The Hidden Costs of Inflation Targeting: Income Distribution and Central Bank Deviations Post-Crisis

This podcast episode delves into the origins, mechanisms, and often-overlooked consequences of inflation targeting as a central bank policy. It explains that inflation targeting, which began almost accidentally in New Zealand in the late 1980s, functions as a modern form of "incomes policy." Central banks aim to control wage growth and inflation through public announcements (the "carrot") and, if necessary, by raising interest rates (the "stick") to slow the economy. A key argument is that this approach implicitly suppresses the income growth of one group (wage earners) while potentially benefiting another (interest income earners), making it a distributional policy, albeit one that often lacks explicit justification on income distribution grounds.

The discussion highlights a critical distinction between contemporary inflation targeting and historical incomes policies, such as the Kennedy-Johnson guideposts or Canada's Anti-Inflation Board. Historically, such policies, whether voluntary or compulsory, were often justified on the basis of maintaining income distribution neutrality, ensuring real wages grew with productivity. However, the speaker argues that with the advent of inflation targeting regimes in the early 1990s, this crucial discussion about income distribution disappeared. Empirical evidence, including research funded by the host institution, suggests a correlation between the implementation of these regimes and a decline in labor's share of income, indicating a distributional bias that is no longer explicitly addressed or justified by central banks.

The episode further scrutinizes the theoretical underpinnings of inflation targeting, particularly the premise that achieving an "optimal" inflation rate (often 2%) leads to the highest productivity growth and economic welfare. This justification, rooted in the idea of an economy gravitating around a natural level of unemployment, is challenged. The speaker references a widely cited 1982 paper by Bank of Canada economists that purported to show a negative relationship between inflation and productivity growth, but argues this finding was based on the specific, short-term context of the 1970s oil price shocks and lacks current empirical support. Despite this, the belief persists as a "faith" within central banking circles.

Finally, the podcast reveals a significant divergence between central bank rhetoric and actual behavior, especially following the 2008 financial crisis. While central banks continue to pay "lip service" to inflation targeting, their reaction functions, particularly in countries like Canada, show they prioritized other macroeconomic concerns. Despite stable inflation rates, interest rates plummeted to near zero, indicating a focus on preventing economic collapse, addressing unemployment, and managing record household debt levels, rather than strictly adhering to the inflation target. This suggests a pragmatic, albeit unacknowledged, shift in central bank priorities away from a sole focus on inflation, especially when faced with severe economic crises.