Inflation targeting remains relevant

Over the past year or two, there have been several kinds of attack on inflation targeting as a way to run monetary policy.

First, there have been those, like Joseph Stiglitz, who dismiss it as highly damaging to the citizens of those countries whose central banks practise it.

In an article in the New Zealand media last year, Stiglitz claimed that "inflation targeting is being put to the test and it will almost certainly fail." He listed 23 countries which had adopted inflation targeting - including New Zealand, but curiously omitting the euro area - and extended his sympathies "to the unfortunate citizens" of those countries. He expressed the hope that "most countries will have the good sense not to implement inflation targeting."

But Stiglitz - whose Nobel Prize in economics had nothing whatsoever to do with monetary policy, or indeed with macroeconomics more generally - was totally wrong. He set up a straw man by defining inflation targeting as meaning that "whenever price growth exceeds a target level, interest rates should be raised."

No central banker running an inflation targeting monetary policy would apply such a simplistic approach to interest rates. The Reserve Bank of New Zealand was the first central bank to formally adopt inflation targeting in the late 1980s and from the very beginning it was made clear, both in the agreement between the minister of finance and the governor which embodied that approach and in umpteen statements made by the central bank, that monetary policy would "look through" changes in prices which were driven by factors totally outside the influence of domestic monetary policy. That has clearly been the practice of other inflation targeting central banks also.

Then there have been those who have argued that, in conditions of severe recession such as those which have beset many developed-country economies over the past year or two, stimulating economic activity is vastly more important than keeping inflation within some pre-determined target, and that in these circumstances inflation targeting should be abandoned.

But those who argue this way have often forgotten that an inflation target normally has not just a "ceiling" but also a "floor" - and that both are important. If an economy suffers a severe fall in activity, the likelihood is that inflation will be falling towards or through the floor, obliging an inflation targeting central bank to ease policy. In other words, an inflation targeting central bank will, in these circumstances, be adopting a monetary policy which will tend both to prevent the inflation rate falling through the floor and one which will tend to stimulate activity. Indeed, to the extent that the central bank can credibly commit to keeping the inflation rate above the floor it plays an important role in preventing the development of deflationary expectations.

Then there are those who argue that, while keeping consumer price inflation within target may be highly desirable, it simply isn't sufficient - that monetary policy should also try to avoid asset price bubbles, or indeed sharp falls in asset prices. I have a good deal of sympathy with this view. Keeping consumer price inflation under control is clearly very desirable, but as we have all now seen, asset price bubbles can also cause an enormous amount of economic and social damage, particularly when they burst. I am very comfortable with the argument that central banks may need to supplement their control over short-term interest rates, aimed at consumer price inflation, with a policy aimed at influencing asset prices - possibly varying the required minimum capital that banks must hold or using some other lever directly on the supply of credit.

Finally, there are those who have somehow persuaded themselves that monetary policy can both keep inflation under control and achieve some other economic goal which may be inconsistent with the maintenance of control over inflation. The recurring theme in New Zealand is that monetary policy should be operated not just to keep inflation under control but also to stabilise the exchange rate. Some critics of the inflation targeting regime seem to imagine that exporters would be helped if, when the nominal exchange rate appreciates, the central bank were to reduce interest rates in order to encourage a fall in the exchange rate. But of course as central bankers know only too well, while that might help exporters in the very short run, it would do nothing to help in the longer run as the lower interest rates and lower exchange rate pushed up the domestic inflation rate. Of course, what matters to exporters in the longer run is not the nominal exchange rate, but the real exchange rate. The central bank can affect the real exchange rate in the short run but can have no influence on it over the longer term.

The essentially very simple idea of inflation targeting has a lot of life in it yet.

Don Brash was governor of the Reserve Bank of New Zealand from 1988 to 2002