Mark Carney: Flexibility versus credibility in inflation-targeting
frameworks
Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the 7th BIS Annual
Conference, Lucerne, Switzerland, 27 June 2008.
* * *
It is an honour for me to participate in this panel alongside Martin Feldstein and Stanley
Fischer. Just as central bankers are forward looking in the conduct of monetary policy, it is
entirely appropriate that the BIS coordinate a session that looks beyond price stability to the
challenges ahead. With the challenges that we currently face, it is understandable that some
may desire greater flexibility in the conduct of monetary policy. However, the value of this
greater flexibility depends on the extent to which it detracts from monetary policy credibility. I
will concentrate my brief remarks today on the themes of flexibility and credibility.
I would like to state at the outset that what follows is a discussion of ideas worthy of
consideration. It should not be seen as having any bearing on the current conduct of
monetary policy in Canada. The Bank's current inflation-control agreement with the
Government of Canada will remain in effect until the end of 2011. Changes to our agreement
with the Government, if any were desired by both parties, would only come into effect
thereafter.
Arguments for greater flexibility
There are two broad classes of arguments for greater flexibility in the design and application
of monetary policy frameworks. The BIS has done a great deal of useful work on asset-price
targeting in particular and on the complicated interplay between monetary policy and
financial stability in general. My fellow Canadian, Bill White, framed the discussion about
flexibility for inflation targeters with his paper "Is Price Stability Enough?" In this paper, Bill
argues that policy-makers should respond flexibly to shocks that create persistent financial
imbalances. In particular, he suggests that policy-makers should extend the inflation horizon
and pre-emptively tighten policy when faced with such shocks. This would have the practical
consequence of purposely deviating from the inflation target temporarily in order to avoid
more costly deflationary busts down the road.
Others argue that globalization creates similar imperatives. For instance, throughout this
decade, there has been a secular disinflation (relative to target) in goods prices, reflecting
the efficiencies from creating global supply chains and outsourcing some production to
emerging markets. Some suggest that these same emerging markets are creating persistent
commodity-price inflation.1 Finally, the current international monetary order - wherein a large
dollar block coexists with floating currencies - may create additional shocks, including low
long-term interest rates and unevenly distributed exchange rate adjustment. Should any of
these forces be taken into consideration in either the design of monetary policy frameworks
or the choice of monetary policy parameters?
Flexibility and adjustment
Arguments for flexibility in monetary policy frameworks can be considered in the context of
the broader principle that policy flexibility helps lower adjustment costs. In theory, social
welfare is reduced when there are constraints on the ability of policy-makers to optimize
economic adjustment. Policy frameworks should be flexible enough for the natural
adjustment processes in the economy to determine the speed of adjustment to shocks.
Throughout this decade in Canada, we have seen how policies that promote flexibility in
labour and product markets reduce adjustment costs. In contrast, policy constraints on
market prices - such as fixed exchange rates or subsidized energy prices - make
adjustment to economic shocks more costly. If a shock is major and has widespread
consequences, such rigidities impose costs on other countries because those flexible prices
must adjust in an unnecessarily large or rapid way.
In the face of large and possibly persistent shocks, the design and parameterization of
monetary policy frameworks depends in part on the trade-off between flexibility and
credibility. This, in turn, is a function of both the extent to which (inflexible) rules enhance
credibility and our ability to make the judgments required to deploy any flexibility in a credible
manner.
The principle of policy flexibility is already embodied in our macroeconomic models. When
we calculate the policy response to shocks in these models, it is optimal for policy to allow
inflation to return to target at different speeds, depending on the type and characteristics of
the shocks hitting the economy. This implies different amplitudes of the inflation cycle and
different time horizons for inflation to return to target.
In contrast, the parameters in today's inflation-targeting frameworks generally do not vary
with the type of shocks hitting the economy. For example, the numeric value of the target
itself is held constant in the face of all shocks, even though it might sometimes be beneficial
to temporarily adjust it to lean against the wind. This point can also be cast in terms of
making the operational target - i.e., core inflation - a function of the shocks hitting the
economy. As well, the band or confidence interval around the target is held constant, even
though it may sometimes be beneficial to worry less about inflation volatility in a period of
highly volatile, but transient, shocks. Finally, the time horizon for returning inflation to target is
usually held constant. As a consequence, it can be too short to factor in fully the longer-run
disruptions associated with, for example, building asset imbalances.
The current parameters are not arbitrary. In Canada, the 2-per-cent target for the total
consumer price index reflects the measurement bias inherent in the CPI, the risks associated
with the zero lower bound and concerns about downward nominal wage rigidities. The
1-percentage-point range around the target reflects the unconditional variance of the inflation
process.2 The 18- to 24-month time horizon reflects the lagged response to monetary policy
action.3
This inflexibility has significant value. It provides clarity of objectives and holds central
bankers accountable. When policy lacks credibility, it can be beneficial to have simple
inflexible elements in the framework because they demonstrate the policy-makers'
commitment to that policy. If the inflation target is achieved, it enhances the credibility of the
central bank and creates a virtuous circle whereby increased policy credibility further anchors
inflation expectations, which then contribute to a more stable macroeconomic environment,
which, in turn, enhances policy credibility. We should be careful neither to underweight the
value of resulting simple heuristics nor to minimize the risks of complicating them.
