Here is a thought experiment that illuminates the challenges facing macroeconomic policymakers in the United States and the rest of the industrial world.
Imagine that in a brief period, inflation expectations around the industrial world, as inferred from the indexed bond market or the inflation swaps market, rose by nearly 50 basis points to a level well above the 2 percent target, with larger increases foreseen at longer horizons. Imagine that at the same time, survey measures of inflation expectations such as those calculated by the University of Michigan and New York Fed in the United States were rising sharply. Imagine also that commodity prices were soaring and that the dollar experienced a once-every-15-years decline. Imagine that the market anticipated future monetary policy in the United States that was far tighter than the Fed’s own policy projections. Imagine that measures of gross domestic product growth were accelerating, with increasing signs of a worldwide boom. Imagine also that no serious efforts were underway to reduce budget deficits. Finally, suppose that policymakers were comfortable with current policy settings based on the argument that Phillips curve models predicted that inflation would revert over time to target due to the supposed relationship between unemployment and price increases. I think it is fair to assert that in this hypothetical circumstance, there would be pervasive concern that policy was behind the curve — that much was at risk as inflation expectations were becoming unanchored and that a substantial set of policy adjustments were appropriate. The key point would be that allowing not just a temporary increase in inflation but also a shift to above target inflation expectations could be very costly.
We are living in a world that is the mirror image of the hypothetical one I just described. Market measures of inflation expectations have been collapsing and, on the Fed’s preferred inflation measure, are now in the range of 1 to 1.25 percent over the next decade. Inflation expectations are even lower in Europe and Japan. Survey measures have shown sharp declines in recent months. Commodity prices are at multi-decade lows, and the dollar has only risen as rapidly as it has in the past 18 months twice during the past 40 years when the value of the dollar has fluctuated freely. The Fed’s most recent forecasts call for short-term interest rates to rise almost 2 percent in the next two years, while the market foresees an increase of only about 0.5 percent. Consensus forecasts are for U.S. GDP growth of only about 1.5 percent for the six months from October to this month. And the Fed is forecasting a return to its 2 percent inflation target on the basis of models that are not convincing to most outside observers.
Despite the apparent symmetry, the current mood is nothing like the one posited in my hypothetical example. While there is certainly substantial anxiety about the macro environment, as judged from the meeting of the Group of 20 major economies in Shanghai last month, there is no evidence that policymakers globally are acting strongly to restore their credibility as inflation expectations fall below target. In a world that is one major adverse shock away from a global recession, little if anything was agreed upon to spur demand. Central bankers communicated a sense that there was relatively little left that they could do to strengthen growth or even to raise inflation. This message was reinforced by the highly negative market reaction to Japan’s move to negative interest rates. No significant announcements regarding non-monetary measures to stimulate growth or a return to target inflation were forthcoming.
Perhaps this should not be surprising. In the 1970s, it took years for policymakers to recognize how far behind the curve they were on inflation and to make strong policy adjustments. Policymakers continued to worry about a supposed lack of demand long after it was an important problem. The first attempts to contain inflation were too timid to be effective, and success was achieved only with highly determined policy. A crucial step was the abandonment of the idea that the problem was structural in nature rather than driven by macroeconomic policy.
Today’s risks of embedded “lowflation” tilting toward deflation and of secular stagnation in output growth are at least as serious as the inflation problem of the 1970s. They, too, will require shifts in policy paradigms if they are to be resolved. In all likelihood, the important elements will be a combination of fiscal expansion drawing on the opportunity created by super low rates and unconventional monetary policies and, in extremis, further experimentation with unconventional monetary policies.