The heads of the key central banks have been meeting in the American resort of Jackson Hole each August since 1978.
Ever since, it has become a major conference, an event that financial markets follow in minute detail.
And this time, too, the central bankers came up with the goods. Fed chair Janet Yellen was the first to come out and clearly state the possibility of raising the inflation target.
A week earlier, John C. Williams, president of the San Francisco Federal Reserve Bank, had already said the big reserve banks should either raise inflation targets or completely abandon attempts to control inflation and concentrate on controlling nominal growth. Otherwise, he warned, it would be impossible to continue to cope with the trend towards ever-lower market interest rates and inflation.
Six years ago, the central bankers had rebuffed the former International Monetary Fund chief economist Oliver Blanchard when he suggested that the central banks should raise their inflation targets from 2 percent to 4 percent. Now the idea seems to be gaining currency. No wonder: the policies that have been pursued in the meantime – like quantitative easing through the massive purchase of bonds – have now reached their limits, without lifting the inflation rate much above zero.
“There is a line between what monetary policy can do, and what it should do.”
Monetary policy in the world’s established industrial states is more expansive than ever before. But the impact on real economies has been negligible. Growth rates lie well below the average levels of previous decades. Unemployment is high, especially in Europe, and productivity growth is receding. Accordingly inflation rates have hardly reacted to the low interest rates and massive liquidity injections by the central banks.
Now, the banks are asking what would happen when large industrial states slide into the next recession. How should the central banks react if they can’t cut their interest rates? Their interest policy scope is the sum of the natural rate and the inflation target of the central banks, as defined by IMF economist Lawrence Ball.
The natural rate can be understood as the interest rate which is not affected by monetary policy – not by the exchange rate nor inflation nor the growth rate. Mr. Williams defines the natural interest rate as the real interest rate, on which monetary policy has neither an expansionary nor restrictive effect, but a neutral one. By his analysis, over the last few decades, this natural rate has sunk and in the United States is now close to zero and is in negative territory in the euro zone.
If Mr. Williams is correct then the natural interest rate will increasingly restrict the scope central banks have for action. He and other economists argue that the only way to regain this scope is to raise the inflation targets.
But their argument is not convincing. Firstly, the natural interest rate is just a theoretical construct. It cannot be observed but inferred from other parameters using economic models. Depending on how it’s measured, people’s estimates of the natural rate vary greatly.
Secondly, raising the inflation targets alone is not enough for monetary policy to create growth. The central banks must also have the instrumental possibility to stimulate price increases.
That’s exactly what the Fed has been trying to do – and the European Central Bank and the Bank of Japan too – with an ever more expansionary monetary policy, but without noticeable success. That raises the question of why, with the established policy instruments, it should be any easier to reach an inflation target of 4 percent than it is to reach a target of 2 percent.
There’s also a third argument against Mr. Williams’ idea. The last few years have showed very clearly that even massive interest rate and liquidity policy stimulus from central banks don’t lead businesses to borrow more heavily if they lack confidence in the economy. That can be seen in the euro zone and also in Japan.
On the contrary, the more the central banks go into crisis mode and attempt ever more creative maneuvers to bring the economy to heel, the more they rattle investors. A business won’t take even an interest free loan if it’s not certain that it will be able to pay it back without problems in the future.
In one thing though, Mr. Williams is correct.
He says that there is a line between what monetary can do, and what it should do. Fiscal policy-making and other policy measures must also play their part, he says, to create the conditions which foster economic stability.
That is more sensible than insisting on raised inflation targets. Monetary policy has done all that it could. Now, as ever, what’s needed in many countries and especially in the euro zone, are reforms that improve the climate for investors.
Countries with monetary policy scope like Germany must invest to modernize their infrastructure and prepare the education system for the demands of digitalization.
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