I still believe in inflation targeting

The current economic crisis - which has now lasted so long it should eventually require a name change - has naturally called into question deeply held assumptions and rigid ideologies. And that's a good thing.

One thing which has been questioned is the wisdom of "inflation targeting". The argument is that since inflation targeting was designed to flatten out economic growth and prevent booms and busts, then it is obviously a failure.

I still think that inflation targeting is needed for the following reasons:
  • While the crisis is international, it began in the US. The Federal Reserve Bank certainly adjusted interest rates according to inflation, but there was no "inflation target" that was used.
  • One of the basic rules behind inflation targeting is to ensure that real interest rates (interest rate minus the inflation rate) are positive. Under Greenspan between 2003-2005, real interest rates in the US were negative. Not only did the Fed not have an explicit inflation target, it did not even follow judicious monetary guidelines to ensure that real interest rates remained positive.
  • The European Central Bank (ECB) was not consistent in its application of its own inflation target in regards to the Euro. For most of the ECB's life, inflation exceeded its 2% inflation target.
  • Despite these problems, inflation in many Western countries in the past decade was low. Yet even low inflation rates did not avert the crisis from developing.
  • The solution is not to abandon inflation targeting, but to actually practice and enforce it.
I am very well aware that one of the louder voices in this economic crisis is the one which says "capitalism has not failed because capitalism was never tried". Arguing that inflation targeting is still necessary makes me feel like one of these ideologues. Nevertheless I believe the clear evidence is that both the Fed and (to a lesser extent) the ECB were not involved in inflation targeting per se, either explicitly (by keeping inflation below an arbitrary level) or implicitly (by ensuring real interest rates remained positive). If "inflation targeting" is to be defined as the Fed's and the ECB's actions over the past decade then it must certainly be abandoned and replaced by a harsher, stricter inflation killing regime.

Let me rehash one of my typical arguments about Absolute Price Stability. Had inflation targeting been far stricter in the last ten years and aimed at neither inflation nor deflation, but rather a zero net change in consumer prices, then this crisis would never have occurred in the first place. Higher interest rates would have prevented a subprime bubble, it would have dampened economic activity enough to prevent ultra-high oil prices, it would have provided a reasonable alternative to investing in the share market and it would have prevented excessive lending and over-leveraging.

So the reason why I believe in inflation targeting is because, if it was actually tried and if Absolute Price Stability was its goal, the current crisis and mess would never have occurred in the first place.

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