P248 inflation targeting(2)

Is inflation targeting dead?to ‘lean against the wind’, tightening policy – and, in expectation, undershooting thetarget – if asset prices and balance sheets are thought to be rising too quickly 3 . But evenif the debate is about orders of magnitude rather than absolutes, it’s understandablethat the financial Crisis has added to calls for all sorts of policies, including monetarypolicy, to do more to prevent its recurrence in future.Large though the benefits of preventing financial crises would undoubtedly be, however,the costs of doing it through monetary policy alone are not negligible either. This isparticular the case if – as was true in the UK – domestic banks have large overseasexposures (Figure 2). Simulations by Bean et al. (2010) suggest that, to stabilise realhouse prices in the UK from 2004 on, interest rates would have to have been severalpercentage points higher and, by mid-2007, GDP 3.3% lower. But domestic mortgages,the most interest rate-sensitive part of their domestic balance sheets, accounted for lessthan a quarter of UK banks’ assets immediately prior to the Crisis and have contributedonly a tiny fraction of their losses since (Figure 3 compares loss rates on UK mortgageswith those in the US). Instead, it was losses on overseas assets – including US mortgages– that did most of the damage (Broadbent 2012). So while stabilising domestic houseprices would probably have involved material costs in foregone output, it’s less clear itwould have done much to reduce the likelihood or costs of the financial Crisis.3 Suppose a rigid inflation targeter seeks to minimise only the variance of inflation around its target V[π-]. This can bebroken down into two parts, the variance of expected inflation around the target and the variance of the control error:V[π-π – ]=V[π^e-π̅ ]+V[π – -π – ^e]. In simple linear economic models the second term depends only on the distribution ofexogenous shocks and is unaffected by policy. But if (plausibly) an asset-price bubble increases the dispersion of futureinflation outcomes, and if tighter monetary policy makes it harder for them to grow, there would be a case for policy torespond to rapid growth in asset prices – beyond any impact they may have on expected inflation – even with nothingother than inflation in the objective. For more on the reaction to asset prices under inflation targeting see Bean (2003).55