DG ECFIN Comments on:

Daniel L. Thornton

The Evolution to Inflation Targeting: How Did We Get Here and Where Do We Need to Go?

Lars Jonung

DG ECFIN, EUROPEAN COMMISSION, Brussels

6th Norges Bank Monetary Policy Conference, June 11-12, 2009

The views expressed are my own and should not be attributed to the European Commission

DG ECFIN

The structure of the paper:

1. The evolution of US monetary policy in the past 50 years (since the author took his first course in economics 45 years ago). (13.5 pages)

2.The “dramatic shift to inflation targeting (IT)” in spite of “widespread scepticism” in the US economics profession to the ability of central banks to control inflation. (4 pages)

3. The success of IT (1 page)

4. The dangers to IT (14 pages)

5. Implications for inflation-targeting central banks (0.5 page)

DG ECFIN My comment is based on two issues:

The first issue: Why do economic policies change course?

I focus on the causes of the process where the old paradigm for stabilization policy (the monetary regime) is replaced by a new paradigm – a new regime

DG ECFIN

By answering the question why economic policies change course, I will provide an answer to

A) Why was inflation targeting introduced? (Thorntons’s Section 2: the dramatic shift to IT)

B) Why will inflation targeting be abandoned in the future? (Or: Where are the threats to inflation targeting?) (Thorntons’s Section 4: the dangers to IT)

In this way I will complement the discussion by Thornton

DG ECFIN

The second issue: The international dimension (the history of IT):

The paper by Thornton deals with the US record as if the FED has been an inflation targeting central bank.

But the US has not officially adopted inflation targeting. It may be a closet inflation targeting central bank but it is not a true IT central bank with an explicit target for the rate of inflation (or the price level).

Inflation targeting is not a US invention. US is not a leader but a follower.

DG ECFIN

Gunnar Myrdal in Monetary Equilibrium, 1939, p 8: Gunnar Myrdal in Monetary Equilibrium, 1939, p 8:

Myrdal complained about the “English school of theorists” (Marshall, Pigou, Hawtry and Keynes):

“suffers somewhat from the attractive Anglo-Saxon kind of unnecessary originality, which has its roots in certain systematic gaps in the knowledge of the German language on the part of the majority of English economists."

If Myrdal had read Thornton’s paper today?

DG ECFIN

The international dimension:

It all started with Knut Wicksell in April 14, 1898 in Nationalekonomiska Föreningen where he presented his ideas from Geldzins und Güterpreise (Interest and Prices).

He suggested a simple rule:

DG ECFIN

Wicksell’s rule for monetary policy:

“when the price level is rising, the rate of discount should be raised until the movement of prices is halted; when prices are falling, the rate of discount should be lowered until price stability is achieved.”

This is the origin of IT.

DG ECFIN

Wicksell’s forecast in 1898 for the adoption of IT:

‘Once a clear insight into the causes of the changes in the value of money and of the present instability thereof has been gained, the men concerned with the practical aspect will surely show themselves equal to the task of availing themselves of this insight to create a completely stable money value to the advantage of world commerce. Once the causes of the evil have been found, the therapy and, above all, the prevention of the disease will prove a comparatively simple matter.’

Wicksell had a strong belief in the rationality of central bankers

DG ECFIN

Irving Fisher’s forecast in 1935 (Stabilized Money) for the adoption of IT:

“when knowledge of the Swedish experiment becomes generally available, the Swedish principles for monetary policy are sure to become accepted everywhere”

DG ECFIN

Erik Lindahl’s forecast in 1934 (Sweden’s monetary program) for the adoption of IT:

IT belongs to the future but it will probably take a century for the world to adopt IT

“a new era in monetary history has begun in Sweden. In time, so much knowledge of free currencies will be gathered that the monetary system can be guided ‘scientifically’, that is according to some norm.”

DG ECFIN

Why did it take such a long time for IT to be adopted?

Why was Lindahl’s forecast more correct than Fisher’s and Wicksell’s?

One answer is found in the literature on policy changes…

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DG ECFIN

The literature suggests that IT was adopted in the 1990s because the old monetary regime – in most cases a regime based on pegged exchange rates - was discredited – it had proved to be a failure.

And there was a promising alternative to be tried, that is IT

See Figure 1. The policy learning process. A stylized picture.

DG ECFIN

Figure 1. The policy learning process. A stylized picture

Macroeconomic Policy Policy Policy disturbance reaction effects learning (1) (2) (3) (4)

Lessons from the BrettonWoods system:External balance and afixed exchange rate.

1969-70:Outflow of foreignreserves. Deterioratingcurrent accountbalance. Tendencytowards inflation.

1970-72:Policy of restraint.Contractive fiscaland monetary policy.

1971-73:Rising unemployment.”The lost years”.

Lessons of the ”lostyears”: Expansive keyne-sian fiscal policy suitableto maintain full employ-ment

1973-74:OPEC I.Oil price shock.Supply disturbance.

