Central Bank Innovation
Running out of tools
One of the main responsibilities of a central bank is to help its respective economy achieve price stability. Currently, the US Federal Reserve (the “Fed”), like many other central banks, is aiming for a 2% increase each year in the price of goods and services.
However, the rate of inflation has been stubbornly low in many developed economies since the end of the financial crisis. The US annual rate of inflation, for example, was last measured at 1.1% for the 12 months to end-August 2016. In Europe, the UK and Japan, central bankers are also struggling to get prices to rise by anything like the annual 2% target that they all hold.
This prompted John Williams, a key member of the committee that sets interest rates within the Fed to ask the rhetorical question: “is the Fed’s inflation target too low?”
Wages and inflation subdued
Intuitively, very low inflation might appear to be a good thing. But one of the main problems associated with low inflation is a corresponding lack of wage growth. Many pay deals are based on inflation rates. Since 2010, annual wage growth has been slowly recovering from around 1.5% to around between 2% and 3.5% in the UK and the US. However, this does not allow for underemployment, i.e. the proliferation of part-time work in which employees would rather be working and earning more. Low wage growth leads to low spending by workers, leading to slowing economic growth. So central bankers are keen to keep prices rising by a certain amount each year.
The lack of inflation is proving to be something of a conundrum. After all, according to economic theory, low unemployment should lead to more competition for jobs, resulting in higher wages. This increases the overall level of demand, which allows companies to put prices up. However, UK unemployment has fallen from more than 8% in the wake of the financial crisis, to less than 5% and yet wage growth and inflation remain stubbornly low. Between 2007 and 2015 wages in the UK fell by 10.4%, a drop equalled only by wages in Greece over this period.
The responses from central bankers so far have included record low, or even negative interest rates, and quantitative easing, (QE, effectively electronically “printing” new money). But their various stimulus measures have had limited success.
There are numerous theories as to why.
Globalisation is one culprit. Firstly, in a global economy, employers can effectively import talent from abroad, or outsource to overseas factories and call centres without raising wages. Secondly, in a global economy, there is worldwide competition, so domestic prices can only be pushed up so far before consumers turn to cheaper alternatives from overseas.
From 2000-2010, Western businesses were increasingly having to compete with China, which had increased its share of global exports throughout the 1990s from 2% to 10%. Global manufacturers flocked to China because of low wages and the cheap currency. This lowered the prices of consumer goods throughout the rest of the world. For example, in the UK, the clothing sub-index of the Consumer Price Index (the commonly used measure of annual inflation) fell by over 40% between 1990 and 2008 due to cheap imports from China and the Far East. But this drop was masked by the consumption boom in the UK that kept upward pressure on demand and prices. Cheap Chinese imports offset the effect of high domestic demand, keeping inflation steady and everyone was happy.
The financial crisis took the steam out of domestic demand and has since been compounded by falling commodity and energy prices over the past two years. This combination has made the prospect of getting inflation up towards its target level a considerable challenge.
But increasingly, economists and central bankers might consider that inflation targeting could be too simplistic an approach. It’s probably not possible to assess the true state of a complex economy by looking at one or two variables.
Instead, central banks might need to employ a broader range of tools that would afford them more choices and policy responses. Central bankers, including those at the Fed, are starting to debate this issue publicly. Mario Draghi, the President of the European Central Bank (ECB), has been explicit in his belief that governments need to step in and apply tax and spending measures to help stimulate inflation.
Many might argue that central banks have done all they can. At its most recent interest rates decision meeting, the Bank of Japan appeared to both abandon its two-year inflation target and prepare the way for it to withdraw from monetary policy measures further down the road. The Fed is considering raising interest rates at the moment, but this sets it apart from the other central banks. The likelihood of a rate rise in the UK seems unlikely in the near future, while the ECB has granted Mario Draghi the approval to extend its current round of QE, should the data imply that this could be necessary.
The cold fact is that there is only so much a central bank can do. Once interest rates are pushing down to zero, and asset prices have been distorted by QE, other measures have to be considered. If Mario Draghi has his way, fiscal policy will have to pick up the baton at some stage if inflation is to be supported.
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