Inflation is dead, long live inflation. The implications of this are huge, if true, not just for the markets but for monetary and fiscal policy. For twenty five years—about a generation—inflation has only been on a declining trend. Many in the market now cannot even comprehend high inflation as it has never happened in the world they have lived in. Multiple reasons have been put forward to explain its demise, including advances in technology, the expansion to a global labour market, increased competitiveness and free trade. After so many years of consistently having 1-2% inflation, the memories of higher levels are fading fast, anchoring expectations at very low levels. Moreover, it appears that the correlation between unemployment and inflation has vanished, sowing doubts about the Phillips curve framework as a guide to monetary policy implementation. In a recent speech, Andy Haldane of the Bank of England noted that the recently observed flat Phillips Curve is akin to the one estimated to exist pre the industrial revolution when laws precluded workers from demanding wage increases. Vive la change!
I am not convinced that higher levels of inflation can never return. One would have to rescind the laws of economics and suppose that when global slack is finally absorbed, prices will not respond and be pressured higher. But for argument’s sake, let’s pretend that inflation is now cemented below the level that many Central banks are targeting. What then, is an explicit inflation targeting central bank suppose to do? If inflation is unresponsive to increasing domestic economic growth, why bother keeping the pedal to the metal? Recent evidence would suggest that keeping rates too low for too long in an attempt to achieve an unattainable inflation target will only cause distortions to financial asset prices. This increases the vulnerability of the real economy to any sizeable correction in the markets. If stimulative monetary policy is more effective at generating asset price inflation rather than increasing the general price level, why increase financial stability risk if you are not getting closer to achieving your mandate.
At this point, it may be relevant to remember the genesis of the 2% inflation target. The Bank of New Zealand was the first explicit inflation targeting central bank and so it had little guidance in terms of the level they should target. When their targeting was introduced in December 1990, the ultimate objective was to achieve an inflation rate somewhere between 0-2%. In 1996, this was subsequently raised to 1-3%. Both in New Zealand and Canada, the 2% inflation target was chosen, not because it is the optimal level of inflation for the economy to function at its best but because it was deemed to be the best rate of inflation to keep monetary policy relevant and effective.
The current inflation target was chosen because back in the old days when central bankers thought they were constrained by zero as a bottom to rates, they decided that if inflation was around 2% and they pushed their target rates down to zero, negative real rates of about 2% would be sufficient stimulus, in most cases, to manage the usual downswings of the economy.
Now if you talk to central bankers, they will tell you that the zero lower bound no longer applies. At their disposal they have asset purchases and negative interest rates. Major swaths of the globe now have, or had, negative interest rates and asset purchases and lived to tell the tale. If quantitative easing and negative rates are ultimately proven to have been effective (jury still out) in stimulating real growth and keeping deflation at bay, then targets of 2% inflation need no longer apply. With estimates of an effective lower bound somewhere between -0.75 and -1.00%, an inflation targeting central bank could easily lower their explicit inflation target to centre around 1% and still have room to provide sufficient monetary policy stimulus.
Obviously there are huge implications for a lowering of the inflation target on the economy (in terms of contracts written, etc), on yields and on the Government’s ability to inflate debt away. That discussion is for another day.
If the structure of the purported new economy drastically decreases the likelihood of inflation climbing above current targets for sustained periods of time, those Bank’s that have explicit target ranges will have to adapt or else lose their credibility. We may go back to the future and use the 0-2% target initially imposed in NZ instead of our 1-3% range, or drop explicit numbers and go for a less prescriptive target of “low and stable” prices. Or maybe other central banks will fall in line with the Fed’s original clarified mandate imposed on them in 1977 by Congress before they publicly announced a preferred inflation rate of 2%. In the original, the Fed was given the goals of maximizing employment, stabilize prices and have moderate long-term rates. Sort of what they have now.
The Bank of Canada’s inflation target agreement with the Federal government is valid until 2021. A lot of water will flow under the bridge over the next four years. But if the global Phillips curve remains flattish and evolving evidence starts to validate the effectiveness of alternative approaches to providing monetary stimulus, lower targets for inflation are a real possibility. Suddenly current yields on 5 year and 10 year bonds look ever more enticing.
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