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Today’s inflation hawks are crowing over nothing.Not only do we have the most divided Fed since 1992, we’ve watched the European Central Bank repeatedly refuse to cut interest rates all year despite the clearly flagging eurozone economy.
But honestly, it just doesn’t make sense.
Obviously, no one is about to deny that inflation can bring with it damaging consequences. It makes sense for central banks to maintain a strict watch over price stability. And both the ECB’s and the Fed’s success at sticking to inflation rates around 2% has — on the whole — been been exemplary for the last 12 and 20 years, respectively.
The fact remains that inflation is the lesser of three evils when compared with deflation and recession.
Deflation Is Dangerous
Morgan Stanley’s Global Economics Team explains the evils of both deflation and premature monetary tightening:
There is still no consensus today about how to escape deflation once the economy falls into such a state. Cognisant of this, economists’ single most important policy recommendation regarding deflation is: do not allow it in the first place! The practical monetary policy implication of this is to be aggressive and, perhaps more importantly, to be proactive in the face of downside risks…
The past also offers insights about what not to do…The policy prescription therefore is to avoid premature tightening, as this could tip the economy (back) into recession or deflation. The way we would put it is: err on the side of caution when exiting – in other words, it’s better to exit too late rather than too early.
A Little Inflation Isn’t That Bad And It’s Easier To Control
And exiting an easy monetary policy too late is not the end of the world. In the United States, where inflation stood stable at 2.0% in October, the reality is that modest inflation growth will not throw the economy down the tube, and has not proved difficult to bring under control in the last 20 years. Since 1991, the longest continuous period of inflation over 3% was just 14 months.
Again, from Morgan Stanley:
Erring on the side of caution likely implies exiting too late, which in turn means elevated medium-term inflation risks. Yet, it is rational for a risk-averse central bank to prefer the lesser of two evils: if inflation is the price for avoiding deflation, then so be it – because central banks know how to deal with inflation.
Recent Economic Data Is Not Great
In that vein, the economic data coming out of both the United States and Europe right now suggests that the Fed’s hawks and the ECB are being too stodgy about price stability.
In the U.S., we’ve seen a lackluster recovery amid mounting trepidation over the federal government’s debt sustainability and ability to get anything done. Sure, this month’s economic data outperformed expectations, but only because earlier predictions were so bad. The Citigroup Economic Surprise Index suggests exactly that. It shows that we started to see economic data beating expectations around August (when the slope turned more sharply upwards), but not because that data is particularly spectacular.
Targeting Nominal GDP
Not to mention the debate over whether the Fed should use NGDP, rather than real GDP, as a prime indicator of the U.S.’s ability to service debt. Along the lines of that thinking, the Fed would announce plans to increase the country’s nominal GDP in unconventional ways — think buying factories instead of Treasuries or Mortgage Backed Securities.
Supporters of this argument think that the money supply might still not be loose enough, and support this kind of plan even if it deliberately increases inflation. That idea has caused a stir recently, with various prominent investement firms and even Chicago Fed President Charles Evans hinting that the Fed might consider such a move.
Policymakers Need To Do Something Now
But regardless of this debate, the biggest concern in monetary policy today should be that the Fed might be running out of tools to do more to stoke the flames of growth if it has to — not that inflation in the medium term could be a bit of a risk.
Signs that growth in Europe is slowing down are even more ominous. Despite inflation of 3% in September, not even the ECB is talking about upside risks to price stability anymore as growth flags across the euro area.
Former ECB forecaster and current head of Nomura’s global inflation strategy team Laurent Bilke told Bloomberg, “The economic outlook in Europe is worsening, taking any future pressure out of the oil market, which means the inflation rate will fall below 2 per cent early next year.”
What’s more, it’s not even clear that 3% inflation — over target but completely reasonable in a developed economy — would be harmful.
The eurozone is in the middle of what could be an even greater crisis than Lehman. It simply will not make it out of this mess if it cannot restore growth. Non-standard lending and refi measures are not enough to do this in a deteriorating economic environment. Holding rates flat at 2.25% is simply not using the necessary tools to fix the EZ’s problems.
Inflation is bad, but recession and the threat of deflation are even worse. The Fed has seemingly done what it can but should certainly not be considering raising rates in what is very clearly a fragile recovery. The ECB can and must go further if it wants to even try to bolster growth and prevent sovereigns and banks from actually seeing the frightening impact of a worst-case scenario.
Both the ECB and the FOMC will make new policy decisions next week. Let’s just hope they ignore the hawks.
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