Cental banks told to ditch inflation targeting, focus on debt

Inflation targeting is ‘like a compass with a broken needle’, says BIS economist Claudio Borio.

US Fed chairwoman Janet Yellen says ‘additional gradual rate hikes are likely to be appropriate over the next few years’. Picture: AP

One of the world’s leading monetary economists has launched an unprecedented attack on the inflation targeting framework that has guided central banks for the past 20 years, saying it is “like a compass with a broken needle” and needs to be overhauled.

Claudio Borio, who is head of the monetary and economic department of the Bank for International Settlements, says central banks have much less influence on inflation and much greater impact on “real” (after inflation) interest rates than the globally accepted theories of central banking suggest.

In a provocative speech in London on Friday, Borio said central banks should relax their efforts to get inflation back to their target bands and instead pay greater attention to the dangerous build-up of debt that ultra-low interest rates have encouraged.

He said his analysis showed “the desirability of greater tolerance for deviations of inflation from point targets while putting more weight on financial stability”.

Although the Swiss-based BIS acts as a central clearing house for the world’s central banks, it has often taken an independent and critical approach to central bank orthodoxy. Borio has long urged that central banks should pay greater heed to financial stability, having co-authored key papers on the subject in the early 2000s with Philip Lowe, now Reserve Bank governor.

However, Borio’s speech goes much further than suggesting a shift in emphasis, declaring that the intellectual foundation of modern central banking is flawed. The failure of inflation to respond to either a decade of record low interest rates or the fall in unemployment to historic low points in major economies points to the failure of central bank theory.

That theory, which is based on work done by a Swedish economist Knut Wicksell in the late 19th century, holds that in any economy, there is a natural return on capital. When interest rates are set below that level, savings would fall and spending would rise, pushing inflation higher. When rates are set above that natural, or neutral level, savings rise, and spending and inflation fall.

WEB Business Uren debt soars

Where the central bank sets its policy interest rate has no effect on the natural or neutral rate of return, which instead responds to factors such as productivity, economic growth, demographic variables and, according to the work of French economist Thomas Piketty, The Economics of Inequality. The central bank’s rate of interest just affects the price level. It is argued that long-term bond rates set by the market ultimately converge on the neutral rate.

“Inflation is the compass needle that is supposed to tell us where the natural rate is: control inflation and you will know that you have reached your destination,” Borio says, before adding the needle is “broken”.

Borio says the idea of a neutral or natural rate of interest is “an abstract, unobservable, model dependent concept” that is hard to establish. “If one takes the model as true, it becomes almost a tautology to say that, since inflation is not rising and economies are close to full employment, the natural rate must have fallen.”

US Federal Reserve chairwoman Janet Yellen last week expressed the outlook for US rates in precisely these terms as she explained why rates would have to rise, despite core inflation in the US falling this year. She said that while the neutral rate of interest had fallen, it was still higher than the current federal funds rate, which remained stimulatory.

“Because we expect the neutral level of federal funds rate to rise somewhat over time, additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion,” she said.

However, Borio says there is no independent evidence for what the existence of a neutral rate. The BIS has analysed the factors thought to influence real (after inflation) interest rates going back to the 1870s across 19 countries, and then looked at what monetary policy was doing at the time. Although the relationships hold over the last 30 years, they break down when going further back in history.

“No consistent pattern emerges — a sign that the relationships may be spurious,” Borio says.

During the gold standard period, central banks did not shift interest rates when output or unemployment varied, but after-inflation interest rates did not react, with price levels and interest rates remaining stable and varying little over long periods. “Nominal and real interest rates were remarkably stable and did not deviate much from each other.”

However, there were huge swings in growth, the return of capital and the other variables supposed to influence real interest rates. Borio suggests that “monetary policy had a persistent impact on the real interest rate without exerting a strong influence on inflation”.

He argues that the long decline in both real and nominal interest rates over the last 30 years dates back to the efforts by former Federal Reserve governor Paul Volker to crack inflation by lifting rates in the early 1980s, and says monetary policy may have an effect on real interest rates lasting for decades.

“Milton Friedman’s popular dictum ‘inflation is always and everywhere a monetary phenomenon’ requires nuancing,” says Borio. “No doubt, there is a sense in which this dictum is true. Inflation cannot continue for very long unless the central bank accommodates it. And the central bank can surely bring inflation down if it wants to.”

However, he says real factors also have persistent effects on wages and prices. The impact of globalisation and technology are at the heart of the fall in inflation and central banks are powerless to reverse. Moreover, they are favourable forces, reflecting abundant supply rather than the weakness of demand, so there is no reason for central banks to try.

Borio says current policy is creating the risk of a “debt trap”, with low rates having encouraged so much debt to be accumulated that central banks can now not lift rates for fear of inflicting economic damage.

“The huge and long lasting costs of financial busts and banking crises are well documented. As long as monetary policy has a material influence on the financial cycle, such costs are simply too large to be ignored.”

Under Philip Lowe, the RBA has brought a much sharper focus to financial stability, which is now written into the bank’s agreement with the government. Lowe has also said he is no hurry to get inflation back to the 2-3 per cent target band and is mindful of the risks to financial stability from encouraging further household borrowing.

However, the RBA is far from abandoning the theory that central bank interest rates affect inflation. Assistant governor Luci Ellis commented last week: “We believe that, ultimately, the forces of supply and demand do assert themselves. Wage growth and inflation should therefore pick up in these economies at some point. However, it could take a while.”