Central banks need to come up with a new fix

This article appeared originally in Gulf News: link to original article

Is being close to full employment a good thing? This is the new obsession for central banks post the 2007-08 crisis.

A few central banks had close to zero interest rates, a few went as far as charging you for the money you deposit with banks, and others decided to print money to purchase debt and create liquidity in the market. Put in a different way, it’s a debt transfer from everyone else, except individuals, to the government.

The idea here is that banks, corporations, etc, recently enriched with the new print would be encouraged to hire more, and perhaps even increase the minimum wage and perks for current employees. For others, it may even mean reinstating previous packages and benefits that were reduced post-crisis in return for some form of employment.

And in the midst of all of that, there was inflation. The tale here is one about inflation, where the article will discuss the dilemma facing central banks today and what could be a possible way out.

When banks increase liquidity in markets, whether by spending from their foreign cash reserves or by printing money, inflation should follow. Or at least that’s what we thought we knew. This link however is now debatable.

Economists are talking about a broken link in the Philips Curve — rising inflation generates employment — where the relationship is not as straightforward as it used to be. So what happened? The zero and negative interest rates, as well as quantitative easing, are tools that markets are not accustomed to.

Firstly, interest rates were reduced close to zero. When that didn’t work, money was printed simultaneously. Other central banks introduced negative interest rates.

All in all, central banks were left with no room to manoeuvre rates further, neither were they able to further escalate their actions after central banks’ balance sheet reached record levels of debt. Inflation, meanwhile, stayed a mere target.

Central banks, as a result, are now looking for a U-turn. That started with the US announcing that it will start “tapering” its quantitative easing, which means reducing the monthly amounts the Fed spends to purchase debt from the markets. At the same time, it started hiking rates that sent shocks across all markets.

Printing money boosts inflation. Raising interest rates chokes inflation. And this is a scenario that other central banks would find themselves in. In addition to all of that, employment levels have increased in countries that applied the above mentioned tactics.

Relationship status? It’s complicated.

Logically speaking, all of the mentioned central bank remedies should have worked towards increasing inflation, prior to raising interest rates — even though one could debate that a gradual hike is not a major issue. Those remedies didn’t work because the inflation-employment link has broken, and possibly to a beyond-repair one.

Also, there is a post-crisis trauma, where governments and central banks want one thing, and people want a different thing altogether. The net result of that is inflation that wouldn’t budge.

Unconventional times require unconventional measures. The Philips curve may have become obsolete with the dramatic steps taken to provide liquidity and take a shot at a 2 per cent inflation rate.

This also means that governments spending money and expecting the public to thus go ahead and spend money cannot be taken for granted anymore. Governments should realise that different markets react to stimulus differently in different times, and that a more fine-tuned, targeted approach must be followed to achieve inflation and employment targets.

This includes, but is not limited to, revising central banks’ models as well as other models to incorporate new tools available to central banks, and possibly quantify and incorporate peoples’ behaviour prior to and post a financial crisis. The 2007-08 crisis is a whole new data point. The last thought that I want to leave you with: why a 2 per cent inflation target?