Central banks target inflation By Scott Sumner

Andrew Sentance has a new post in the Financial Times, which is critical of the Fed’s refusal to raise interest rates. The word ‘inflation’ does not appear in the article. Here’s how it begins:

These are tough times for monetary policymakers. That is undeniable. In autumn 2008 and early 2009, the task was easy. Cut interest rates as fast as you can to as low a level as possible.

If this “task was as “easy” as Sentance suggests, then one wonders why the monetary policymakers did not in fact do this. The ECB policy rate didn’t hit zero until 2013, and has since fallen even lower. So zero is not “as low a level as possible” and I don’t think 5 years is “as fast as you can”. Indeed even in the US rates weren’t cut to zero at the September meeting after Lehman failed, or even in the late October meeting after the biggest banking crisis since 1933, plus a collapsing economy. Was December “as fast as you can”? I believe that I could have cut them faster. And are Fed rates “as low as possible”? If so, why did one Fed President recommend an even lower rate this week? Is he bad at math? And why is the lowest rate in Sweden and Switzerland and Germany lower than the lowest rate in the US, which is lower than the lowest rate in the UK?

Second, if interest rates cannot rise now, when will they increase? In the case of the US, growth has averaged over 2 per cent for more than six years since the recovery started in mid-2009. Unemployment has halved from around 10 per cent to 5 per cent over roughly the same period. Yet interest rates remain stuck — close to zero. A similar position prevails in the UK. A multitude of reasons have been advanced for delaying the first rate rise: sluggish growth in all the major western economies in 2011-12; the euro crisis in 2013-14; and now the Fed is citing weak economic growth in China and the impact this has on financial markets. If you look around hard enough, there can always be a reason for not raising interest rates. But that highlights the key problem. Monetary policymakers are very timid at the moment. They are lions who have lost their roar.

When will rates increase? Perhaps when increasing rates will move the US closer to the Fed’s 2% long run inflation target, not further away (as is the case today.) Yes “you can always find a reason for not raising interest rates.” But when discussing those reasons, wouldn’t you want to mention the Fed’s actual inflation target? Isn’t inflation targeting the core of modern central bank policy?

In fairness, the Fed has a dual mandate, and there is an argument for allowing inflation to run below target when employment is above target. There’s even an argument that employment will soon be above target, and hence inflation should run a bit below target.

But even under that assumption (which I don’t accept) it’s hard to argue for a rate increase. The real problem is that the market doesn’t just expect the Fed to fall short of 2% inflation for a few years, but rather for 30 years. Raising rates now would put you even further below the long run inflation target, leading to a loss of credibility.

The Fed shouldn’t have set a 2% inflation target. But if they announce that they are targeting inflation at 2%, then they should act in such a way that we’ll get roughly 2% inflation, at least over an extended period of time (not every single year.)

The discussion of UK and US monetary policy is taking place on the basis of a false premise — that we can maintain near-zero official rates indefinitely — and that this would somehow be a satisfactory basis for economic growth over the medium term. I do not believe that, and I do not meet many people in the business and financial world who do either. If they do have a view about long-term near-zero interest rates, it is that this is likely to drag the UK and/or the US into a low growth equilibrium like Japan. That would be a major policy failure for the leading western economies.

This is what might be called the “Neo-Fisherian fallacy”, confusing cause and effect. Low rates in Japan are the effect of tight money (as Friedman pointed out in 1997.) Raising the fed funds target now won’t make the economy grow faster, indeed just the opposite.

However — in cricketing parlance — the Fed is now on the back foot. Their decisions are getting behind the curve. A sharp interest rate correction between 2016 and 2018 is becoming increasingly likely. Central bank independence is not delivering the benefits we have been promised.

Actual, the markets are telling us that a future interest rate surge is getting less and less likely. Beware of former central bankers who think they know more than the markets. Regarding central bank independence, we were promised that it would deliver two things:

1. Low inflation.

2. Avoidance of stop/go policies timed to the election cycle.

It has delivered both. Which promise does Sentance think it has not delivered?

The real problem is not that central banks haven’t done what their critics asked them to do, rather the real problem it is that central banks have done what their critics asked them to do. Today’s critics of low interest rates are mostly on the right. These critics have argued for years that central banks should focus like a laser on a low inflation target, and basically ignore unemployment. Central banks did this and gave us the Great Recession. Now critics on the right complain that the central banks are not raising rates, and write columns pointing to the low unemployment, but not even mentioning the below target inflation.

Recall that Sentance said:

If you look around hard enough, there can always be a reason for not raising interest rates.

I’d say if you look hard enough you can always find a way to claim Fed policy is too expansionary. There were even people making that claim in 2008-09, when the need for stimulus was “easy” to see.