FT Alphaville " Inflation targeting and the output gap This argument is brought to you by Deutsche Bank. Their analysts don't much like inflation targeting, which essentially entails the central bank aiming to minimise the output gap. They argue that it has led to excessive credit growth which eventually bred financial instability. More specifically (emphasis ours): ... new borrowing relative to GDP is a good proxy for the output gap. In contrast to the latter, however, new borrowing can be measured quite precisely. ... the traditional monetary policy approach of trying to minimize the output gap may go along with unsustainable credit growth that leads to over-indebtedness, financial fragility, and eventually a financial crisis. Monitoring credit growth is therefore essential to safeguard against financial instability. Furthermore: Monetary policy may need the support of fiscal policy to ensure total credit growth that is consistent with financial stability. We have been here before - Deutsche Bank themselves have argued that because credit growth is a stock variable, domestic demand growth should be correlated with the credit impulse (roughly the change in credit growth) rather than credit growth itself - and the arguments against pure inflation targeting have been gaining ground for quite a while. Anyway, the analysts" argument-propre is based on that idea that the "so-called Taylor Rule," which is consistent with inflation targeting, is only by chance consistent with non-explosive credit growth. They argue that such as coincidence didn't hold in the US nor in the euro area during the 1990s and 2000s when output gaps of zero did occur (the grey line hits in the x-axis in the charts below) ... but this was accompanied by unsustainable credit growth: Back over to Deutsche Bank: Figures 7-8 have interesting implications for the sustainability of economic growth. In both regions, an output gap of 0% is consistent with nominal credit growth of 7.0%. Potential nominal GDP growth averaged 4.8% in the US over the observed period and less than 4.0% in the euro area. In other words, when the output gap was 0%, the credit was rising faster than nominal GDP and the debt ratio was rising. An output gap of 0% would have suggested that the economy was performing at its potential and on a growth path that is generally perceived as being sustainable. Unless there were worrisome signals from actual inflation, the Taylor Rule would have suggested that policy interest rates were appropriate at existing levels. However, the right hand scale of these charts suggests that growth at potential went along with credit growth that was faster than nominal GDP growth. In other words, growth in line with potential was associated with an ever-increasing debt to GDP ratio. As for the policy difference between the two periods: In the late 1990s private sector new borrowing increased as a % of GDP despite interest rate hikes. The increase in new borrowing was due perhaps in part to increased expectations of returns to capital, in part perhaps due to the IT revolution. Policy makers could have increased rates further, but they might have run the risk of creating distortions in other parts of the economy. If monetary policymakers could not limit the increase in private sector borrowing, they could at least lower government borrowing to ensure that total borrowing in the economy was unchanged. This they duly did - the Federal budget balance moved from a deficit of 4.7% ofGDP in 1992 to a surplus of 2.4% in 2000. Total borrowing in the US (Figure 11) increased only marginally. Compare that to the 2000s when the problem was twofold, say the analysts at Deutsche -- interest rates were hiked too gradually and predictably to prevent the surge in private sector new borrowing, and at the same time government continued to run hefty fiscal deficits. Total borrowing in the US surged to extremely high levels, at a time when the outlook for nominal GDP growth was not that high. Private sector credit growth surged, but government borrowing did nothing to offset it. The team at Deutsche Bank argue that the US Federal Reserve should have seen the rise in new borrowing, realised that this indicated an economy operating well above its potential and on its way towards financial fragility. Under these circumstances, they should have hiked rates aggressively: If this had failed to cause lending growth to moderate, however, then government borrowing should have been curtailed. Instead, policymakers allowed private debt levels to surge even as governments ran substantial budget deficits. US policymakers added fiscal profligacy to their monetary recklessness. A more cautious fiscal stance might not have prevented the credit crisis, but it would have left the US government with the fiscal space to respond without concern for the debt implications. In July 2000 the CBO projected that the US would run abudget surplus of on average 3% of GDP over the nextdecade. Instead, the budget balance averaged -2.0%between 2001 and 2008. If the 2000 budget projectionshad been achieved, the US would have entered the creditcrisis with a debt to GDP ratio of 6.0%. Thus, they argue: ...economic policy should be conducted in a two dimensional framework, where not only the output gap but also new borrowing relative to GDP is closely monitored. Our proxy for new borrowing relative to GDP is credit growth. Credit growth that is stronger than nominal GDP growth will inevitably lead to over-borrowing and possibly a financial crisis. To check whether the debt ratio for the economy is headed towards unsustainable levels, we can calculate the steady state debt ratio implied by current levels of new borrowing. If this steady state debt ratio seems too high there is a case for slowing down new borrowing, irrespective of the size of the output gap. This may require action by both monetary and fiscal policy. The full note (with attendant wonkiness) is in the usual place. Related links: Four trends in central bank-land - FT Alphaville Inflation targeting, back in the frame - FT Alphaville BoE shifts on inflation targeting - John Kemp This entry was posted by David Keohane on Thursday, June 7th, 2012 at 10:14 and is filed under Capital markets. Tagged with inflation targeting.