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Symposium 2012

Proposal - The Future of Central Banking: Inflation Targeting versus Financial Stability

The Challenge

The global financial crisis has led to a profound rethinking of the consensus on monetary policy. Before the crisis, most monetary economists agreed that "flexible inflation targeting"—in which cent ...

The global financial crisis has led to a profound rethinking of the consensus on monetary policy. Before the crisis, most monetary economists agreed that "flexible inflation targeting"—in which central banks focus on maintaining price stability and stabilizing the output gap—was an appropriate and sufficient mandate for conducting monetary policy. Key assumptions underlying the consensus were that this mandate would automatically lead to financial stability and that the framework of monetary policy could deal with cross-border capital flows.

The Challenge

Unconventional monetary central bank policies after the GFC (i.e., Fed’s QEs and ECB’s outright monetary transactions) have supported asset prices and restored some market confidence so far, but will they succeed in engineering more robust and sustainable economic growth, employment, and financial stability over the medium term? If yes, “inflation targeting” would surely loose its flavor, but if no, should central banks return to “inflation targeting” framework as a means to restore economic and financial fundamentals?

Unconventional monetary policies are unlikely to succeed in restoring robust economic fundamentals and lasting financial stability over the long term.

  • In the midst of the global financial crisis, the Fed aggressively injected emergency liquidity, intervened to fix disrupted markets. In the process, it rescued the global financial system and investors from the risk of a disorderly meltdown, potentially wide spread bank failures, and the consequential economic and social suffering.
  • Later on, the Fed continued on several occasions to counter the real threat of deflation and recession. More recently, in the context QE3, the Fed has push up its agenda to a new level—that is explicitly targeting a more robust growth, lower unemployment, and stable low inflation. So far, the Fed’s intension is more than clear: the ultra-loose monetary policy will continue well into an economic recovery (i.e., the quantitative easing, targeted asset purchases and forward looking guidance of the multi-year zero-bound interest rates)..

For ordinary folks like me, the Fed policies have essentially inserted a sizeable wedge between market values and underlying economic fundamentals.

  • Recent upward trend in virtually all asset prices is no equal to improved fundamentals. At this moment, the Fed gets inadequate support from the fiscal policies and other structural adjustments due to a polarized Congress and election cycle.
  • The ECB is also deep in the policy experimentation mode with its own Outright Monetary Transactions (OMT). Emerging economies are facing their own growth slowdown and spillover effects of the unconventional monetary policies of the advanced economies. They are likely to engage rate cuts and policy easing, as Korea and Brazil have done last week.
  • If the critical hand-off from a global-wide, ultra-loose monetary policies to fundamentals do not materialize, the reaction of markets will not be pleasant. As Mario Draghi, president of the ECB, said in his European Parliament speech last week that “the OMT is designed to overcome one reason of financial fragmentation”, but the capital flight and the financial fragmentation of the 17-member euro area underscored the need for structural reforms. “You can’t have a union when you have certain countries that are permanent creditors and a set of countries that are permanent debtors. … So part of this rebalancing will be achieved by regaining competitiveness”.

“Inflation targeting” by itself is a blunt tool; it won’t be sufficient to generate economic growth and financial stability without fiscal discipline, sound regulations, and adherence to prudent monetary policies by other major economies.

  • Cross-border capital flows could undermine a single country’s effort under “inflation targeting”.
  • Financial leverage had reached to a monstrous proportion before the GFC, and “inflation targeting” is an inadequate instrument to contain leverage then and will not facilitate an orderly de-leverage of the financial system now.

Finally, major advance economies faced sizable sovereign debt and financial debt overhang and thus safeguarding debt services has paramount importance. To that end, “inflation targeting” may not be the right framework, as the expectation of disinflation or deflation could discourage consumption and investment, trigger debt distress and defaults, and endanger the financial system from sharply rising non-performing assets.

Proposed Solution

  1. Adopting a more broad-based, transparent, and credible monetary policy rule in a new “normal” macro environment: the Fed has taken a lead on this by clearly communicating its rules (to target an overall better economic performance), its conditions to reverse course, and its final exit strategies (even the size of the balance sheet). Most other central banks, however, are still reacting to the unconventional monetary environment and lagged behind in redefine their own respective intermediate targets (inflation or otherwise). In particular, they have not come out clean on their responses to a “reverse Volker-rule” entailed by the Fed policy.
  2. Toughening up capital requirements in the context of Basel III. Unconventional monetary policies entail risks to the financial system, through prices and volatility. The huge amount of liquidity injected to the financial system by the Fed and risk-on trades pushed prices to what would normally be regarded as bubble territory, with some already there. The un-wounding process should be cushioned by sufficient capital buffer.
  3. Using the breathing space created by the unconventional monetary policy wisely by address key fiscal, debt, and structural issues.
  4. Fast tracking structural reforms to improve fundamental in the next few years, particularly for emerging markets, to ensure financial sustainability when major central banks cease or unwound their unconventional monetary policies eventually.

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