The Inflation Targeting Dilemma: Why Central Banks Must Reassess Their Policies

As an economist involved in the design and implementation of inflation targets for over three decades, I have always been a staunch supporter of the approach. However, recent events have raised serious concerns about the efficacy and sustainability of such policies, given the challenges posed by global supply chain disruptions, geopolitical tensions, and persistent inflationary pressures.

The Two Lessons from Mini-Monetary Mistakes

The past two years have highlighted two key lessons for policymakers in their efforts to control inflationary pressures:

• First, central banks were initially slow to react and misdiagnosed a broad-based, lasting price increase as a temporary, energy-specific one. As a result, they failed to tighten monetary policies promptly, making them feel complacent or ineffective in controlling inflation.
• Second, central banks overreacted and engaged in a game of catch-up, raising interest rates aggressively to curb inflation, just as demand was stalling, leading to a worse growth situation. This created uncertainty among investors and pushed up inflation expectations, causing market volatility and wobbling the credibility of central banks.

These mini-monetary mistakes have left central banks grappling with the dilemma of ” sticking” with their current policies to curb further economic harm or “twisting” their approach to counter future inflationary pressures.

The Global Shift in Price Levels and its Impact on Monetary Policy

The world has experienced an upward shift in global prices caused by supply chain disruptions and geopolitical tensions. The supply chains have become more fragmented and fragile, pushing prices higher, particularly concerning the availability of skilled labor. This has led to stickier and higher global prices, as evidenced by high and sticky rates of underlying or core inflation.

This shift upward in the equilibrium global price level represents a reversal of the golden age of globalization, which contributed to consistently lower inflation rates in many countries, including Japan, the US, and the eurozone, by extending and deepening global supply chains.

This reflationary trend is expected to persist for years, posing significant challenges for monetary policymakers worldwide. They must choose whether to tolerate above-target inflation or continue raising rates to counter stickier and higher prices.

Preventing Future Mini-Monetary Mistakes

The policy question that arises looking ahead is how to prevent a recurrence of mini-monetary mistakes in the event of persistent upward pressure on global prices. Here are two options:

• First, central banks could maintain their current targets and treat inflation overshoots as unexpected price surprises. However, since further overshoots would surprise nobody, such an approach could further erode the credibility of central banks.
• Second, and perhaps more feasible, is the permanent shifting of inflation targets to 3%, thereby reducing the scale of inflation overshoots and avoiding the risks of overreacting to inflation.

Related Facts

• Inflation in most countries has risen to multiples of the targets adopted by their central banks, posing significant challenges for policymakers looking to control it.
• The golden age of globalization, which occurred after the Second World War and contributed to lower inflation rates, is now over, with supply chains being more fragmented and fragile.
• The upward shift in the equilibrium global price level is expected to persist for several years, creating a dilemma for central banks regarding whether to tolerate above-target inflation or continue raising rates to counter persistent inflationary pressures.

Key Takeaway

Central banks must reassess their policies to address the challenges of global supply chain disruptions, geopolitical tensions, and persistent inflationary pressures. Shifting inflation targets permanently upward may be a viable solution to prevent overreacting to inflation and avoid further erosion of central banks’ credibility.

Conclusion

Central banks’ challenges are unprecedented, and policymakers must demonstrate flexibility and responsiveness in their approach. While inflation targeting has been a reliable policy in the past, it may not be sufficient to tackle the complexities of today’s economic landscape. By reassessing their policies and exploring new approaches, central banks can better equip themselves to navigate the challenges ahead and maintain financial stability.