Central banks and the inflation-targeting disaster

Monetary policymakers are supposed to keep price rises under control. The energy shock and the aftermath of the pandemic has left them humbled. Where does blame lie?

April 21, 2023
Exasperated: central bank governors like Andrew Bailey have failed to hold inflation levels down
Exasperated: central bank governors like Andrew Bailey have failed to hold inflation levels down. Credit: UPI / Alamy Stock Photo

The flare-up in prices over the past two years has caused a crisis of confidence in the central banks of America, Britain and Europe which are supposed to control inflation. The Bank of England (BoE) is mandated by government to keep inflation steady at 2 per cent, but today is struggling to haul it down from the double-digit rates that have savaged living standards. The story is similar for many other central banks which have staked their credibility on hitting their inflation targets—then missed them. 

Consumers’ everyday experience when shopping and paying bills is now far removed from the price stability that these targets were supposed to deliver. So were central bankers just unlucky, or did they get things wrong? More fundamentally, and despite being a central component of economic and monetary regimes around the world, is the whole idea of inflation-targeting flawed?

Inflation-targeting has now been in place in Britain for 30 years. The spur was sterling’s ignominious departure, in September 1992, from the European exchange rate mechanism (ERM), which tied the pound to the Deutsche Mark and in so doing harnessed Germany’s anti-inflationary credibility. After “Black Wednesday” a new approach was urgently needed to reassure markets that inflation, which had only recently fallen from highs of over 8 per cent, would stay under control. Within a month, the government announced that Britain would adopt inflation-targeting.

For most of the past three decades, that decision has been regarded as an inspired move. In 1997 the incoming Labour government strengthened the set-up by making the BoE operationally independent in carrying out monetary policy. Unlike earlier attempts to keep prices stable through trying to control the money supply in the late 1970s and early 1980s, and the brief spell in the ERM in the early 1990s, inflation-targeting has shown staying power. That’s because it seemed to work, taming the post-war scourge of high inflation.

Nothing succeeds like success. First introduced by New Zealand in the late 1980s, inflation-targeting by independent central banks became the dominant monetary regime around the world. When Europe’s monetary union came into being in 1999, the new independent European Central Bank (ECB) had the job of ensuring price stability. An inflation target of 2 per cent has become the norm among advanced economies. For much of the past decade, the world’s main central banks—America’s Federal Reserve, the ECB and the BoE—have been fretting about inflation being below rather than above that target. 

Things now look very different. In October 2022, the 30th anniversary of inflation-targeting in Britain, inflation reached a peak of 11.1 per cent—the highest for not just three but four decades. But for the Treasury’s “Energy Price Guarantee” subsidising the bills paid by consumers, inflation would have peaked at 13.6 per cent in early 2023, according to the Office for Budget Responsibility (OBR).

In their defence, central bankers can point to two unforeseeable shocks that would have rocked any monetary regime. First, the pandemic was a once-in-a-century event that disrupted supply chains and caused bottlenecks and temporary shortages as economies recovered from lockdowns. That was bound to generate big price rises. Second, the resulting take-off in inflation was then turbocharged by an off-the-scale increase in European energy prices as Russia constricted gas supply following its invasion of Ukraine.

As these shocks subside, so should inflation. Already, in America, the rate has fallen from a peak of 8.9 per cent last June to 5 per cent in March. It’s a similar story in the eurozone, where inflation has retreated from a high of 10.6 per cent last October to 6.9 per cent in March. Inflation has remained stubbornly high in Britain, at 10.1 per cent in March. Even so, it is still expected to tumble in coming months, with the OBR forecasting a rate of around 3 per cent by the end of the year.

Policymakers can point to unforeseeable shocks that would have rocked any monetary regime

And yet is that really enough to let central banks off the hook? At the very least their policies surely contributed to the intensity of the inflation upsurge. All three major central banks were woefully slow to recognise the gravity of the crisis. The Federal Reserve spent most of 2021 insisting that the rise in US inflation was a transitory affair. Across the Atlantic, both the ECB and the BoE were similarly asleep at the wheel. They neglected the potential inflationary impact of the massive monetary injections they had made during the pandemic, which were all the more potent since they accompanied fiscal stimulus on a grand scale.

To the extent that monetary misjudgements have contributed to the inflationary crisis, there is at least a solution. Just like anyone else, central bankers can learn from their mistakes. The most important thing is to have a healthy scepticism about what their models are forecasting, especially during a time of extraordinary disruption.

But could the root problem be the targeting regime itself? The violent inflationary upsurge of the past two years is, after all, not the only shock that has occurred since central banks were put in charge. The financial crisis of 2008, another once-in-a-century event, occurred on their watch. That crisis occurred after a long credit boom which they did too little to restrain because inflation was under control. And yet ensuring financial stability has historically and rightly been the responsibility of central banks.

That highlights an inherent flaw in any targeting system, as Britain of all countries should appreciate, given its chequered history of using targets in the public services. Setting an overriding goal fails to allow for trade-offs, in this case between achieving price and financial stability and more generally between the short- and the long-term. In particular, it may be better sometimes not to cut interest rates when inflation is below target if that loosening in monetary policy encourages financial excesses. 

Over-zealous pursuit of the 2 per cent inflation target has brought its own excesses in the past decade, through the repeated use of quantitative easing (QE), whereby central banks make large-scale purchases of bonds with newly-created electronic money. When the BoE first resorted to QE in March 2009, as an emergency measure to bolster an economy brought low by the financial crisis, it was for £75bn over three months. By the end of 2021, when it completed its last purchase programme, the Bank had acquired an astonishing £875bn of government bonds—a third of total public debt. The scale of QE, not just in Britain but in America and Europe, has created a dangerous dependence of financial markets on central banks, which in turn have become entangled with the finance ministries whose debt they have bought.

Central banks’ success in keeping inflation under control may be largely illusory

The avowed aim of QE has been to ward off low inflation and to prevent outright deflation when there is no further room to lower interest rates. However, fears of deflation may have been exaggerated. Ever since the depression of the early 1930s there have been worries about a recurrence of a pernicious debt-deflation spiral, in which the burden of debt rises in real terms as prices fall. But according to a 2015 study by the Bank for International Settlements, which covered 140 years of evidence and 38 economies, the 1930s were an exception. The authors found that other episodes of deflation did not inflict similar damage.

Inflation targeting put central banks in charge. But their purported success in keeping inflation under control for most of the past 30 years may be largely illusory. Much larger forces were at work, notably the opening-up of the global economy to low-cost producers, above all in China. That effect may now have played out, ushering in a new era when the global environment is more inflationary.

If the current system of inflation-targeting is flawed, what could replace it? One way forward would be to move away from spuriously precise targets to more general goals, which would allow central bankers greater room to balance price and financial stability. Another would be to reconsider responsibilities. At times when there is no longer scope to cut interest rates, the job of achieving price stability could explicitly become a joint one with the finance ministry. That would force into the open the question of whether fiscal rather than monetary policy through QE should be used to stimulate the economy. At the very least, there should be a tough-minded and clear-eyed review of inflation-targeting conducted by outsiders, not just insiders invested in the current defective system.