Why IMF may be wrong on 'inflation targeting'

While independent central banks initially anchored inflationary expectations, major structural changes in the global economy helped to keep, and are keeping, inflation under check

The changing structure of the global economy is leading to rethinking on a number of long established macroeconomic relationships, particularly in the wake of the recent global financial and economic crisis. One of these is the relationship between inflation and the business cycle that has critical implications for the conduct of monetary policy by central banks.

There was a sharp decline in the consumer price index-based inflation in both developed and developing countries over the last two decades. According to International Monetary Fund (IMF) data, it averaged under seven per cent in developing countries between 2002 and 2010, as against 38.4 per cent between 1992 and 2001. In developed countries, it fell by about 20 per cent from 2.4 per cent to 1.9 per cent.
 

This decline coincided with monetary policies largely transiting to a regime of "inflation targeting" across the globe. Central banks adopted variants of the Taylor rule of monetary policies that adjusted short-term interest rates to where current growth stood relative to potential growth, and current inflation relative to targeted inflation.

In its recent World Economic Outlook of April 2013, the IMF set the two developments alongside and drew a causal relationship between "inflation targeting" and why the inflation dog has desisted from barking.

While independent central banks can be credited for initially anchoring inflationary expectations, the reality, however, is that "inflation targeting" also inflated the asset bubbles that were the ultimate triggers of the recent global financial crisis.

The IMF has perhaps failed to give due credit to two major structural changes in the global economy that kept, and are keeping, inflation low, undermining the traditional role of consumer price inflation as a robust marker of business cycles.

First, there was the entry of two humongous developing countries, namely China and India, into the global labour market for goods and services, respectively. Between them, they account for about 40 per cent of the global population and virtually unlimited supply of cheap labour. Likewise, other populous low-income countries, such as Bangladesh, Vietnam and Indonesia, also entered the global labour market.

Second, there was an acceleration of globalising tendencies, with tariff walls coming down to nominal levels, rise of global production chains, services becoming more tradable through the use of information technology, and large two-way capital flows. Goods and services exports as a proportion of the gross domestic product rose from about 20 per cent between 1992 and 2001 to cross 30 per cent by 2007. Gross exports and imports rose even more sharply.

Consumer price inflation remained low even as the global economy grew at the unprecedented of over five per cent between 2004 and 2007. In a closed economy, such "overheating" would have generated inflationary pressures. With increasing globalisation, however, excess domestic demand was easily accommodated by cheap supply overseas.

Such spillages widen current account deficits (CADs). Ordinarily, a widening CAD leads to depreciation that narrows the current account gap. Depreciation also leads to inflationary pressures. However, systemically large CADs were in high-income reserve-issuing currencies countries. The current account surpluses of developing countries - facilitated and sustained by currency pegs that prevented their exchange rates from adjusting - were parked in these very countries. The reserve currencies, therefore, did not depreciate relative to their major "surplus" trading partners. Their consumers, thereby, gained from the deflationary forces triggered by productivity shifts in the big developing countries.

The deflationary impact on consumer prices was felt in both developed and developing countries. Although the fall was more dramatic, inflation nevertheless remained higher in developing countries since CADs exposed some of them to currency depreciation that raised the price of tradables. Currency depreciation, however, was frequently muted by large capital inflows.

The upshot of these structural changes in the global economy was the "great moderation". Economists now started talking about the end of business cycles, a new "Goldilocks economy" of low inflation - high growth, and "dark matter" that propped up the US dollar against mounting external deficits. Central banks were either deluded by the "great moderation" into keeping interest rates low, leading to excessive leverage and liquidity and/or, as argued by Alan Greenspan, they lost control over long-term interest rates as large capital flows, amplified through the shadow banking system, neutralised their interventions at the short-end of the yield curve.

The liquidity overhang had to find some outlet, and it did so by raising the prices of assets, particularly financial assets and those physical assets, such as housing, and commodities like oil, food and gold, that doubled up as financial assets. The consequential "wealth effect" increased consumer demand despite stagnant and falling labour incomes.

Central banks were alive to the build-up of assets bubbles. Greenspan spoke of "irrational exuberance". However, these bubbles passed under their policy radar since they were focussed on core consumer price inflation that discounted the price of volatile "financial commodities" like oil. Their preference was for cleaning up afterwards, rather than calling asset bubbles and pricking them, lest they also pricked the business cycle in the process.

The subprime crisis in the US pricked the asset bubble, unleashing deflationary pressures through deleveraging, collapse of the money multiplier, and demand compression. Deflation was, however, averted by massive liquidity injections by central banks that are once again inflating asset bubbles, rather than stoking inflation to targeted levels. Likewise, current market speculation over "tapering" of quantitative easing has dented asset prices.

Even if output in advanced economies were to get back to full potential, consumer price inflation may not rise commensurately because deflationary forces are still at work. Of course, the position could change if the world moves towards greater protectionism in response to high levels of unemployment in advanced economies. There is also a risk that central banks in advanced economies may keep interest rates below the inflation rate for an extended period to pay down public debt that has increased dramatically in the last few years as a result of crisis management.

If inflation is no longer a robust marker of business cycles, what other markers can take its place or at least supplement it? Since the anomaly of low inflation and high growth was induced by the wealth effect of inflating asset prices and growing leverage, these are automatic candidates. Both asset prices and leverage reflect the level of liquidity and demand in the economy. Central banks, therefore, need to keep their weather eye open to the credit cycle in addition to the business cycle. How, and whether, monetary policy rules, including the Taylor rule, change to accommodate new markers, or whether policy makers complacently persist with "inflation targeting" following IMF's findings and continue to fuel asset bubbles, remains to be seen.

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The writer is a civil servant. These views are personal