1974-76:Policy of ”bridgingover”.Expansion viafiscal policy.

1977-78:”Costs-crisis”.Growing budgetdeficit and crises indifferent industries. Lessons from OPEC I:

Expansive fiscal policycreates imbalances.Devaluations ”work”.

1979-80:OPEC II.Oil price shock.Supply disturbance.

1980-82:Fiscal austerity pack-age.Devaluation in 1981.Offensive ”super-devaluation” in 1982.

1983-85:Strong inflationaryimpulse. Rising pro-fits.

Lessons from OPEC II:Rule-bound policy basedon a fixed exchange rate.Hard currency policy.

Episode 1

Episode 2

Episode 3

1986-90:Boom due to creditexpansion.Overheating. Realinterest rate shock.Financial crisis.

1990-92:Strong defence of thefixed krona rate.Government supportto the financial sys-tem.

1991-95:Rapidly increasingunemployment andbudget deficits.Deflation. Floatingkrona rate.

Lessons of the 1990s:Institutional reforms,independent Riksbank, astricter budget process.Floating krona or totallyfixed rate. (EMU)

Episode 4

The future:Next disturbance orcrisis of unknownnature.

Tight fiscal policy.Low inflation policy.EMU rules.

Unknown outcome?

Episode 5

New lessons oftomorrow’s crisis.

DG ECFIN

Policy-makers learn during and after crises

Crises create “a window of opportunity” for rejecting a monetary regime that is perceived as a failure.

Crises are the major driving force behind policy changes.

The 1930s and the 1990s are prime examples

DG ECFIN

Intellectual cross-country contagion

Policy export (import) of inflation targeting was (and is) another driving force behind the spread of IT

DG ECFIN

The role of the economics profession (of new economic theories)?

Economists often enter after the actual event – giving intellectual support for the new monetary regime.

DG ECFIN

Thornton’s explanation of the move to inflation targeting (in the US):

1. Central banks can control inflation (Volcker’s disinflation 1979-87)

2. Fiscal policy was “running large and persistent deficits” while the inflation was kept low

3. The rejection of a permanent Phillips curve trade-off

The role of crises as driving policy changes is neglected

DG ECFIN

The future of IT(The dangers to IT)

Thornton’s threats:

1- Dual mandate – flexible IT

2. A little inflation is good for economic growth

3. Hierarchial mandate

DG ECFINThe future of IT(The dangers to IT)

The history of switches of monetary regimes identifies a clear danger to the supremacy of IT:

If the global financial crisis of today is regarded as caused by inflation targeting, then inflation targeting is in great danger. It will be a victim of the crisis – replaced by something new.

DG ECFIN

The future of IT(The dangers to IT)

There are signs of rising critique of IT

Joseph Stiglitz (May 6th, 2008) Burma Digest: The failure of inflation targeting:

One hopes that most countries will have the good sense not to implement inflation targeting; my sympathies go to the unfortunate citizens of those that do. (Among the list of those who have officially adopted inflation targeting in one form or another are: Israel, the Czech Republic, Poland, Brazil, Chile, Colombia, South Africa, Thailand, Korea, Mexico, Hungary, Peru, the Philippines, Slovakia, Indonesia, Romania, New Zealand, Canada, the United Kingdom, Sweden, Australia, Iceland, and Norway.)

DG ECFIN

Implications for IT central banks

Thornton’s advice: Central banks should be open, honest and realistic about IT

DG ECFIN

Implications for IT central banks

My advice – based on monetary history:

1. Central banks should blame the present crisis on anything but inflation targeting.

2. Central banks should argue that inflation targeting is the best regime to minimize the risk of future crises.

DG ECFIN

This is the way to give IT a life in the future

You have to win the blame-game

Otherwise IT is likely to end up on the scrap-heap of monetary regimes

DG ECFIN Comments on:

Daniel L. Thornton

The Evolution to Inflation Targeting: How Did We Get Here and Where Do We Need to Go?

Lars Jonung

DG ECFIN, EUROPEAN COMMISSION, Brussels

6th Norges Bank Monetary Policy Conference, June 11-12, 2009

The views expressed are my own and should not be attributed to the European Commission

DG ECFIN

A personal note:

I am a strong supporter of inflation targeting.

In 1978 a proposal that the Riksbank should move to IT based on a corridor between 0 and 2 percent rate of inflation per year.

But I made no forecast when …

And I see no alternative regime in the future except a modified IT regime encompassing asset prices – although Wicksell did not discuss asset prices.

DG ECFIN

DG ECFIN

The structure of the paper:

1. The evolution of US monetary policy in the past 50 years (since the author took his first course in economics 45 years ago). (13.5 pages)

2.The “dramatic shift to inflation targeting (IT)” in spite of “widespread scepticism” in the US economics profession to the ability of central banks to control inflation. (4 pages)

3. The success of IT (1 page)

4. The dangers to IT (14 pages)

5. Implications for inflation-targeting central banks (0.5 page)