Rewriting the central bank rule book on inflation

Central bank policy within the developed world has been marked over the past decade by a systematic failure to achieve pre-set inflation targets. In response central banks globally are reviewing the way they approach the setting of monetary policy. Over the longer term this change in behaviour further clouds the outlook for financial markets.

Central bankers have no model of inflation expectations

The great irony of modern monetary policy is that despite most central banks having adopted inflation targeting as an explicit objective there is no effective means of consistently modelling inflation expectations. This is not to say that central bankers don’t have ways of inferring the potential impact of actions on inflation expectations. Central bankers have at their disposal a broad range of observable data, including current inflation, historic patterns, as well as models/rules of thumb to assist in determining how inflation could behave going forward. There are however two central considerations which create an issue when trying to model inflation expectations with any form of consistency:

• External events, such as technological innovations, can alter the interlinkage between the various drivers of inflation expectations.
• More importantly the central banker’s own actions can become the key driver impacting inflation expectations. Most central bankers view that one of the key objectives of successful monetary policy is the anchoring of inflation expectations(1). The result of successfully achieving the anchoring of inflation expectations is that it is the ‘anchor’ itself which becomes the key driver of inflation expectations. Hence, one of the key factors altering the historical relationships with inflation expectations is the anti-inflation credibility of the central bankers themselves.

The issues associated with modelling such a key input as inflation expectations is particularly important given the long lags involved between changes in monetary policy and their impact on the economy. The existence of such lags has meant that to date central bankers have tended to base their actions upon medium-term (2-3 years out) forecasts of inflation.

Why is this increasingly relevant now?

The shortcomings inherent in the ability to model inflation expectations have become more relevant as central bankers have found themselves consistently undershooting their stated inflation targets. The consistent undershooting of inflation has occurred despite central bank forecasts signalling that based on traditional relationships, such as unemployment rates and wages growth, inflation should be moving back upwards towards their desired targets. This failure to have a working model for forecasting inflation expectations not only makes setting monetary policy more difficult but also removes a key means for managing inflation expectations. The ongoing disconnect between actual inflation and forecasts increases the risk that inflation expectations could become anchored materially lower than the central bank’s target. Due to this risk for the first time in nearly 30 years central bankers are trying to work out how to manage monetary policy to push inflation expectations higher.

The paradox faced by central bankers in pushing up inflation expectations

While, based on past experience, central bankers know how to reduce inflation expectations, the lack of a working model also makes it less clear how to go about increasing inflation expectations. The fall-back position for central bankers is to set aside forecasts to guide policy and expectations and to instead focus on actual inflation outcomes as the key guide. This highlights the paradox for central bankers that to manage an increase in inflation expectations via increases in actual inflation they must be prepared to allow inflation to rise higher than agents currently expect; i.e. remove the anchor around current inflation expectations. By allowing themselves to fall behind the actual inflation cycle central bankers can now reset inflation expectations at a higher level by weakening the current anchor point. Paradoxically, using actual inflation to push inflation expectations higher central bankers may need to undermine part of the very anti-inflation credibility they have worked so hard to establish in the first place; i.e. need inflation to overshoot on the upside.

Is a change in behaviour actually occurring?

Central banks are notoriously ambiguous regarding the drivers behind decision making but there are grounds for believing that a refocussing on actual inflation to determine policy is occurring. While in the past central bankers have tended to try and preempt increases in inflation, rather than try and act based upon a forecast increase in inflation, there appears to be an increasing bias for central banks to hold off acting until such time that inflation is rising. Indeed, several major central banks, most notably the US Federal Reserve, have more recently been highlighting the symmetry implicit in inflation targets. By doing so they are emphasising that after having undershot their inflation targets for some time they are prepared to accept a comparable inflation overshoot of the same target; i.e. the inflation target is an average and not an upper bound. Such rhetoric points to a recognition that to raise inflation expectations back towards the longer-term target requires proving to agents that higher inflation is not just a possibility but that it will be tolerated.

The central bank ‘rule book’ has changed

The ‘rule book’ by which central bankers have played for over a generation appears to be changing with the potential to create additional uncertainty for investors. This shift in policy reflects, among other things, the recognition that greater emphasis needs to be placed on actual inflation rather than inflation forecasts when setting monetary policy. While in the shorter term this shift in focus has been positive for financial markets, longer term its impact is less clear. By altering their perceived behaviour central bankers may be increasing the level of uncertainty in the financial markets as participants try and preempt changes in monetary policy. The end result of this heightened uncertainty is likely to be an increase in financial market volatility particularly in those markets which are more sensitive to changes in inflation. All this is of course academic to financial market participants while inflation stays low, but when inflation begins to rise then the impacts arising from this change in central bank behaviour will be felt by investors and they are unlikely to be positive.