Welcome the new world of managed inflation

The announcement by the Fed’s chairman, Jerome Powel during the virtual Jackson Hole meeting of central bankers last week that the Fed will now target an “average” rate of inflation of 2 per

cent rather than aiming for that in the short term surprised the markets. The implication was that monetary policy will remain accommodating for a long time to come and interest rates are

unlikely to rise much from their current 0-0.25 per cent range, even if inflation picks up to above the 2 per cent target. It also means that inflation may be higher than it otherwise might

be and for longer. Inevitably it has resulted in a slight steepening of the yield curve — meaning long term interest rates are rising ahead of short term rates — as a result, making it less

likely that we will see a recurrence of the inverse yield curve we’ve seen over the past year even if the economic recovery post-Covid loses some steam.

How significant is this move? It is an acceptance that previous decisions to raise rates at the first signs of accelerating inflation expectations, even when growth was tepid, may have been

a mistake. Jean Claude Trichet, the former head of the European Central Bank, did exactly that when he raised Eurozone rates twice in 2011 while the Eurozone was slipping back to recession.

That said, it is hardly a departure from recent policy, not just in the US but elsewhere in the developed world. It is more the confirmation of a trend that has been going on for some time

but hadn’t been voiced so clearly before — that monetary policy globally is no longer a tool to keep inflation under control, but a means to assist economic growth and prosperity overall.

At least now it is explicitly acknowledged that if inflation rises above target for a while after a period of undershooting, the Fed will not raise rates if the US is not maximising its

employment potential. It is not clear how long and how high inflation will have to be in these circumstances.

That has to be viewed against the fact that inflation in the US was just 1 percent in July and has averaged just 1.3 per cent since 2012. Low inflation has been enjoyed by many advanced

economies thanks to globalisation rather than brilliant central bank policies to contain it.

The truth is that monetary policy has come a long way in the last decade. Central bankers have become much more activist. They opted for unconventional monetary policy during and after the

financial crisis and have done so again in the wake of the Covid-19 pandemic. That has meant a massive injection of liquidity in the form mainly of Quantitative Easing, which involves buying

government bonds in the secondary market. And yet inflation has not gone up to any discernible extent. Economies have been able to sustain long periods of low unemployment without wages

rising sufficiently to fuel much higher inflationary expectations.

This new Central Bank activism has varied in size from place to place. It was taken up far more enthusiastically in the early years in the US, UK and Japan, with the ECB coming to it

slightly later under Mario Draghi. His successor at the ECB, Christine Lagarde, has followed this with an extra €1.3trillion pledge to help with the fallout from the Coronavirus crisis. This

includes buying government bonds across the region, including Greek bonds for the first time since the “Grexit” crisis.

Active monetary policy has its detractors — Germany’s constitutional court, for example. But politicians generally like it. Until the Fed started aggressively cutting rates again as the

Covid crisis mounted, President Trump was constantly accusing it of not relaxing fast enough. So-called “Abenomics” in Japan — named after the now departing long-serving prime Minister

Shinzō Abe — included the central bank of Japan offering a huge programme of QE. And President Macron just last week praised the ECB for buoying the European economy during the pandemic,

saying: “As long as we maintain this monetary policy we’ll get by”. As it happens, despite the extra liquidity so far, the Eurozone rate of inflation languishes at around 0.4 per cent,

Germany’s July inflation was zero and Spain is in deflation.

In the UK, inflation has been above target at various stages since the financial crisis and post-Brexit, but monetary policy has remained resolutely accommodating. The BoE announced new QE

in March, initially to the tune of  £200 billion. They have since added an extra £100 billion and more may follow. And its own inflation targeting policy is under review.

All the information we have shows that, if the Central Banks had stuck to the old ways, growth would certainly have been lower. What that means is that monetary activism is here to stay.

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