by Kenneth Rogoff
CAMBRIDGE – The world’s major central banks continue to express concern about inflationary spillover from their recession-fighting efforts. That is a mistake. Weighed against the political, social, and economic risks of continued slow growth after a once-in-a-century financial crisis, a sustained burst of moderate inflation is not something to worry about. On the contrary, in most regions, it should be embraced.
Illustration by Chris Van Es
Perhaps the case for moderate inflation (say, 4-6% annually) is not so compelling as it was at the outset of the crisis, when I first raised the issue. Back then, against a backdrop of government reluctance to force debt write-downs, along with massively over-valued real housing prices and excessive real wages in some sectors, moderate inflation would have been extremely helpful.
The consensus at the time, of course, was that a robust “V-shaped” recovery was around the corner, and it was foolish to embrace inflation heterodoxy. I thought otherwise, based on research underlying my 2009 book with Carmen M. Reinhart, This Time is Different. Examining previous deep financial crises, there was every reason to be concerned that the employment decline would be catastrophically deep and the recovery extraordinarily slow. A proper assessment of the medium-term risks would have helped to justify my conclusion in December 2008 that “It will take every tool in the box to fix today’s once-in-a-century financial crisis.”
Five years on, public, private, and external debt are at record levels in many countries. There is still a need for huge relative wage adjustments between Europe’s periphery and its core. But the world’s major central banks seem not to have noticed.
In the United States, the Federal Reserve has sent bond markets into a tizzy by signaling that quantitative easing (QE) might be coming to an end. The proposed exit seems to reflect a truce accord among the Fed’s hawks and doves. The doves got massive liquidity, but, with the economy now strengthening, the hawks are insisting on bringing QE to an end.
This is a modern-day variant of the classic prescription to start tightening before inflation sets in too deeply, even if employment has not fully recovered. As William McChesney Martin, who served as Fed Chairman in the 1950’s and 1960’s, once quipped, the central bank’s job is “to take away the punch bowl just as the party gets going.”
The trouble is that this is no ordinary recession, and a lot people have not had any punch yet, let alone too much. Yes, there are legitimate technical concerns that QE is distorting asset prices, but bursting bubbles simply are not the main risk now. Right now is the US’s best chance yet for a real, sustained recovery from the financial crisis. And it would be a catastrophe if the recovery were derailed by excessive devotion to anti-inflation shibboleths, much as some central banks were excessively devoted to the gold standard during the 1920’s and 1930’s.
Japan faces a different conundrum. Haruhiko Kuroda, the Bank of Japan’s new governor, has sent a clear signal to markets that the BOJ is targeting 2% annual inflation, after years of near-zero price growth.
But, with longer-term interest rates now creeping up slightly, the BOJ seems to be pausing. What did Kuroda and his colleagues expect? If the BOJ were to succeed in raising inflation expectations, long-term interest rates would necessarily have to reflect a correspondingly higher inflation premium. As long as nominal interest rates are rising because of inflation expectations, the increase is part of the solution, not part of the problem.
The BOJ would be right to worry, of course, if interest rates were rising because of a growing risk premium, rather than because of higher inflation expectations. The risk premium could rise, for example, if investors became uncertain about whether Kuroda would adhere to his commitment. The solution, as always with monetary policy, is a clear, consistent, and unambiguous communication strategy.
The European Central Bank is in a different place entirely. Because the ECB has already been using its balance sheet to help bring down borrowing costs in the eurozone’s periphery, it has been cautious in its approach to monetary easing. But higher inflation would help to accelerate desperately needed adjustment in Europe’s commercial banks, where many loans remain on the books at far above market value. It would also provide a backdrop against which wages in Germany could rise without necessarily having to fall in the periphery.
Each of the world’s major central banks can make plausible arguments for caution. And central bankers are right to insist on structural reforms and credible plans for balancing budgets in the long term. But, unfortunately, we are nowhere near the point at which policymakers should be getting cold feet about inflation risks. They should be spiking the punch bowl more, not taking it away.
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