Is inflation targeting useful in a period of financial chaos? Indeed, was it ever useful?

1. Is inflation targeting useful in a period of financial chaos? Indeed, was it ever useful? ***** Marc Lavoie and Mario Seccareccia University of Ottawa

2. Outline • Inflation targeting obsession • Inflation targeting in the past • Inflation targeting during financial chaos (now)

3. Inflation targeting obsession *

4. Clinging to inflation targeting • While the rest of the world is plunging into financial chaos and depression, the Bank of Canada still claims that: • “Low, stable, and predictable inflation is the best contribution that monetary policy can make to the economic and the financial welfare of Canadians” (Monetary Policy Report, April 2009, p. 25; same sentence in Carney’s speech of 1st of April 2009). • “Any unconventional action initiated by the Bank must have as its primary objective the achievement and maintenance of the Bank’s 2 per cent inflation target” (Deputy Governor Murray, May 2009)

5. Obsessed with inflation targeting • Two weeks after the near-meltdown of interbank lending on August 13, 2007, Deputy Governor Duguay’s speech was about whether Canada should move to price level targeting (August 27). • The latest issue of the Bank of Canada Review (21 May 2009) is entirely devoted to the issue of whether the inflation target should be lowered and whether the Bank should abandon inflation targeting in favour of price level targeting.

6. Lowering the inflation target: Milton Friedman born again • The most abstract neoclassical models conclude that the optimal inflation rate is negative (deflation) and equal to the growth rate of productivity. • We are back to Friedman’s theory of the optimum quantity of money, according to which the nominal interest rate ought to be zero, with the real rate equal to the growth rate of productivity.

7. 0% inflation target now • One major objection against lowering the inflation target is that there could be large unemployment costs during the traverse towards the lower inflation rate. • Clearly now would be the best time for the Bank of Canada to implement 0% inflation targeting or price level targeting, as the subprime crisis has already brought the inflation rate down to zero.

8. Inflation targeting in the past **

9. Inflation targeting: Myth versus historical reality • Inflation targeting (IT) is a lineal descendant of a monetary policy framework going back to the views of Knut Wicksell over a century ago in which the central bank is assumed to set interest rates in such a way as to achieve a certain desired rate of inflation. • As pointed out by Svensson (2008), this normally entails (1) an announced numerical inflation target (and/or range); (2) an inflation forecast; and (3) a highly publicized mechanism through which the inflation target can be achieved, usually in the form of a precisely defined transmission mechanism of monetary policy.

10. The “lock in” effect of IT • While all modern central bankers have inflation as principal argument in their reaction function, inflation targeters go a step further than the “New Consensus” neo-Wicksellian approach by arguing that the official targeting “locks in” inflation expectations to the target rate. Hence, the added feature is that, whenever there is a shock to the inflation rate, no only does the central bank stand ready to combat inflation through higher doses of interest rates but inflation expectations are assumed to revert automatically back to the inflation target.

11. The inflation anchor • In Canada, it is almost an article of faith in every central bank quarterly monetary policy report that medium-term inflation expectations are assumed to remain well anchored because of the Bank of Canada’s official commitment to its 2 percent inflation target (see, for instance, Bank of Canada 2009: 14).

12. Inflation guideposts versus inflation targeting • It may be argued that IT is just another form of incomes policy quite familiar to Post-Keynesians as a cure for inflation. This is so for two reasons: (1) It is a voluntary guideline which is expected to mold inflation expectations so that they converge on the announced inflation target, much as the “Guideposts” in the U.S. and the “Prices and Incomes Commission” in Canada of the late 1960s were expected to do so with their guidelines. (2) But, unlike voluntary guidelines, the central bank can also supposedly enforce the inflation target by means of interest rate policy. Hence, through its enforcement capacity, it is assumed that IT would be more efficient in achieving its goal than traditional incomes policies.

13. Does IT work? • If one examines IT countries individually, there is visible evidence (especially with the pioneering IT countries during the early 1990s, such as New Zealand, Canada, Sweden, Australia and the UK), that IT countries fared better on the inflation front when comparing the pre-IT to the post-IT periods. • However, when doing cross-country comparisons of IT and non-IT countries, one finds strong evidence that non-IT countries generally also improved their performance during the same period.

15. Explanation of limited empirical support for IT • Two possible explanations: • the positive externality or spillover effect of IT; • a third common factor that impacts on both IT and non-IT countries.

16. Some econometric evidence • To test whether IT policy has impacted on inflation performance, we have conducted some simple regression analysis that was fashionable during the 1970s in testing the impact of incomes policies using empirical observations from two countries, Canada and the U.S. • Both have somewhat different official mandates with regards to combating inflation. • Given the relative size and significance of both countries internationally, it was believed that the“spillover” effect from Canada would be extremely low (if not zero!).

