The Federal Reserve recently conducted its annual conference in Jackson Hole, Wyoming. Prominent on the agenda were discussions of inflation, or the lack thereof. Many central banks around the world have inflation targets, and have been frustrated by their inability to reach them.
It has been more than 25 years since inflation targeting first arrived on the scene, and it has grown to dominate monetary frameworks. But it is currently facing a stern test. The outcome of this examination will have direct consequences for the paths of global interest rates and global markets.
Evolution of Modern Monetary Regimes
In the 1970s, inflation in developed markets had reached levels that would be considered excessive in emerging markets today. The year-over-year increase in consumer prices peaked at 15% in the United States and in continental Europe, and at 25% in the United Kingdom and Japan. A succession of oil shocks had a lot to do with this; while the shocks were temporary, their impact on inflation expectations was more lasting.
The common central bank reaction to the surge of inflation during that era was to raise short-term interest rates. But nominal interest rates rose by less than inflation, leading to a steep decline in real interest rates that added fuel to economic activity. As a result, inflation and interest rates reached multi-decade highs.
In the search for a solution, central banks shifted strategy and began to closely monitor and manage the national money supply. Slowly but surely, inflation was tamed. The effort coincided with a series of recessions in developed markets; debate continues as to whether this was the result of restrictive monetary policy or the consequences of industrial damage done by the realignment in energy prices. A steep correction in the price of crude oil (which declined from $37 per barrel in 1979 to less than $15 per barrel in 1986) also helped to bring inflation back under control.
Ultimately, however, money supply targeting ran its course. Defining money became more difficult, and linkages between money, credit and inflation were weakened by globalization and disintermediation. These developments led central banks on a search for a new policy paradigm. And at the beginning of the 1990s, they found one.
Price stability is a ubiquitous element of global central bank mandates, and for good reason. A predictable inflation environment provides a favorable foundation for economic growth and employment. Excessive inflation reduces purchasing power and cuts into investment returns. And hyperinflation can destabilize countries and lead to extreme political outcomes.
Formal inflation targeting was first adopted by the Reserve Bank of New Zealand (RBNZ) in 1990. (An interesting RBNZ retrospective on that decision can be found here.) Canada followed the next year, and the United Kingdom the year after that. The U.S. Federal Reserve ultimately adopted a target in early 2012. (Alan Greenspan was not a fan, deeming such a target as poorly founded and as an encroachment on his discretion.)