It is an article of faith among central bankers that the decisions they make about how much money to create and what interest rate to charge for it will determine the rate of inflation – at least over moderate lengths of time.
For more than a decade that belief has been undermined by inflation that has remained weak despite trillions of dollars pumped into the world’s biggest economies through quantitative easing programs and ultra-low interest rates.
That prompted the top central banks to review how they do business, and on Thursday the European Central Bank joined the Federal Reserve and the Bank of Japan in pursuing an ambitious reset in hopes of reasserting control.
The ECB’s new framework, in contemplating the occasional “transitory period” when inflation exceeds its formal 2% target in hopes of ensuring that target is met over time, is a step short of the more explicit promise the U.S. central bank made last year to encourage periods of high inflation to offset years when price increases were too weak.
But their shared diagnosis paints a similarly troubling picture of a developed world seemingly set in a rut of slow economic growth, low productivity, aging populations, and perennially weak inflation that may be difficult to coax higher.
“The euro area economy and the global economy have been undergoing profound structural changes,” the ECB said in announcing its new framework, echoing language used by Fed officials in announcing their new strategy last year. “Declining trend growth, which can be linked to slower productivity growth and demographic factors, and the legacy of the global financial crisis have driven down equilibrium real interest rates.”
That, in turn, has given the ECB less room to use interest rate policy alone to help boost economic activity, and forced it, like the Fed, to resort more often to other measures – bond-buying for example – when economic conditions weaken.
The BOJ led the way down that path early this century.
The aims of the new U.S. and European inflation strategies, and those pursued so far unsuccessfully in Japan, are the same: Get the pace of price increases high enough so inflation-adjusted interest rates can also increase, giving the central banks room to use rate cuts as their main policy tool in times of stress.
CHASING AN AVERAGE
The concept of using inflation averaging has been slow to evolve. All three central banks at first adopted simple inflation targets of 2%, trusting that they understood inflation dynamics well enough to hit that level and stay there.
Over time, they realized that between technology, globalization, demographics and other factors, inflation had become difficult to budge. Even more problematic, the continued “misses” against a well-publicized target risked resetting public expectations that inflation would remain weak.
Research by current and former Fed officials raised the stakes. They found that in a situation where equilibrium interest rates were low and central banks were repeatedly forced to cut their policy rates to near zero, inflation expectations would fall – permanently, a damaging outcome that would cement weak prices, wages, and growth as the norm.
Fed Vice Chair Richard Clarida, whose earlier academic research affirmed the advantages of simple inflation targeting, detailed this past January how subsequent studies by New York Fed President John Williams and others concluded more aggressive approaches were needed when interest rates were expected to keep collapsing to zero.
Interest rates stuck near zero “tend to deliver inflation expectations that, in each business cycle, become anchored at a level below the target,” Clarida said in a presentation to Stanford University’s Hoover Institution. “It can open up the risk of the downward spiral in both actual and expected inflation that has been observed in some other major economies.”
The Fed’s new policy has been in place for just over 10 months. Its experience shows the challenges the ECB now faces.
The coronavirus pandemic and subsequent economic reopening have complicated the inflation outlook, with supply bottlenecks driving up prices more than – and perhaps for longer than – anticipated and a labor squeeze starting to drive up workers’ pay.
That has led to some new hawkish voices inside the Fed and hints at faster interest rate hikes from the U.S. central bank despite its stated promise to let inflation run above target “for some time.”
With the Fed yet to prove its new design in practice, bond markets have noticed.
The yield on the 10-year U.S. Treasury note , far from anticipating higher inflation and growth, has been falling, and on Thursday hit 1.25%, the lowest level since mid-February and a drop of nearly half a percentage point from mid-May.
As with the Fed, the ECB will have to translate its new strategy into policies that work.
The new strategy marks “a historic shift for the ECB,” by acknowledging inflation may need to exceed 2% at some point, wrote Andrew Kenningham, chief Europe economist for Capital Economics. But it “will not make it easy for the ECB to escape from the grips of low inflation.”