Here is a thought experiment that illuminates the challenges currently facing macroeconomic policymakers in the US and the rest of the industrial world.

Imagine that in a brief period inflation expectations around the industrial world, as inferred from both the markets for indexed bonds or inflation swaps, rose by nearly 50 basis points to a level well above the 2 per cent target with larger increases foreseen at longer horizons.

Imagine that at the same time survey measures of inflation expectations, such as those calculated by the University of Michigan and New York Federal Reserve in the US, were rising sharply.

Imagine also that commodity prices were soaring and that the dollar experienced a decline seen once every 15 years.

Imagine that the market estimate of future monetary policy in the US was far tighter than the Federal Reserve’s own policy projections.

Imagine that measures of gross domestic product growth were accelerating with increasing signs of a worldwide boom.

Imagine too that no serious efforts were under way to reduce deficits.

Finally, suppose that officials were comfortable with current policy settings based on the argument that Phillips curve models predicted that inflation would revert over time to target due to the supposed relationship between unemployment and price increases.

I think it is fair to assert that in this hypothetical circumstance there would be pervasive concern that policy was behind the curve. There would be fears that much was at risk as inflation expectations were becoming unanchored and that a substantial set of policy adjustments were appropriate.

The key point is that allowing not just a temporary increase in inflation but a shift to abovetarget inflation expectations could be very costly.

At present we are living in a world that is the mirror image of the hypothetical one just described. Market measures of inflation expectations have been collapsing and on the Fed’s preferred inflation measure are now in the range of 1-1.25 per cent over the next decade.

Inflation expectations are even lower in Europe and Japan. Survey measures have shown sharp declines in recent months. Commodity prices are at multi-decade lows and the dollar has only risen as rapidly as in the past 18 months twice during the past 40 years when it has fluctuated widely.

The Fed’s most recent forecasts call for interest rates to rise almost 2 per cent in the next two years, while the market foresees an increase of only about 0.5 per cent.

Consensus forecasts are for US growth of only about 1.5 per cent for the six months from last October to March. And the Fed is forecasting a return to its 2 per cent inflation target on the basis of models that are not convincing to most outside observers.

Despite the apparent symmetry, the current mood is nothing like the one posited in my hypothetical example.

While there is certainly substantial anxiety about the macroeconomic environment, as judged from the meeting of the Group of 20 big economies in Shanghai last week, there is no evidence that policymakers are acting strongly to restore their credibility as inflation expectations fall below target.

In a world that is one major adverse shock away from a global recession, little if anything directed at spurring demand was agreed. Central bankers communicated a sense that there was relatively little left that they can do to strengthen growth or even to raise inflation. This message was reinforced by the highly negative market reaction to Japan’s move to negative interest rates. No significant announcements regarding non-monetary measures to stimulate growth or a return to target inflation were forthcoming, either.

Perhaps this should not be surprising. In the 1970s it took years for policymakers to recognise how far behind the curve they were on inflation and to make strong policy adjustments.

Policymakers continued to worry about a supposed lack of demand long after it was an important problem. The first attempts to contain inflation were too timid to be effective and success was achieved only with highly determined policy. A crucial step was the abandonment of the idea that the problem was structural in nature rather than driven by macroeconomic policy.

Today’s risks of embedded low inflation tilting towards deflation and of secular stagnation in output growth are at least as serious as the inflation problem of the 1970s. They too will require shifts in policy paradigms if they are to be resolved.

In all likelihood the important elements will be a combination of fiscal expansion drawing on the opportunity created by super low rates and, in extremis, further experimentation with unconventional monetary policies.



The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary

Letter in response to this column:

Helicopter money, but in a more logical form / From Robert Strauss