It is with regret that we announce the death of Inflation Targeting.    The monetary regime, known affectionately as “IT” to its friends, evidently passed away in September 2008.   That the demise of IT has not been officially announced until now testifies to the esteem in which it was widely held, its usefulness as a figurehead for central banks, and fears that there might be no good candidates to assume its position as preferred anchor for monetary policy.

Inflation Targeting was born in New Zealand in March 1990.   Admired for its transparency and accountability, it achieved success there, and soon also in Canada, Australia, the UK, Sweden and Israel.  It subsequently became popular as well in Latin America (Brazil, Chile, Mexico, Colombia, and Peru) and in other developing countries (South Africa, South Korea, Indonesia, Thailand and Turkey, among others).   

One reason that IT gained such wide acceptance as the champion nominal anchor was the failure of its predecessor, exchange rate targeting, in the currency crises of the 1990s.   Pegged exchange rates had succumbed to fatal speculative attacks in many of these countries.  The authorities needed something new to anchor the public’s expectations of monetary policy.  IT was in the right place at the right time.

Before the reign of exchange rate targeting, in turn, the fashion in the early 1980s had been money supply targeting, the brainchild of monetarist Milton Friedman.   The money supply rule had succumbed to violent money demand shocks rather quickly.  Friedman’s general argument for rules over discretion, in order to make a commitment to low inflation credible, however, is still very influential.

Inflation Targeting was best known as a rule that told central banks to set a target range for the yearly rate of change of the Consumer Price Index (CPI) and to try their best to attain it.    Close cousins included targeting the price level (instead of the inflation rate) and targeting the core inflation rate (that is, excluding the volatile food and energy components of prices) instead of the headline number.    

There were also proponents of Flexible Inflation Targeting, who held that it was fine to put some weight on real GDP growth in the short run, so long as there was a clear target for CPI inflation in the longer term.     But some felt that if the definition of IT were stretched too far, it would lose its meaning.

Regardless, Inflation Targeting has taken some heavy blows over the last four years, analogous to the crises that hit exchange rate targets in the 1990s.   Perhaps the biggest setback came in September 2008, when it became clear that central banks that had been relying on IT had not paid enough attention to asset bubbles. 

Central bankers had told themselves that they were giving asset markets all the attention they deserved, by specifying that housing prices and equity prices could be taken into account to the extent that they carried information regarding goods inflation.  But this escape clause proved insufficient:  When the global financial crisis hit, suggesting at least in retrospect that monetary policy had been too loose during the years 2003-06, it was neither preceded nor followed by an upsurge in inflation.  

That the boom-bust cycle could take place without inflation should not have come as a surprise.  The same thing had happened when asset market bubbles ended in crashes in the United States in 1929, Japan in 1990, and Thailand and Korea in 1997.  And the Greenspan hope that monetary easing could clean up the mess in the aftermath of such a crash proved wrong in the great recession of 2008-09.

While the lack of response to asset market bubbles was probably the biggest failing of Inflation Targeting, another major setback was inappropriate responses to supply shocks and terms of trade shocks.  An economy is healthier if monetary policy responds to an increase in the world prices of its exported commodities by tightening enough to appreciate the currency.   But CPI targeting instead tells the central bank to appreciate in response to an increase in the world price of the imported commodities — exactly the opposite of accommodating the adverse shift in the terms of trade.  For example, it is widely suspected that the reason for the otherwise-puzzling decision of the European Central Bank to raise interest rates in July 2008, as the world was sliding into the worst recession since the 1930s, was that oil prices were just then reaching an all-time high.  Oil prices get a substantial weight in the CPI, so stabilizing the CPI when dollar oil prices go up requires appreciating versus the dollar.

One promising candidate to take the position of preferred nominal anchor has lately received some enthusiastic support in the blogs:  Nominal GDP Targeting.   The idea is not new.  It had been a candidate to succeed money targeting in the 1980s, since it did not share the latter’s vulnerability to velocity shocks. 

