Right now the debate in central banks is about the shape of the recovery. If the optimists are right, central banks will soon be confronted with a much bigger issue: should they tolerate a spike in inflation rates, or take the punch bowl away early?
The debate has already started. Lael Brainard, a member of the Federal Reserve’s board of governors, advocated the adoption of the concept of “average inflation” of 2 per cent. Vítor Constâncio, a former vice-president of the European Central Bank, wants the ECB to take that direction in its upcoming policy review. I have some sympathies for the argument but also reservations.
In its favour is that an average target would give central banks more flexibility in times like these. In the eurozone, annual core inflation has been below 2 per cent for more than 10 years. A temporary inflation overshoot might be a good thing.
But the big caveat is that central bankers do not really understand how inflation works. There are lots of theories and approaches, theoretical and statistical, but none that has been able to explain persistently what is going on in the real world.
In the case of the ECB, that lack of understanding is best symbolised by the almost comical failure of its inflation forecasts. The forecast went wrong because of a false belief that inflation would eventually return to the 2 per cent target. A random number generator, a monkey with a dartboard, or even a horoscope would have outperformed the ECB here.
The problem is not that somebody got a forecast wrong. We all do, all the time. The troubling bit is that these forecasts reveal a basic lack of understanding of the underlying inflation process. There is some recent evidence that globalisation may have changed the inflation process. Even if true, this is not necessarily a helpful observation either. We do not know exactly what kind of period we are entering.
An average inflation target may look good now when you are coming from a period of below-target inflation. But if inflation were to rise above the target and stay there, a central bank that follows an average target would, at some point, have to put on the brakes sharply in order to meet that average. Once you have a target you make yourself vulnerable.
You can of course take the view that if this problem were to arise in the future, the target could change yet again. But then you run the risk that people no longer take you seriously. Inflation targeting has been successful because it managed to anchor expectations — until it did not. In this situation it would be better to do some deep thinking rather than apply a quick fix.
Behind the notion of inflation targeting lies a theoretical model.
It was all the rage at the time, but I believe it no longer constitutes a good description of our world today. Linked to this is the notion of central bank independence, which is justified on the grounds that central bankers operate something that looks to the outside world like a rigorous and objective policy.
Once policy becomes discretionary, it becomes political. And when that happens, the politicians will want to take over. We should remember that it is not a natural state of affairs that policymaking institutions should be politically independent. It is the exception, not the rule.
In the eurozone, an additional issue is likely to come up very soon — debt monetisation. We are hearing the first economists start arguing that a rise in inflation is a price worth paying to avoid a catastrophic collapse in sovereign debt markets. I like the refreshing honesty of the argument.
The ECB’s pandemic purchasing programme does indeed constitute a form of debt monetisation that may well trigger a rise in inflation in the future. But this argument presumes that the rise in inflation will be temporary. How do we know? We saw in the last decade that inflation can go off target and get stuck at the new lower level. If you push it up through policy, it might get stuck there too. One might argue that this is a risk worth taking, but it is a risk nonetheless.
If the ECB conducts its policy review and adopts an average target of, say, 2 per cent, it would give itself more flexibility. But that looks to me like a retrospective justification of what they want to do anyway. And then one day they will wake up and find that their shiny new flexible target is forcing their hands in a direction they don’t want.
munchau@eurointelligence.com
Source: Economy - ft.com
