A dangerous expectations gap has been developing between what monetary policy can deliver and what it is expected to deliver. Monetary policy cannot fine-tune inflation, let alone economic activity within narrow ranges. Nor can it be relied on as a de facto engine of growth. The media and financial industry razzmatazz surrounding policy decisions suggests that we have long lost that sense of realism.
This expectations gap complicates the conduct of policy and decision-making. Ultimately, it could even undermine central bank independence and legitimacy. However, the toughest challenges for monetary policy regimes are probably still to come.
Politics and fiscal policy set to complicate monetary policy
The political environment is becoming less conducive to stability-orientated monetary policy. The pressure on central banks to take a short-term view is growing alongside the demands placed on them. In such an environment, institutional safeguards such as central bank independence become all the more precious. But they can help only up to a point.
We should not take too much comfort from the recent rather painless reduction in inflation compared with the past. Circumstances have been extraordinary. The typical future fight against inflation is likely to follow more familiar patterns and cause bigger costs. This would be especially the case if it took place in a less globalised world: firms and workers would regain pricing power and would make it easier to resist a drop in purchasing power and profit margins.
The unsustainability of fiscal trajectories represents another major threat. This is probably the biggest longer-term threat to macroeconomic and financial stability in the years ahead – and hence a threat to the monetary policy regime itself.
Monetary and fiscal policy are joined at the hip. There are clear limits to what monetary policy can do if fiscal policy is out of kilter. Both policies need to operate firmly with a ‘region of stability’ consistent with sustainable growth.
Against this backdrop, inflation-targeting regimes – the de facto prevailing monetary standard – cannot afford to stay still. Inflation-targeting does not represent the end of monetary policy history. It is just one, if exceptionally long, chapter in that history.
How could inflation targeting be adjusted to make it fit for purpose longer term? A comprehensive analysis of the challenges the framework has faced since its inception points to a number of suggestions.
Ensuring the inflation-targeting regime is fit for purpose
First, hardwiring a low-inflation regime should remain a priority. The behavioural definition of price stability suggested by Paul Volcker and Alan Greenspan is especially apt – a condition in which inflation does not materially influence people’s behaviour. The objective should be not so much anchoring inflation expectations but making them irrelevant. Raising current targets from the generally accepted 2% level, as some observers have proposed, would be a bad idea. Quite apart from undermining the central bank’s credibility, this would endanger the self-stabilising properties of inflation in a low-inflation regime, which is one reason why transitions from low- to high-inflation regimes tend to be self-reinforcing.
Second, relative to how the targets have been generally interpreted in the past, the key adjustment would be to have greater tolerance for moderate, even if persistent, shortfalls of inflation from narrowly defined targets. This would help retain room for manoeuvre and would allow central banks to take into account more systematically the longer-term damage from the consequences of low interest rates, which weaken the financial side of the economy. Implementing such a strategy would require addressing what Martin Feldstein and Raghu Rajan have aptly termed the ‘deflation bogeyman’ – the view that deflation is a kind of red line that, once crossed, gives rise to a self-reinforcing downward spiral in economic activity or to a depression trap. There is no systematic link between falling price levels and weak economic activity. The Great Depression is an exception that reflected broader forces.
Third, we should consider further how best to use the additional room for manoeuvre to tackle the financial cycle. This would call for lengthening horizons as far as possible. It would require upgrading the role of financial conditions, credit aggregates and property prices among the set of indicators that central banks follow. And, analytically, it would call for less reliance on macroeconomic models based on the standard ‘shock-propagation-return-to-steady-state’ paradigm and more on approaches that allow for endogenous and possibly unstable fluctuations.
Fourth, some further adjustments can enhance the effectiveness of the framework, contributing to its nimbleness and the retention of safety margins. One is less reliance on forms of forward guidance that provide specific information about the future path of interest rates beyond the central bank’s reaction function. These can unduly constrain a central bank’s ability to respond to rapidly changing conditions. And they can unduly compress risk premia and encourage risk-taking. In the extreme, rather than guiding markets, the central bank may end up being taken down the wrong path, as the emergence of fragilities in the financial system can force its hand.
Another adjustment is putting a premium on exit strategies whenever the central bank is called up to take exceptional measures to stabilise the system and the economy. The difficulties in reducing historically large and risky central bank balance sheets are testimony to the challenges involved.
A reasonable principle is that central bank balance sheets should be as small and riskless as possible, subject to fulfilling mandates effectively. Except possibly for the need to hold foreign exchange reserves for precautionary purposes, balance sheets can be quite small. Central bank balance sheets should be elastic – ready to increase when circumstances require it. Given the economic and political economy costs of larger balance sheets, the initial size is a hindrance, not a plus.
‘Sustainable’ is the key word
In the regime I have in mind, the central bank keeps a sharp focus on the medium term. It seeks to ensure that the financial side of the economy, which it influences and through which it operates, does not end up derailing the economy, whether through inflation or financial instability, broadly defined. The central bank sets the monetary preconditions for sustainable growth but does not end up being relied on as the engine of growth.
It is a regime in which the operational definition of the inflation target is consistent with that overarching objective. The target is low enough so that inflation does not materially influence agents’ behaviour, but flexible enough to allow the central bank to take into account the financial forces that can generate damage down the road.
In this regime, the central bank’s reaction function calls for forceful responses when inflation threatens to get out of control but allows for greater tolerance for moderate, even if persistent, shortfalls from target.
Does this have implications for mandates? Not so much if, by mandate, we mean the general goals that may be set out in the central bank’s law or in agreements with the government. We have seen inflation-targeting regimes being operated in broadly similar ways despite different mandates. But it does have implications for the way in which mandates are interpreted and, above all, communicated.
The word often missing here is ‘sustainable’. Once sustainability is added as an explicit consideration, whether in terms of inflation, output, employment or financial stability, all the pieces of the jigsaw puzzle fall into place.
Claudio Borio is Head of the Monetary and Economic Department at the Bank for International Settlements.
This is an edited version of the concluding part of his OMFIF lecture, given in London, 13 November 2024. Read the full analysis and unabridged text, ‘Whither inflation targeting as a global monetary standard?’ here.
