We may now be at a third watershed in the evolution of monetary policy.
Following the recent global financial crisis, John B Taylor argued that a contributory factor was that US monetary policy was too loose as it deviated from his eponymous rule. What were the factors underlying this deviation The story begins with the sharp decline in consumer price index-based inflation in both developed and developing countries over the last two decades. According to IMF data, it averaged under 7% in developing countries between 2002 and 2010, as against 38.4% between 1992 and 2001. In developed countries, it fell by about 20%, from 2.4% to 1.9%. On the basis of this data the IMF in its World Economic Outlook of April 2013 concluded that inflation-targeting by central banks had been eminently successful.
Inflation-targeting, however, was never an end in itself. It was the canary in the gold mine that central bankers watched to set the equilibrium interest rate at which incomes are optimally distributed between savings/investment and consumption so as to keep the economy growing at the production possibility frontier, or its potential growth rate. If core consumer price inflation were however to lose its sensitivity to the business cycle, the targeted inflation would also cease to ensure macro-economic stability. This is precisely what happened. Core inflation remained remarkably stable, despite sharp fluctuations in growth and periodic fluctuations in commodity prices. Savings declined, while investment and consumption increased, leading to an ever-widening US current account deficit (CAD). The Phillips curve became unstable all over again. The problem was much deeper than a simple deviation from the Taylor rule, as the connection between core CPI inflation and economic growth in the Taylor rule was predicated on a robust Phillips curve.
What was happening And how was it that the US Federal Reserve was able to keep interest rates low although US savings were declining The answer lies in increasing globalisation.
First, there was the entry of two humongous developing Asian economies, China and India, into the global labour market for goods and services, at a time when rapid productivity shifts were taking place in these countries as large numbers of people moved out of low productivity agriculture. Between them, they account for about 40% of the global population and virtually unlimited supply of cheap labour. Other populous low-income Asian countries such as Bangladesh, Vietnam and Indonesia, were never far behind. The attendant productivity and efficiency gains had a disinflationary impact on consumer prices, as excess domestic demand in advanced economies like the US was easily accommodated by cheap supply overseas without inflationary outcomes.
Second, such spillages widen CADs that ordinarily lead to currency depreciation and inflationary pressures. However, systemically large CADs were in high-income reserve-issuing currencies countries where the counterpart current account surpluses of developing countries were parked. The reserve currencies, therefore, did not depreciate relative to their major surplus trading partners, as the savings glut in emerging markets exercised a downward pressure on global interest rates. Central banks were either deluded by the low core inflation into keeping interest rates unduly low, or, as argued by Alan Greenspan, they lost control over long-term interest rates as large capital flows, amplified through an innovative shadow banking system, neutralised their interventions at the short-end of the yield curve. The liquidity overhang from loose monetary policy had to find some outlet, however, and it did so by raising the price of financial assets instead of consumer prices, with several physical assets such as housing, and commodities like oil, food and gold, crossing over to become financial assets. The consequential wealth effect increased consumer demand despite stagnant labour incomes, while a mis-aligned policy rate fuelled a strong credit and liquidity bubble that enabled consumers in advanced economies gain from these disinflationary forces.
Thus, monetary policy focused on inflation-targeting inflated asset bubbles even as core CPI remained stable. It is not as though central bankers were blind to asset bubbles. However, the dominant Keynesian paradigm was focused on short-term demand management of the business cycle that was challenged in its understanding of the dynamic of financial markets. It was impervious to longer-term financial cycles underscored by the Austrian School of Von Mises, Von Hayek, et al, where financial markets occupied centre stage.
An unreformed monetary policy framework is once again inflating asset bubbles, rather than stoking inflation to targeted levels. If anything, the distortions arising out of inflation-targeting have been magnified in the post-crisis period, whether measured in terms of core inflation, asset inflation and deviation from the Taylor rule. Going forward, there is the added risk that central banks in advanced economies may be constrained to keeping interest rates too low out of fear of triggering another financial crisis, and also to pay down public debt that has increased dramatically in the last few years as a result of crisis management.
If inflation is no longer a robust marker of business cycles, what other markers should supplement it Since the anomaly of low inflation and high growth in advanced economies was induced by the wealth effect of inflating asset prices and growing leverage, these are automatic candidates. Monetary aggregates can also capture an emerging credit bubble; for instance, when growth in M3 is out of sync with nominal GDP growth through sharp increases in the money multiplier.
It could plausibly be argued that while inflation-targeting no longer works for advanced countries, it is still relevant for developing countries where inflation remains an issue. With tightly regulated financial markets, and continued use of monetary aggregates, they have also been able to largely contain a destabilising interface between the financial and credit cycles. Indeed, John B Taylor has argued that his eponymous rule is, mutatis mutandis, relevant for developing country central banks. There are, however, other factors emasculating inflation-targeting in emerging markets.
First, with food and fuel comprising a substantial chunk of the expenditure basket, core inflation seems much less relevant as a policy marker on the one hand. On the other hand, non-core inflation is much less amenable to monetary policy actions. The latter may also be becoming volatile as commodities have become increasingly financialised through derivatives.
Second, volatile cross-border capital flows are now driving business cycles, including asset prices, in emerging markets, and simultaneously exerting disinflationary and inflationary pressures through exchange rate fluctuations. This constrains their central banks, following inflation-targeting, to tighten policy just when the external cycle turns and growth collapses, and vice-versa. They have consequently found it impossible to use a single policy instrument, the short-term interest rate, to simultaneously target both the domestic growth-inflation cycle and the external financial cycle which is subject to the vagaries of monetary policies emanating from reserve currency issuing countries. Their inflation-targeting keeps running up against the impossible trinity or policy trilemma as, according to the widely accepted Tinbergen rule, a policy instrument can be effective only if it has a single objective.
To recapitulate the central arguments, there have been two major watersheds in the conduct of macro-economic policies in the post-war period. The first was the shift from fiscal policy to greater reliance on monetary policy to stabilise business cycles. The second was the adoption of rule-bound monetary policies such as the Taylor rule, which used core consumer price inflation as the canary in the goldmine to stabilise the business cycle at its production possibility frontier. In the wake of the global financial crisis, a third inflexion point in the conduct of macro-economic policy may have been reached with inflation-targeting, as currently conducted by central banks in both advanced economies and emerging markets, breaking down. In advanced countries, it is stymied by asset and credit bubbles, and in developing countries by the nature of inflationary pressures and volatile capital flows. Repair of the macroeconomic framework in advanced economies would involve tweaking monetary policy rules to take stock of credit cycles in addition to the business cycle. Emerging markets need to find ways of targeting non-core inflation, and also a separate policy instrument to target the external financial cycle so that the interest rate instrument can be freed up for targeting the domestic growth-inflation cycle.
The author is secretary, Economic Advisory Council to the Prime Minister. Views are personal