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12-01-2015, 09:56 PM
Deflation tests central banks
MICHAEL J. CASEY THE WALL STREET JOURNAL JANUARY 13, 2015 12:00AM
Deflation tests central banks
The threat of the moment for the global economy, deflation, provides a moment of reckoning for central banks. Source: AFP
A CORE tenet of modern central banking is being put to a critical test by the disinflation sweeping through the global economy.
Inflation targeting, first adopted in 1988 by the Reserve Bank of New Zealand when it set a strict, quantified objective to replace the more vague goals that had previously dictated interest-rate decisions, has since been embraced by central banks throughout the industrialised world.
The strategy, which aims to produce ongoing modest price increases according to an annualised target rate, has had notable success in containing inflation. But the dramatic recent downturn in consumer-price data suggests it might not do so well fighting the threat of the moment, deflation.
It is a moment of reckoning for central banks, which until the crisis of 2008 had basked in the apparent success of their fixation on consumer-price inflation during an era known as the Great Moderation. Although the financial crisis later proved that monetary policy makers had dangerously overlooked the parallel problem of financial-asset inflation, their subsequent actions in slashing interest rates to zero and using “quantitative easing” bond purchases to calm markets perpetuated their image as all-powerful economic stewards.
Now, however, with outright price declines exposing a glaring failure to meet inflation targets and much of the global economy in a funk, the entire policy framework is open to question.
“This is a real challenge (for central banks), a challenge they haven’t really faced in the era of inflation-targeting regimes,” said Bruce Kasman, chief economist at JPMorgan Chase.
The Organisation for Economic Co-operation and Development said last week that the combined consumer-price index for its 34 industrialised-country members dropped to 1.5 per cent in November, from 1.7 per cent in October. Already those numbers are below formal targets applied by most major central banks.
Though they use a variety of benchmarks and give allowances for short-term fluctuations in things such as energy prices, most OECD central banks use a medium-term inflation goal at or around 2 per cent. A few have midpoint targets at 3 per cent or above.
More important, with oil prices relentlessly falling, wages stagnating and weak manufacturing activity in China and the eurozone leaving a glut of unsold goods and idle factories, many countries’ CPI readings are showing repeated monthly declines. These trends will ensure that the annual rate of CPI change for the G4 — the US, eurozone, Japan and Britain — will go negative in the months ahead, says JPMorgan’s Kasman. That will put them more than two percentage points below target.
The problem is that this could foment expectations of future price declines. As Japan learned over two decades of deflationary trends and the world saw in more destructive terms during the Great Depression, this raises the risk that consumers and businesses defer spending and investment, creating a vicious, self-perpetuating cycle of economic stagnation. Even in the US, whose economy is outperforming most others, one bond-market measure of inflation expectations, the five-year forward five-year break-even rate for inflation-adjusted Treasury securities, is at its lowest level since December 2000.
For some, the solution is to replace inflation targeting with strategies that could better stir future inflation expectations.
One flaw of inflation targeting, says Texas State University economist David Beckworth, is that it requires that central banks predict the hard-to-measure “output gap”, measuring the distance between an economy’s actual production and its theoretical potential. In theory, inflation arises when that gap disappears. It also means that in targeting inflation, they frequently misinterpret benign and typically short-lived “supply shock” effects, such as those caused by disruptions or surges in commodity production, as if they represent more sustained changes in the overall level of prices, he says.
This leads to harmful policy mistakes such as the European Central Bank’s mid-crisis rate increases in 2008 and 2011, added Beckworth, who instead advocates using a controversial strategy known as nominal GDP targeting. Under that system, policymakers would aim for an optimal level of overall economic output, expressed in current dollar terms, and not concern themselves with whether the growth to get there comes from inflation or real economic expansion.
“Nominal GDP says, look, we don’t know what the output gap is and what is behind inflation, so let’s just focus on something that we can measure,” Beckworth says.
Getting nominal GDP back to its pre-crisis upward track would require a big burst of inflation, however, and many worry this would remove a key anchor for people to make predictable investment decisions. Others contend that ending inflation targets would expose central banks, particularly in developing countries, to political pressure.
Inflation targeting has been more successful “at creating an environment of international monetary policy co-ordination” than even the Bretton Woods system of fixed exchange rates that ended in 1973, says Stephen Cecchetti, a Brandeis University professor and former head of monetary and economic development at the Bank for International Settlements. Because central bankers have set similar target levels around 2 per cent, they have reduced differentiation in inflation, exchange rates and interest rates, he says. They could change those targets now to stir higher inflation expectations, Cecchetti added, “but everybody would have to do it together”.
