The West’s Punch Bowl Monetary Policy

Published on Project, by Sylvester Eijffinger and Edin Mujagic, March 01, 2011.

… In that sense, emerging-market countries’ central banks have learned the lesson of the 1970’s and 1980’s, when inflation ruled the world and crippled economic growth – in large part because central banks did not act in a timely fashion. Central banks like the Fed and the Bank of England seem to have forgotten that history.

So, what should Western central banks do? 

In the first place, use of a “core inflation” indicator should be put aside. There is much to say for using core inflation in conducting monetary policy and explaining decisions to the public, but only when price increases of food and energy – which core inflation strips out – are temporary in nature. That seems not to be the case any more.

In the United Kingdom, for example, supposedly “temporary” factors have been keeping the inflation rate well above the target for almost two years. The ECB recently published a report saying that food prices will most likely increase further, because demand is structurally higher than supply. The same can probably be said of various commodities, including oil, demand for which has been structurally underestimated.

Second, Western central banks should start rolling back the emergency measures put in place in response to the financial and economic crisis. This applies particularly to the Fed, which in the autumn of 2010 launched a second round of quantitative easing to stimulate economic growth and employment in the short run, but also to the Bank of England, which is criticized for being too lax.

Finally, in order to stand a chance of preventing inflation from increasing much further, real interest rates must, at the very least, be equal to zero or slightly positive. That has not been the case for a long time, and still is not the case with headline inflation running at 2.2% in the eurozone and 1.5% in the US. Even when we look at core inflation, real interest rates in the US are still deep in negative territory. The picture is especially grim for the UK, with the official interest rate at 0.5% and inflation at 3.3%.

In order to prevent inflation from spiraling out of control, the Fed should increase the federal funds rate from almost 0% now to at least 3% within a year or so. In the same timeframe, the ECB should move its official rate from 1% to at least 2%, while the Bank of England should aim for 5%.

Choosing a short-term boost to economic growth and employment, rather than enforcing price stability, wrecked the world economy in the 1970’s and 1980’s. The outcome may not be much different this time around if Western central banks maintain their current monetary policies for much longer.

For years, these banks’ officials have invited their counterparts from developing and emerging-market countries to conferences and meetings in order to teach them the tricks of the trade. Maybe now the time has come for the teachers to learn from their students. (full text).

(Sylvester Eijffinger is Professor of Financial Economics at Tilburg University in the Netherlands. Edin Mujagic is a monetary economist at ECR Research and Tilburg University).

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