A paradigm shift in global Central Bank policies
By Siddharth Singh, 16th February, 2015
In recent decades, central banks globally have moved towards inflation rate targeting. That is, they use instruments such as interest rates to steer the inflation rates towards pre-decided targets or try to keep these rates in a pre-decided band. In the past, central banks had tried targeting money supply and exchange rates, only to to underwhelmed with the lack of success. A brief history of inflation rate targeting is available here. The key advantage of inflation rate targeting is the transparency of purpose and outcome.
Further, in recent years, there has been a slowdown in the global economy since the financial crisis broke out. In the words of Raghuram Rajan, India’s central bank Governor,
“…(quoting Christine Lagarde) we are experiencing the ‘new mediocre.’ The implication is that growth is unacceptably low relative to potential and that more can be done to lift it, especially given that some major economies are flirting with deflation.”
Warwick J. McKibbin, Professor of economics at the Australian National University and Senior Fellow at the Brookings Institution, claims that,
“Inflation targeting (…) has become a widespread guiding principle for many central banks. This is about to change. There are two main reasons. One is related to some key flaws in inflation targeting in a world driven by productivity or supply shocks and the other relates to the problem of having a large number of countries with excessive levels of government debt.”
He claims that there are serious problems with inflation targeting. He writes,
“The mantra that central banks in emerging countries should follow inflation targeting has caused problems for the real economy in many cases. The benefits of credibility in policy was offset by real output losses from overly tight policy. But it is even more relevant today for advanced economies because of the current problems in these economies of falling productivity and rising risk. Inflation targeting is not the best framework for central banks in these circumstances.”
He suggests that the problem can be addressed by nominal GDP targeting. The difference in the approaches would be the following:
“An inflation targeting central bank would tighten policy in response to rising inflation. A central bank following a nominal GDP target would combine the rise in inflation with the fall in real GDP and not tighten policy or may even loosen policy if the expected fall in real GDP is larger than the expected rise in inflation. The outcome for the real economy would be better but expectations from having a clear policy rule would not be undermined.”
Whether central banks actually switch their policy objectives or not, only time will tell. But if they did, it would be a paradigm shift in the way central banks operate globally.
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