From Stephen S. Roach, former Chairman of Morgan Stanley Asia and the firm’s chief economist, senior fellow at Yale University’s Jackson Institute of Global Affairs, and a senior lecturer at Yale’s School of Management. Notwithstanding the mainstream credentials, Roach has often swum against the tide on his economic calls, and he’s been right more often than wrong. His only mistake here is not mentioning debt as the overriding factor in deflation, but the rest of the article is pretty good. From Roach, at project-syndicate.org:
BEIJING – Fixated on inflation targeting in a world without inflation, central banks have lost their way. With benchmark interest rates stuck at the dreaded zero bound, monetary policy has been transformed from an agent of price stability into an engine of financial instability. A new approach is desperately needed.
The US Federal Reserve exemplifies this policy dilemma. After the Federal Open Market Committee decided in September to defer yet again the start of its long-awaited normalization of monetary policy, its inflation doves are openly campaigning for another delay.
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For the inflation-targeting purists, the argument seems impeccable. The headline consumer-price index (CPI) is near zero, and “core” or underlying inflation – the Fed’s favorite indicator – remains significantly below the seemingly sacrosanct 2% target. With a long-anemic recovery looking shaky again, the doves contend that there is no reason to rush ahead with interest-rate hikes.
Of course, there is more to it than that. Because monetary policy operates with lags, central banks must avoid fixating on the here and now, and instead use imperfect forecasts to anticipate the future effects of their decisions. In the Fed’s case, the presumption that the US will soon approach full employment has caused the so-called dual mandate to collapse into one target: getting inflation back to 2%.
Here, the Fed is making a fatal mistake, as it relies heavily on a timeworn inflation-forecasting methodology that filters out the “special factors” driving the often volatile prices of goods like food and energy. The logic is that the price fluctuations will eventually subside, and headline price indicators will converge on the core rate of inflation.
This approach failed spectacularly when it was adopted in the 1970s, causing the Fed to underestimate virulent inflation. And it is failing today, leading the Fed consistently to overestimate underlying inflation. Indeed, with oil prices having plunged by 50% over the past year, the Fed stubbornly maintains that faster price growth – and the precious inflation rate of 2% – is just around the corner.
Missing from this logic is an appreciation of the new and powerful global forces that are bearing down on inflation. According to the International Monetary Fund’s latest outlook, the price deflator for all advanced economies should increase by just 1.5% annually, on average, from now to 2020 – not much higher than the crisis-depressed 1.1% pace of the last six years. Moreover, most wholesale prices around the world remain in outright deflation.
But, rather than recognize the likely drivers of these developments – namely, a seemingly chronic shortfall of global aggregate demand amid a supply glut and a deflationary profusion of technological innovations and new supply chains – the Fed continues to minimize the deflationary impact of global forces. It would rather attribute low inflation to successful inflation targeting, and the Great Moderation that it presumably spawned.
To continue reading: The Wrong War for Central Banking
