Inflation planning key to Central Banks' interest rate policies.... but do they still understand it ?

Thursday 3rd September 2015

Inflation planning key to Central Banks' interest rate policies.... but do they still understand it ?

Ref : "Those Inflation Targets Keep Getting Harder to Hit" , Bloomberg Online

Ref : "Weak inflation adds to ECB easing conundrum" , The Financial Times, p.6

It seems mischievous for us to even ask whether some of the brightest economic brains around (we presume) employed by central banks may no longer be in total control of this key element of economic strategy. But since we're not the only ones asking the question, and since the results of attempts to boost inflation numbers around the globe have been less than totally successful, let's assume the question is a valid one. With a growing economy and its consequent wage pressures pushing the US Federal Reserve to raise rates, and at the same time a lack of growth and of any true signs of inflation pushing the European Central Bank the other way, it might also be a sensible time to ask it.

Generally speaking, central bankers like a little inflation.... typically around 2.0%. Apart from signifying that demand (and by extension the economy) is strong enough to push prices higher, it enables interest rates to be set below the inflation rate which encourages borrowing. It also allows the less well performing businesses to avoid lay-offs by giving workers wage hikes below the inflation rate. Neither is possible if inflation is at zero.

Since the crisis of 2008, the so-called developed economies have embarked on unprecedented programmes of monetary easing, via near-zero interest rates and Quantitative Easing, in efforts to restart growth and engineer a return to a healthy (and controlled) inflation environment. At best, you'd have to say the results have been mixed. In the US and the UK, the policy has been at least partially successful although inflationary pressures have been grudgingly slow to follow better growth numbers. In the Eurozone, and particularly in Japan, plainly the strategy has so far been notably unsuccessful.

At the recent gathering of the great and the good in Jackson Hole, academics offered some disturbing home truths about what they considered was a lack of understanding amongst central bankers as to how inflation now works, and how best to manage it. In particular, they argued that central bank planning makes little provision for the possibility of financial shocks, which obviously can disrupt economic output. We can assume they had China's slowdown and the resultant market turmoil in mind. Moreover, the consequences of such an event (in this case a rout in commodity prices) can be an even more direct and obvious drag on inflation. An accusation also levelled at central banks is that they have failed to take into account a particular effect of that catch-all term "globalization"  --  the ability to export wage pressures abroad. Prof. Orphanides of MIT went as far as to call trying to influence inflation while not understanding it "a recipe for disaster".

Seem a little harsh ? Perhaps. At the risk of contradicting the Professor, it would seem fair to say that central banks retain the ability to "influence" inflation, but no longer to control it. The issue has gone global, and the days of central banks being able to successfully meet their own inflation targets within their own currency zone may have gone.