The Many Paths Ahead for Monetary Policy

I heard a common theme in my recent encounters with clients and central bank officials in Frankfurt, London, Beijing, Tokyo, Auckland, Wellington and Berkeley. Despite very different cyclical conditions and growth trajectories, central bankers everywhere generally think inflation is too low for comfort. Still, near-term policy paths are likely to diverge.

European Central Bank: The ECB expects eurozone inflation will return to 2% only very slowly, no matter what exact policy actions they take in December. There is a sort of “pent-up price deflation” in the eurozone to follow the trend in wage deflation, which we could read as a parallel to Federal Reserve Chair Janet Yellen’s “pent-up wage deflation” thesis for why U.S. wage growth has remained stagnant in recent years.

People’s Bank of China: In Beijing, officials and clients expressed a cautious view on the economic outlook. Yet, the message on currency policy was clear: A large devaluation of the yuan anytime soon is neither necessary nor likely. Together, these two messages suggest that further domestic monetary and fiscal easing is China’s most likely course of action.

Bank of Japan: The BOJ may stay on its current course until sometime next year or even later. Two reasons: We will likely see a supplementary budget bringing some fiscal easing for 2016, and “core core” inflation (what we call just “core” in the U.S., i.e., ex energy and food) has at last been trending up toward 1% recently, a trend I see as friendly to BOJ Governor Haruhiko Kuroda’s current programming. (For more on the BOJ and inflation, please see this recent post from PIMCO’s Tomoya Masanao.)

Reserve Bank of New Zealand: I’ve always viewed this small, open, commodity-producing economy with an inflation-targeting central bank as a leading indicator for similar economies such as Australia, Canada and Norway. The RBNZ, like many of its peers, is facing a dilemma: plunging commodity prices imply a negative terms-of-trade shock, inflation is running way below target, but domestic property prices are going through the roof. The response? Use macroprudential policy tools to deflate the property market while cutting interest rates further to weaken the currency and raise inflation expectations.

Federal Reserve: As Richard Clarida discussed recently, the FOMC has been discussing Fed staff estimates of r*, the neutral real interest rate. Last week at a conference in Berkeley, San Francisco Fed President John Williams offered a closer look at r*, which has been declining over the past two decades, recently stabilizing around zero in real terms. A key implication of r* is that the zero lower bound for interest rates may be hit more frequently in economic downturns – one more reason the coming Fed rate hike cycle will be the most dovish ever.