Central bankers in rich countries seem to find it increasingly irresistible to scratch their itch for “normalisation”. In the FT today, Chris Giles notes a flurry of hawkish signals from the Bank of England, a full decade after it last raised interest rates. The Federal Reserve, of course, is plodding ahead with its tightening cycle and readying itself to reduce the amount of securities it owns - Wednesday’s release of minutes from its June meeting may give more hints of when. The European Central Bank rattled markets when Mario Draghi, its president, talked of reflationary forces last week. Roger Blitz has drawn up a scorecard of central banks’ policy signals and finds that several smaller ones, such as Sweden’s Riksbank, are beginning to lean in a less accommodating direction.
Among financial traders, there is even talk of a “Sintra pact”: the perception is that the meeting of central bankers in Portugal, where Draghi made his remarks, saw tacit co-ordination towards tighter policy. Although traders are prone to overinterpret the signals they see, there is some logic to this. If central bankers yearn for normalisation - of getting back to the pre-crisis normal - it would serve them to do so in a more or less synchronised manner to avoid causing financial imbalances in the process.
If this is the case, they are making a mistake. An understanding to “normalise” together, if one exists, would not be a suicide pact, unlike the universal and premature switch to severe fiscal consolidation in 2010. But it would be one of self-mutilation. As Gavyn Davies explains in his latest column, the global recovery is showing up in economic growth but not in accelerating inflation. Many had expected that once the big drop in commodities prices two to three years ago had worked its way through the price system, inflation would pick up again after being temporarily subdued. But there is no sign of this.
Davies suggests rightly that this looks like a positive global supply shock that would push activity and inflation in the opposite direction, as productive capacity expands more than anticipated. If that is indeed the cause of the present “lowflation” regime, monetary policy ought “to shift policy in the same direction as the signal from inflation, in this case towards less tightening”. That is not happening.
When Free Lunch examined the effect of commodity prices on inflation a year ago, we pointed out the curious finding that oil price shocks seem to affect inflation expectations up to 10 years into the future. The best explanation is that markets expect central banks to be unwilling to stimulate demand to catch up with the boost to an economy’s capacity that a positive supply shock creates, allowing the “output gap” between actual activity and full employment of the economy’s resources to persist for longer than necessary. Current conditions seem to bear out this view with inflation remaining stubbornly low and in some cases slowing. If a positive supply shock is really buoying the global economy, macroeconomic policy should be loosened, not tightened. (The exception is the UK, where Brexit constitutes an imminent negative supply shock - a much more unpleasant situation for a central bank to handle, and one complicated by its likely negative effect on aggregate demand, too).
The conclusion to draw from this assessment is rather sombre. It means, first of all, that central bankers’ desire for normalisation distracts them from fulfilling their mandates in a timely manner. Second, it entails real and unnecessary costs being borne by households and businesses in the form of lost income.
Finally, these cyclical considerations come on top of the fact that real interest rates consistent with a full-employment equilibrium have fallen, and, as Hélène Rey explains in her recent Andrew Crockett lecture, look set to stay low for some time. That means current policy is in fact more normal than the desire to normalise seems to presuppose.
We might all be better served by ditching the term normalisation altogether. It implies, incorrectly, that there is something wrong or excessive about the current monetary policy stance. If today’s policy conditions are abnormal, it is an abnormality that policymakers should embrace rather than avoid.
