Inflation Targeting During Negative Supply Shocks

Inflation targeting has in recent decades been adopted by more and more central banks and has until recently been considered a success. Yet that was never true. Instead, what seemingly was a success for central bank policy in the form of high growth and low inflation was instead a result of various positive supply shocks, most related to globalization and the entry of China, India and other emerging economies into the world economy. Because these factors often pushed inflation below the inflation target, central banks responded by inflating more in order to push up inflation to the target. But because central bank policy in the short term has much stronger effect on asset prices than consumer prices, the main result of this was to create asset price bubbles.

Now, for a number of reasons, including the lagged effect on consumer prices from previous monetary inflation, we are seeing what could be described as negative supply shocks, which have resulted in the combination of weaker growth and higher consumer price inflation in America, Europe, Japan and many other parts of the world.

This have led a number of observers, including the IMF and Joseph Stiglitz, to call for suspension of the inflation target during the current era of rising inflation. They point out that particularly in third world countries, where food constitutes a much higher proportion of the consumer price index, pushing down inflation to the target would require a tightening of monetary policy that is so dramatic that it would cause a severe economic downturn.

However, not pushing down inflation now in the same way as inflation was pushed up in the past would make inflation targeting asymmetric and would cause inflation and inflationary expectations to rise permanently. Something which would cause permanent damage to the economy. So, the correct conclusion is not that we should have asymmetric inflation targeting rather than symmetric, the conclusion is that inflation targeting is in itself damaging, whether applied in an asymmetric or symmetric way.