The trend in inflation is confusing those in charge of monetary policy. After a significant uptick in the last part of 2017, it has really stagnated, in stark contrast with the growing dynamism of the economy. If the European Central Bank is considering, not without a certain amount of complacency, a phenomenon which allows them ample margin to calmly amble towards normalisation, the debate surrounding the issue is significantly more controversial in the US. The fact that prices are clearly below the target level has even been likened to a complete failure with respect to monetary policy management. Let’s not forget the poisoned dart launched at Janet Yellen by President Trump when he described her ironically as the champion of low inflation. A veiled accusation that she purposely slowed the pace of expansion, as if the variable in question depended on the will of the Federal Reserve. Of course during the electoral campaign he had reproached her with quite the opposite, accusing her openly of doping the economy in favour of his democratic rival. A completely confusing exercise which can only be explained by a self-assured sense of objectivity. It’s true of course that Yellen provided ammunition for twisted interpretations as she confessed time after time her frustration and confusion in the face of the weak trend in prices. In this way, she fuelled the endorsement that she was somewhat to blame, due to a lack of foundation.
By categorising it as a problem, the inflation gap is now a key element in the monetary debate on the other side of the pond. The markets are always in favour of pushing credit laxness to the limit. So they are reacting with obvious satisfaction to the uncertainty which such an inopportune situation is fuelling for the Fed. It’s no wonder, offering the perfect excuse for the sector which is more inclined to caution within the FOMC. On top of that, it’s an excuse based on a phenomenon for which nobody seems to have even a hint of any convincing explanation. Factors like the recent fiscal reform pale into insignificance compared with its capacity for influence. The reform will only represent a deterioration in the budget balance of 0.8%, less than a fifth of the deficit registered this year. With this kind of wicker work, the slight increase in activity which is forecast would not justify any kind of preventative monetary tightening.
Last year, when the trend in prices seemed to be clearly on the upside, Janet Yellen herself was careful about applying the brakes and warnings to mitigate the monetary response to the foreseeable acceleration in inflation. She defended as an axiom the trend towards a progressive and relentless reduction in neutral interest rates, the fruit of a sustained shrinkage in productivity and an unfavourable demographic trend, with its corollary contractive effect on potential growth. With such flimsy credentials, she came up with the idea of a symetric consideration of the inflation target, transferring it into a temporary average and offsetting, in this way, phases of insufficiency with phases when the target is exceeded. She even suggested the possibility of raising the target level, although never in the end openly proposed such a forced measure. So her inheritance is markedly accommadative which her successor Powell will take care to maintain. No wonder that his nomination as Fed chair is largely the result of the 180 degree turn made by the White House. It swapped its primative monetary rigour for the priority of boosting growth, whatever the price. The well-intentioned prospects of expansion offered by the fanciful forecasts of the person in charge of the Treasury is a demonstration of this new policy mix.
It’s ironic that the efforts made to decouple inflation from rate rises have coincided with a lack of dynamism in prices during a phase of economic expansion. Lots of different explanations have been given: a precarious labour market, where the high utilisation of this productive factor is not translating into a rise in salaries as happened before; the growing predominance of a services sector with higher potential to expand without needing excessive additional resources in terms of workforce or investments; raw material prices, in particular energy prices, which are still at minimum levels, etc…Given all this, in monetary policy terms it’s less interesting finding out the structural causes for this behaviour than evaluating how this policy should react to it. Reducing everything to meeting a target, no matter how key it is as part of the forward guidance strategy, runs the risk of confusing this instrumental element with its very basis, that of maintaining stability.
The very emphasis which is given to this instrument continues to involve intentions which to a large extent are unconnected to actual monetary policy. At the moment, it seems a mere pretext for the expansionary proposals of the US administration, anxious to present the best balance it can for these first years of its legislature. Despite the fact the excesses will be paid for later with a more pronounced recession.
The fact that price levels remain markedly moderate could only be problematical if they reflect a sharp weakness in aggregate spending. If they are accompanied by a close to potential level of growth, the result is equivalent to an optimum which verges on squaring the circle. Everyone is aware that it’s a balance which is difficult to perpetuate since, sooner or later, there will be an uptick in inflation. But the real problem with this variable at the moment is its apparent inability to serve as an advanced signal of an excessive economic acceleration. It’s pretty mystifying that the sustained strength in activity has not translated into tensions, either in prices or, even less so, in production costs.
Against this backdrop where there is a lack of reliable references, the debate comes down to finding out whether it’s a good thing to intervene to prevent a potential heating up in the absence of unequivoval signs which advise this. In principal, delaying the option for too long runs the risk of incurring the disproportionate costs of any kind of forced landing. Furthermore, avoiding raising rates in a bullish phase implies having less fire power to combat a potential contraction when it happens. Prudence would encourage normalising monetary policy as soon as possible, so it can serve as an efficient instrument for maintaining stability. A role which is far from being filled after years of massive injections of liquidity and rates close to zero. The hikes in the federal rates have been so unhurried and modest that they have hardly had any influence on the markets. And as far as the paring of the central bank’s balance sheet is concerned, this is going at such a slow pace that it will take nearly a decade to trim the accumulated adiposity. For that reason, even though there are no immediate threats, implementing a slant which is less accommodative would be the best antidote in the face of sharp, forced hikes in rates in the future.
No matter how convincing these reasons are, the danger in choking off activity ahead of time with preventative credit tightening is no less certain. Above all because of the possibility of unleashing a spiral of financial instability in the face of an abrupt change in debt conditions. We should not underestimate the impact of this kind of move in an environment where there is such little aversion to risk and an excessive accumulation of liabilities. No to mention the destabilising effect on the global economy of a notable appreciation in the dollar. The declining levels of long-term rates, a reflection of diminished inflation expectations, seriously limit the reach of the intervention given the possibility of an inverted curve happening. This could disrupt the assignation of resources, fuel mistrust and accelerate the contraction. A series of factors which could take their toll without any objective reasons to justify them.
Deep down, the key to all economic policy, including monetary policy, is to ensure a sustained and stable pace of growth. Only the intrinsic difficulty in anticipating this magnitude with a minimum level of accuracy advocates the use of indicators like inflation or the jobless rate to serve as a guide. Indicators which, as can be seen, are not very reliable as predictive elements in the current environment. If prices seem to escape the logic of an expansionary cycle, if full employment stops fuelling tensions in the labour market, it will be compulsory to give a more decisive role to the evolution of growth, despite its limitations. Without doubt, the main thing has to do with the somewhat arbitrary character which can be assigned to the economy’s potential expansion, a yardstick and indispensable reference for diagnosing possible overheating. With all the caution that’s required, introducing this variable as a complementary element in monetary policy management, either quite plainly or under the modality of nominal GDP, seems inevitable in order to avoid unexpected headwinds.