Why central banks should be “behind the curve”
Central banks in the United States, the UK, and Europe are increasingly shifting their monetary policy guidance to an explicit stance to let inflation run above their inflation target for a while before they react with higher interest rates. Some people who are afraid of runaway inflation criticise central banks for this commitment to being “behind the curve”, claiming that the consequences for the economy could be devastating.
Yes, the consequences could be devastating, but have they thought of the alternative? The problem that central bankers face (and why I would never accept a job on a monetary policy committee) is that they are trying to target an interest rate that cannot be measured directly and is only knowable long after the fact. Central bankers have to estimate the real interest rate that is consistent with an economy running at full capacity and inflation at the target rate – the real natural rate of interest, referred to as r-star.
If central banks overestimate r-star, they are hiking interest rates too fast and thus create an economic slowdown that creates higher unemployment and leads to disinflation or even deflation. Meanwhile, if they underestimate r-star, central banks are likely to leave monetary policy too loose for too long, creating higher inflation and an overheating labour market.
The San Francisco Fed has recently run a simulation of what would have happened in 2016, had the Fed been able to correctly estimate r-star back then, vs. what would have happened if they had overestimated or underestimated r-star. The chart below shows the impact on US unemployment. Note that the consequences to the economy are not symmetrical. If the Fed overestimates r-star and becomes too restrictive too soon, unemployment increases by 1.5 to 2 percentage points above the level that would be achieved with a correct estimate. But if the Fed underestimates r-star and remains too loose unemployment rates drop by about 1 to 1.5 percentage points vs. a correct estimate. Yes, the labour market overheats, but the relative damage is less than if the central bank is too restrictive.
US unemployment for different estimation errors of r-star
Source: Federal Reserve Board of San Francisco
But things become even more consequential if we look at inflation. A central bank that is too restrictive reduces inflation towards zero very quickly and may cause deflation very easily. A central bank that remains too accommodative, on the other hand, triggers higher inflation but not runaway inflation. Furthermore, we know how to fight runaway inflation. If inflation really gets out of hand and climbs above 3% or 4% and then stays there, all the central bank has to do is hike interest rates rapidly and surprise investors with these hikes. The Fed has done that in the early 1980s to end the runaway inflation of the 1970s and again in March 1994 when it hiked policy rates from 3% to 6% within 12 months. This is a particularly interesting episode because back in 1994, inflation wasn’t very high. The annual inflation rate in March 1994 was 2.5%. With the interest rate hikes in place, it topped at 3.1% and then immediately dropped back to 2.5% in spring 1995. The Fed’s intervention in 1994 was effective in catching inflation.
US inflation for different estimation errors of r-star
Source: Federal Reserve Board of San Francisco
However, for more than a decade now, the Fed and other central banks in Europe have had the opposite problem. They wanted to push inflation higher but couldn’t. One major problem is that monetary policy rates are now close to zero or negative. This means that if the central bank becomes too restrictive it doesn’t have the ammunition to loosen monetary policy enough to avoid the negative effects of disinflation and deflation.
And if know you can catch higher inflation that appears if you underestimate r-star but you don’t have any tools in place to avoid deflation if you overestimate r-star, the best policy is to err on the side of underestimating r-star and remain too loose in your policies for too long rather than restrict the recovery too soon. Zero interest rates change the game and central banks are right to change their policies as the game changes.