Thursday, December 3, 2009

Inflation Targeting: When Creator and Creature Collide

The death of inflation targeting has been covered in this blog here, here and here. Yesterday we got news from the Wall Street Journal that, in a coup de grâce, the creator has come to terms with the need to kill the creation (HT Selva Brasilis).

The creator's name is Ben Bernanke. The creature's name is inflation targeting. Bernanke devoted a large part of his successful career as a scholar to the analysis of inflation targeting regimes. This was probably the main reason for his appointment as Fed Chairman, as explained in this Bloomberg article of 2005:

The nomination [of Bernanke], which is subject to confirmation by the U.S. Senate, may nudge the Fed in the direction of more than 20 foreign central banks that pursue numerical inflation levels or ranges, said global economists and former central bankers.

Here's however the big irony: Bernanke was appointed to bring the creature to life inside Fed's labs. Once there, however, he became responsible for pulling the plug on his own creation.

I'll use Bernanke's own words to make the point. In an American Economic Review article of 2001, Bernanke the Princeton Professor said:

In recent decades, asset booms and busts have been important factors in macroeconomic fluctuations in both industrial and developing countries. In light of this experience, how, if at all, should central banks respond to asset price volatility? ...

The inflation-targeting approach gives a specific answer to the question of how central bankers should respond to asset prices: changes in asset prices should affect the central bank's policy only to the extent that they affect the central bank's forecast of inflation.

What Bernanke meant is that, as long as inflation is expected to remain low and around the target, the Fed should not try to "shoot bubbles." Now, contrast the statement above with what Bernanke the Fed Chairman said recently, according to yesterday's WSJ article:

"The best approach here if at all possible is to use supervisory and regulatory methods to restrain undue risk-taking and to make sure the system is resilient in case an asset price bubble bursts in the future," Mr. Bernanke said in answer to a question after a speech in New York last month. ...

Mr. Bernanke is leaving himself hedged. If he felt stamping out a bubble with higher rates would forestall a rise in inflation or stabilize the economy, "We'd have to think about that very seriously," he told the New York Economic Club recently. "We can never say never."

So, what has happened? While I worked in the Central Bank of Brazil a few years ago I tried to bring to to the attention of some of my colleagues that inflation targeting is a monetary regime that lacks a credible nominal anchor. I discovered later that John Cochrane had the same intuition and was able to formalize it in this excellent critique of inflation targeting. Most central bank economists that I met however would prefer to follow Bernanke's inflation targeting cookbook without making any serious attempt to think about its economic foundations (or lack thereof). Many among them would also choose, mostly because of Bernanke's diagnostic reproduced above, to ignore asset price runs that would periodically infest economies based on new-Keynesian interest rate rules such as is the case with inflation targeting. What followed is history: welcome to "bubble world"!

Mistakes made by central banks during the inflation targeting years are a good example of a big problem in science: the institutionalization of scientific consensus. The Hadley CRU "Climategate" scandal is another example of the same problem, although in the latter case there was serious unethical conduct by some scientists and extreme politicization of the scientific community - something that I've never witnessed at such an inordinate level during my years in central banking.

Dissent, as long as based on the scientific method, should never be silenced. Indeed, it should be welcomed by all that are intellectually curious, ethical and passionate about science.

No comments: