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Strict inflation targets for central banks have caused economic harm

The writer is the author ofThe price of time: the real story of importance’

A great experiment in monetary policy is coming to an end. Last week, the European Central Bank announced its largest rate hike in two decades, cutting its benchmark rate to just zero percent. Never before, over the course of some 5,000 years of lending, have interest rates sunk so low. Those who lament the consequences of easy money are quick to blame the central bankers. But the problem stems from the strict inflation mandates they have to follow.

In 1990, the Reserve Bank of New Zealand became the first central bank to set a formal target. In 1997, a newly independent Bank of England was also targeted, as was the ECB when it opened a year later. After the global financial crisis, both the Federal Reserve and the Bank of Japan jumped on board. What BOJ governor Haruhiko Kuroda called the “global standard” — an inflation target on the order of 2 percent — served several functions: providing central banks with a clearly defined benchmark, anchoring inflation expectations, and relieving politicians of responsibility for monetary policy.

The problem is that when an institution is guided by a specific target, critical judgment is usually suspended. As the late political scientist Donald Campbell wrote, “the more a quantitative social indicator is used for social decision-making,” the greater the risk that it will disrupt and corrupt the processes involved. This problem is well known in monetary policy makers circles. In the 1970s, Charles Goodhart of the London School of Economics noted that whenever the BoE targeted a specific measure of the money supply, the measure’s previous relationship with inflation broke down. Goodhart’s law states that any measure used for auditing is unreliable.

Inflation targeting is true to its form. Thanks in large part to globalization and technological advances, inflationary pressures eased in the 1990s, allowing central bankers to cut interest rates. After the dotcom crisis at the turn of the century, fears of deflation led the Federal Reserve to set the Fed rate at a post-war low of 1 percent. A global credit boom followed. The subsequent failure unleashed even stronger deflationary pressures. The Fed continued to cut its key rate to zero. Interest rates in Europe and Japan turned negative for the first time in history.

Over the next decade, central bankers justified their actions by referring to their inflation targets. Yet these goals caused a number of corruptions and disruptions. Ultra-low interest rates pushed the US stock market to near-record valuations, sparking: the “everything bubble” in a wide variety of assets ranging from cryptocurrencies to vintage cars. Forced to “chasing returns”, investors took more risk. The fall in long-term interest rates hurt savings and caused a huge increase in pension deficits. Easy money kept zombie companies afloat and flooded Silicon Valley with blind capital. Businesses and governments took advantage of cheap credit to take on more debt.

Most economists assume that interest rates simply reflect what’s going on in what they call the “real economy.” But, as Claudio Borio of the Bank for International Settlements argues, the cost of borrowing reflects and in turn influences economic activity. According to Borio, the era of ultra-low interest rates has thrown the global economy far out of balance. As he puts it, low rates led to even lower rates.

During the pandemic, central bankers were still trying to meet their inflation targets as they cut interest rates and squeezed trillions of dollars, much of which was used by their governments to cover the extraordinary costs of lockdowns. Now inflation is back and central banks are trying to regain control without crashing the economy or triggering another financial crisis. The fact that policy rates on both sides of the Atlantic remain well below inflation suggests that monetary policymakers are no longer blindly following their inflation targets to the exclusion of all other considerations.

This is welcome. But elected politicians cannot continue to evade their responsibility. They need to rethink central bank mandates, taking into account the impact of monetary policy not only on short-term inflation, but also on asset valuations (especially real estate), leverage, financial stability and investment. The experiment with zero and negative interest rates has caused considerable damage. It should never be repeated. As Mervyn King, the former BoE governor, says, “We haven’t focused on those things we should have focused on and we focused on those things we shouldn’t have, and there’s no health in the economy. “

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