Session 4: The central bank’s responsibility for price and macro stability
Ricardo Reis, Columbia University
Michael Woodford, Columbia University
The unique role of central banks to provide a country with its means of payment makes it natural for them to also have responsibility for price stability.
Since the early 1990s there has been broad consensus that the central banks’ use of a flexible inflation target, which the Riksbank was a pioneer in introducing, has functioned well. But developments since the financial crisis have caused this to be questioned. Over several years, many central banks have not succeeded in attaining their set inflation targets. Discussions have mainly focused on whether the inflation target should be supplemented with other targets, such as employment. But targets connected to growth in the economy, GDP, have also been proposed.
Ricardo Reis said that although the central banks have used a number of new tools to attain the flexible inflation target, including forward guidance and unconventional measures such as quantitative easing (purchases of bonds on the open market), much more could be done without needing to use, for instance, helicopter money.
He also advocated more rule-governed targets for central banks and that the inflation target should be replaced, not always, but to a greater extent than now, by a price target, and that there should be greater focus on employment.
Michael Woodford pointed out that even if central banks had not succeeded in attaining their inflation targets, they had served both the central banks and the economy well. The flexible inflation target has considerable advantages as it is easy to understand and firmly anchored in many countries. It is also relevant to private individuals and makes their decision-making easier, which is not the case with a GDP target, which is more abstract and can be more easily misinterpreted by the general public.
The flexible inflation target has also played an important role as anchor for expectations of future inflation and has thus had considerable significance in reducing the macroeconomic instability in connection with the financial crisis 2007-2009, and also later. Unlike the 1930s Depression, inflation expectations did not fall during the most recent financial crisis. This caused substantial problems in the 1930s. Nor did the most recent fluctuations in the oil price have the same negative socioeconomic effects as in the 1970s, when they triggered a destructive wage-price spiral that pushed up inflation.
Although other sub-targets, such as employment and financial stability, are important and relevant, today's flexible inflation target has advantages that mean its special status should be preserved, according to Michael Woodford. He said that when communicating with the markets the central banks need to supplement the flexible inflation target with, for instance, the expected GDP development, to create a stronger link between the inflation target and the way the economy in general is developing.
