Quantitative Easing

A big mess: low inflation leads to global central bank reset


WASHINGTON: It’s an article of faith among central bankers that the decisions they make about how much money to create and what interest rate to charge will determine the rate of inflation – at least over moderate durations.

For more than a decade, this belief has been undermined by inflation which has remained low despite trillions of dollars pumped into the world’s largest economies through quantitative easing programs and lower interest rates. ultra-low.

This prompted major central banks to rethink how they operate, and on Thursday the European Central Bank joined the Federal Reserve and the Bank of Japan in pursuing an ambitious reset in hopes of regaining control.

The new ECB framework, envisioning the occasional “transitional period” in which inflation exceeds its official 2% target in the hope of ensuring that the target is met over time, falls short of the target. a more explicit promise the US central bank made last year to encourage periods of high inflation to compensate for years when price increases were too low.

But their common diagnosis paints an equally troubling picture of a developed world seemingly plunged into a rut of slow economic growth, low productivity, aging populations and still low inflation that can be difficult to escalate. .

“The euro area economy and the global economy have undergone profound structural changes,” the ECB said as it announced its new framework, echoing the language used by Fed officials to announce their new year strategy last. “Downward trend growth, which may be related to slower productivity growth and demographics, and the legacy of the global financial crisis have driven down equilibrium real interest rates. ”

This, in turn, gave the ECB less leeway to use interest rate policy on its own to help stimulate economic activity and forced it, like the Fed, to resort more often to other measures – buying bonds, for example – when economic conditions weaken.

The BOJ led the way at the start of this century.

The objectives of the new US and European inflation strategies, and those pursued so far unsuccessfully in Japan, are the same: to achieve a rate of price increase high enough for inflation-corrected interest rates to rise. may also rise, giving central banks the ability to use rates as their primary policy tool in times of stress.

The concept of using the average inflation has been slow to evolve. The three central banks initially adopted simple inflation targets of 2%, convinced that they understood inflation dynamics well enough to reach and stay there.

They did not do it.

Over time, they realized that between technology, globalization, demographics and other factors, inflation had become difficult to budge. Even more problematic, pursuing “hiccups” on a well-publicized target risked resetting public expectations that inflation would remain low.

Research by current and former Fed officials has upped the ante. They found that in a situation where equilibrium interest rates were low and central banks were repeatedly forced to cut their policy rates to near zero, inflation expectations would fall – permanently, a damaging result that would cement low prices, wages and growth as the norm. .

Fed Vice Chairman Richard Clarida, whose previous academic research affirmed the benefits of simple inflation targeting, explained last January how subsequent studies by New York Fed Chairman John Williams, and others concluded that more aggressive approaches were needed when interest rates were to continue to fall to zero. .

Interest rates stuck near zero “tend to provide inflation expectations which, with each business cycle, anchor below target,” Clarida said in a presentation at the Hoover Institution from Stanford University. “This may open the risk of the downward spiral of real and expected inflation that has been observed in some other major economies.”

The new Fed policy has been in place for a little over 10 months. Its experience shows the challenges the ECB is now facing.

The coronavirus pandemic and the economic reopening that followed complicated the outlook for inflation, with supply bottlenecks pushing prices up more than – and possibly longer than – expected and a squeeze in the market. labor force starting to increase the wages of workers.

This has led to new hawkish voices within the Fed and hinted at faster interest rate hikes from the US central bank despite its stated promise to let inflation exceed target “for a while. time”.

While the Fed has yet to prove its new design in practice, the bond markets have noticed.

The yield on the 10-year US Treasury bill, far from anticipating higher inflation and growth, fell to 1.25% on Thursday, its lowest level since mid-February and a drop of almost half a percentage point from mid-May. .

As with the Fed, the ECB will need to translate its new strategy into policies that work.

The new strategy marks “a historic shift for the ECB”, recognizing that inflation may have to exceed 2% at some point, wrote Andrew Kenningham, chief economist Europe for Capital Economics. But that “will not allow the ECB to easily escape the clutches of low inflation”.


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