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

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Is inflation targeting dead? Central Banking After the CrisisTwo effects of the CrisisIn thinking about the second claim, it is important to recognise that the financial Crisishad two effects on the economy:• First, cascading losses in the financial system, elevated credit risks and, in somecountries, worries about sovereign-debt sustainability had a large impact on financialsystems’ ability to intermediate credit and therefore in the demand for goodsand services. Falling house prices and collapsing housing investment also triggeredsharp falls in aggregate demand and large increases in unemployment in economiesthat experienced housing bubbles. With prices sticky, the reduction in demand hasbeen felt largely in a much reduced level of real economic activity and not in lowerinflation.• Second, severe stress across financial systems in many countries weakened themonetary transmission mechanism. This latter constraint became particularly apparentonce central banks cut interest rates to the (zero) lower bound and traditionalinterest-rate policy became ineffective. Thus, monetary policymakers have had tocontend with a large decline in economic activity at precisely the same moment asmonetary policy lost much of its effectiveness.To increase the potency of monetary policy, it would be helpful to raise inflationexpectations, which would reduce expected real interest rates since the nominalinterestrate is frozen at (close to) zero in many countries. Unfortunately, under inflationtargeting the expected inflation rate is typically constant and equal to the objective.Thus, the difficulty central banks face in stimulating the economy arises becausenominal-interest rates are stuck at zero, coupled with the fact that the expected rate ofinflation is well anchored at the target.38
Is inflation targeting passé?Raising inflation expectationsOne way to raise inflation expectations after an adverse shock is to announce a pricelevel path which rises at a rate corresponding to the inflation target, say, 2% per year.If the bursting of a financial bubble leads to unusually low inflation, the price level willfall below this path. Monetary policy will therefore temporarily aim for inflation above2% in order to return the price level to the path 1 .While the economics is straightforward, it turns out that even after the massivecontractionary shock many economies have experienced in recent years, price levelshave not fallen below a 2% growth path (see Figure 1). Therefore price-level targetingwould now not call for monetary-policy easing.Figure 1. Price levels13012512011511010510095908599 00 01 02 03 04 05 06 07 08 09 10 11 12EA UK USSource: ECB, ONS, Fred.1 See Eggertsson and Woodford (2003) for a discussion of price targeting at the lower bound.39
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Page 5 and 6: ContentsForewordviiIntroduction 10L
Page 7 and 8: ForewordSince the onset of the Glob
Page 9 and 10: ForewordThe limits of monetary poli
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Page 13 and 14: Introductionboth transparent commun
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Page 19 and 20: Introductionuntil unemployment fell
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Page 25 and 26: Introductionenhance actual growth,
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Page 29 and 30: IntroductionConcluding remarksInfla
Page 31 and 32: Who killed the inflation target?Lor
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Page 66 and 67: The evolution of modern centralbank
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Is inflation targeting dead? Centra
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Nominal-GDP targets, without losing
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A broader mandate: Why inflationtar
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Will central banking change?Charles
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Central banking after the Crisis:Ch
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Challenges to inflation targeting a
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