Will inflation be targeted? May 1, 2008 at 7:58 pm

Central banks have over the last few years been either rather successful at inflation targeting or rather lucky that inflation has remained low (but positive). FT alphaville cites some research from Morgan Stanley questioning whether this happy state will persist.

For me there are two parts to this question. Does inflation targeting work? And if it does, will central banks actually practice it?

On the first certainly when inflation has been rising in the major economies recently raising rates seems to have reined in inflation. However we have not really seriously flirted with a deflationary environment so the evidence concerning raising a too-low inflation rate is scanty. But that was definitely an issue in Japan: with rates close to zero they had nowhere to go if the only policy tool is control of the short rate. The efficacy of targeting therefore gets a ‘not proven’ from me.

The second point is more problematic. The FED, for instance, seems to have abandoned inflation targeting entirely in order to protect the financial system. When you consider the manipulation of the inflation index in the US (the official inflation figure is now known to some as ‘inflation ex-inflation’ – see here for an independent calculation) this response becomes even more troubling. So it seems that central banks will target inflation only if there is not something more important they need to use short rates for.

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