Nominal GDP Targeting was never adopted at that time.  But now it is back.  Its fans point that it would not, like Inflation Targeting, have the problem of excessive tightening in response to adverse supply shocks.    Nominal GDP targeting stabilizes demand, which is really all that can be asked of monetary policy.  (An adverse supply shock is automatically divided between inflation and real GDP, equally, which is pretty much what a central bank with discretion would do anyway.)

A dark horse candidate is Product Price Targeting.  It would focus on stabilizing an index of producer prices rather than an index of consumer prices, and so would not like IT have the problem of responding perversely to terms of trade shocks.  The supporters of both Nominal GDP targeting and Product Price Targeting claim that IT sometimes gave the public the misleading impression that it would stabilize the cost of living even in the face of supply shocks or terms of trade shocks, over which central banks have no control.

IT is survived by the gold standard, an elderly distant relative.   Although some eccentrics favor a return to gold as the monetary anchor, most would prefer to leave this relic of another age to its peaceful retirement, reminiscing over burnished fables of its long lost youth.

[This post originally appeared as an op-ed in Project Syndicate.]

The prices of minerals, hydrocarbons, and agricultural commodities have been on a veritable roller coaster. Although commodity prices are always more variable than those for manufactured goods and services, commodity markets over the last five years have seen extraordinary volatility.

Countries that specialize in the export of oil, copper, iron ore, wheat, coffee, or other commodities have boomed.  But they are highly vulnerable. Dollar commodity prices could plunge at any time, as a result of a new global recession, a hard landing in China, an increase in real interest rates in the United States, fluctuations in climate, or random sector-specific factors.

Countries that have outstanding debt in dollars or other foreign currencies are especially vulnerable. If their export revenues were to plunge relative to their debt-service obligations, the result could be crashes reminiscent of Latin America’s debt crisis in 1982 or the Asian and Russian currency crises of 1997-1998.

Many developing countries have made progress since the 1990’s in shifting from dollar-denominated debt toward foreign direct investment and other types of capital inflows, or in paying down their liabilities altogether. But some commodity exporters still seek ways to borrow that won’t expose them to excessive risk.

Commodity bonds may offer a neat way to circumvent these risks. Exporters of any particular commodity should issue debt that is denominated in terms of the price of that commodity, rather than in dollars or any other currency. Jamaica, for example, would issue alumina bonds; Nigeria would issue oil bonds; Sierra Leone would issue iron-ore bonds; and Mongolia would issue copper bonds. Investors would be able to buy Guatemala’s coffee bonds, Côte d’Ivoire’s cocoa bonds, Liberia’s rubber bonds, Mali’s cotton bonds; and Ghana’s gold bonds.

The advantage of such bonds is that in the event of a decline in the world price of the underlying commodity, the country’s debt-to-export ratio need not rise. The cost of debt service adjusts automatically, without the severe disruption that results from loss of confidence, crisis, debt restructuring, and so forth.

The idea is not new. (The oldest reference I know is Lessard & Williamson, 1985.)  So, why has it not been tried before? When one asks finance ministers in commodity-exporting debtor countries, they frequently reply that they fear insufficient demand for commodity bonds.

That is a surprising proposition, given that commodity bonds have an obvious latent market, rooted in real economic fundamentals. After all, steel companies have an inherent need to hedge against fluctuations in the price of iron ore, just as airlines and utilities have an inherent need to hedge against fluctuations in the price of oil.  Each of these commodities is an important input for major corporations. Surely there is at least as much natural demand for commodity bonds as there is for credit-default swaps and some of the bizarrely complicated derivatives that are currently traded!

It takes liquidity to make a market successful, and it can be difficult to get a new one started until it achieves a certain critical mass. The problem may be that there are not many investors who want to take a long position on oil and Nigerian credit risk simultaneously.

A multilateral agency such as the World Bank could play a critical role in launching a market in commodity bonds. The fit would be particularly good in those countries where the Bank is already lending money.

Here is how it would work. Instead of denominating a loan to Nigeria in terms of dollars, the Bank would denominate it in terms of the price of oil; it would then turn around and lay off its exposure to the world oil price by issuing that same quantity of bonds denominated in oil. If the Bank lends to multiple oil-exporting countries, the market for oil bonds that it creates would be that much larger and more liquid. It can serve an additional important pooling function in cases where there are different grades or varieties of the product (as with oil or coffee), and where prices can diverge enough to make an important difference to the exporters.  The Bank could link the bond it issues to an oil price index, a weighted average of various product grades.

