All Brakes and No Engine, Central Banks Seek New Inflation Ideas

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Adam Posen grabs an imaginary flagpole with two hands and waves it back and forth in his office at the Peterson Institute for International Economics in Washington. “We want inflation to go up!’’ he shouts, as if issuing orders from some central bank rooftop. “Inflation! Go up!’’

It’s a funny and sad parody of central banking in 2019. Policy makers, who spent decades designing strategies to kill off inflation and keep a stake through its heart, are now trying to resuscitate it –- and finding that they can’t.

That’s deeply disturbing for the central bankers. They’re supposed to be able to control inflation –- it says so in the textbooks –- and many set specific targets. Yet in the recovery from the Great Recession, prices have mostly fallen short of those goals.

“If you announce a target and you’re not able to get there,’’ says Posen, a former member of the Bank of England’s interest rate-setting board, “it can make your inflation problems worse’’ –- because public confidence will erode.

Persistently cheap stuff might not sound like something to alarm the public. But in their definitive 1999 book on inflation-targeting, Posen and co-authors including former Federal Reserve chairman Ben S. Bernanke explain why zero inflation would be a risky goal. The economy could easily tip into deflation, dragging wages lower too and making debt harder to service.

Year of Introspection

Economists say that at least a little inflation helps employers manage their wage bills, and enables central banks to keep interest rates comfortably above the floor, so there’s room to cut in recessions.

That ammunition is lacking right now. And quantitative easing, the tool for central bankers who can’t reduce rates below zero, is fraught with political risks because it’s reckoned to enrich holders of financial assets.

The whole dilemma has triggered a bout of introspection among central bankers and the politicians who oversee them. Questions are getting asked about inflation-targeting, the dominant framework for monetary policy since it was adopted by New Zealand in 1990.

The Fed has declared 2019 a year of strategy review; in Europe, policy makers like Finland’s Olli Rehn have called for something similar; in Japan, the finance minister and business leaders have wondered aloud if 2 percent is too high a bar.

In a debate that’s global and multi-faceted, three critiques keep resurfacing.

Change the Policy

On this view, inflation targeting is a sound idea but central banks might not be providing enough stimulus to make it work.

In other words, low inflation is partly a product of monetary policies that have been too timid, says Athanasios Orphanides, a former member of the ECB’s Governing Council. In some cases that’s only become clear in hindsight, while in others -- and especially in Europe -- central bankers made a deliberate decision not to use all the tools at their disposal, he said.

Still haunted by inflation monsters from the 1970s, central bankers treated their targets like hard ceilings and worried that the slightest upward breach would unhinge expectations. They failed to see that traditional assumptions about labor-market slack and prices were falling apart. Economic frameworks based on scarcity don’t seem to explain why overall prices remain so low.

Policy makers are demonstrating that they can learn and adjust, as the Fed did between December and January when it signaled a pause in rate hikes, says Orphanides, now a professor at MIT’s Sloan School of Management. “I haven’t seen any convincing evidence so far that something different from basic inflation-targeting would be an improvement.’’

Change the Numbers

This line of argument says inflation targets are mis-specified: They should be higher in some economies and lower in others -– or treated as averages over time.

In different ways, such ideas are under examination at the Fed and in Japan, where Finance Minister Taro Aso recently raised eyebrows.

“For the general public, there isn’t a single person out there saying it’s outrageous we haven’t reached 2 percent,’’ he told reporters last month. “You have to think about the possibility that things will go wrong if you focus too much on 2 percent.’’

It was Aso who agreed on that number with the Bank of Japan back in 2013. But gargantuan stimulus hasn’t gotten there. Halving the target to 1 percent “wouldn’t be a problem,’’ says
Martin Schulz, senior economist at Tokyo’s Fujitsu Research Institute.

In the U.S., Fed officials have shown interest in so-called “make-up strategies’’ that allow inflation to drift above-target for a time, so that it averages 2 percent over the business cycle.

The Fed says it will report the findings of its policy review in the first half of 2020. Some economists suspect the framework is already shifting and overshoots will be tolerated –- assuming they can be engineered in the first place. Others including Olivier Blanchard have suggested a higher target, say 4 percent, though the Fed is adamant that won’t happen.

Change the Regime?

The maximal critique would call time on an era when central banks were tasked with steering economies almost alone.

From weak bargaining power on the part of labor to the concentration of output in giant firms, there could be numerous non-monetary reasons for low inflation. These forces, some economists say, simply lie beyond the reach of central bankers and their interest-rate tools.

Modern Monetary Theory, with its call for government spending to take over the reins, pushes this idea hardest. Even in the mainstream, the idea of closer cooperation between central banks and fiscal authorities is gaining ground.

Posen, for example, says it’s fine to have an inflation target –- but tweaking it may not achieve much, and could backfire if central banks still can’t hit it. “You need real factors to push inflation higher,’’ he says.

Large-scale government initiatives in fields like clean energy or health care could “crowd investment in,’’ says Posen, even if that amounts to a kind of economic regime-change. The subsequent boost to demand and prices could help economies achieve escape velocity and get out of a low-productivity, low-investment cycle. And that in turn would raise neutral rates of interest, allowing central banks to move further away from the zero boundary they dread.

Budgets aren’t the only potential tool. Competition policy could be another. There are precedents. The break-up of the Bell System monopoly in the 1980s and the Telecommunications Act of 1996 unleashed waves of investment.

But it’s clear where the momentum is. Much of the current debate, says Schulz at the Fujitsu Research Institute, is gravitating toward “fiscal policy becoming the new monetary policy.’’

--With assistance from Brett Miller, Piotr Skolimowski, Jana Randow and Alex Tanzi.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net;Enda Curran in Hong Kong at ecurran8@bloomberg.net

To contact the editors responsible for this story: Brendan Murray at brmurray@bloomberg.net, Ben Holland

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