While global economists and academics at Jackson Hole, the annual US monetary policy conference, looked for clues on the likelihood of a US interest rate hike in late 2016, Federal Reserve chairwoman Janet Yellen focused instead on discussing the limitations of monetary policy.
Behind the scenes, say market commentators, the Fed and other central banks are quietly urging global political leaders to develop other policy tools to stimulate demand.
One monetary policy concept that has grown in popularity in recent times is raising inflation targets to give central bankers more scope to stimulate borrowing.
The rationale is that weak economic performance has lowered the “neutral” real rate of interest, and raising the inflation target – say, to 4% from 2%, as has been suggested in the US – would lead central banks to keep the nominal rate of interest higher during stronger times. This would give monetary policymakers greater room to pursue deeper rate cuts to stimulate economic demand during difficult times.
Carl Tannenbaum, Northern Trust’s chief economist, said: “Allowing inflation to run a little hot would lower the probability of hitting the zero lower bound, the point at which monetary policy loses potency.
"Greater room to use interest rate policy would reduce the need to implement further unconventional monetary policy measures and fiscal activism," he added. "Central bank balance sheets are already swollen and public debt levels remain high in the developed economies.”
Other economists and buy-side executives see merit in the idea, but express doubts stemming from the change in the nature of global inflation. While developed nations have higher consumer price levels and therefore need low inflation to remain competitive, the primary concern in the post-global financial crisis era is not that prices may spiral out of control, but that developed nations are struggling to generate even normal levels of inflation.
Richard Jerram, Bank of Singapore’s chief economist, told AsianInvestor that 2% inflation targets “were chosen for a reason”. Empirical research suggests that higher inflation damages the efficiency of the price mechanism and leads to resource misallocation, he noted.
Yet there remains the question of whether monetary policy becomes ineffective when interest rates fall to zero and what could be done about that.
Conventional thinking says that the way to combat falling prices is to cut interest rates and stimulate borrowing, noted Mark Tinker, Axa Framlington’s head of Asia. “But it’s increasingly coming into question whether that is the right thing to do, and does it really work? Because if you’ve got an economy which is deleveraging, cutting the price of borrowing isn’t going to make them borrow any more.”
The best example is Japan, where the central bank, despite failing to hit its 1% inflation goal, set a target of 2% in January 2013. While inflation rose temporarily on the back of higher energy prices and a sales tax hike, the rise in target was a failure, despite negative policy rates and massive expansion in the Bank of Japan’s balance sheet.
Eric Stein, co-director of global income at US asset manager Eaton Vance, was also doubtful about the benefits of higher inflation targets. He thinks the Fed is actually close to its inflation target, based on core inflation and in particular core services inflation.
The main argument against a higher target is that 4% inflation could have some negative consequences, said Stein. “Theory would say a good rate of inflation would be one that doesn’t affect business decision-making."
He suggested that rates between zero and 2% would not have a significant effect on business decision-makers. At 4%, however, they would, argued Stein, “and there would be more ‘costs’ to society”.
Stein suggests the whole premise of higher inflation targets is based on the idea that monetary policy should be doing more. “I disagree with that assessment; I think monetary policy has already taken more than its fair share of the burden and if policymakers want to do more, the burden should fall on regulatory and fiscal policy.”
Jerram’s preferred longer-term solution would be structural reforms that raise productivity or the return on capital, which would push the neutral rate higher. “I think that a higher inflation target is far from the best solution to the problem. It seems to illustrate the current trend of pressing the central bank to provide solutions to problems that are better tackled by other parts of government.”
Tinker thinks fiscal policy will be brought into play. He cited the upcoming elections in the US and parts of Europe, and a collapse of consensus that austerity is the way forward, as factors that will drive tax cuts and other measures, including infrastructure expansion. “Pretty much every politician is talking about fiscal expansion,” he said.
The message coming out of Jackson Hole, added Tinker, is that politicians must do something with fiscal policy.
In a following article, AsianInvestor will explore the fiscal policy issue in more detail and look at how infrastructure investment could play a major role in stimulating global demand.