Should central banks persist with inflation targeting?

The crisis has triggered vigorous and wide-ranging debate on the role and responsibilities of central banks and raises three big questions:

Should central banks persist with inflation targeting? In the years before the crisis there was a powerful intellectual consensus in favor of inflation targeting—that is, basing monetary policy on achieving a target inflation rate, usually consumer prices. Even where central banks did not target a precise inflation rate, their policy objectives were informed, if not dominated, by price stability. This approach seemed successful. There was an extended period of price stability accompanied by stable growth and low unemployment. In the world before the crisis, central bankers were a triumphant lot. The unraveling of the Great Moderation has diluted, if not dissolved, the consensus around solely targeting inflation. The mainstream view before the crisis was that price stability and financial stability reinforce each other. The crisis has proved that wrong: price stability does not necessarily ensure financial stability.
The crisis has given fresh impetus to the “new environment hypothesis” that pure inflation targeting is inadvisable and that the mandate of central banks should extend beyond price stability to include bank regulation and supervision, financial stability, and preventing asset price bubbles.

What is the role of central banks in preventing asset price bubbles? The emerging view is that preventing an asset price buildup should be within the purview of a central bank. Opinion is divided, however, on whether central banks should prevent asset bubbles through monetary policy action or through regulatory action. What is indisputable, though, is that central banks’ efforts to check asset price bubbles demand not just analytical capability but mature judgment of the nature of the risk.

Should central banks also engage in bank regulation and supervision? In many regulatory models the central bank is purely a monetary authority, with bank regulation and supervision vested in another agency. The emerging view is that the crisis was caused, at least in part, by a lack of coordination and communication between central banks and supervisors and, in the interest of financial stability, it is optimal to entrust regulation and supervision of banks to central banks. Admittedly, this is not a settled issue. There is no one-size-fits-all answer, as is clear from the variety of regulatory models around. Each country and each central bank will have to resolve this issue according to its specific circumstances.

Source: Governor of the Reserve Bank of India, Duvvuri Subbarao, in a recent speech