MICHAEL J. CASEY THE WALL STREET JOURNAL JANUARY 13, 2015 12:00AM
Deflation tests central banks
The threat of the moment for the global economy, deflation, provides a moment of reckoning for central banks. Source: AFP
A CORE tenet of modern central banking is being put to a critical test by the disinflation sweeping through the global economy.
Inflation targeting, first adopted in 1988 by the Reserve Bank of New Zealand when it set a strict, quantified objective to replace the more vague goals that had previously dictated interest-rate decisions, has since been embraced by central banks throughout the industrialised world.
The strategy, which aims to produce ongoing modest price increases according to an annualised target rate, has had notable success in containing inflation. But the dramatic recent downturn in consumer-price data suggests it might not do so well fighting the threat of the moment, deflation.
It is a moment of reckoning for central banks, which until the crisis of 2008 had basked in the apparent success of their fixation on consumer-price inflation during an era known as the Great Moderation. Although the financial crisis later proved that monetary policy makers had dangerously overlooked the parallel problem of financial-asset inflation, their subsequent actions in slashing interest rates to zero and using “quantitative easing” bond purchases to calm markets perpetuated their image as all-powerful economic stewards.
Now, however, with outright price declines exposing a glaring failure to meet inflation targets and much of the global economy in a funk, the entire policy framework is open to question.
“This is a real challenge (for central banks), a challenge they haven’t really faced in the era of inflation-targeting regimes,” said Bruce Kasman, chief economist at JPMorgan Chase.
The Organisation for Economic Co-operation and Development said last week that the combined consumer-price index for its 34 industrialised-country members dropped to 1.5 per cent in November, from 1.7 per cent in October. Already those numbers are below formal targets applied by most major central banks.
Though they use a variety of benchmarks and give allowances for short-term fluctuations in things such as energy prices, most OECD central banks use a medium-term inflation goal at or around 2 per cent. A few have midpoint targets at 3 per cent or above.
More important, with oil prices relentlessly falling, wages stagnating and weak manufacturing activity in China and the eurozone leaving a glut of unsold goods and idle factories, many countries’ CPI readings are showing repeated monthly declines. These trends will ensure that the annual rate of CPI change for the G4 — the US, eurozone, Japan and Britain — will go negative in the months ahead, says JPMorgan’s Kasman. That will put them more than two percentage points below target.
The problem is that this could foment expectations of future price declines. As Japan learned over two decades of deflationary trends and the world saw in more destructive terms during the Great Depression, this raises the risk that consumers and businesses defer spending and investment, creating a vicious, self-perpetuating cycle of economic stagnation. Even in the US, whose economy is outperforming most others, one bond-market measure of inflation expectations, the five-year forward five-year break-even rate for inflation-adjusted Treasury securities, is at its lowest level since December 2000.
For some, the solution is to replace inflation targeting with strategies that could better stir future inflation expectations.
One flaw of inflation targeting, says Texas State University economist David Beckworth, is that it requires that central banks predict the hard-to-measure “output gap”, measuring the distance between an economy’s actual production and its theoretical potential. In theory, inflation arises when that gap disappears. It also means that in targeting inflation, they frequently misinterpret benign and typically short-lived “supply shock” effects, such as those caused by disruptions or surges in commodity production, as if they represent more sustained changes in the overall level of prices, he says.
This leads to harmful policy mistakes such as the European Central Bank’s mid-crisis rate increases in 2008 and 2011, added Beckworth, who instead advocates using a controversial strategy known as nominal GDP targeting. Under that system, policymakers would aim for an optimal level of overall economic output, expressed in current dollar terms, and not concern themselves with whether the growth to get there comes from inflation or real economic expansion.
“Nominal GDP says, look, we don’t know what the output gap is and what is behind inflation, so let’s just focus on something that we can measure,” Beckworth says.
Getting nominal GDP back to its pre-crisis upward track would require a big burst of inflation, however, and many worry this would remove a key anchor for people to make predictable investment decisions. Others contend that ending inflation targets would expose central banks, particularly in developing countries, to political pressure.
Inflation targeting has been more successful “at creating an environment of international monetary policy co-ordination” than even the Bretton Woods system of fixed exchange rates that ended in 1973, says Stephen Cecchetti, a Brandeis University professor and former head of monetary and economic development at the Bank for International Settlements. Because central bankers have set similar target levels around 2 per cent, they have reduced differentiation in inflation, exchange rates and interest rates, he says. They could change those targets now to stir higher inflation expectations, Cecchetti added, “but everybody would have to do it together”.