Is inflation targeting dead? Central Banking After the Crisis - Vox

Is inflation targeting dead? Central Banking After the CrisisRefining inflation-targeting frameworksPrice stability was clearly not enough to deliver financial stability. This raises twoseparate challenges for inflation-targeting regimes. First, it is essential that we integratefinancial-stability considerations into inflation-targeting frameworks. The build-upof financial imbalances before the financial Crisis occurred during a period of lowand stable inflation (see centre panel of Figure 1). There are two ways to interpretthis observation. One is that inflation targeting in its prevailing form, with a pointinflation target to be met over a specified time horizon of a year or two, preventedcentral banks from leaning more aggressively against these imbalances. With broaderand more flexible mandates, ones that went beyond narrowly defined inflation targets,central banks would have maintained a tighter monetary-policy stance to curb thebuild-up of leverage and the underpricing of risk. An alternative view is that centralbanks simply lacked the tools they needed to mitigate financial-stability risks at a timewhen policymakers were pursuing price stability. Interest-rate increases high enough toeffectively mitigate pre-Crisis debt-fuelled property booms would also have caused amajor economic contraction. Some other tools, ones more appropriate to moderating thefinancial cycle – such as countercyclical capital requirements on lenders or maximumloan-to-value ratios applied to borrowers – are needed for times like this.Inflation-targeting regimes face a second challenge: a mechanism capable of providingmonetary stimulus even when the nominal interest rate hits zero. The severity of thefinancial Crisis and the recession that followed quickly drove policy rates to zero. Thedesire to provide further monetary stimulus has led to a number of innovations in theform of what are now commonly referred to as ‘unconventional’ policies. However,some have questioned the effectiveness of these tools in the light of the observation thatoutput in many economies remains well below the level implied by an extrapolationof the pre-Crisis trend. Because central banks are expected to tighten once inflationmoves above the target, inflation targeting is seen as standing in the way of a credible116