Inflation targets have left central banks in a bind
Implausible though it may sound, the collapse of Silicon Valley Bank casts an interesting light on the vexed question of whether central bank inflation targets should be raised to reduce the risk that overtight monetary policy will precipitate a recession. This is because SVB, however inept its risk management and investment judgment, was ultimately a victim of the US Federal Reserve’s monetary policy regime.In the period after the financial crisis of 2007-9, deflationary forces were the overwhelming challenge for central bank policymakers. Their problem was not how to bring inflation down to within target, but how to raise it up to the target level. This they could only do by resorting to ultra-low and even negative nominal interest rates.A consequence of this extreme monetary licence, as Edward Chancellor points out in his book The Price of Time, has been a plethora of market distortions including the creation of the “everything bubble” in which prices of almost all assets were propelled to astronomic heights. With the income on assets severely depressed, investors were driven to search for yield regardless of risk.That, in essence, was the story of SVB, banker to countless tech companies. At the height of the tech boom it experienced a tidal inflow of deposits. Because this exceeded potential lending opportunities by far, it had to find investment outlets for the money. With short-term paper offering next to nothing, it searched for yield and locked up funds in $120bn worth of mainly highly rated long dated mortgage-backed securities.Long-dated instruments are particularly vulnerable to rising interest rates. So when the Fed belatedly tightened monetary policy in response to unexpectedly high inflation, the decline in the mark-to-market value of the SVB portfolio came close to wiping out its capital. This would not have mattered if the depositors retained confidence in the bank because there would have been no losses if the securities were held to maturity. But the tech community panicked; there was a run on deposits; and SVB had to sell the devalued assets, thereby precipitating its own bankruptcy. We may now be at just the start of a series of financial instability episodes which will add to the risk that in trying to wrest inflation back to 2 per cent, the Fed and other central banks will do serious damage to output and employment.No surprise, then, that there is a growing chorus arguing for raising inflation targets from 2 to 3 per cent. Nor is this unreasonable if, as former Bank of England chief economist Andy Haldane has argued, we are witnessing a shift upwards in the global equilibrium price level. There is anyway no theoretical justification for equating 2 per cent with price stability.Yet moving the goalposts would look like surrendering to inflation. Central banks’ already depleted credibility would suffer huge damage and inflation expectations would rocket. So they will fudge, possibly following Haldane’s suggestion either to extend the time horizon for meeting the 2 per cent target or temporarily suspending it while promising to refix at the earliest possible date.But that leaves two wider questions. What we have learned about inflation targeting is that in deflationary times it causes seeds of financial instability to be sown. Then when inflation returns it causes financial crises to erupt as interest rates are hiked to get back to the inflation target. In fact it only seems to work when prices are anyway stable.Oh dear. A case, then, for regime change? Unfortunately, any other regime might entail increased discretion and thus weaker accountability. Tweaking the existing regime may be the least bad option. Then there is the question of how a 2 per cent target affects governments’ ability to shrink the current very high public debt levels.The traditional remedy is a combination of growth, which produces buoyant tax revenues to help pay down the debt, and inflation, which shrinks the real value of debt. Yet growth is anaemic and a 2 per cent inflation target reduces the scope for informal default through inflation.In the general panic after SVB’s collapse, banks rushed to borrow $330bn of backstop funding from the Fed. Speculation is mounting that the Fed may defer further rate hikes. We are stuck, then, in the longstanding bind whereby policy does not lean against booms but eases aggressively in busts while debt goes on rising inexorably. There can be no happy ending to this [email protected] More
