IMF Rethink

Who would have thunk it. Seems like there is a pretty radical rethink of monetary policy verities going on at the IMF of all places. The exchange rate rethink seems especially relevant to Canadian monetary policy and they will be aghast at the Bank of Canada on the case for higher inflation targets.

From today’s FT

IMF floats plan to raise inflation targets

By Chris Giles in London

Financial Times, February 12 2010

International Monetary Fund economists are challenging economic orthodoxy on Friday by suggesting that many pre-crisis policy tools should be redesigned and some sacred cows considered for slaughter.

A staff paper co-authored by Olivier Blanchard, IMF chief economist, says the financial and economic crisis has “exposed flaws in the pre-crisis policy framework” and “forces us to think about the architecture of post-crisis macroeconomic policy”.

Suggestions include raising inflation targets from about 2 per cent to about 4 per cent so that monetary policy can better respond to shocks; automatic lump-sum payments for poorer families if unemployment rises above certain thresholds; exchange-rate intervention for smaller economies that depend heavily on trade; and giving central banks huge new regulatory tools so they can smooth the path of the economy.

The political momentum behind many of the ideas is absent, Mr Blanchard accepted. The IMF is taking a gamble by spelling out the flaws in current thinking, even if it is in a staff paper rather than formal recommendations.

Some of the tools suggested have been used in the crisis, but boosting the Federal Reserve’s powers, for instance, is highly controversial in the US.

The suggestion that inflation targets should be raised to 4 per cent will cause many central bankers to choke on their breakfasts, since they have spent their whole careers gaining and preserving the credibility of keeping inflation at levels close to 2 per cent.

Mr Blanchard said the idea of raising inflation targets should not be seen as outlandish. “If we had had more margin to play with on interest rates, we would probably have had to use fiscal policy less [in the crisis],” he told the Financial Times. He recognised that higher inflation and higher interest rates in normal times would have costs, but they might be a price worth paying because they would make monetary policy more effective in crisis periods.

“Nobody knows the cost of inflation – between 2 per cent and 4 per cent – so I think people could get used to 4 per cent and the distortions could be small,” said Mr Blanchard

‘If we had had more margin to play with on interest rates, we would probably have had to use fiscal policy less [in the crisis]‘
Olivier Blanchard, IMF chief economist

He stressed that higher inflation targets were only one of many ideas that should be considered. He was particularly hopeful that the idea of central bankers having many policy tools, rather than just interest rates, would gain momentum.

The paper suggests giving central bankers “cyclical regulatory tools”, including bank capital ratios to limit or expand leverage, liquidity ratios to regulate liquidity, loan-to-value limits to control domestic mortgage borrowing and margin requirements to have some control over equities.

For decades, central bankers’ only tool has been the interest rate. Some economists have suggested these should be used more actively to “lean against the wind” of credit markets. But Mr Blanchard robustly rejected such an approach. “[This] strikes me as totally stupid,” he said.

The paper recognises that fiscal policy became a vital tool for boosting demand in the crisis, and says its success should be formalised with measures such as “temporary transfers targeted at low-income or liquidity-constrained households”.

Many emerging markets needed to keep exchange rates stable, he said. They should stop saying they simply followed inflation targets, when active policies to stabilise exchange rates “were more sensible than their rhetoric”.


  • I wonder how much this represents new thinking on monetary policy or just the fact that the authors’ think (rightly or wrongly) that they will have to tolerate more inflation than they would normally like. If they are working with a quantity theory of money, which they most likely are, they must be anticipating both higher real interest rates and higher inflation. So imagine a 4% inflation rate with an 7-8 % unemployment rate and 5-6% nominal interest rate.

    This could just be Monetarism Mark III rather than any real re-think.

  • I thought inflation rates were supposed to be set based on target expectations of future demand and growth in the business environment? You mean to tell me instead of raising interest rates to attract investments into government instruments and accumulate cash so we can grow out of the depression, they just want to go ahead and raise the inflation rate with no real growth in the economy?

    Um, I’m missing something but even my self-taught economics tells me that this is just going to make things worse for everybody involved. How about we let savers be savers and spenders be spenders without having to save the spenders and punish the savers.

    PS: About the other comment, do you suggest that a raise in inflation rates and a raise in nominal interest rates would actually help stimulate the economy?

  • Inflation is a problem right now, especially if you plan to buy & hold 10y, 30y government bonds or US treasuries. If Greece gets a bailout from the ECB, expect risk appetite to come back with a vengeance and weakening US dollar. If ECB lets Greece default to imply no bailouts for Italy, Spain, Portugal will strengthen the USD, and slaughter risk appetite.

    “Americans are spent out, unemployed and can’t use their homes as ATMs,” said David Gilmore, at Foreign Exchange Analytics in Essex, Conn. “We need foreigners to pick up the slack, but a strong dollar certainly won’t help that.

    This analysis is striking given Canadian commentary of a robust US that will lead a recovery in exports if our currency exchange was pegged to the dollar

    Acutally the FEDs recent commentary solidifies a point of view that the FED will try all means unconventional ways to decrease laquidity through the use of the discount rate avoiding more traditional tools such as the key funds rate because of the risks to bailed sectors.

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