Let’s take a quick break from worrying about coronavirus.Let’s take a look at the Federal Reserve’s inflation targeting regime instead. Stop right there! Don’t touch that “back” browser button! I promise you this will actually be interesting.
The US central bank, the Federal Reserve, is currently reviewing its monetary strategy. We’re likely to hear about the outcome before the middle of this year.
Given that the Fed is arguably the most important influence on the US stockmarket, the US bond market, and the US dollar, that means any policy changes it puts in place matter to investors, regardless of whether we want to admit it or not.
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So what do we need to watch out for? The key is the inflation target.
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The Fed’s strange approach to inflation
Today, the Fed has a 2% inflation target. Inflation in the US shouldn’t get too far above or too far below this level. If it goes above it, the Fed should tighten monetary policy. If it goes below 2%, it should loosen policy.
Inflation is now roughly around 2-ish% depending on the measure you use (it’s lower by the Fed’s preferred measure, right enough). However, it has spent quite a lot of time in recent years being well below 2%.
So now, rather than thinking about raising interest rates, the Fed is discussing whether it should allow inflation to run “hot” for a while. In other words, the Fed would tolerate inflation at quite a bit above 2%, to make up for the period of time during which inflation was “too low”.
At first sight, this idea is baffling. And to be honest with you, to anyone bar a central banker, it is pretty baffling.
The fate every central banker fears – turning Japanese
“Prices have not been rising quickly enough for the last decade. So we need to make sure that they rise much more quickly over the next decade so as to make up for it.”
That feels like a form of monetary masochism. I mean, most of us quite like the price of things to stay as low as possible. This feels like being told that we’ve had it too good for too long and now we must pay the price.
So here’s the rationale: central bankers place a lot of faith in the idea of inflation expectations. If the likes of you and I get too comfortable with low inflation, then we’ll stop expecting prices to go up. If we stop expecting prices to go up, we won’t be so desperate to spend money before its value collapses.
If we stop being so desperate to spend money, then the velocity of money (the rate at which money changes hands in the economy) will slow down. If the velocity of money slows down, then inflation will fall further. If inflation falls further, consumer expectations for future price increases will fall too.
Eventually we’ll end up in a spiral of doom, where no one spends anything because they think they’ll be able to get everything cheaper in the future. And thus deflation will take hold, the economy will go into deep freeze, no one will ever spend anything or do anything, and we’ll all sit at home until we starve, stubbornly refusing to buy cornflakes because we know that cornflakes will be 1p cheaper tomorrow.
OK maybe I’m exaggerating. A bit.
But basically all central bankers fear that their country will turn into Japan. Why turning into Japan – a nation with virtually zero unemployment whose GDP per head has grown at a perfectly acceptable rate relative to all of its peers – would be a bad thing is not all that clear to anyone but central bankers.
The half-baked foundations of our monetary system
One of the reasons I’m explaining all this to you, is to try to give you a sense of just how half-baked the foundations of our monetary regime are. We act like this is science – as though by pulling the right levers at the right time, a small group of central bankers can perfectly calibrate the economy.
This is patent drivel.
The real reason the Fed wants to change its inflation-targeting regime just now is because it needs an excuse to keep interest rates low.
I mean, if you genuinely think that inflation targeting should be symmetrical over time, then our recent disinflationary phase was surely only payback for the double-digit madness of the 1970s and early 1980s, no?
And the problems faced by Japan and the eurozone are nothing to do with inflation expectations. The problems there are all down to inefficient banking systems. That’s not something that either the US or the UK have a problem with.
So ignore the nonsense theories; it’s all about political pragmatism. The Fed can’t jack up interest rates because the S&P 500 can’t cope with rates being any higher than they are now. We saw that in the wobble of 2018.
In this sense, the MMT (Modern Monetary Theory, or Magic Money Tree, according to taste) people are right. The only restraint on government money printing is the point at which inflation becomes so painful that it cannot be ignored politically.
Of course, as history amply demonstrates, by that time you’re usually looking at the collapse of empire, riots in the streets, irreversible currency debasement and all that good stuff. But that’s all something to worry about another day.
For now, the point is this: the Fed will take whatever excuse it needs to keep interest rates nice and low for the foreseeable future. And if coronavirus gives it even half an excuse, expect to see more money printing before the year is out.
