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Pessimistic central banks cannot handle the good news

Cardiff Garcia
Federal Reserve Board Chairwoman Janet Yellen
Jim Watson | AFP | Getty Images

You know the type. The relative or friend so congenitally pessimistic that good news unsettles him, as if he would prefer that a bad outcome justify his cynicism rather than embrace a happy surprise.

The central banks of advanced economies are stuck in such a mindset.

For the past 18 months they have witnessed economic growth with little inflation, and jobs growth with only modestly rising wages. Inflation fell to just two per cent in June for the Group of 20 biggest economies, the slowest pace in almost eight years, according to new figures from the OECD. Inflation rates in the US, the eurozone and Japan all remain well below their target.

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Yet Janet Yellen has pushed ahead with plans to start shrinking the Federal Reserve's balance sheet in September, Mario Draghi has sent mixed signals since his hawkish remarks at Sintra in June, and last month Haruhiko Kuroda once again pushed back the Bank of Japan's timetable for hitting its inflation target.

The good news that the Fed, ECB and BoJ seem hesitant to accept is not the lack of price or wage growth itself, but rather what it communicates: that an economic expansion without accelerating inflation suggests an economy that should be allowed to continue growing without policymakers slowing it down.

A central bank's willingness to tighten policy despite meagre inflation is sometimes considered optimistic, as policymakers expect the economy will return to full employment and targeted inflation despite less support from policy. But this is the wrong framing.

Pre-emptively tightening policy actually represents a deeper pessimism about an economy's room to expand before it runs into structural obstacles. Inflation after all is the result of demand outpacing supply — very roughly, consumers buying stuff at a faster clip than businesses can make the stuff — just as wage growth is the result of businesses hiring workers faster than workers become available. Withdrawing policy support requires the belief that the supply side of the economy won't keep up.

Which is why, again, it should be fantastic news that inflation remains unexpectedly weak despite surprisingly decent growth in developed economies since the start of 2016 — growth which itself survived the political volatility and populist mania that swept the US and parts of Europe.

Rather than greeting this development as a gift that allows them to keep bolstering their economies, central banks are instead cautious, as if they don't quite believe what is plainly manifest in the data.

The Fed's experience is instructive. Its pessimism is traceable to the early years of the recovery, with its proxy for the natural rate of unemployment rising and then peaking at 5.6 per cent by late 2011. In plain language, the Fed had estimated that if the unemployment rate fell beneath 5.6 per cent, inflation would accelerate.

As the pace of the labour market recovery strengthened, the actual unemployment rate plunged through that number all the way down to the current 4.3 per cent, with inflation still quiescent. The Fed's projection for the natural rate was also lowered to reflect the improvement, but its overestimation throughout the recovery reveals its excessive gloom all along about US economic potential.

Potential growth and the natural rate are conceptually useful but admittedly murky concepts. Economists lack the ability to measure them with any precision. But, at the very least, weak inflation is evidence that supply has kept pace with demand, even as weak wage growth is evidence that enough workers have become available to accommodate the rising need for them.

Had the Fed been more hopeful, it would have likely attempted a different, more aggressive policy from the beginning. Instead, throughout the recovery it has updated its approach only haltingly in response to the data — reluctantly launching multiple editions of quantitative easing, experimenting clumsily with its communications, repeatedly overestimating inflation and starkly demonstrating more tolerance for undershooting its target rather than overshooting.

Economists are increasingly reinvigorating the idea that, after a severe downturn, running an economy "hot", or temporarily above its inflation target, can further enlarge its potential. A failure to support even growth that merely reaches the inflation target would therefore risk a permanently, and needlessly, lower trajectory for recovery. Ms Yellen argued for more research into the idea last year but in January said that she herself would not provide a test case.

Too bad. A stubbornly downbeat friend can be ignored. But when central banks are obstinate in their lack of confidence, the world remains at their mercy if their pessimism becomes self-fulfilling.

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