An alternative for some commodity exporters is to hedge their risk by selling on the futures market. But an important disadvantage of derivatives is their short maturity. A West African country with newly discovered oil reserves needs to finance exploration, drilling, and pipeline construction, which means that it needs to hedge at a time horizon of 10-20 years, not 90 days.

Another disadvantage of derivatives is that they require a high degree of sophistication –both technical and political. In the event of an increase in a commodity’s price, a finance minister who has done a perfect job ex ante of hedging export-price risk on the futures market will suddenly find himself accused ex post of having gambled away the national patrimony. This principal-agent problem is much diminished in the case of commodity bonds.

If the international financial wizards can get together and act on this idea now, commodity exporters might be able to avoid calamity the next time the world price of their product takes a plunge.  The World Bank should take up the cause.

     Robert Zoellick put a few sentences about gold toward the end of a column in today’s FT that are drawing a lot of attention.   I doubt very much if the World Bank President has in mind a return to the gold standard, but goldbugs and critics alike are talking as if he does.

      Even if one placed overwhelming weight on the objective of price stability — enough weight to contemplate a rigid straightjacket for monetary policy — gold would not be a suitable anchor.   The economy would be hostage to the vagaries of the world gold market, as it was in the 19^th century:   suffering inflation during periods of gold discoveries and deflation during periods of gold drought.   This is well-known.   I am confident Zoellick understands it.   (He and I were in the same macroeconomics seminar at Swarthmore College in the 1970s.)

      I think he is making another point.  The world is moving away from a monetary system in which the dollar is the overwhelmingly dominant international reserve asset.  The dollar’s share of international reserves has been declining ever since Richard Nixon unilaterally ended the Bretton Woods system in 1971.   The dollar’s unique role is not an eternal god-given constant of the universe, any more than it was for pound sterling.  The US currency of course replaced the pound in the first half of the 20^th century, with a lag of 25 years or more after the US surpassed the UK economically.

      Will some asset replace the dollar, then?  No, not a single asset.  But we are probably moving to a system where there will be as many as a half dozen international reserve assets.  First, there is the euro.  Despite the serious troubles facing it this year, the euro has been a competitor for the dollar since it came into being 11 years ago.  Both the yen and the Swiss franc have to some extent played safe haven roles during the last three years of global financial turmoil.  The pound is not out completely.   Some day the renminbi will be added to the roster of major international currencies, when China’s financial markets are sufficiently developed and open.    Even the SDR (special drawing right) came back from the dead in 2009.

      And, yes, gold too has re-joined the world monetary system.  Gold was seen as an anachronism as recently as a couple of years ago.  The world’s central banks had been gradually selling off their stocks.   But all that changed in 2009.  The People’s Bank of China, the Reserve Bank of India and other central banks in Asia have bought gold.  Understandably, they want to diversify their reserves.    It appears that central banks have stopped selling gold even among advanced countries and that aggregate gold reserves have risen over the last year.   This is a multiple reserve asset system.      

[For those interested in gold and other mineral commodities, I have some relevant writings.  Others' views on Zoellick are at the New York Times.]

          Numbers newly reported from the IMF’s COFER data base show that in the most recent quarter, the spring of 2009, the share of central banks’ foreign exchange reserve holdings that they allocate to dollars resumed its downward trend.   The dollar share has been gradually sliding since the beginning of the decade – perhaps because of the birth of a possible rival, the euro, in 1999, or perhaps because of the long-term path of tremendous fiscal and monetary expansion on which the United States embarked in 2001.   

          During the four quarters preceding the most recent one, the share of the aggregate portfolio that the world’s central banks allocated to dollars had temporarily reversed its downward direction.  Arithmetically, the main source of this increase in the dollar’s share was its appreciation against other currencies.   But another source was the action of central banks in industrialized countries, acquiring dollars more rapidly than other currencies.   The movement of the raw quantity shares can be seen in the first graph below, and the movement in the shares properly valued at current exchange rates in the second graph.   (I am grateful to Ted Truman and Dan Xie, both of the Petersen Institute for International Economics, for these graphs.)   

