Goodhart’s Law – in Good Times and in Bad

A large part of the success of central banks all around the world during what became known as the Great Moderation is often attributed to the successful anchoring of inflation expectations to the levels that central banks would like to see – generally defined as 2% in most of the industrialized world. In basic theory this is awesome: if the inflation rate, through some kind of phillips curve or any other structural relationship you prefer, is linked to the aggregate level of economic activity in a stable way, than a stable inflation rate also leads to a stable level of economic activity.

In comes Charles Goodhart, former member of the Bank of England’s Monetary Policy Committee, who stated something as profound as at the same time similar to the famous Lucas Critique: Goodhart’s Law. In it’s most common version it says that “when a measure becomes a target, it ceases to be a good measure”. In other words, once a central bank (or in theory indeed any institution with enough clout to consistently affect the economy) states that it will do whatever it needs to in order to keep a given indicator at a level it so desires, the market structure will be affected by this, expectations of market agents will adapt, and the target will be achieved, even if the central bank does not really even do much – it just has to credibly promise that it would.

First of all, and on a very deep level, this of course could be seen as qualifying the very success of central banks in “anchoring” inflation rates. Has inflation in the past two decades been so tame because central banks have become better, or simply because they somehow managed to credibly make everyone believe that they have become better? In the end, the answer doesn’t matter much – it is outcomes that we want, who cares about how we get there. However, while the upside to this stable inflation anchoring in good times is enormous, it seems to have come back to haunt us at a time when we most need our monetary authorities to act. Even though inflation both in the US as well as in the Eurozone is considerably below target, inflation expectations are awkwardly close to those targets over the near-term (e.g. here for the Eurozone). Given most central banks nowadays target the forecast, they might interpret this as signalling that there is no real big need to act, and thus not act in the first place. I personally find this to be one of the most compelling explanations as to why the ECB continues to fail to do its job. As Draghi stated, “inflation expectations are firmly anchored in line with price stability“. Exactly. That’s the problem.

The Fed is in a somewhat better position since it does not only target inflation but also full employment – even if inflation sticks to 2%, as long as unemployment is above target it will (or should) ease monetary policy. The ECB, on the other hand, focuses essentially solely on inflation, and at the moment there are great doubts as to whether inflation (particularly inflation expectations) are of any use at all as a signal for what it should be doing. This monthly bulletin by the ECB (dating back to 2011, .pdf), for example, states that “well anchored expectations have contributed to enhancing the effectiveness of monetary policy and will assist the ongoing economic recovery”. Sure, stable inflation expectations also prevent us from falling into outright deflation in a scneario were we assume the central bank to be asleep. Further, as Clarida states (.pdf), “inflation inertia is the enemy of reflation once deflation set in”. However, I would state that somewhat differently: inflation inertia (in the context of this post in terms of expectations) is the enemy of reflation – period. At the moment it mostly provides a convenient excuse for central banks to do less than they should. Currently, it would seem that those well-anchored inflation expectations are part of what’s preventing effective monetary policy in the first place.


5 thoughts on “Goodhart’s Law – in Good Times and in Bad

  1. When you say “central banks do less than they should” what exactly do you mean? Normal interest rate policy is out. So even though I agree that not raising rates is not enough (not enough to achieve the current inflation target, let alone the fact that I find this target too low, but that’s another question), I’m not sure what the ECB in particular ought to do. QE? Difficult because the ECB, unlike the Fed, is not backed by a central fiscal authority. Forward guidance? Very difficult, because it involves promising to be irresponsible in the future. NGDP targeting? Impossible without changing the ECB statute. So what do YOU want?

    • Well, we’re kind of running in circles here – I still think my post on the options of the ECB at the ZLB answers most of your questions as to what I think the ECB should do.

      As to QE, I am not sure that is correct. All the eurozone member states receive any earnings lucrated by ECB operations, yet technically the central bank cannot default as long as the governments keep granting it the monopoly of issuing new money and this issuing of money does not endanger its main goal of price stability. This might endanger the ECBs independence, but at its core is not too different from the Fed. With its OMT program, the ECB is already engaging in something similar to QE if it were not for it’s misguided efforts to sterilize these bond purchases. And that leaving aside the fact that, while the program has lowered interest spreads in the periphery, it actually represents a fiscal transfer from this periphery to the core, as all interest payments on the bonds of e.g. Spain are of course paid in full by the Spanish treasury yet then distributed back to all member states corresponding to their equity shares in the ECBs capital. In other words, the ECBs OMT operations mean that, as a side effect, Madrid is actually sending money to Berlin when it should be the other way around.

      • Oh sorry, I somehow forgot about your earlier post, which does answer most of my questions.

        As regards OMT. That’s really a puzzle. It is true that since the announcement of OMT, yield spreads have come down a great deal in the periphery. And the common explanation is that OMT was Draghi’s way to provide a backstop for troubled Eurozone governments in order to calm investors. But if you look at the way OMT is actually designed (conditionality, full sterilization) it is very unclear how it should provide an effective backstop.

        I don’t know why you think OMT is QE, if by the latter we understand bloating the central bank’s balance sheet. OMT does not increase the ECB’s balance sheet because of full sterilization. It only changes the composition of the balance sheet.

      • I am at the moment somehow surprisingly incapable of finding actual figures on the size of OMT purchases, but from what I recall reading what surprises me the most is that it actually is mostly words with little action – it seems the announcement in itself did the most of the work (yet I could be wrong). As far I understand it, the ECB (even though it is technically not allowed to) essentially said that, for all intents and purposes, there will be someone (itself) buying the bonds of troubled economies even if the market does not, moving us from the bad equilibrium to the good one in terms of self-fulfilling liquidity crisis – that’s always how I understood the basic concept.

        As to OMT and QE – sure, there are important differences, but I’m not sure why you think the ECB needs a central fiscal authority to “back it” in order to do something more closely resembling actual QE. While there might be political issues involved, they way I see it is that if the ECB can do OMTs it can do QE as well. The potential fiscal issues of central bank balance sheets in general is a fascinating topic – I might do a post on that when I get to it.

  2. I think there haven’t been any OMT purchases so far. So yes, the announcement of the program alone seems to have done the trick. I think this is broadly consistent with the multiple equilibria theory which you alluded to in your reply. What this theory says is needed to coordinate investors on the good equilibrium is a credible commitment by the central bank to soak up any excess supply of bonds in the market (above a certain threshold). It isn’t necessary for the central bank to actually buy anything. In fact, in the equilibrium with credible commitment the central bank never buys anything. Now apparently the market believes OMT is a credible commitment. My question is, why does the market believe that?

    Quantitative Easing is printing money to buy more risky/less liquid assets (like long-term gov bonds) which increases the risk of central bank insolvency. If, say, Greece defaults on a sufficiently large amount of bonds, the ECB’s net worth is wiped out. The way I understand the statutes of the ECB, an insolvency could be averted only if the national CBs inject more capital into the ECB which must eventually come from the national fiscal authorities. So averting ECB insolvency requires de facto unanimous consent by the member states. Not impossible, but much more difficult than if there were one common Eurozone fiscus.

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