Inflation targeting has become the favoured policy framework of virtually all the main central banks in the past couple of decades.
Under this regime, central banks set a medium-term target for inflation, usually a CPI rate of around 2%, and then attempt to steer actual inflation towards the target, using policy tools such as interest rates and quantitative easing.
To some extent, the adoption of inflation targeting was a response to the failure of previous monetary policy regimes, such as controlling the money supply or currency pegs. Keeping inflation close to target was seen as the best way that monetary policy could support long-term growth in the economy. It all sounds great in theory, but implementing inflation targeting in practice has proved a lot more challenging. In fact, it has failed over the past decade, but not in the way most people might have expected. Central banks have certainly been able to bring inflation down to target by raising interest rates. In this decade, though, there has been a widespread failure to get inflation back up to the target level — generally 2% — despite extremely loose monetary conditions.
Central banks have cut rates to near 0% or even negative levels and launched large scale asset purchase schemes or QE, in an attempt to drive inflation back up to target. However, underlying inflation has remained stubbornly low at close to 0% in Japan, 1% in the eurozone and 1.6%-1.7% in the US. Only the UK has seen inflation rise, but this is largely due to the sharp fall in sterling last year.
Many reasons have been advanced for the low level inflation in recent years, even in economies that have seen strong growth and a return to full employment, like the US and Germany. The lingering effects of the 2008-09 financial crash, especially in terms of deleveraging, as well as increased competition as a result of globalisation, are often cited.
The main reason would appear to be a complete absence of wage inflation.
Wage growth has remained remarkably subdued in this cycle, even in economies like the US, Britain, Germany and Japan, where unemployment rates have fallen to very low levels. It would seem that structural changes in labour markets are acting as a major dampener on wage inflation.
A shift from permanent employment and career jobs to contract work, falling unionisation, advances in technology, increased global competition as well as low productivity growth are all acting to supress wage inflation and making it difficult for central banks to achieve inflation targets.
As a result, monetary policy has remained very loose, even in economies where the recovery is well-advanced and full employment has largely been achieved.
There are concerns, though, that very loose monetary policies are now generating asset price inflation, most notably in financial markets. Both stock and bond markets are at very elevated levels, while credit spreads are very tight.
The question is whether abundant central bank liquidity and very low rates are causing risk to be mispriced in markets, sowing the seeds of another financial crisis. Another concern is that low interest rates hit savers and pension funds hard. Furthermore, central banks’ already bloated balance sheets from QE and low interest rates, leaves them with very little ammunition to counteract the next downturn in economic activity.
These concerns make it difficult to justify keeping rates extremely low in a vain attempt to lift inflation back to target, especially when the factors holding down consumer prices may be little impacted by monetary policy. Hence, there would seem to be a good case for returning rates to more normal levels and reducing the size of central banks’ balance sheets in strong economies that are close to full employment, despite continuing low inflation.
This would require a recasting of the parameters of monetary policy through either lowering the target rate for inflation or broadening the definition of price stability to include asset prices, or taking other factors into consideration such as unemployment and GDP.
Oliver Mangan is chief economist at AIB
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