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Yesterday, Federal Reserve chair Jerome Powell confirmed that he’ll be looking to end quantitative tightening (QT) later this year.
The exact process has still to be worked out (when do they do it? How much money is left swimming around? How do they get rid of all the mortgage-backed securities while still hanging on to all the government debt?)
But overall, there’s nothing particularly new here. The market already knew QT was on its way out.
What’s more interesting to me is that there’s another policy adjustment that they’re looking at right now which could be far more important in the long run.
The great inflation conundrum
The Federal Reserve is puzzled, along with lots of other people. Some of the world’s biggest economies (the US, Japan, the UK, and Germany among them) are at or near full employment. And growth – until very recently at least – has been solid, if not amazing.
Yet inflation simply isn’t rising as fast as they would like it to. Being central bankers, they see the economy as being a bit like a machine. If you pull the right lever or press the right button, then it should do what you want it to.
Therefore, if inflation is not taking off, they can’t be pulling the levers in the right way.
So they’ve decided to take a look at how they do things. One thing that they want to explore is the inflation target. They are exploring the idea of replacing it with a range of ideas, one of which is known as “price-level targeting”.
This all sounds quite technical. But it’s not really. In fact it’s quite important.
Say you are aiming for 2% inflation – then that’s your goal. If you are above 2%, you should try to get down from there. If you are below it, you should try to get up.
This is one reason the European Central Bank’s inflation target is “below, but close to, 2%”. It’s an “asymmetric” inflation target – if the number is above 2%, you’re in a bad place.
As far as central banks go, it is one of the “harder” currency inflation targets out there, which is both to encourage confidence in the euro and to keep the Germans happy.
If you look at the Bank of England, on the other hand, the inflation target is 2%, with the governor having to write a letter to apologise to the chancellor if inflation falls below 1% or goes above 3%. This is a symmetrical inflation target – it’s as bad to be close to prices falling or being static as it is to be well above the target.
Anyway, having a straightforward inflation target of 2% (which is what the Fed also adopted in 2012) suggests that you want to keep inflation knocking around those levels at any given time.
However, if you aim for a 2% average over a period of time, then that’s a different thing. If you want inflation to average 2% over the course of a year, and you spend the first six months at 1%, then you’re going to have to average 3% over the final six if you want to hit the 2%.
In other words, to hit your target over the period, you would have to actively encourage and accept inflation rising to 3%. Otherwise you’d be in dereliction of duty.
In effect, this is “price-level targeting” – it’s the idea that when inflation is “too” low, you need to have an offsetting period of time when it’s “too” high.
Another step on the road to an inflationary denouement
Of course, if you looked at an economy where inflation spent most of the first half of the year near 1%, then the latter half climbing towards 3%, then you’d probably be at least a little bit concerned that inflation was going in the wrong direction fast.
And you’d be right.
But let’s say that this economy is also heavily indebted, to the extent where the people running monetary policy were aware that raising interest rates would cause a huge recession. The most obvious route out of that sort of stick situation is to get rid of the debt.
The least painful way to get rid of debt (at a societal level, if not at the individual level) is by inflating it away. You don’t have to have any uncomfortable discussions about who wins and who loses in the debt jubilee. Instead you have a stealthy solution that is no more fair, but doesn’t involve obvious picking and choosing of favourites.
And if you’ve just gone through a period of low prices or deflation, then the perfect excuse is to have some form of price-level targeting. Because then you have carte blanche to do whatever it takes to actively drive inflation higher, to compensate for the deflationary days you’ve just come out of.
Crucially though, it does rather depend on people not entirely realising that this is what you’re trying to do. It’s fine if people suspect that it’s what you want to do. But you need to have plausible deniability on your side – you can’t just stand up and say: “it’s our policy to penalise savers and lenders by eroding the value of debt.”
Hence the jargon.
Will this happen? We’ll find out later this year. My main point is that it’s just another official endorsement of the “inflation at any cost” policy.
I write a lot more on inflation, the Fed, and the long-term challenge to the dollar as the global reserve currency in the upcoming issue of MoneyWeek, out on Friday.
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