This week’s news that US core inflation came in lower than expected in July has increased the likelihood that the US Federal Reserve will keep interest rates on hold for the rest of this year. True, there may be some boost in the form of inflation emanating from China, where producer prices have recently shown strength. But the Fed and other central banks face a structural predicament from which they will not escape via an increase in import prices.
An apparent slow drift down in the natural rate of interest and trend growth across nations means a lower long-term level of policy rates, less room to cut during recessions and the need to resort to extraordinary and possibly distorting measures such as quantitative easing.
John Williams, president of the San Francisco Federal Reserve, this week posited a solution: that the Fed might increase its inflation target, allowing the economy to run faster than otherwise and pushing interest rates higher. This would allow bigger cuts in rates during recessions.
Yet as a practical matter, it is hard to argue in the current conjuncture that the Fed is chafing against the constraints of its policy framework. The central bank has leeway it is choosing not to use. The 2 per cent inflation target did not force the Fed’s open market committee to raise interest rates in December last year for the first time since 2006. The increase was a purely unforced error, as would be another rate increase in the near future.
The Fed’s main problem at the moment is not its framework, but overestimating inflationary pressure and underestimating the cost of yet more undershooting of its target. Raising the target is likely only to mean that the central bank misses it by more and thereby leaches credibility.
If the Fed is to adjust its goal, it would make more sense to adopt another of Mr Williams’ suggestions and target a price level rather than an inflation rate, aiming to follow a period of inflation running below target by spending an equivalent time above it. That would encourage it to run the economy at a faster rate while avoiding a confusing change in the numerical target which, as Fed chair Janet Yellen said in a speech in September, would raise suspicions that the goalposts would be opportunistically moved again.
In any case, policymakers should be concentrating on hitting the current target, not talking about changing it. Holding central bankers solely responsible for inflation is part of the problem. Stable positive inflation comes when demand is bumping up against the economy’s output capacity. If central banks are struggling to generate such demand without extraordinary and potentially distortionary actions, it is up to finance ministries to do their part by stimulative fiscal policy.
Although there have been a few signs of fiscal policy turning stimulative in the large advanced economies, they are a long way from accepting the full role that taxing and spending should have in boosting demand.
Formally sharing responsibility for hitting an inflation target between monetary and fiscal policymakers is going too far: it would merely encourage blame-shifting. But central bankers could certainly be more open about the need for boosts from more public spending or tax cuts, or both, to help address the issue of chronically underperforming growth and low inflation.
Mr Williams deserves credit for increasing the salience of the discussion about targets. Yet the immediate need is to use monetary and fiscal tools better within the existing framework, rather than to tinker with the workings of the system.
