Recently, Borio et al (2018) wrote a paper about how monetary policy is stuck between a ‘growing financial cycle’ and low rates of inflation. Although the growing financial cycles ask for an increase in the rate of interest, low inflation forces central banks to keep interest rates low. But is inflation really the golden tool that central banks should count on?
The central bank sets the short term nominal interest rate and has, via this instrument and via asset purchases, the ability to influence long term nominal interest rates. Given the rate of inflation and the expected future rate of inflation, the central bank has the ability to set the real interest rate. The idea is that when the real rate is below the natural interest rate, inflation will pick up via an increase in aggregate demand that leads to an output level that is above the natural output level. So if inflation is below target, this means that the real rate is too high relative to its natural counterpart: the central bank must keep interest rates low.
But the problem is that the empirical link between inflation and output is not so clear. Borio examined the relation between inflation and output growth and found only a weak correlation between the two. However, there is a strong relation between the decline in asset prices and declines in output levels:
Source: Borio et al (2018)
So when inflation is not a good indicator of whether market rates are below or above the natural rate it might be dangerous to base monetary policy on it. It might just not be the golden tool to determine whether the economy is getting off its long term track or not. It might be that the buildup of financial imbalances gives us a better idea of whether the economy is moving off its long term growth path. The current policy of inflation targeting might then only make things worse, as the low rates fuel the further growth of financial imbalances.
Inflation is also used as an indicator that tells whether the unemployment rate is under or above its natural level. The natural level of employment is found by NAIRU (Non Accelerating Inflation Rate of Unemployment). When inflation is accelerating, it would mean that the unemployment rate is lower than its natural counterpart and vice versa.
The problem with the Phillips curve and with NAIRU is that policymakers can easily revise the estimates of potential output and the natural level of unemployment. So when inflation is lower than expected, one can just revise the estimates of the natural level of output downwards and the natural level of unemployment upwards in order to explain the lower inflation. These revisions are only correct if the assumptions are correct.
We seem to lean a lot on assumptions about inflation here. When inflation is being used as a golden tool while it is not, we might do the opposite of fixing the economy.