“There was a time when there was a tight tie between inflation and unemployment,” said U.S. Federal Reserve chairman Jerome Powell on Wednesday, in response to a reporter’s question. “That time is long gone.”
If you want to understand why the Fed isn’t raising interest rates, or tapering bond purchases, or why – to borrow a line Mr. Powell used last summer – it’s “not even thinking about thinking about” those things, you have to look at how some ideas central to central banking have evolved over the past few decades.
Generals are always kitted out to fight the last war, and since the 1980s central bankers from Ottawa to Frankfurt have been eager, at times too eager, to go hard and heavy at the slightest signs of inflation. It was understandable, given the battle scars of the 1970s. Thereafter, “price stability” became the central banker’s creed. The mere hint of inflation above 2 per cent was believed to demand a swift and overwhelming response. Inflation below 2 per cent? That wouldn’t be a problem, would it?
Mr. Powell is not your grandfather’s central banker because this isn’t your grandfather’s economy. As the chair of the Fed reminded listeners on Wednesday, the past 25 years provided repeated examples of unemployment dropping to levels that old models assumed would cause inflation to rocket into the stratosphere, without anything of the sort ever happening.
In the 1990s and early 2000s, U.S. unemployment fell below 5 per cent – once believed to be the natural rate of unemployment, below which inflation would take off – with only muted inflation effects. Economists revised the U.S. natural rate down to around 4 per cent, but unemployment went below it in 2018 and 2019, again without triggering a spiral of higher wages and prices.
Mr. Powell is not saying that inflation no longer exists, or that a central banker should never take action to suppress it. It is rather that the trade-offs are somewhat different than they were once assumed to be, because international trade and labour markets are different than they once were. Acting against inflation, before there is inflation, would now do more harm than good, with workers paying the price.
The worry of the past decade has been not inflation but deflation – persistent low demand, in a co-dependent relationship with persistent, self-reinforcing low growth. It’s why the Fed and the Bank of Canada have interest-rate trigger fingers that aren’t particularly itchy.
As a result, while Wednesday’s Fed statement stressed the need to keep inflation expectations anchored around 2 per cent, the U.S. central bank said that means “aiming for inflation moderately above 2 per cent for some time.” Why?
Because inflation has long run lower. Two per cent is the target; it’s not the maximum level, with higher inflation earning a failing grade, and lower earning bonus points. If anything, inflation moderately below 2 per cent may be far more dangerous than inflation moderately above.
The Fed wants inflation averaging 2 per cent over the long term, which means that if the pace falls below target in a recession, it will be allowed to exceed it for a time thereafter.
And Mr. Powell stressed that he won’t be withdrawing any monetary stimulus yet – or even thinking about thinking about it – because the prediction of the coming rapid economic recovery is just that: A prediction. Stock markets are pricing it in, as are bond markets. It will hopefully come to pass. But the Fed isn’t interested in tightening its extremely supportive monetary policy until it sees hard evidence of the need for such a move.
Expect to hear likewise from the Bank of Canada, because to the extent it does not align with the Fed, it risks pushing up the loonie, and undermining exports.
Are there dangers in all this? Yes. Just look at Canada’s housing market.
Years of cheap money may not have caused a spike in the consumer price index, but it has led to a non-stop run up in the price of real estate. Canada has little wage-and-price inflation, and a lot of asset-price inflation.
The answer, however, is not for central bankers to cool the housing market by slowing the economy. It’s for Ottawa to take steps to encourage investment in productive assets, while discouraging the kind of borrowing that is blowing up bubbles, and making Canadian housing unaffordable.
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