy because of they fear second-round inflation change effects, which would result from the temporary inflation shock becoming embedded in inflation expectations. A credible inflation targeting regime can therefore have important benefits in terms of output and employment stability. (The financial crisis has made it clear that central banks put too much faith in the sufficiency of inflation targeting, taking a too relaxed attitude to the build up of financial vulnerabilities due to excessive credit growth. But this is not an argument against inflation targeting per se. Rather it points to the need to use other instruments – including macro prudential tools – to ensure stability. )
The key question is whether the benefits of an inflation targeting regime could be obtained with a higher inflation target. While there are risks to increasing an inflation target, the institutional structures of an independent central bank with an unambiguous mandate to achieve the inflation target over the medium run should allow the important benefits of an inflation-targeting regime to be protected.
With the euro zone facing an existential threat, it is not enough to repeat mantras about the benefits of price stability. Recognising the full range of objectives – including the value of a credible inflation targeting regime – it is time to reconsider the appropriate inflation-targeting regime for a euro zone in crisis.