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

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Is inflation targeting dead? Central Banking After the Crisisof the financial system, but, by acting through that channel on market rates, it also hadmacroeconomic effects. Indeed, empirical research shows that it did have small butsignificant effects on the real economy -- at least in the phase preceding the sovereigncrisis (see Lenza, Pill and Reichlin 2010; and Giannone, Lenza, Pill and Reichlin 2012).Although it is possible that the existence of a credible commitment to a medium terminflation target has made things easier in difficult times (albeit, something difficult toestablish), the challenges of the day have demanded the use of new tools which havefocused on ‘market making’ interventions in key segments of the financial market. Thishas been the case even when, as in the Eurozone, the lower bound was not binding (seeGiannone, Lenza and Reichlin 2013 for evidence on this point). It suggests that themain problem has not been the fact that the policy interest rate had reached zero, butthat its relation to key market rates had been broken thereby impairing the transmissionmechanism in a situation where liquidity and solvency problems have been difficult todisentangle. The use of new tools is not in conflict with inflation targeting but had someconsequences which have challenged the framework.These policies have been effective, but have carried risks. These risks were alreadyclear in 2009-2010 but they became obvious when the debt crisis exploded in 2011.Liquidity injection acted, in some cases, as a temporary relief for institutions which infact were facing solvency problems. It is very hard to draw a line between liquidity andsolvency problems in practice. But when a central bank becomes involved in dealingwith solvency problems the line between monetary and fiscal policy becomes unclear. Inthe Eurozone, it became increasingly evident that the market was segmented, that somebanks were not solvent and were being artificially kept alive. As the Eurozone Crisisdeepened and cross border financial flows dried up, the interdependence between bankrisk and sovereign risk became apparent and the ECB’s provision of unlimited liquidityto banks located in the Eurozone periphery became similar to financing governments.The more recent phase of ECB policy, leading up to the so-called Outright MonetaryTransactions is an even a clearer case of a policy which is hard to label. In this case theECB announced that it will act as lender of last resort to achieve an objective which136
Challenges to inflation targeting after the crisisit defines in terms of monetary policy but which has implications beyond that. Therationale for Outright Monetary Transactions, in ECB communication, is the presenceof a wedge between the policy rate and market rates in the countries of the peripherywhere sovereign risk had affected the cost of funding for banks. In a monetary unionpart of that risk is associated with the possibility of that country exiting the euro, theso-called ‘redenomination risk’. This has been the justification for ECB action and itscommunication to the effect that it is prepared to act to preserve the integrity of the euro.Obviously here also the distinction between monetary and fiscal interventions is hardto draw. In fact this difficulty can be seen in the controversial debate which precededthe announcement of Outright Monetary Transactions, in the ECB’s reluctance to usethis instrument, and in the introduction of conditions for the intervention in terms ofbudgetary policy and economic reform.Perhaps the ECB would not have been led there if governments had done their part indealing with solvency issues, as these are essentially fiscal. However, this may not bea helpful comment, as central banks will often find themselves in this situation whenan economy is struggling to deal with a debt overhang. The debt overhang is indeedthe key issue facing both monetary and fiscal policy after the Crisis: not only in theEurozone but also in the UK, the US and Japan. In none of these jurisdictions has nonstandardmonetary policy acted explicitly to finance governments or failing banks butin all of them non-standard monetary policies have been conceived as tools designed tokeep the economy alive in presence of a debt overhang.Why is this a challenge for inflation targeting? There are two reasons.• The first is the game of ‘chicken’ between central banks and governments;Unable to deal with the fundamental causes of debt, government asks the central bankto keep both banks and sovereign alive in order to buy time. Independence is gone andthe incentive structure is wrong.• The second reason is the accumulation of credit risk in the central bank’s balancesheet;137
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Is Inflation Targeting Dead?Central
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ContentsForewordviiIntroduction 10L
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ForewordSince the onset of the Glob
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ForewordThe limits of monetary poli
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Introduction• Perpetrator: Inflat
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Introductionboth transparent commun
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Introduction• Financial crises of
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IntroductionThis posed a novel prob
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Introductionuntil unemployment fell
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Introductionbalance-sheet impairmen
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Introduction• Consideration of su
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Introductionenhance actual growth,
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Introductionrather than interpretin
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IntroductionConcluding remarksInfla
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Who killed the inflation target?Lor
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Who killed the inflation target?How
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Who killed the inflation target?red
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Is inflation targeting passé?Stefa
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Is inflation targeting passé?Raisi
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Is inflation targeting passé?In su
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Monetary targetry: Might Carneymake
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Is inflation targeting dead? Centra
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The evolution of modern centralbank
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Inflation targeting: Fix it, don’
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Is inflation targeting dead? Central Banking After the Crisis - Vox

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