Sometimes you can learn the lessons of history too well. Today’s top central bankers formed their ideas about monetary policy from the inflation of the 1970s and the recessions that followed. The slump that began in 2008 is different, and calls those ideas into doubt.
As a result, a consensus that was almost unquestioned five years ago -- that central banks should be shielded from politics and given a simple mandate to keep inflation low -- may be breaking down. What might replace it isn’t clear.
The upheaval caused by the recent recession challenged monetary orthodoxies in at least one very specific way. In ordinary circumstances, central banks control demand through short-term interest rates. What happens when they lower interest rates and demand is still anemic?
Once rates are close to zero, monetary policy has to look for other ways to stimulate demand. That’s where quantitative easing comes in. As the recession dragged on, central banks bought long-dated government bonds and other securities to press down on longer-term interest rates directly.
The “zero lower bound” unsettles the old thinking partly because it demands untested innovations such as QE, but also because it attacks the earlier consensus head on. The logic of monetary policy under current conditions may call for a spell of deliberately higher inflation -- higher, that is, than the inflation target the central bank has previously committed itself to.
The details get complicated, but the basic reasoning is straightforward. Although nominal interest rates can’t fall to less than nothing, real (inflation-adjusted) interest rates can. To push real short-term interest rates as low as it deems necessary, a central bank merely has to achieve a sufficiently high rate of inflation. (A nominal interest rate of 3 percent is a real rate of 3 percent if prices are expected to be stable, but a real rate of only 1 percent if inflation is expected to be 2 percent.)
In fact, the central bank only has to promise to raise inflation and be believed -- that’s enough to change real rates. This is a promise a central bank, and only a central bank, is in a position to make.
Could it therefore make sense for the Federal Reserve to promise, say, three years of 4 percent inflation as a way to drive real short-term interest rates lower? Theoretically, it turns out, the answer is yes. Yet the idea fills most central bankers, raised on the consensus forged in the 1980s, with dread.
The dread is understandable. If higher inflation becomes entrenched, bringing it down again may require a policy-induced recession. Any central banker will tell you that anchoring inflation expectations is vital for economic stability. Few want to be suspected of even considering a controlled dose of higher inflation -- in fact many would say there is no such thing.
This thinking is counterproductive. Modern central banks pay lip service to the idea of transparency and insist they want their actions to be better understood. When it comes to discussing the trade-off between inflation and a more rapid recovery, they prefer to look away.
Lately, however, this reluctance has collided with the inescapable reality that, with all the advanced economies growing so slowly, maintaining or increasing monetary stimulus through QE is necessary. At the same time, central banks know that doing QE while promising to keep inflation very low is partly self-defeating.
Which brings us to the important question: As part of a new monetary-policy framework, can central banks openly aim for a therapeutic spell of higher-than-target inflation while containing the danger that the treatment would go too far?
The answer’s unclear, and the central banks’ unwillingness to confront the issue squarely isn’t helping the discussion. Our view is that a new target, tied to nominal incomes or to the level of future prices rather than the rate of inflation, could serve this purpose. (For a more thorough examination of this idea, see this accompanying essay.)
There are good reasons to fear inflation. But no one should be so afraid that the subject can’t even be discussed.
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