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Thursday, November 10, 2005

Inflation Targeting 'Wholly Inadequate"?

This is the view of Morgan Stanley's Joaquim Fels who argues - in a very interesting piece on Mortgan Stanley - that it is excess liquidity, not excess savings, that is driving the low interest environment. The whole article is worth a read, but here is a taster:

"While there are good fundamental reasons to be bearish on bonds (higher inflation) and risky assets (slower economic growth), excess liquidity is likely to remain plentiful, which should cushion any sell-off in some asset classes and could even pump up new bubbles in others (equities?). And, turning to monetary policy, central banks need to find new approaches to deal with the liquidity monster. An old-fashioned concept like inflation targeting is certainly not the answer, in my view — in fact, it may be part of the problem."

"According to our calculations, global excess liquidity has been on a steep upward trend since about 1995. Between 1995 and 2005, the credit-to-GDP ratio has risen by 25%, broad money-to-GDP by 32%, and narrow money to GDP by no less than 55%. The steep rise especially in narrow money reflects the fact that this aggregate is particularly sensitive to short-term interest rates, which were reduced sharply following the bursting of the equity bubble in 2000. Thus, monetary easing has produced an unprecedented amount of liquidity not needed to finance transactions in the real economy and available to chase bond, equity and other asset prices higher."

"Against this backdrop, it strikes me that the concept of ‘inflation-targeting’, as it is commonly understood, is wholly inadequate to deal with the excess liquidity issue. Many central banks who have applied the concept directly or indirectly in the past are becoming increasingly aware of the limits of this approach. It is a great concept if you want to acquire credibility and want to bring about disinflation. But, once inflation is low and stable, credibility may become a curse as it encourages excessively low interest rates and excessively high risk-taking."

"There are two possible ways out. The first is to stick to inflation targeting in principle but extend the time horizon for the inflation forecast exercise to 3 to 5 years out, and to explicitly incorporate risks to longer-term price stability emanating from asset price developments into the forecast exercise and into the monetary policy stance derived from the process. This could imply tolerating, say, an undershoot of consumer price inflation below target for some time and pursue a less expansionary policy so as to prevent a build-up of financial sector imbalances that could give rise either to higher inflation or, if bubbles burst, to deflation over the medium to longer term."