What central banks should target
What should central banks target? Since the early 1990s, the answer has increasingly been “consumer price inflation”. But this has never been undisputed. Today, there are four alternative positions. It is believed that central banks should target asset prices. Another thinks they should aim for a “fair” interest rate. Yet another thinks they should target real business. The latter thinks they should aim for another nominal target, such as the price level or the nominal gross domestic product. These are important debates. But the reality remains: central banking is an art, not a science. Art should be guided by sensible goals coupled with a deep awareness of uncertainty.
Since the early 1990s, the prevailing view among central bankers and economists has been that the best target is inflation. The approach was pioneered in New Zealand in 1990 and quickly followed by Canada and the UK. The US Federal Reserve followed in 2012. The European Central Bank is also an effective inflation target, although its target is a 2% ceiling and therefore not symmetric. According to Paul Fisher of Warwick Business School, 67 central banks had inflation targets in 2018.
The rationale for inflation targeting has three elements. The first is that an instrument—in this case, monetary policy—can only serve one purpose. The second is that a central bank can only pursue any nominal objective. The third is that inflation is an understandable and politically acceptable objective.
A subset of those who think central banks should target asset prices agree that there should be only one target. But they want them to target the price of a commodity, usually gold. Maybe at some point they will want them to target bitcoin as the ultimate reserve asset instead. The objection to a gold standard is that it eliminates discretion, which has proven intolerable. Today, the “gold bug” view has become a curiosity.
A more widely held view today is that central banks should target debt growth or a range of asset prices, such as those of houses or stocks. The New Zealand government, for example, has just told its central bank to target real estate prices. People who think this often argue that explosive increases in asset prices fuel inequality and create macroeconomic instability.
There are at least four strong objections to asset price targeting. First, since asset prices are volatile, targeting them would make monetary policy very volatile and thus generate great macroeconomic instability. Second, no one knows what the “good” equity should be, the price of real estate or the level of private debt. Third, central banks must in any case consider asset prices and debt growth in assessing the state of the economy. Finally, if central banks want to influence asset prices or leverage, they should instead use a wide range of regulatory tools.
Perhaps the most ludicrous argument is that of wealth inequality. It is absurd to argue for more restrictive monetary policy and therefore higher unemployment, which is painfully real for its victims, in order to reduce wealth inequality, which is only a ratio. In 2020, wealth at the 20th percentile of the income distribution in the United States was $6,400 and at the 40th $67,500. The top 0.1% started at nearly $43 million. What difference would it make to those with next to nothing if the latter were to double? If people want less wealth inequality, they should advocate for wealth and inheritance taxes.
A view not unrelated to the above is that the central bank should aim for a positive real interest rate. The implicit belief is that we know what the real interest rate should be and that the central bank is responsible for keeping it so low for so long. Neither is justified. The appropriate interest rate depends on the general conditions of the economy, particularly savings and investment. In addition, the central bank must set a rate compatible with macroeconomic equilibrium. So the underlying realities ultimately shape what he can do.
Using monetary policy to target asset prices, rather than just factoring them in, is madness. However, it is not absurd to consider the real activity. Indeed, the Fed is already mandated to take unemployment into account. Fortunately, inflation targeting is compatible with making real activity the ultimate goal. The weaker the relationship between inflation and unemployment, the more the bank must aim for maximum employment, subject to inflation. Recently, the Fed even turned to average inflation targeting. This will allow it to target real activity more aggressively, offsetting a long period of below-target inflation with above-target inflation. Targeting the price level or nominal GDP could reinforce such an objective.
In sum, the central bank’s current overall approach is clearly the least bad. That doesn’t mean it’s easy to use.
It is highly likely that the monetary policy needed to generate maximum employment and stable inflation is compatible with all sorts of crazy activity in the financial system. Surely we see a lot of them now. But no sane central bank would deliberately create recessions in order to save finance from itself. On the contrary, it must save the economy from finance through strict regulation, particularly of leverage.
Likewise, it is possible for an exceptional crisis, such as the pandemic, to generate policy errors, including unexpectedly high inflation. Andy Haldane, the chief economist of the Bank of England, rightly pointed to this risk in a recent thought-provoking speech.
Central banks must always be vigilant. But no one should imagine that there is an alternative diet that will solve all difficulties. Central banks will make mistakes. But they should be kept simple.
Follow Martin Wolf with myFT and on Twitter
Letters in response to this column:
The Fed’s Stance Is Stupid Even If It’s Well Meaning / By Peter R Fisher, Tuck School of Business at Dartmouth, Hanover, NH, USA
Let’s relive the 70s habit of targeting the money supply / From Professor Tim Congdon, President, Institute for International Monetary Research, University of Buckingham, Buckingham, Buckinghamshire, UK
Fed inflation targeting is more than just talk / By Konstantinos Gravas, Department of History and Philosophy of Science, National and Kapodistrian University of Athens, Athens, Greece