17. Inflation equations

18. Empirical evidence from the inflation equations • Inflation in Canada is largely determined by its lagged value and unit labour costs, with none of the other variables being empirically significant, including the dummy variable. • With the exception of the capacity utilization variable, in the US all variables were significant, including (surprisingly) the dummy variable. This would suggest that there was probably a common third factor impacting on labour costs in both Canada and the US (perhaps via globalization and NAFTA) with a greater depressing effect on prices in the US since the early 1990s. Moreover, the fact that the dummy variable was significant for the US data but not for Canada would suggest that IT played no significant role in the evolution of prices outside of its possible effects on costs. • When specified in ratios with Canada-US inflation ratios being dependent variable, results are much worse, with only unit labour costs being just below the borderline of statistical significance.

19. Empirical evaluation of the reaction functions • Could it be that the adoption of IT affected the nature of the reaction functions between the two countries? The gap between the real interest rates set by the two central banks in Canada and in the US did decline a great deal during the 1990s (see chart below). • To evaluate the effects, we have specified and tested various Taylor Rule specifications both for the complete period from 1967 to 2008 and for the two sub-periods: 1967-1990 and 1991-2008.

21. Taylor rule reaction functions, Canada

22. Taylor rule reaction functions, United States

23. Modified Taylor rule with lagged dependent variable and US interest rate

24. Empirical results of interest rate determination under IT • Empirical results in Tables 2(a) and 2(b) suggest that while the Taylor specification fits well US data, the evidence for Canada is nonexistent. Moreover the dummy is insignificant for the US (as one would expect) and also below the borderline of significance in Canada. • Table 2(c) is perhaps the most devastating for the IT supporters in Canada. Indeed, the evidence suggests that none of the traditional variables to be found in a standard Taylor Rule equation are statistically significant in Canada. On the other hand, the past value of interest rates (thereby suggesting inertia in the evolution of interest rates in Canada) and the Federal Funds rate in the U.S. all dominate. • These results are particularly problematic for IT supporters in Canada who have often emphasized the virtues of IT policy cum a floating exchange rate. It would appear that, although the monetary authorities can pursue independent interest policy, in practice that is not the case.

25. Inflation targeting today(Or are we back to the pre-IT past?) ***

26. The Bank of Canada admits that conventional monetary policy is now nearly helpless • The inflation rate is approaching negative territory and the overnight interest rate is nearly at zero, so that the real overnight rate can’t be negative anymore. • The spreads between the overnight rate and market rates are much higher than they used to, so that the reduction in the overnight rate has not been as effective as if spreads had remained constant. • Since 2007:QIII, loan officers have been tightening lending conditions, and still are.

27. Tightening credit conditions Source: Bank of Canada website, Senior Loan Officer Survey, 13 April 2009

28. The new framework for a zero-interest rate policy (ZIRP) • Conditional promise to keep the target overnight rate where it is for more than a year • Set the deposit rate on bank balances at the target overnight rate • Credit easing : the Bank purchases certain private sector assets in certain credit markets. • Quantitative easing (unsterilized operations)

29. Quantitative easing • We are right now in a situation of quasi quantitative easing. • Since 21 April 2009, settlement balances are set each day at $3 B by the central bank (banks have $3B reserves, instead of zero as before).

30. Misleading claims on behalf of quantity easing • “The expansion of the amount of settlement balances available to [banks] would encourage them to acquire assets or increase the supply of credit to households and businesses. This would increase the supply of deposits” (Bank of Canada, Monetary Policy Report, Annex, 23 April 2009). • “[Quantitative easing injects] additional central bank reserves into the financial system, which deposit-taking institutions can use to generate additional loans” (Deputy Governor John Murray, May 2009)

31. Quantitative easing = monetarism • “All quantitative easing is, by definition, ‘unsterilized’. Although this is correctly viewed as unconventional, it closely resembles the way monetary policy is described in most undergraduate textbooks, and is broadly similar to how it was conducted in the heyday of monetarism” (Deputy Governor John Murray, May 2009).

32. Quantitative easing is useless • It assumes that credit is supply-constrained. • It assumes that banks will grant more loans because they have more settlement balances. • The only effect might be to lower interest rates on some assets. Will this have an impact on lending rates or on the exchange rate?

33. The inflation target and the current recession • This is a real challenge for the Bank of Canada. • We will see whether the Bank can truly control inflation rates. • The officials at the Bank of Japan did not believe that inflation targeting was useful when the central bank was trying to raise the rate of price inflation (instead of reducing it). “Given that the interest rate is zero, no policy measures are available to lift the inflation rate to positive territory” (BoJ arguments as assessed by Ito, 1994).