P248 inflation targeting(2)

Introductionbalance-sheet impairments that obstruct the flow of funds to productive parts in theeconomy. In upturns, diligence is required to avoid imbalances that make the economyvulnerable to liquidity and deflationary spirals.This perspective holds great promise – and there are indications that central banks arealready using aspects of it to guide the balance-sheet leveraging policies. The Fed, forexample, has focused on mortgage-backed securities, while the ECB has focused onbank-owned securities. More analysis and evidence is likely to be needed before itmakes its way into the toolkit.This sequence of ‘challenge and response’ has moved inflation targeting a very longway from what it was before Lehman’s fall. Many of our authors worry that this shiftmay lead to disaster – even though each step seems justified at the time.Future pitfallsThe exceptional policies which central banks have implemented to deal with the Criseshave blurred the distinction between monetary and fiscal policy. This challengescentral banks’ independence, and thereby the principle of inflation targeting. “Weare nearing a critical juncture for modern central banking,” as Mohamed EL-Erian putit. Central bankers stepped outside their conventional roles to prevent the first GreatRecession from being the second Great Depression. “But with other policymakersessentially missing in action, they have found themselves pushed further and furtheraway from their operational comfort zones, forced into ever more experimentation withincreasingly uncertain longer-term outcomes.” The threat is twofold.Game of chickenThe first threat is the ‘game of chicken’ that governments are playing with central banks.Governments seem to be hoping to shift some of the political costs to central banks by21