share this article!

Reuters, WASHINGTON, July 8 – Central bankers believe that the decisions they make about how much money to issue and what interest rate to charge for it will affect the rate of inflation, at least over reasonable time periods. Inflation has remained low for more than a decade, despite trillions of dollars being injected into the world’s largest economies through quantitative easing programs and ultra-low interest rates. That forced the world’s leading central banks to rethink their strategies, and the European Central Bank joined the Federal Reserve and the Bank of Japan on Thursday in launching an ambitious reset in the hopes of regaining control. find out more In contemplating the occasional “transitory period” when inflation exceeds its formal 2 percent target in the hopes of ensuring that target is met over time, the ECB’s new framework falls short of the more explicit promise made by the US central bank last year to encourage periods of high inflation to offset years of too low price increases. However, their common diagnosis paints a similarly alarming image of a developed world stuck in a rut of poor economic growth, low productivity, aging populations, and low inflation that may be difficult to raise. The ECB claimed in presenting its new framework that “the euro area economy and the world economy have been experiencing fundamental structural changes,” matching wording used by Fed officials in outlining their new strategy last year. “Equilibrium real interest rates have been driven down by declining trend growth, which can be attributed to weaker productivity growth and demographic issues, as well as the residue of the global financial crisis.” As a result, the ECB has less room to employ interest rate policy alone to increase economic activity, forcing it, like the Fed, to rely more heavily on other tools, such as bond purchases, when economic circumstances deteriorate. Early in this century, the BOJ blazed a trail along that path. The goals of the new US and European inflation strategies, as well as those tried and failed in Japan, are the same: Increase the rate of price rises to the point that inflation-adjusted interest rates rise as well, allowing central banks to employ rate cuts as their primary policy tool in times of stress. SEARCHING FOR AN AVERAGE Inflation averaging is a concept that has taken a long time to catch on. All three central banks initially set straightforward inflation targets of 2%, believing that they had a good enough understanding of inflation dynamics to hit and maintain that level. They didn’t do it. Over time, they discovered that inflation had become impossible to control due to technological advancements, globalization, demographic shifts, and other causes. Even worse, the continued “misses” against a well-publicized target threatened resetting public expectations of ongoing low inflation. Current and former Fed officials conducted research that elevated the stakes. They discovered that if equilibrium interest rates were low and central banks were continually forced to slash policy rates to near zero, inflation expectations would plummet – permanently, a negative outcome that would cement low prices, wages, and growth as the norm. When interest rates were expected to continue falling to zero, Fed Vice Chair Richard Clarida, whose earlier academic research affirmed the benefits of simple inflation targeting, detailed how subsequent studies by New York Fed President John Williams and others concluded that more aggressive approaches were needed. In a lecture to Stanford University’s Hoover Institution, Clarida warned that interest rates around zero “tend to deliver inflation expectations that, in each business cycle, get anchored at a level below the target.” “It raises the potential of a downward spiral in both actual and predicted inflation, as some other big economies have seen.” ‘HISTORIC SHIFT’ is a term used to describe a change in history. The Fed’s new policy has only been in effect for a little over a year. Its experience demonstrates the difficulties the ECB is currently facing. The coronavirus outbreak and consequent economic recovery have muddled the inflation picture, with supply bottlenecks driving up prices faster than expected – and maybe for longer – and a labor shortage beginning to force up workers’ wages. Despite its declared vow to let inflation run beyond target “for some time,” this has led to some new hawkish voices within the Fed and hints at speedier interest rate hikes from the US central bank. Bond markets have taken notice of the Fed’s new design, which has yet to be proven in practice. Far from anticipating stronger inflation and growth, the yield on the 10-year US Treasury note has been decreasing, reaching 1.25 percent on Thursday, the lowest level since mid-February and a loss of about half a percentage point since mid-May. The ECB, like the Fed, will have to translate its new approach into effective policy. According to Andrew Kenningham, chief Europe economist at Capital Economics, the new policy represents “a historic shift for the ECB,” as it acknowledges that inflation may need to reach 2% at some point. It will, however, “make it difficult for the ECB to escape the shackles of low inflation.” Howard Schneider contributed reporting, while Dan Burns and Paul Simao edited the piece. The Thomson Reuters Trust Principles are our standards./nRead More

share this article!