Inflation-targeting central banks usually benefit from what some economists have labelled a “divine coincidence”.
This is when the best policy response to inflation also turns out to be the best response to unemployment. A central bank should raise its policy rate when inflation is high and the unemployment rate is low — and vice versa. All else equal, the effect of such a policy response is that inflation and unemployment will return to their long-run levels.
An absence of a trade-off in achieving an inflation target and stabilising unemployment makes the lives of central bankers relatively easy — most of the time. But, alas, this divine coincidence doesn’t always hold.
The stagflating ‘70s
In the 1970s, central bankers faced a dilemma due to massive spikes in oil prices that resulted in less-than-divine sounding “stagflation” - that is, simultaneously high inflation and unemployment. If central banks pushed interest rates high enough to put a lid on inflation, they would increase unemployment further. But if they tried to hold interest rates down, they risked inflation spiralling out of control.
Most economists believe that central banks were too timid in the 1970s and inflation targeting was developed in the late 1980s and early 1990s as a way to make sure central bankers would keep their eye on the inflation ball whenever the divine coincidence failed again.
A surprising downside to the divine coincidence
The divine coincidence hasn’t really failed since the 1970s. For example, the recent global financial crisis led to lower inflation and higher unemployment in most countries. In this case, central bankers faced no dilemma in pushing interest rates downwards. Their only dilemma was what to do after their policy rates hit the zero lower bound.
But there is a surprising downside to the divine coincidence holding over the past quarter century. It seems to have lulled most everyone into thinking central bankers are miracle workers who can hit two targets with one arrow.
Worse yet, if central bankers can hit two targets, why not ask for more? Shouldn’t they also keep house prices under control? Stock prices? The exchange rate? Bank lending rates?
This idea of targeting bank lending rates has received much attention over the past few weeks in Australia, where the major banks have raised their mortgage rates, supposedly to cover increased costs related to changing capital requirements from Basel III.
Following this increase in bank lending rates, there were public calls for the Reserve Bank of Australia (RBA) to cut its policy rate to help bring mortgage rates back down. The RBA wisely chose not to listen.
But it is notable how easily the (implicit) idea that the RBA should target mortgage rate spreads could become such a focus of the public discussion surrounding monetary policy.
What’s the problem?
Public officials should want to cool an overheating housing market. They should want to minimise anti-competitive practices in the banking industry. And surely they should want a low and stable rate of inflation.
But they just can’t use one instrument - that is, the policy rate — to achieve all of these wonderful outcomes at the same time.
In the absence of more widespread divine coincidences, different desired outcomes will always require different policy instruments. And most practical tools to achieve outcomes other than just low and stable inflation have big distributional consequences.
For example, if policymakers really want to prevent an overheated housing market, they need to design tax and planning policies that influence demand and supply of housing. These have very different effects on homeowners and renters and are clearly more the domain of governments (national and local), rather than a central bank.
Likewise, if policymakers really want to make the banking system more competitive, they should do so via the regulatory environment. To be sure, any policy changes along these lines ought to involve consultation with the central bank given that there is a likely trade-off between a more competitive banking system and greater systemic risks, at least if the recent experience of the global financial crisis is any indication.
But the point is that such policy should not be conducted by a central bank alone. And it definitely shouldn’t be done by adjustments to the policy rate. This would be a misguided “duct tape” solution to a more serious architectural flaw.
Who is steering the ship?
Inflation targeting central bankers need to focus on their main objective of stabilising inflation and not be sidetracked into trying to correct all other macroeconomic and financial problems. They are not miracle workers — although they have generally delivered on their inflation targets.
To the extent the divine coincidence has held, inflation targeting central bankers have been lucky enough to also help stabilise unemployment. But they should not be expected to offset the effects of an uncompetitive banking system — or ill-conceived fiscal policy, for that matter. Their objective of low and stable inflation should always guide their decisions, not a response to the decisions of others with different objectives.
We should expect central banks to be focused on the inflation horizon, not to be divine.