Two initiatives in central banking circles have attracted global attention as of late, one by the U.S., the other by Europe. The two new policies are different in nature, but both are a departure from past practices— something that may eventually put the two central banks’ credibility at stake.
The first is the Average Inflation Targeting (AIT), which the U.S. Federal Reserve initiated in August 2020 — a departure from the conventional framework of inflation-targeting. The Fed set a 2% long-term inflation target in 2012, but actual inflation has remained disappointingly below the target and long-term inflation expectations have been sluggish over the past two years.
Theoretically, the new framework should be more powerful in terms of raising inflation, since the duration of the current monetary easing measures of a virtually zero-interest rate policy will surely be extended, given that the underperforming period of the previous policy will be added to the future period of maintaining the low interest rate course.
Under the new framework, the Fed intends to offset periods that undershot the 2% target with periods that overshot the target rate. For example, if an inflation rate of 1.5% continued for the past three years, the current low interest rate policy will be maintained until an inflation rate of around 2.5% is achieved from now on for the next three years or longer, which would average out to the 2% target.
As individuals, companies and markets fully understand this and begin to expect future inflation to be higher and stabilize at around 2%, these changes will immediately lead to a higher actual inflation rate and long-term inflation expectation.
However, the Federal Reserve adopted this looser form of average inflation targeting without indicating how precisely and how long the average 2% will be pursued. As Federal Reserve Chair Jerome Powell admittedly called it, it’s a “flexible form.”
As a result, the difference from the conventional framework has become too ambiguous for the public to understand. Perhaps because of this, long-term inflation expectations after the announcement have remained sluggish. The vague expression may be due to the fear that inflation might accelerate excessively if inflation exceeding 2% is permitted for many years.
Furthermore, there are new risks in the new framework.
As long as the inflation rate doesn’t rise above 2%, the current low interest rates will have to be maintained — which could erode confidence in monetary policy. It’s a high-risk tactic, because no additional monetary easing tools were added.
Maintaining excessively low interest rates for too long could spur the depreciation of the dollar, which would further flood the global financial sector with excess liquidity, leading to asset bubbles. That would further cause a disconnect from the real economy, as well as worsening income and asset inequality.
On the other hand, the European Central Bank (ECB) issued a positive, forward-looking initiative in September. Beginning next year, it will accept sustainability-linked bonds as collateral for bank loans and as assets eligible for its asset-purchase programs.
While the ECB has been buying green bonds in the private sector, this move is in line with the European Union’s new growth strategy of a so-called “European Green Deal,” which will promote investment and employment in industries and projects that contribute to the greening of the environment, such as renewable energy.
To that end, the EU has developed a framework to classify environmentally sustainable economic activities. The ECB will focus on sustainability-linked bonds whose coupons are tied to performance targets based on environmental objectives set out in the EU’s taxonomy regulation and others.
Before assuming her current post, Christine Lagarde, the president of the ECB, expressed her willingness to work on the greening of assets held by the ECB. Criticism has been growing that many of the corporate bonds held by the ECB are issued by companies with high emissions.
The ECB is currently conducting a monetary policy strategy review that also includes how it can respond to climate change. The ECB maintains a market-neutral principle of buying financial assets based on the size of the market for each asset. This principle may be abandoned in the future to promote the greening of assets through the active purchases of bonds issued by companies with low emission track records.
If that happens, the time may come when the central bank may place greater emphasis on environmental sustainability in its operations — in addition to its traditional mandates of price and financial stability. The flip side is that the ECB may become overburdened by having additional objectives when it has already been failing to achieve the price stability target of about 2% for the better part of the last eight years.
Both central banks face challenges ahead in demonstrating the credibility of their respective monetary policies if the inflation target cannot be achieved.
Further monetary easing may become inevitable for the Fed to make the AIT effective and for the ECB to justify greater emphasis on the environment.
Sayuri Shirai is a professor at Keio University and a former Policy Board member of the Bank of Japan.
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