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The road not taken

25 August 2016 By Swaha Pattanaik

There is a big risk of missing the wood for the trees at Jackson Hole. As in previous years, investors will be monitoring the gathering of global central bankers, which takes place on Aug. 25-27, for clues about when U.S. policy rates will next rise. What matters more, however, is whether the Wyoming national park brings out iconoclastic tendencies in Federal Reserve Chair Janet Yellen and her international peers.

A global overhaul of monetary policymaking is increasingly pressing as reality challenges established economic orthodoxies. Central bankers are confronting some big questions. For example, why has inflation taken so long to pick up even though central banks have slashed interest rates to record lows and deployed unusual tactics, such as buying assets? Why is wage growth so sluggish even though unemployment is falling? Are developed economies simply doomed to grow more slowly than in previous decades?

These interconnected mysteries pose two problems for rate-setters. First, most of them target inflation, whose behavior they are increasingly unable to explain or control. Second, their current range of policy tools may not be up to the job if economies are indeed permanently stuck in a lower gear.

When the trend growth rate falls, so does what economists call the natural interest rate – the level of short-term rates at which monetary policy is neither too tight nor too loose. The lower the natural rate, the less room central banks have to reduce borrowing costs in a recession.

Yellen and her counterparts have little influence over the potential growth rate, which depends on broader factors such as demographics and productivity. These are matters for government policy. Nevertheless, central bankers need a new compass.

One idea doing the rounds is to be bolder and aim for inflation rates that are higher than the goal of around 2 percent used by most developed economies. Another is to target a steadily rising level of prices. This would force rate-setters who undershot their objective in one year to play catch-up the next.

But tinkering with inflation goals is an inadequate response to the current challenge. Central banks can hit such targets, as they did before the 2008 financial crisis, and nevertheless store up problems for the future. Or they can be so fixated in correcting a shortfall that they turn a blind eye to asset price bubbles that might be more detrimental to the economy.

Another option would be to switch to targeting a nominal level of gross domestic product (GDP), one of several alternatives recently floated by San Francisco Fed President John Williams. This makes some sense. After all, inflation targets are a means to an end: an economy where growth is ticking along nicely. So why not aim for that outcome explicitly?

One problem is that economic output depends on a host of factors that are beyond central banks’ control. They might need a whole suite of new powers to have even a vague chance of delivering a GDP target. This in turn would involve greater political accountability than is compatible with their independence.

A better option might be to simply require central banks to play their part in promoting sustainable economic growth and stability. This approach has drawbacks. Targets are easy to monitor. A vague objective would make it harder to judge whether rate-setters are doing their job properly. Investors might also find it harder to predict how central banks will behave, which would make asset prices more volatile and risk amplifying economic shocks. Businesses, employees, and consumers would no longer have an explicit anchor for their inflation expectations.

Yet none of this justifies clinging to targets. It’s already hard to blame Yellen and her peers for missing goals that are beyond their influence. And financial markets are already whipsawed by central bankers’ comments and decisions. Also, lower expectations of future inflation suggest that stated goals are no longer credible. The transparency and simplicity of aiming for an annual increase in prices is no longer any good for either rate-setters, who face increasing fire for doing too much or too little, or for politicians, who abrogated too many responsibilities in recent years. It’s time for the iconoclasts to topple central banks’ inflation targets.


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