The Inflation Conundrum
A lack of inflation in advanced economies since the global financial crisis has prompted something of a re-think regarding the future of central bank monetary policy frameworks going forward. In November 2018, the US Federal Reserve (the Fed) embarked upon a broad review of the “strategy, tools, and communication practices it uses to pursue the monetary policy goals established by the Congress: maximum employment and price stability”. Its statement suggested that, in currently meeting these goals, the time was right to assess whether or not the monetary policy framework could be improved to better meet future challenges.
Emergency measures deployed during the financial crisis have now become part of the standard monetary policy toolkit, with central bankers seemingly comfortable with these developments. In a 2016 speech by ECB President Mario Draghi, he suggested that unintended consequences of unconventional monetary policy could be minimised as experience filled in the remaining knowledge gaps. He also stated that we should not be afraid to use unconventional tools such as asset purchases to ensure price stability. His argument was that central banks should be just as committed to fighting inflation that is too low as inflation that is too high. More recently, he wrote, “substantial monetary policy stimulus remains essential to ensure the continued build-up of domestic price pressures over the medium term”.
Barclays made some interesting comments in their recent Equity Gilt Study. In it, they observed that the current inflation targeting regime, born in the 1990s will soon have reached a lifespan associated with other historical monetary-policy regimes: the Gold Standard (1870s-1914) and the Bretton Woods system (1948-1973), as well as the periods between wars (1919-1939) and between Bretton Woods and IT (1973- 1990s), when no single policy framework dominated.
Is the Federal Reserve open to a period of above target inflation?
Critics, including a vociferous President, have suggested that the Fed is too focussed on ‘phantom’ inflation and should refrain from hiking interest rates until there is actual evidence of inflation taking hold in the economy. Recent comments by the Minneapolis Federal Reserve President suggested that, because actual inflation had averaged below the 2% target for the past several years, the Federal Reserve should be comfortable allowing it to creep above target for several years. This would be a subtle change from its current dogma where any deviation from target should be addressed with an appropriate policy response.
European Central Bank inflation target debate
Again, the ECB has persistently undershot its target of 2% over the last few years (and does not foresee that changing any time soon). Unlike the Bank of England and the Fed, the ECBs target is asymmetrical: “the ECB aims to maintain inflation rates below, but close to, 2% over the medium term.” This more vaguely defined inflation target leaves some room for interpretation – how close is close and what constitutes medium term? Why is this significant? Well, the speed at which the ECB winds down its EUR 2.5 trillion-asset purchase scheme is dependent on making “sufficient progress” towards a “sustained adjustment in the path of inflation”. Inflation hawks and doves within the ECB are likely to have contrasting views on the interpretation of this.
Current and forecasted inflation figures for the UK
Consumer Price Inflation (CPI) held steady at 1.9% in March, despite forecasts of a rise to 2%. This is likely a symptom of Brexit-related uncertainty, leading to more circumspect shopping habits in the short term and forcing retailers to discount prices, even in the face of rising input costs and subsequently tighter margins. Inflation data in some of the more discretionary components, such as games & toys (including computer games) fell back the most; however, food and clothing prices were also weaker than expected. This, however, could mark the last sub two percent reading for some time. According to Capital Economics, with a no-deal Brexit averted, for now at least, there is little reason to think inflation will remain weak. They point to a number of specific factors such as a scheduled rise in the utility price cap and broader factors such as stronger wage growth versus weak productivity growth. Together, they forecast that domestically generated inflation will be pushed up to 2.5-3% by early next year. The upside to this shorter-term soft patch is that it will allow the Bank of England to sit on its hands until the Brexit drama unfolds further.
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