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Is there too little inflation?

John Redwood, Charles Stanley’s Chief Global Economist, looks at current central bank thinking on inflation.

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John Redwood

in Features


I have long been critical of the idea that interest rates should be set according to a judgement of how close to national capacity an economy is running. It is difficult to define capacity, and it ignores access to global markets, which alter the way an economy responds to shortages at home. I am pleased to see that central banks are reconsidering their adherence to this piece of old economic theory.

The Fed has decided on a comprehensive rethink of its monetary policy. One of the three questions it is raising in its extended planned conversation with America this year is should it offset the periods when inflation undershoots. Should it allow inflation to be above target after a shortfall? Should it seek a longer-term average outcome of 2% inflation, where today it seeks to keep inflation at 2%, once it has recovered.

The Fed has had a bruising last year. It thought it was doing a good job, gradually raising interest rates against a background of respectable economic growth and a Presidential fiscal stimulus with generous tax cuts. The central bank had a concept of normal, seeking a neutral interest rate that was neither too low nor too high, but would be closer to the long-term rate than the crisis rates set after the banking crash. It was also well embarked on cutting the size of its balance sheet. To try to pull the US economy out of the banking induced recession at the end of the last decade, the Fed created money and bought up government bonds and mortgage securities to direct more cash into the system. By 2018 the Fed thought it was time to run off these purchases, reducing commercial bank holdings of cash at the Central Bank at the same time.

The markets wobbled badly, objecting that the Fed was tightening money too far and too fast. The President used a megaphone tweet to express his dislike of higher interest rates, explaining how they would get in the way of his wish to create faster growth. The markets won, and by the turn of the year the Fed was hinting it would not be raising rates another three times in 2019 as planned. It also decided to reduce the pace of balance sheet squeeze and promised an end to that by the autumn.

The economic explanation of the change of thinking has now followed. Vice Chairman Richard Clarida gave an important lecture on 9 April 2019. Reaffirming its commitment to the dual mandate of “maximum employment with price stability” (2% inflation) he argued that the neutral interest rate to achieve this had fallen, with a lower rate likely to persist for years. He stated that the “short run Phillips curve appears to have flattened”. This curve is the basis of much central bank thinking, saying that as an economy approaches full employment so inflation rises. On both sides of the Atlantic rates are set based on how close to full capacity the economy is and how much of an inflation threat particularly through higher wages that might pose. Mr Clarida now accepts this can be misleading. He acknowledges that an ageing population, different attitudes to risk taking and technology can alter the trade off, with less inflation for any given level of output. All this matters, as it implies in future a new policy will emerge that is more accommodating, with the Fed fighting too little inflation more than the possibility of too much in the future.

Mr Clarida could have drawn on the work of the Bank of England on this issue from some time ago. The Governor of the UK Bank set out some of their thinking in a lecture on 18 September 2017. He argued that the Phillips curve had shifted downwards and had flattened. His reasons were largely dependent on the way global capacity and global price trends have more influence now on open economies that trade a lot. He pointed out that an excess of labour, particularly low skilled labour worldwide, meant wages were slow to rise even as an economy like the UK – or by implication the US – moved to full employment. Migrations brought new workers to open economies, and the world trading system offered goods and services from lower wage economies. The US and UK have run large trade deficits as they have indirectly imported labour in this way.

It looks as if the Fed is going to loosen, probably by changing its approach to how it responds to an inflation undershoot. The enquiry will take until next year to report, but expect some practical changes before then. Meanwhile the Bank of England which correctly worked out that the Phillips curve is much flatter than it used to be still carries on setting rates as if full employment and national capacity were the main things that matter. Perhaps they need to incorporate this into their rate setting process more clearly.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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