Tuesday, June 26, 2007

Leijonhufvud on inflation targeting (fg)

Here you can find an excellent article on the perils of inflation targeting written by Axel Leijonhufvud. His main points can be summarized as follows:

  • We are now in a Wicksellian world of pure inside money in which no determinate equilibrium for the price level exists
  • Monetary policy then becomes the art of using the federal funds rate to control the rate of change of the price level
  • In a macroeconomic situation in which no goods inflation occurs liquidtiy spreads into asset markets
  • The absence of goods inflation stems from foreign exchange rate policies. The prevention of foreign currency appreciation and stable export elasticities led U.S. inflation in check (own annotation: but this might not sound convincing for a quantitiy theorist)
  • Overall liquidity reduced risk spreads which in turn induced risky and speculative investments
  • Thus,
    a number of very large failures – LTCM, Enron, Amaranth – have occurred causing nary a macroeconomic ripple, and this is frequently cited as proof of the resilience that recent financial innovations have imparted to the system. It may be, however, that the more appropriate conclusion to draw is that macroeconomic developments are more likely to trigger trouble in financial markets than vice versa

I can aggree on Leijonhufvud's concerns. However, in my view one could improve the situation by either following a price-level-path-targeting rather an inflation-targeting framework or by reacting to past target misses in an inflation-targeting setting (which is de facto the same). See for example Orphanides/Williams or Vestin.