Monetary policy is at an inflection point. The extraordinary support from central banks is being gradually scaled back as economies improve and financial markets remain calm. Yet investors remain sceptical about how much central banks will raise interest rates by, because inflation remains stubbornly low across most of the advanced world.
Historically, declining unemployment has usually been closely followed by healthy increases in inflation. But this relationship – described by the Phillips Curve * – has weakened significantly since the financial crisis. Even in economies like the US, Germany and Japan, where the unemployment rate has fallen below estimates of its natural rate, there are few signs of rapidly building inflation pressures.
This inflation ‘puzzle’ is prompting much soul-searching. Has the Phillips Curve broken down completely? Or is it that policy needs to remain looser for longer to overcome the cyclical and structural forces weighing on inflation? The answers to these questions, which will swirl around well into next year, have major consequences for the future of monetary policy and asset pricing.
The Bank for International Settlements (BIS) is leading the charge for a rethinking of monetary policy frameworks. It argues that low inflation is mainly due to the benign effects of globalisation and technological advances. The BIS also thinks that central banks’ commitment to ultra-low interest rates is distorting the economy and amplifying financial cycles. The upshot is that central banks put less weight on their inflation targets and withdraw policy support more quickly.
The wider central-bank community is unconvinced by this line of argument. There is agreement that there are structural restraints on inflation and that wages and consumer prices have become less responsive to changes in unemployment. But most central banks also think that inflation is still low because the recovery from the crisis has been so weak and spare capacity has not been completely eliminated. They have therefore drawn a very different lesson from the era of low inflation than the BIS: policy should be kept accommodative for longer, and it will simply take time for healing from past crises and the gradual erosion of spare capacity to be felt.
These debates are far from academic. In my view, it would be dangerous for central banks to give up on their medium-term inflation objectives. Doing so would lock in low inflation and low interest rates for longer, as well as further dampening inflation expectations. It would also undermine the ability of central banks to fight future recessions and deflationary shocks. That is because there would be less room for real interest rates and real wages to adjust. That would only serve to increase output and financial-market volatility. Moreover, if a drop in inflation has been accepted once, why not again? Meanwhile, the real value of debt obligations would come down more slowly, weighing on demand.
As for credit and asset price imbalances, the financial crisis showed just how destabilising they can be. But the crisis was mostly a failure of regulation not of monetary policy. Accordingly, the financial cycle is best managed using targeted regulation, more effective micro and macroprudential supervision, and the maintenance of ‘flexible’ inflation mandates that ensure that monetary and financial policymakers are singing from the same hymn sheet.
Reassuringly, central banks have not yet given up on their inflation objectives. Their reaction functions are therefore unlikely to change significantly in the near term. But the challenges of conducting monetary policy in a world of less responsive inflation and lower average growth and interest rates will not go away.
As a result, further policy experimentation is inevitable, especially when the next recession hits. Among the options being debated is for central banks to purchase real assets instead of just financial ones when unconventional policies are needed, and to coordinate those purchases with governments. Ben Bernanke (former Chairman of the US Federal Reserve) recently suggested that central banks should turn to temporary price-level targeting – whereby they would commit to compensating for periods of below-target inflation with periods of above-target inflation when policy rates have reached their lower bound. They may also explore mechanisms to reduce the lower bound itself by finding safer ways to deliver negative interest rates. Of course, with experimentation always come unintended consequences. Investors may think that the last decade has been difficult to navigate. But they ain’t seen nothing yet.
* The Phillips Curve describes the theoretical and historical empirical relationship between changes in economic slack and either wage or consumer price inflation. Normally it would be expected that as unemployment rates fall toward their natural or structural rates, underlying inflation rates would increase. In practice, however, both the position and slope of this curve has tended to shift over time, as has the amount of time it takes for changes in the labour market to impact wages and prices.