Central banking has undergone an evolution. Jay Powell, who as head of the US Federal Reserve is arguably the most important economic policymaker in the world, has said he will tolerate higher inflation to boost growth and jobs in the US. That marks a significant shift in the framework that has shaped central bankers’ decisions for decades – that of inflation targeting.
Under this framework central banks promise to hit a price goal – usually of 2 per cent – over the course of the years ahead, regardless of their earlier performance. Mr Powell has broken with tradition by saying the Fed will pay attention to previous misses, and aim to average out inflation at 2 per cent over the longer term.
This evolution was sorely needed. As central banks gained independence to set rates as they saw fit over the course of the 1990s, inflation targeting helped boost credibility and offered political cover by providing a clear framework through which technocrats would make decisions. The economic thinking behind it was that when central banks clearly communicated their intentions, businesses and individuals would adjust their expectations of what would happen to prices. This, in turn, would help spur investment and keep wages in check.
Since the financial crisis the major central banks have largely fallen short of their targets, however, undermining trust in the framework along the way. Averaging out inflation is more realistic in that it gives the Fed room to better allow for factors – such as the pandemic – which have an economic impact that is beyond its gift to offset fully. It will also buy the Fed time to keep rates close to zero as the economy recovers, preparing the ground for stronger job creation.
However, the strategy carries risks. By moving the goalposts, Mr Powell is implicitly issuing a mea culpa for those earlier inflation misses. Some might query whether the framework should not be abandoned altogether. A question mark will hang, too, over whether or not central banks can ever spur inflation back up to 2 per cent – let alone higher than that. A big reason why policy makers have missed their targets in recent years is that they now have far less space to cut rates than they had in the past. While both the Fed and the Bank of England have yet to venture below the zero bound, negative rates have done far less to raise inflation than officials in the eurozone had hoped.
Mr Powell’s shift of stance will not remove suspicions that central banks are running short of ammunition: more must be done to boost their policy options. There is also a risk, under the averaging approach, that high inflation triggered by supply shocks could prompt the Fed to tighten policy too much in the face of weak demand.
Central bankers on both sides of the Atlantic remain wary of the Japanese experience of stagnant inflation and growth for decades despite aggressive easing. It was the fear of Japanification that drove Mr Powell early last year to launch a review of the Fed’s monetary policy framework, with others, such as the Bank of England and the European Central Bank, following suit. Yet Japan teaches us too that the effectiveness of boosting inflation via low rates and money printing is undermined without fiscal expansion and public confidence in the economic climate.
Mr Powell’s shift is no cure-all. Ultimately, to create the conditions under which economies can thrive, technocrats need the help of the lawmakers they serve. Yet his more pragmatic, relaxed stance on inflation will help provide firmer foundations for a recovery.