Central bankers, who pushed the boundaries of monetary policy in their fight against the financial crisis, are reverting back to their more cautious ways as they struggle to understand where the global economy is headed.
The recovery in the United States is wheezing, yet the Federal Reserve Board is determined not to overreact. The U.S. central bank's "accommodative policy is appropriate," Federal Reserve Bank of Chicago president Charles Evans told reporters in Indianapolis on Tuesday even as fresh data showed existing-home sales plunged in July to the lowest level since 1995.
Mr. Evans' comments show how the Fed is grappling with difficult choices as the U.S. economy continues to deteriorate. The latest U.S. housing numbers follow an alarming report last week that 500,000 Americans had filed for jobless benefits, suggesting the lack of employment remains a significant threat to the world's largest economy, where the unemployment rate was 9.5 per cent last month.
North American stock prices fell Tuesday as the 27-per-cent drop in purchases of pre-owned homes exacerbated worries that the U.S. could slide into another recession. Oil also dropped. The yen rose to a 15-year high as investors sought a safe haven from tumultuous U.S. markets.
"I am increasingly uncomfortable with the lack of noticeable improvement in the labour market," Mr. Evans told reporters, according to Bloomberg News. Mr. Evans, who participates in the Fed's debate about where to set monetary policy but lacks an official vote, said he expects a "very modest recovery" and that he likely will have to revise his growth forecast for 2010 lower.
Earlier this month, the Fed's policy setting committee reluctantly decided to resume purchasing Treasuries to keep interest rates low and cash in the system. A report in the Wall Street Journal Tuesday said at least seven of 17 officials who took part in the discussion on Aug. 10 opposed the move, suggesting there remains considerable unease about maintaining unconventional approaches to monetary policy.
"The case for aggressive monetary policy in the U.S. is pretty strong," said Bill Robson, president of the Toronto-based CD Howe Institute. "The difficulty is the exit strategy. The environment they are operating in is quite different from what they have seen historically. The mood is corrosive. That means the machine through which monetary policy is run isn't working as it normally would."
The global recession showed, among other things, that policy makers had underestimated the need to keep an eye on financial markets. But with the evidence of the crisis showing how misguided policy choices can cause severe damage, central bankers are extremely wary to adopt new theories until they've been thoroughly studied.
The same is true in Canada, where the central bank remains reluctant to change its approach to setting interest rates even though four years of research suggest a couple of alternative approaches hold promise.
Canada's current approach to monetary policy - raising and lowering the benchmark interest rate to keep the annual inflation rate advancing at about 2 per cent - has "shown its worth in both turbulent and tranquil times," John Murray, a deputy governor at the central bank, said Tuesday. "This represents a high bar against which any future changes must be judged."
Since 2006, the central bank has been studying the merits of dropping the inflation target to a rate lower than 2 per cent and the potential benefits of attempting to achieve a certain level of inflation over time, rather than tying policy decisions to the annual rate of price increases.
Speaking to the Canadian Association for Business Economics, Mr. Murray said the bank's research suggests both approaches show promise. A wide range of models show that "economic welfare" is maximized at inflation rates lower than 2 per cent and research suggests the gains from switching to price-level targeting "are probably positive," he said in his speech.
But "considerable uncertainty" remains about how large the gains from targeting a lower rate of inflation would be, Mr. Murray said. As for price-level targeting, he acknowledged that the Bank of Canada's models assume investors, executives and other economic actors understand it as well as they understand the current regime. Confusion would affect inflation expectations, and by extension, the path of inflation itself.
"It is a significant change," said Michael Gregory, a senior economist at BMO Nesbitt Burns in Toronto. "The economic backdrop may not be conducive to doing these kinds of changes right now. They have bigger issues than fine tuning the inflation target."
With a file from Bloomberg NewsReport Typo/Error