Investors are starting to question whether central banks are out of monetary ammunition. They are increasingly sceptical that another round of asset purchases would do much good and many fear that cutting rates deep(er) into negative territory would prove counterproductive. The search is on for a new way to stimulate the economy.
You may be surprised to learn that the answer lies in a radical re-working of ‘forward guidance’ Many investors dismiss the central bankers’ recent habit of talking about the decisions that they may take in the future as a statement of the obvious – that policymakers will raise rates once they are sufficiently confident that inflation will return to target. The radical re-write of forward guidance involves something quite different: it signals a fundamental shift in monetary strategy.
Too little inflation is thought to be just as bad as too much. A sustained period of low, no or sub-zero inflation is assumed to impose a significant cost on society. One way to gauge that cost is to think about how far the price level has fallen below the path it would otherwise have followed if the central bank had been achieving its target for inflation. Policymakers will try to avoid this situation occurring by pre-emptively easing policy in response to shocks but once in deflation, they will simply try to drive inflation back to the target. As far as the price level is concerned, bygones are bygones. The price level will remain permanently below the path it might otherwise have taken. This is the point of departure for the re-working of forward guidance.
Rather than simply trying to achieve the inflation target, in the future policymakers could attempt to compensate for their failure to achieve that target in the past by driving the price level back towards its pre-crisis path. But in order to right the wrongs of recent history, the central bank has to systematically over-shoot the inflation target in the future and the larger the undershoot over the past, present and near-future, the larger the over-shoot that must be delivered in the future. In effect, the inflation target is temporarily suspended and a target path for the price level put in its place. Policy must be kept looser for longer to achieve that path, an that should lead to easier monetary conditions today as investors anticipate lower real interest rates in the future.
Unfortunately, implementing a target path for the price level is problematic for two reasons:
(i) Firstly, investors may question whether the central bank will keep its word and keep policy loose once inflation is back in line with the target, or whether it will find some excuse to renege and switch back to a stance consistent with inflation targeting once the danger of deflation has passed.
(ii) Secondly, some investors may question whether the central bank will be able to deliver above-target inflation even if it wanted to, given the persistent weakness of inflation. If investors do not believe that the over-shoot will happen for either or both reasons then the guidance will prove ineffective: monetary conditions will not ease today.
The best that the central bank can do to solve the first problem is to publish an explicit target for the required increase in the price level (or perhaps the level of nominal GDP) and then stake its reputation on achieving that goal. The solution to the second problem lies in announcing a significant easing in the stance alongside the commitment to convince investors that you will do whatever it takes to achieve the goal.
This is not an academic debate. The principle of aiming for over-shoots was referenced in the Accounts of the latest ECB meeting. After all, the ECB’s latest projections (from December 2015, the next set being due in March 2016) point to a significant cumulative shortfall in the price level by end-2018 (see exhibit 1). However, it is a big step from thinking about over-shoots to making a binding commitment to deliver them and announcing the large stimulus package that would make that commitment credible. This is probably too large of a step for the Council to take at their next meeting on 10 March 2016 in Frankfurt. But, if the situation continues to deteriorate then the Council may slowly come round to the idea, as it did to the idea of Quantitative Easing (QE). It will be important for the entire Eurosystem (including the Bundesbank) to back the strategy, if and when it is adopted. After all, the acid test for this strategy is what you do when inflation is over-shooting the target and by that point, there will be a new President at the helm of the ECB. What seems clear is that if any central bank commits to over-shoot and the strategy is perceived to deliver results – in particular, raising inflation expectations – then others are likely to follow in their footsteps.
Exhibit 1: Falling short – the ECB’s latest macroeconomic projections suggest the rate of inflation (consumer price inflation in percentage, year-on-year terms) in the eurozone will not reach the ECB’s stated target of ‘close to but below 2%‘ by the end of 2018