US Federal Reserve is way off target with its fixation on inflation
Stephen Roach says the misguided monetary policies of central banks are creating financial instability, and a new approach is urgently needed
Fixated on inflation targeting in a world without inflation, central banks have lost their way. With benchmark interest rates stuck at the dreaded zero bound, monetary policy has been transformed from an agent of price stability into an engine of financial instability.
The US Federal Reserve exemplifies this policy dilemma. After it decided last month to defer yet again its normalisation of monetary policy, its inflation doves are openly campaigning for another delay.
Their argument seems impeccable. The headline consumer price index is near zero, and "core" or underlying inflation remains significantly below the seemingly sacrosanct 2 per cent target. With a recovery looking shaky again, the doves contend that there is no reason to rush ahead with interest-rate hikes.
Of course, there is more to it than that. The Fed relies on an inflation-forecasting methodology that filters out the "special factors" driving the often volatile prices of goods like food and energy. This approach failed spectacularly when it was adopted in the 1970s, causing the Fed to underestimate virulent inflation. And it is failing today, leading the Fed to overestimate underlying inflation.
Missing from this logic is an appreciation of the new and powerful global forces that are bearing down on inflation. According to the International Monetary Fund's latest outlook, the price deflator for all advanced economies should increase by just 1.5 per cent annually, on average, from now to 2020 - not much higher than the crisis-depressed 1.1 per cent pace of the last six years. Moreover, most wholesale prices around the world remain in outright deflation.
But, rather than recognise the likely drivers of these developments - a shortfall of global aggregate demand amid a supply glut and a deflationary profusion of technological innovations and new supply chains - the Fed continues to minimise the deflationary impact of global forces. A price-targeting Fed has erred consistently on the side of easy money.
The consequences have been problematic, to say the least. Over the past 15 years, financial markets have become unhinged, with a profusion of asset and credit bubbles leading to a series of crises. Not only have central banks failed repeatedly to get the inflation forecast right; they now risk fuelling renewed financial instability and sparking another crisis. To be sure, inflation targeting was once essential to limit runaway price growth. In today's inflationless world, however, it is counterproductive. Yet the inflation targeters who dominate today's major central banks insist on fighting yesterday's war.
Stephen S. Roach is a faculty member at Yale University and former chairman of Morgan Stanley Asia. Copyright: Project Syndicate