The vicious circle of inflation: is it now time for monetary policy normalisation?

Central banks and inflationBalloons at Dawn

J. L. M. Campuzano (Spanish Banking Association) | Stable inflation centred around levels of 2.0%…A scenario dominated by rising inflation is as complicated as one where deflation and potential low economic growth can create a vicious circle difficult to exit. Especially in a context of high indebtedness. Put so simply, the rationality behind the extreme monetary measures implemented by the ECB and other major central banks during the crisis is understandable. But what happens when the crisis is over?

There is an important debate behind this question. For some, including the BIS, monetary policy normalisation needs to start. For others, apart from the Fed, now is not the right time. And while we debate over all this, especially on the medium and long-term implications of maintaining financial conditions which are too lax for too long, there is also still time to evaluate the efficiency of the monetary measures already implemented. And indeed on their success, in the case of the unconventional monetary measures when evaluating the impact on inflation expectations.

At the end of the day, with very low interest rates and low (or zero) inflation, the possibility that it would end up affecting inflation expectations was too important not to take action. Extreme and unconventional monetary policy has served to limit the decline in inflation expectations, leaving them at levels close to the 2.0% target in the medium and long-term.

 

But, as you can see from the graphic above, under 2.0%. The inflation expectations in the graphic correspond to the survey of analysts which the ECB carries out periodically. Taking 10-year rates as an indicator of monetary policy, you can see that a drop in rates of 10 basis points in the 10-year German Bund’s case is equivalent to a rise of 5 bp in inflation expectations.

Are you surprised? It’s clear the nominal yield on medium and long-term debt incorporates the expected trend in prices by definition. For example, 10-year interest rates don’t just reflect the expected trend in the official rates over this period, like various factors which can influence them to a greater or lesser degree. And this is the case with inflation. In fact, another school of thought believes that low debt yields, if they are sustained, can end up depressing inflation expectations. These are the discussions going on at present.

Photo credit: Len Radin via Foter.com / CC BY-NC-SA