In recent decades, central bankers’ job had become somewhat boring and frustrating. They were given independence in the 1990s, because that seemed the best way to ensure price stability. The prevailing view (then) was that leaving governments in control of monetary policy would result in economic stimulus that ultimately fueled higher inflation without any appreciable increase in output or employment. The solution was to appoint prudent technocrats whose only task would be to set and adhere to an inflation target.
In one sense, this approach was too successful. Inflation remained subdued for 20 years, and especially after the global financial crisis – an episode that taught central bankers the hard way about the vital importance of financial stability.
Price growth did not decelerate by much, even as the economy tanked in 2009 (the so-called “missing deflation puzzle”), and remained low when the recovery slowly gained steam and led to full employment.
During these two decades, inflation hovered in a narrow corridor around 2% in the United States, between 1-2% in the eurozone, and below 1% in Japan.
Of course, central banks claimed that this low and stable inflation was the result of their skillful monetary policy, despite the handicap of being unable to push interest rates much below zero.
But for an outsider, it remains puzzling as to why, for example, the European Central Bank could not achieve its previous inflation target of “below, but close to, 2% over the medium term,” despite implementing a bond-buying program worth trillions of euros.
The ECB’s own research purports to show that the bank’s asset purchases (quantitative easing) were very effective. But this raises the question of whether a few hundred billion euros more would have achieved the inflation goal.
Moreover, a critical review of central bank research suggests that quantitative easing was not as potent in fighting deflation as some made it out to be. It thus seemed that the ability of monetary policy to push up inflation to exactly 2% was limited.
For central bankers, this was a source of frustration. But the public did not care much, because deflation was never a live danger, and consumers do not really feel the difference between an inflation rate of, say, 1.2% and 2%. The longstanding absence of serious concerns about price stability may have been one reason why central banks recently ventured into other fields, like greening their monetary policy. Furthermore, because inflation had run slightly below target for many years, both the ECB and the US Federal Reserve updated their monetary-policy strategies.
Earlier this year, the ECB adopted a new symmetric 2% inflation target. And in 2020, the Fed stated explicitly that it would allow inflation “moderately above 2% for some time” if it had been persistently below this level previously. Moreover, the Fed, whose dual mandate includes promoting maximum employment, added that it would aim at limiting “shortfalls of employment.”
But the era of stable low inflation that prompted these changes has suddenly ended. Inflation is now increasing sharply on both sides of the Atlantic, owing to the combined impact of massive fiscal stimulus, a stronger-than-expected recovery of private demand, supply constraints stemming from logistical bottlenecks, and higher energy prices. Copyright: Project Syndicate 2021
Daniel Gros is a member of the board and a distinguished fellow at the Centre for European Policy Studies
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