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Why central banks have changed their thinking about inflation

As global economic activity rebounds from the pandemic, investors are increasingly frustrated with the sangfroid central bankers are showing over inflation risks.

Karen MaleyColumnist

A few decades ago, it was relatively easy for financial markets to understand the philosophy of central banks: the job of a vigilant central banker was to keep a close watch on inflationary pressures, and to turn down the heat as soon as they began to bubble up.

But the world’s leading central bankers have altered their modus operandi in response to persistently feeble inflation.

Central bankers are more focused on unemployment then they are on inflation. Louie Douvis

They’re now happy to let inflation bubble away for a bit. After years of undershooting their targets, they want to see evidence of rising cost pressures before they even begin to think about tightening monetary policy to cool the economy.

Last August, the US central bank announced that to compensate for below-target inflation, it would seek to push inflation above its target rate, so that over time, inflation averaged 2 per cent.

And it pledged not to raise interest rates from around zero until inflation is 2 per cent and likely to stay above that, and the US has reached maximum employment.


There are two main reasons for this major switch in central bankers’ approach to inflation.

In the first place, they’ve now become painfully aware that monetary policy loses a lot of its potency if inflation stays too low for too long.

If the neutral interest rate – the rate at which monetary policy is neither expansionary nor contractionary – is already very low, central banks have very little room to provide extra stimulus by cutting short-term interest rates.

Central bankers believe there’s precious little prospect of inflation getting out of control.

But central bankers are now beginning to suspect that they previously over-estimated the natural rate of unemployment – below which cost pressures start to build.

Indeed, some believe that the US central bank scarified around a million jobs by starting to raise interest rates in 2015 based on its overestimate of the natural rate of unemployment.


Moreover, central bankers believe they’re in a position where they can take some risks with inflation. They believe there’s precious little prospect of inflation getting out of control, given that there’s plentiful spare capacity in the labour market, and wage growth is stagnant.

But investors are nervous. They fear that strong inflation pressures could build up as global economic activity rebounds from the coronavirus pandemic.

For instance, the US economy is expected to rebound by around 8 per cent this year – powered along by the combination of ultra-low interest rates, the fiscal boost from the just-signed $US1.9 trillion COVID-relief package and the roll out of vaccinations which will allow most of the economy to reopen.

Worrying parallels

What’s more, investors are concerned about worrying parallels to the 1960s. At the start of the decade US President John Kennedy’s advisers were confident that the government spending could push unemployment lower without generating inflation.

But that approach was taken too far as the decade progressed, with the heavy military spending on the Vietnam War. As a result, inflation, which had been below 2 per cent since 1960, climbed to 5 per cent by the end of the decade.


Financial markets have become fearful that a rapid global recovery will kindle inflationary pressures, which would erode the value of the fixed returns on their bond holdings.

As a result, they sold US bonds, pushing the yield on benchmark US 10-year bonds to 1.63 per cent at the end of last week, the highest level in a year. (Yields rise as bond prices fall.)

Although the yield on the 10-year US bond yield has since eased back slightly, investors will be keeping a very close watch on what comments the US Federal Reserve makes after its key interest-rate setting committee meets this week.

No one is expecting that the Fed will make any tweaks to its present monetary stimulus. Instead, the US central bank will keep its key interest rate near zero, and to continue buying at least $US120 billion ($150 billion) of bonds and mortgage-backed securities each month.

But investors will be looking closely at the Fed’s summary of economic projections, which will be updated for the first time since mid-December.

The US central bank is widely expected to boost its projection for US economic growth this year from its 4.2 per cent.


Central bank hikes

But the big question is whether the US central bank changes its guidance on the timing of future interest rate hikes.

Back in December, the summary showed that Fed officials continued to project interest rates remaining near zero through the end of 2023. And most market participants expect that the Fed will stick to that forecast this week.

This puts the US central bank at odds with market economists, who are forecasting that the US central bank will make two 25 basis point interest rate hikes in 2023.

For their part, central bankers believe that the markets concerns about inflation are over-stated.

In the US, for instance, inflation has run close to or below 2 per cent for most of the past 25 years, even during periods when economic activity has been strong, and the unemployment rate has been low.


At a press conference in late January, the head of the US central bank, Jerome Powell, noted that the world’s major economies had been struggling with disinflationary forces for some time.

“We believe that those global forces – which are, you know, ageing demographics, advancing technology and globalisation – those forces are still in effect.”

Global forces

Although these global forces could change over time, they did not alter at a rapid rate.

Instead of worrying about inflation, Powell said: “I’m much more worried about falling short of a complete recovery... I’m more concerned about that and the damage that will do not just to their lives, but to the United States economy, to the productive capacity of the economy.”

He added that “frankly, we welcome slightly higher inflation... The kind of troubling inflation that people like me grew up with seems far away and unlikely.”


Dr Philip Lowe, the head of the Reserve Bank of Australia, is taking a similar stance.

When he was asked last week whether he was concerned that ultra-loose monetary policy could be fuelling asset price bubbles, Dr Lowe replied that the central bank’s primary concern was the “social and economic costs” from projected high levels of unemployment.

And minutes from the Reserve Bank’s board meeting held earlier this month show that the central bank is not overly worried about consumer price inflation getting out of control, despite the latest run-up in commodity prices.

“This [a sustained increase in consumer price inflation] was considered unlikely for as long as substantial spare capacity remained in labour markets and wages growth remained subdued.”

The minutes add that “the international experience prior to the pandemic had underscored that a sustained period of tightness in labour markets would be needed in order to generate increases in wages growth, and, even then, would put only limited upward pressure on consumer price inflation.”

What’s more, the minutes note that “even if wages growth did pick up, it was also possible that corporate profit margins in some economies could absorb an increase in labour costs before firms passed such costs through to final consumer prices.”

Summary | 4 Annotations
over-estimated the natural rate of unemployment
2021/03/16 10:33
puts the US central bank at odds with market economists
2021/03/16 10:36
the central bank is not overly worried about consumer price inflation getting out of control, despite the latest run-up in commodity prices
2021/03/16 10:38
labour markets
2021/03/16 10:38