Forex Flash: Should inflation targets be abandoned? Part 2 - ING (Barcelona) - Looking back to financial stability , King´s view seems to be that through inflation targets can be inconsistent with longer term financial stability, the appropriate response is ´macro-prudential´ policy, which rules out almost nothing in practical terms. Incidentally, they note that macro-prudential supervision is now under the remit of the BoE.

They note that the business media, which also likes to express an opinion on this subject, tends to like inflation targets. Although there are a range of opinions, the average view seems to be that while targets are not perfect, they are simple and transparent and there is no viable alternative. They feel that this is a pretty defeatist position, especially as there is a growing consensus even within the central bank community that there are amendments and alternative to the current rigid target frameworks.

The continue, “All of which neatly dances around the associated subject of consumer price inflation versus asset prices, and whether in fact a credit growth target might be a better ultimate target for central bank policy, covering both monetary policy and macro-prudential targets, even if augmented by some form of intermediate inflation target. In fact, given that most economists accept the idea that eventually “inflation is always and everywhere a monetary phenomenon, the fact is that most central banks spend remarkably little time talking about credit growth and almost no time considering what the appropriate growth rate for credit is.”

They add, if a flexible inflation target system loses the simplicity of a fixed target, which is apparently the major appeal, then rather than flipping between higher and lower inflation targets to suit different economic conditions, a more practical solution might simply be to augment a simple fixed inflation target with a credit growth target. However, they note that has been tried before by the ECB but was always a poor relation of the inflation pillar within the banks policy framework. ECB policy could have been quite different and the eventual outcome less catastrophic if the credit targets had actually been adhered to and not ignored.

Carney´s preference seems to be for nominal GDP targets and although it can be argued that this is just a halfway house, adding in real GDP growth to the inflation target and neither being neither more transparent nor simpler. With a nominal GDP target, Carnell and Knightley explain that the BoE of fed of BoC would set said target, either in the local currency or more likely in terms of a growth rate or increase over a period from the current level. This, they believe, is that starting point and follows the type of approach the BoC has used in setting clear targets for the timing of rate normalisation to enhance the transparency of policy.

They question whether Carney is advocating a one-off departure from inflation targets during periods of slow activity. In this case they feel that it sounds like complicating inflation targets and further undermining their credibility when there is a return to more normal conditions. Amending targets mid cycle could also be extremely disruptive.

A further point that they highlight is that there will be times, perhaps even prolonged periods when inflation deviates from the long run average without implying that there needs to be a compensating change in real activity to compensate.

In the end, the only conclusion they can find is that to achieve the nominal GDP target, if pursued vigorously would be aggressive QE, coupled with other policies designed to weaken the currency, perhaps even negative deposit rates. However, if anything has been learned under King´s stewardship about QE, it is that such policies experience rapidly diminishing marginal returns. Moreover, as King warned in a speech a few days ago, if we see G7 countries pursuing reflationary policies that will require the unleashing of vast amounts of QE, then this sets up a currency tension that also ought to be taken into account in setting policy. Countries from Switzerland to the Czech Republic are already using active exchange management.

They finish by stating that they are not totally discouraged by Carney´s recent remarks and they appreciate the fact that he does not appear to be shackled by convention and is prepared to consider imaginative alternatives. They also share the suggestion that inflation targets are not the only option for central banks and they certainly don´t rule out nominal GDP targeting entirely either. They simply think that it could be an indifferent substitute for more targeted policies on credit growth and wonder how it would be implemented in practice.