The Daily Telegraph - Business

The re­birth of in­fla­tion?

The Fed­eral Re­serve’s plan to let the US econ­omy run hot could re­vive a mon­ster

- Roger Boo­tle Finance · Business · United Kingdom · Federal Reserve System · United States of America · Bank of England · England

It is 25 years since I wrote my book The Death of In­fla­tion. Through­out this pe­riod I have con­stantly asked my­self whether the con­di­tions that pro­duced low in­fla­tion were about to change and whether the time was right to fore­cast in­fla­tion’s im­mi­nent re­birth. In the event, I never did re­verse my call and, de­spite the oc­ca­sional spike, over­all in­fla­tion has re­mained very sub­dued. But in the past two weeks some­thing has oc­curred to make me think that a resur­gence of in­fla­tion may not be that far off.

This is not to say that in­fla­tion is about to take off in the im­me­di­ate fu­ture. Quite the op­po­site. As it hap­pens, the lat­est UK in­fla­tion fig­ures will be pub­lished this Wed­nes­day. Thanks to a com­bi­na­tion of tem­po­rary fac­tors, the in­fla­tion rate may fall back from last month’s 0.6pc to some­where near zero. In­deed, there is a good chance that the rate could even dip into neg­a­tive ter­ri­tory. In com­ing months in­fla­tion will prob­a­bly move up to some­where just be­low its 2pc tar­get, but not more. For the next cou­ple of years, the de­pressed econ­omy, in­clud­ing a very weak labour mar­ket, should en­sure that in­fla­tion stays low.

But later it could be an al­to­gether dif­fer­ent story. Although all sorts of sup­ply-side shocks can dom­i­nate the in­fla­tion out-turn in the short term, in the long term it de­pends most of all upon the pol­icy regime op­er­ated by the au­thor­i­ties.

The re­cent de­vel­op­ment that has caused my in­fla­tion­ary an­ten­nae to twitch was the change of pol­icy regime an­nounced by the Fed­eral Re­serve, Amer­ica’s cen­tral bank. Up to now, in com­mon with other cen­tral banks, the Fed’s pol­icy regime was to try to achieve in­fla­tion of 2pc at all times. The new pol­icy, how­ever, is to aim to get in­fla­tion to 2pc on av­er­age over a run of years.

This may sound like a mi­nor tech­ni­cal change but it is po­ten­tially mo­men­tous. Un­der the old in­fla­tion tar­get, what­ever hap­pened to in­fla­tion in pre­vi­ous pe­ri­ods had no bear­ing on the cen­tral bank’s tar­get for the fu­ture. So, if in­fla­tion per­sis­tently un­der­shot the 2pc tar­get, in sub­se­quent pe­ri­ods the Fed would still be aim­ing for in­fla­tion of 2pc.

Un­der the new regime, how­ever, if in­fla­tion per­sis­tently un­der­shoots, then the Fed will aim for in­fla­tion above 2pc in the suc­ceed­ing pe­riod. It has been per­sis­tently un­der-shoot­ing. So the con­di­tions are in place for the Fed to aim for in­fla­tion sig­nif­i­cantly above 2pc – at least for a while.

And there has been an­other tweak to the pol­icy regime. The Fed will no longer seek to nip in­fla­tion­ary pres­sures in the bud by rais­ing in­ter­est rates in ad­vance of an in­fla­tion­ary up­surge. Un­der the new regime, in­fla­tion will need to be vis­i­bly on the up be­fore the Fed will raise rates.

This change of regime sug­gests that once ag­gre­gate de­mand re­vives and the econ­omy re­turns to some­thing like nor­mal, we should ex­pect in­fla­tion to lodge for a time above 2pc with­out an im­me­di­ate pol­icy re­sponse from the Fed. In other words, we should ex­pect real in­ter­est rates to be even more neg­a­tive than they are now.

This could bring some ma­jor ben­e­fits. Heav­ily neg­a­tive real rates, con­tin­u­ing for some time, should help to keep ag­gre­gate de­mand strong, and both a strong econ­omy and a lit­tle bit more in­fla­tion would start to erode the debt ra­tio.

You might be able to guess where this is lead­ing. Often ma­jor pol­icy changes do not hap­pen starkly overnight. Rather, there is an edg­ing away from one regime and to­wards an­other. Sup­pose the US does ex­pe­ri­ence a few years of in­fla­tion at about 3pc, with in­ter­est rates still at about zero, and there­fore heav­ily neg­a­tive in real terms, and with the long bond yield an­chored by con­tin­ued bond pur­chases by the Fed.

Would there be the ap­petite to change this pol­icy when a few years of run­ning with in­fla­tion above 2pc has fully com­pen­sated for the in­fla­tion un­der­shoot of pre­vi­ous years? I sus­pect not. In other words, I won­der whether we can see now on the hori­zon the be­gin­nings of a regime where the Fed ac­tively seeks to get in­fla­tion run­ning at a level sig­nif­i­cantly above 2pc, not just for a year or two but as the norm.

Of course, just be­cause cen­tral banks want in­fla­tion to be above 2pc doesn’t mean to say that they will achieve this. Af­ter all, re­cently they haven’t been able to get in­fla­tion up to the 2pc tar­get.

But there are some dif­fer­ences from the sit­u­a­tion that ex­isted be­fore the coro­n­avirus cri­sis. For a start, there has been un­prece­dented mon­e­tary eas­ing, with both in­ter­est rates at all-time lows and mas­sive in­jec­tions of liq­uid­ity. The Ja­panese ex­pe­ri­ence of per­sis­tently fail­ing to get in­fla­tion up to 2pc could prove to be ex­tremely mis­lead­ing. Not only have the Ja­panese au­thor­i­ties re­peat­edly re­sorted to fis­cal tight­en­ing pre­ma­turely but there were sub­stan­tial struc­tural rea­sons for ag­gre­gate de­mand to be weak. Mean­while, the cen­tral bank was never pre­pared to in­ject enough liq­uid­ity to shift the econ­omy out of this sit­u­a­tion.

Here the eco­nomic fun­da­men­tals are sim­i­lar to the po­si­tion that con­fronts the US au­thor­i­ties. But the Bank of Eng­land is obliged to fol­low a man­date set by the Chan­cel­lor of the Ex­che­quer, which, at the mo­ment, obliges it to tar­get an in­fla­tion rate of 2pc at all times. For the Bank to op­er­ate dif­fer­ently, this man­date would have to be changed.

But that does not sound to me as though it would be beyond the wit of man. Af­ter all, we have changed the in­fla­tion tar­get­ing regime be­fore. And if we see a dif­fer­ent regime be­ing suc­cess­ful in the US, then there must be a good chance of it be­ing adopted here as well.

Would the au­thor­i­ties suc­ceed in push­ing in­fla­tion higher? If they did, would this be a good thing? And could they stop in­fla­tion from ac­cel­er­at­ing to higher rates? These are sub­jects for an­other day. But for now, note this: you have been warned.

 ??  ?? The move by Jerome Pow­ell, Fed­eral Re­serve chair­man, sug­gests that US ad­her­ence to the 2pc in­fla­tion tar­get could be wan­ing
The move by Jerome Pow­ell, Fed­eral Re­serve chair­man, sug­gests that US ad­her­ence to the 2pc in­fla­tion tar­get could be wan­ing
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