Many of the world’s most senior central bankers believe monetary policy is close to the limits of what it can responsibly do.
One argument is that if central banks would only commit to higher inflation, then monetary policy would be more effective in boosting demand. Proponents fall into various camps: nominal GDP targeters, those who favour a price-level target, or those who want to raise existing inflation targets.
According to Larry Hatheway of UBS, all work on the assumption that a higher target will influence expectations and stoke “genuine” inflation, ie, broad increases in prices and wages. This in turn will lower real interest rates and boost demand.
Would it matter if central bankers stated a policy goal of (much) higher inflation?
For those not accustomed to the at-times arcane world of academic macroeconomics, the question isn’t as silly as it might sound. The powerful critique of ‘Keynesian fine-tuning’ in the 1960s and 1970s was centred on the role of inflation expectations. If workers, businesses and bondholders expect higher inflation, their rational response would not only ensure that prices, wages and yields would quickly rise, but that any benefits of higher inflation (eg, lower unemployment) would be ephemeral.
Some proponents take a more nuanced view than Mr Hatheway suggests, among them his colleague George Magnus, who advocates targeting nominal GDP only if this framework was coupled with fiscal measures.
However, Mr Hatheway is right to argue that targeting higher inflation would, at present, have little impact on demand:
If output gaps remain wide and borrowers are unwilling borrow, does a statement of intent matter?
The answer, we suspect, is that statements of intent won’t matter because they are inherently non-credible. And that’s not because agents doubt that central bankers will stick to their word to create inflation.
Rather it is because a key assumption of the inflation expectations hypothesis— namely that monetary policy can lift activity via increased credit creation—is not valid in economies where falling (or depressed) asset prices disrupt the transmission of lower interest rates and excess money supply to increased borrowing and spending.
In a world of fiat money it is, of course, not beyond the power of central bankers to create inflation. If the Fed chairman lived up to his Helicopter Ben moniker and started chucking dollars from the sky, it is hard to imagine inflation expectations would remain anchored. But most would say this falls outside the ambit of what could be termed “responsible” monetary policy.
If central banks were to try to boost demand by pumping more cash into the system through what has now become the conventional route – more asset purchases – it’s difficult to imagine that this would have the desired impact, regardless of whether or not they targeted higher inflation. As the $1.6 trillion in excess reserves on the Federal Reserve’s balance sheet suggest, a rise in cash is being offset by a fall in the velocity of circulation. There is not the usual knock-on effect on the price level, or demand, from looser monetary policy because the relationship between cash and credit growth has broken down.
Given the need to de-leverage, credit growth is set to remain weak for a while yet. It is difficult to see how expectations of higher inflation would override this.
So long as credit creation remains impaired, central banks will struggle to generate the escape velocity that’s needed to shake off the current malaise. That’s not to say that monetary policy should not remain supportive. But abandoning existing policy frameworks in favour of ones that would allow for a higher level of inflation will have less benefit than proponents might think.
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