          Whether the temporary reversal from Q2 of 2007 to Q1 of 2008 is measured in quantity terms or in valuation terms, the phenomenon was presumably a (surprisingly strong) safe-haven reaction to the global financial crisis.  Apparently the recent easing of risk and liquidity concerns has now mitigated the flight into dollars.  The central banks that had shifted into dollars have begun to shift back a bit, into euros in particular.

          The gradual downward trend of the dollar’s share during the past decade is a continuation of the trend that began after the end of the Bretton Woods system: from the late 1970s until 1991.  The dollar’s share recovered from 1992 to 2000.  That temporary halt in the longer run trend may have been in part a result of the deficit reduction path that began with George H.W. Bush’s unpopular fiscal reversal and continued through the time of Bill Clinton achievement of fiscal surpluses, until George W. Bush took office and reinstated the chronic deficits.

          The usual response to worries that US macroeconomic profligacy will eventually end the dollar’s privileged position as lead international currency has always been that no asset constitutes a credible alternative for central banks to hold in their portfolios.   I have argued that, since 1999, the euro has constituted a credible alternative.   Based on econometric estimates of the determinants of central banks’ reserve holdings in research with Menzie Chinn, we have even gone so far as to report simulations that show the euro overtaking the dollar by 2022.  Many, like Truman, consider such speculation exaggerated.  They may be right.

           But the euro is not the only alternative to the dollar.  The yen, pound and Swiss franc remain viable alternatives for national authorities to put some of their reserves.  Furthermore, 2009 has seen the resurrection of two international reserve assets that had previously been written off as dead:  the SDR and gold.  My forecast is that we are gradually moving from the dollar standard to a global monetary system that features multiple reserve assets.

Share of central banks foreign exchange reserves allocated to dollars, 1999 QI – 2009 QII       (among industrial countries, among developing countries, and overall)

[Readers wishing to post comments are referred to the SeekingAlpha version.]

Everyone is looking for someone to blame for high prices of oil and other mineral and agricultural commodities. Speculators (among others) are high on the list, followed by the Federal Reserve. While I don’t think blame is necessarily the right concept here, I have been arguing that low real interest rates have worked to raise real commodity prices through a number of channels. Each of these channels could be called “speculation,” if speculation is defined as behavior based on expectations of future prices.

A number of commentators, including Don Kohn and Paul Krugman, have argued that low interest rates and speculation cannot be the sources of the problem, because oil inventories are low. It is true that low interest rates, other things equal, should in theory increase firms’ desire to hold inventories.

US crude oil inventories do not appear to be especially low in the graph above, showing June 1998-June 2008 (from Bloomberg). But it is true that they are not especially high either.

We are talking about relatively integrated world markets, however, so it is world inventories that should matter most. According to the International Energy Agency’s Oil Market Report, oil inventories held in developed countries have been above average during most of the last year, as the next graph shows. They rose sharply in January 2008, which happens to be the month when the very aggressive cuts in US interest rates took place. These numbers are far from conclusive, but still…

The theory is meant to explain the mystery why prices of virtually all mineral and agricultural prices are high, not just oil, and in some ways fits others better. Inventories of some commodities are indeed high now. The price of gold, the last graph shown, is a good example. Here the evidence supports the theory (1) that easy monetary policy has driven up the price, and (2) that one channel is low interest rates making it more attractive to stockpile the yellow metal. But, as with oil, the biggest inventory is the one underground.

[Thanks to Pravin Chandrasekaran.]

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If strong economic growth is not the explanation for the large increases since 2001 in prices of virtually all mineral and agricultural commodities, then what is? One wouldn’t want to try to reduce commodity markets to a single factor, nor to claim proof of any theory by a single data point. Nevertheless, the developments of the last six months provided added support for a theory I have long favored: real interest rates are an important determinant of real commodity prices. High interest rates reduce the demand for storable commodities, or increase the supply, through a variety of channels:

• by increasing the incentive for extraction today rather than tomorrow (think of the rates at which oil is pumped, copper mined, forests logged, or livestock herds culled)
• by decreasing firms’ desire to carry inventories (think of oil inventories held in tanks)
• by encouraging speculators to shift out of spot commodity contracts (think gold), and into treasury bills.

