Q: As a Fed-chairman you fought high inflation, how odd is it for you then to hear the Fed among others calling for higher inflation?
A: I am sorry, but I just do not understand these central banks wanting a little inflation. They say a little bit of inflation is a good thing. The problem is that if a little bit of inflation is a good thing, a little bit more inflation then becomes seen as even better. Experience from history suggests that inflation, when deliberately started, is hard to control and reverse. This wanting a little inflation seems to be the new monetary policy orthodoxy. I know what the argument is, you want some room for the real interest rates to be negative, but the economy does not rest on negative real interest rates over a long period of time.
The other thing is, the language has been corrupted in the process as well. For example, they do not even call it inflation, if prices rise less than 2 percent annually, they now call it the danger of deflation. The modern central banks say we aim for 2 percent annual inflation to actually strengthen our resolve to keep it no more than 2 percent. This is strange; 2 percent inflation is a good thing but above 2 percent is not. And now even that resolve is weakening, some want more than 2 percent inflation as a buffer against deflation.
Aiming for 2 percent inflation every year means that after a decade prices are more than 25 percent higher and that the price level doubles in a generation. That is not price stability but they do call it price stability. As I said: the language has been corrupted in the process.
Q: And those central bankers saying declining prices, deflation, is the worst thing that can happen to our modern economies, how do you look at that?
A: I can understand that we do not want big deflation, that is prices falling 3,4 or 5 percent a year, but to invoke the Great Depression into it…Back then prices fell 10 percent a year, the Great Depression is a completely different story. This idea that with prices falling by couple of tenths of a percent housewives will stop spending money and that they will spend it when prices rise 2 per cent a year, or that when people see prices falling they will stop buying those cheaper t-shirts or cheaper food does not make much sense. By the way, in the US the prices of many goods have not gone up, a lot of price increases is limited to services like medicine. Some of the things we buy regularly have been falling and that is not a terrible situation for the American households.
Q: When you were at the Fed, the Fed was very secretive. Financial analysts sometimes did not even know the FOMC had a meeting and when they did, they had to guess whether you changed the interest rate and if so, in what direction. Nowadays, the Fed signals far in advance what its intensions are. What is your view of this so-called forward guidance?
A: I think it is a mistake to be so concrete about what your approach is months or even years ahead. It is fine to say that you want the economy to grow faster or inflation to be stable for example but when you get very precise about your policy like the Fed started to be some time ago when it said to start thinking about interest rate hikes when the unemployment rate falls to 6,5 percent, you can lose your credibility and the financial markets can work against you. Credibility is an enormous asset for any central bank. Now for example we have the unemployment rate in the US below 6,5 percent for some time, the unemployment turned lower far quicker than the Fed expected it to. Central banks should not be so precise about the outcomes, the fate of the Fed should not depend on its forecasts up to two years ahead. One thing we have learned it that economists are not good at forecasting.
As a central bank you want to lead the markets not the other way around. Sometimes you also want to surprise the markets. That seems impossible in this new approach. One of the consequences is that the sensitivity on the financial markets is high. Recently the Fed essentially said ‘some day we will have to tighten monetary policy’. They had been saying that for quite some time but still there was lot of reaction on the financial markets. If you do not move your interest rate for a long time, when you do as you once must, you are bound to make an impact. And this, the central banks fear. All in all the situation is fragile.
This is just a part of my talk with former chairman Volcker, during which we also talked about the future of the euro, the international financial system post-Bretton Woods, the Volcker-rule and the state of the world economy. e-mail me: firstname.lastname@example.org
Thu, 19 February