Wednesday, 17th January 2018
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John Smiles

Qualified Financial Advisor

Should central banks abandon inflation targets?

Monetary policy appears to be headed towards an inflection point. The extraordinary support from central banks is being scaled back as economies improve and financial markets remain calm.

Investors seem sceptical about how much central banks will raise interest rates by, because inflation remains stubbornly low across most of the advanced world.

Historically, declining unemployment has been closely followed by increases in inflation. This relationship, described as the Phillips Curve, appears to have weakened significantly since the financial crisis. In economies like the USA, Germany and Japan, where unemployment rates have fallen below natural rates, there is little sign of inflation pressures building. Economists are debating if the Phillips Curve model has broken down or if policy needs to remain looser for longer to overcome the cyclical and structural forces weighing on inflation.

The Bank for International Settlements [BIS] is opposing current monetary policy, arguing low inflation is mainly due to the benign effects of globalisation and technical advances and ultra-low interest rates are distorting the economy and amplifying financial cycles. They say central banks should ignore inflation targets and withdraw support more quickly – i.e. increase interest rates.

Central banks agree that wages and consumer prices have become less responsive to changes in unemployment. They believe that inflation is low because the recovery from the crisis has been so weak and spare capacity has not been completely eliminated. They believe that policy should be kept accommodative for longer and it will take time for the healing from past crises to be felt.

The financial crisis was mostly a failure of regulation not of monetary policy, so the financial cycle is best managed using targeted regulation, more effective micro and macro-prudential supervision and maintaining flexible inflation mandates to ensure regulators and policymakers sing from the same hymn sheet.

Central banks will not give up on their inflation targets but lower average growth and interest rates will not go away.

Further policy experimentation is inevitable, especially when the next recession hits, and this may come with unintended consequences. Investors who found the last 10 years were difficult may find the next 10 even more so.

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