All three mechanisms work to reduce the market price of commodities, as happened when real interest rates where high in the early 1980s. A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising commodity prices, as happened in the 1970s, and again during 2001-2004. It’s the original “carry trade.”

The theoretical model can be summarized as follows:

A monetary expansion temporarily lowers the real interest rate (whether via a fall in the nominal interest rate, a rise in expected inflation, or both – as now). Real commodity prices rise. How far? Until commodities are widely considered “overvalued” — so overvalued that there is an expectation of future depreciation (together with the other costs of carrying inventories: storage costs plus any risk premium) that is sufficient to offset the lower interest rate (and other advantages of holding inventories, namely the “convenience yield”). Only then do firms feel they have high enough inventories despite the low carrying cost. In the long run, the general price level adjusts to the change in the money supply. As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were. The theory is the same as Rudiger Dornbusch’s famous theory of exchange rate overshooting, with the price of commodities substituted for the price of foreign exchange.There was already some empirical evidence to support the theory: Monetary policy news and real interest rates, along with other factors, do appear to be significant determinants of real commodity prices historically. (For a simpler illustration, see graph below).

But the events since August 2007 provide a further data point. As economic growth has slowed sharply, both in the US and globally, the Fed has reduced interest rates, both nominal and real. Firms and investors have responded by shifting into commodities, not out. This is why commodity prices have resumed their upward march over the last six months, rather than reversing it.

It is hard to remember now, but mineral and agricultural commodities were considered passé less than ten years ago. Anyone who talked about sectors where the product was as clunky and mundane as copper, corn, and crude petroleum, was considered behind the times. In Alan Greenspan’s phrase, GDP had gotten “lighter;” the economy was becoming weightless, “dematerializing.” Agriculture and mining no longer constituted a large share of the New Economy, and did not matter much in an age dominated by ethereal digital communication, evanescent dotcoms, and externally outsourced services. The Economist magazine in a 1999 cover story forecast that oil might be headed for a price of $5 a barrel.

Since then, of course, we have seen tremendous increases in the prices of most mineral and agricultural commodities, many of them hitting records in nominal and even real terms (see graph). Oil is now well above $100 a barrel, and gold has just crossed the $1000 an ounce line.

The question is why.

There could well be merit to many of the explanations that have been offered for the rise in the price of oil. One is the “peak oil hypothesis,” and another is geopolitical uncertainty in Russia, Nigeria, Venezuela and – above all – the Gulf. Corn prices have been impacted by American subsidies for biofuel. And other special microeconomic factors are relevant in other specific sectors. But it cannot be a coincidence that mineral and agricultural prices have risen virtually across the board. Some macroeconomic explanation is called for.

The popular explanation since 2004 has been rapid growth in the world economy. The strongest growth has of course been coming from China and other recently minted manufacturing powerhouses in Asia, but the expansion has been unusually broad-based – including up to last year the United States and even a reinvigorated Europe. So growth has pushed up demand for energy, minerals, farm products, and other industrial inputs, right?

This reigning explanation now looks suspect. Since last summer the US economy has slowed down noticeably, and is probably entering a recession. Despite talk of decoupling, it is clear that other countries are also slowing down at least to some extent. In its most recent forecast, the IMF World Economic Outlook revised downward the growth rate for virtually every region, including China. The overall global growth rate for 2008 has been marked down by 1.1% (from 5.2 % in July 2007, just before the sub-prime mortgage crisis hit, to 4.1 % as of January 29, 2008). And prospects continue to deteriorate. Yet commodity prices have found their second wind over precisely this period! Up some 25% or more since August 2007, by a number of indices. So much for the growth explanation.

How to explain commodity prices up while the economy turns down? I will offer my answer in my next posting, tomorrow.