When then to be flexible?
Once credibility is achieved and the operation of the framework better understood, could
credibility be retained if the parameters were adjusted to reflect the characteristics of the
shocks hitting the economy at any particular time? Flexible inflation targeting works well with
temporary or one-off shocks. Whether it can adapt to address unique but longer-lived shocks
(such as an asset boom or secular changes wrought by globalization) is the pertinent
question. What constitutes a "unique" shock? Can we expect authorities, if they are granted
flexibility, to be sufficiently disciplined not to decide that all shocks are uniquely virulent?
Everyone always thinks they live in interesting times.
Financial imbalances certainly are interesting. However, it is not clear that monetary
policymakers should be the first line of defence. Recent events in a variety of jurisdictions
demonstrate the shortcomings of the current system where the degree of financial stability is
a by-product, rather than an objective, of regulatory policy. Central banks, as guardians of
macroeconomic stability, naturally ask whether they should play a role. It does not
necessarily follow that that role extends to the conduct of monetary policy. Central banks
may have the ability to foresee macrofinancial instability. Whether they have the appropriate
tools to prevent it is another matter. I am most sympathetic to the idea that policy-makers
should consider the development of macroprudential regulations to restrain procyclical
liquidity creation among financial institutions. The design and scope of such regulation
remains to be determined and in many jurisdictions, including Canada, there are the added
complications of determining where to house this regulatory authority and how to coordinate
it with other regulators.4
If the regulatory framework is appropriately designed, could it be reinforced by monetary
policy? Professor Issing provides one answer. He argues that the ECB's monetary pillar can
act as a signal for flexibility, perhaps in the monetary policy horizon, in the presence of
excess credit creation. Michael Woodford agrees that money and credit can have a useful
role, but cautions against incorporating them in the monetary policy reaction function.5
Do those situations that arise from the globalization process create a case for additional
policy flexibility? There are some practical difficulties such as the conflicting implications
globalization may have for consumer-price inflation. For example, its impact on manufactured
goods prices argues for a lower target; its impact on commodity prices for a higher one.6
Moreover, these conflicting forces are basically price-level effects, though ones that could go
on for some time. Similarly, the current international monetary order argues for tighter policy
due to artificially low long-term interest rates and for looser policy in countries that have seen
excessive exchange rate appreciation. Further complicating matters is the fact that the
globalization process is neither monotonic nor relentless. Its impacts will wax and wane over
time, raising the question of how frequently policy parameters might be adjusted in the face
of these shifting trends. In the pursuit of flexibility, how do we prevent this from looking
terribly arbitrary?
These difficulties are not trivial, so considerable care needs to be taken. The benefit of
greater flexibility may not be worth the risk of forfeited credibility, particularly if it simply adds
to confusion about the conduct of policy. This points to the overriding importance of
communication, rightly stressed by Alan Blinder.7
The current environment underscores many of the strengths of flexible inflation targeting.
The commodity-price shock has resulted in inflation rising above target in a number of
jurisdictions. Provided expectations are well-anchored, policy appropriate, and
communication effective, people will look through this spike to the eventual return of inflation
to its well-understood target. Of course, this implies the need for short-term flexibility in the
target, but a well-designed inflation-targeting regime allows for temporary deviations from
target in the face of shocks. Provided the framework retains credibility, that flexibility can and
should be used.
Price-level targeting
There is one final consideration. Inflation-targeting regimes have one element of flexibility
that could potentially reduce credibility: their use of an annual inflation measure that allows
monetary authorities to overlook price-level adjustments that they believe to be one-off
events. Bygones are bygones. This is not a problem when shocks are small and symmetrical
because the price level will fluctuate around the level consistent with the inflation target.
Indeed, that has been our experience in Canada over 15 years of targeting inflation. Shocks
have been random and the price level has ended up almost exactly where one would have
expected since we adopted a 2-per-cent target. However, if shocks were large and one-sided
and policy did not respond, the price level would drift from the expected path. Such a
persistent error would reduce credibility over time.
It is worth considering whether targeting the price level would enhance policy credibility in the
face of a large, persistent shock. If anticipated, temporary price-level drift could be
accommodated by extending the horizon, while credibility would be retained by the fact that
the drift would be tracked and eventually reversed. If unanticipated, the promise to correct it
that is central to price-level targeting could preserve credibility. The Bank of Canada is
currently pursuing a research agenda to determine the gains from adding greater price-level
memory to the inflation-targeting framework.
Conclusion
To conclude, constraints in the policy framework may have helped to gain credibility for the
framework when it was new, but now that it is better understood, it is time to ask whether we
can do better. In principle, we could do better by making inflexible elements more flexible or
by giving the framework more memory about the price level to compensate for any loss of
credibility. Doing so should increase social welfare by allowing policy to be better aligned
with the natural adjustment processes in the economy, thereby adding to the social welfare
benefits that come from delivering low, stable, and predictable inflation.