Inflation fear shouldn’t constrain monetary policy

Central banks have more room to manoeuvre than inflation hawks think. Even temporarily excessive economic stimulus is unlikely to derail price stability, as a new IMF analysis suggests. Monetary policymakers should use this leeway – especially in the euro zone.

A nagging fear of out-of-control inflation is deeply engrained in the psyche of any proper central banker. For the time being though, they can relax. Current monetary policymakers enjoy more room to manoeuvre than past experiences – and today’s inflation hawks – suggest.

The unfortunate experience of the 1960s and 1970s makes it clear that the threat of an inflationary spiral is not purely hypothetical. However, new research by economists at the International Monetary Fund is comforting. The world has changed since then – because prices no longer move to the same extent as the economy. “Over the past decade or so, inflation in advanced economies has become less responsive to changes in economic slack.”

If prices had responded to the Great Recession that followed the 2008 financial crisis as they did in the 1970s, the U.S. economy would have plunged into deep deflation. The IMF calculates that even with the Federal Reserve’s easy monetary policy, prices would be falling at a 2 percent to 3 percent annual rate. In reality, the Consumer Price Index only fell briefly – by 2.6 percent in the two months between October and December 2008 – and has risen slowly and steadily ever since.

Behind this stability is a self-fulfilling prophecy. If producers and workers expect moderate inflation, they will push for only moderate wage and price increases, and will strongly resist wage and price cuts. Once central banks have a strong reputation for keeping prices fairly stable, the people’s moderate behaviour will help them retain it.

The monetary authorities’ strong reputation, and these well-anchored inflation expectations give much-needed leeway for an expansionary monetary policy – and a cushion of safety. Even if central banks managed to spark excessively fast growth – they should dream of such a problem – the anchors would hold. “Any temporary overstimulation of the economy is likely to have only small effects on inflation”, the IMF concludes.

Are you listening, Frankfurt? Many of the world’s most serious inflation-worriers hang around the European Central Bank. They should read the IMF study and worry less. There is room for more monetary stimulus, and the opportunity should be seized.

This article was initially  published as a Reuters Breakingviews comment on 09 April 2013.

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