Rather than take drastic measures to fight what market participants are calling ‘lowflation,’ Mohamed El-Erian says that it may be better for central banks to stick with the plan they have. He writes at Bloomberg:
Having failed to meet the 2 percent target despite aggressive monetary policy, it is far from obvious that central banks would be able to meet a higher objective. And no one is quite sure how the political system would respond to a central bank that pursues much higher inflation as it tries to offset the shortfalls of prior years. Indeed, until we have a better understanding of how the transmission mechanism has evolved, there is no guarantee that a change in policy approach would do anything more than threaten even greater collateral damage and unintended consequences.
Already, economies on both side of the Atlantic must contend with the risk that a loose monetary policy approach may have overly repressed financial volatility, excessively boosted a range of asset prices beyond what is warranted by economic fundamentals, and encouraged too much risk-taking by non-banks. Indeed, in the Fed minutes, the central bank staff noted that “since the April assessment, vulnerabilities associated with asset valuation pressures had edged up from notable to elevated.” Robust job creation, financial conditions, and the overall health of the economy should guide monetary policy formation rather than the excessive pursuit of a still-misunderstood lowflation.
The lowflation demon is real and, in the case of the U.S., the market now believes that it will likely dissuade the Fed from delivering on the next signaled step in the gradual normalization of monetary policy, including an interest rate hike in the remainder of 2017. Yet a lot more work is needed to understand the causes and consequences of persistently low inflation. Until that happens, central bankers may be well advised to stick with the demon they know rather than end up with one of future financial instability that undermines prospects for growth and prosperity.
Read more here.
The risks of the Fed keeping interest rates too low for too long
Jeremy Jones, CFA
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