Making It Happen
The implication is that a new regime for central bank monetary policy is needed. For emerging countries, a global initiative should aim to de-politicize the delicate issue of exchange rate targets. It should establish the principle that the short-term gains to one country from an undervalued currency are outweighed over time by the pressures that build up, and should agree a flexible system for adjusting rates on a technical rather than political basis.
For the developed countries, consumer price forecasts should be only one pillar of a broader targeting, which should also include a mandate to dampen extreme fluctuations in asset prices. This mandate should not attempt to define asset price level targets, but rather should have a broad set of targets that included a range of valuation measures, and a range of measures of speed of movement. In short, it should acknowledge that there are severe limits to the signal, which can be extracted from asset prices, while at the same time making use of the crucial information that does lie buried in the noise. Such an approach immediately faces the criticism that it is not a clear and simple rule, but unfortunately we do not live in a simple world, and in any event, existing approaches, based on consumer price inflation, include complex modeling processes. Moreover, in determining the points at which verbal or actual exchange rate intervention is applied, central banks around the world already have experience in operating a regime with some of these characteristics, since the intervention points are often based on a combination of level and rate of change.
With hindsight, the era of mixflation, and the credit crisis with which it is intimately linked, seems to have been driven by unforeseen interactions between monetary policies in different countries across the world. There are powerful structural trends, tending to drive up commodity prices from the low relative levels they reached at the start of this decade. But they have been exaggerated, distorted, and reversed, probably temporarily, by the effects of monetary policy. A new regime is now needed to allow the mixflation era to resume in a more sustainable and ordered way.
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