Borio Goes 'Provocative' With New Push for Central Bank Rethink

  • Need to reassess how globalization influences inflation
  • Equilibrium rate models should include financial stability

The accepted way that economists and central banks think about inflation and interest rate-setting is due an overhaul, according to Claudio Borio at the Bank for International Settlements, who has long been pushing for rethink of monetary policy.

In a speech he described as “intentionally provocative,” Borio said they may be underestimating the effect of factors such as globalization and technology on inflation. That means central banks should rethink how they tackle what they perceive as damaging deflationary trends. 

“Could it be that inflation is like a compass with a broken needle?” he said in the text of a speech for delivery in London on Friday. “Might we have overestimated our ability to control inflation, or at least what it would take to do so?”

Borio -- the head of the Basel-based institution’s monetary and economic department -- also said that current methods for figuring out equilibrium interest rates don’t take financial stability risks into account and therefore may need updating, another area with implications for policy making.

Central bankers across major economies are grappling with the fact that inflation has been slow to pick up even as growth improves. Just this week, Federal Reserve Chair Janet Yellen acknowledged that recent price data were a “mystery,” while European Central Bank President Mario Draghi has cited a bevy of factors such as labor market slack.

Borio argues that the fall of the Iron curtain and the rise of China and other emerging market economies have led an internationalization of the markets for products, labor and capital, meaning workers and companies in one country now compete with those in far-flung places. That erodes their ability to set prices.

“To the extent that disinflationary pressures result from forces such as globalization or technology, they should be generally benign: they would reflect favourable supply side developments as opposed to damaging demand weakness. At a minimum, this suggests lengthening the horizon over which it would be desirable to bring inflation back towards target.”

Using data for 19 countries stretching as far back to the 1870s, Borrio also hypothesizes that economists have underestimated the impact of monetary policy on inflation-adjusted interest rates over the time span of more than a decade.

That stands in contrast to the idea that deep-seated forces such as productivity and demographics are to blame. On this “prevailing view,” for which he questions the evidence, Borio highlights Larry Summers, the former Treasury Secretary and a proponent of the “secular stagnation” theory, who argues weak U.S. growth and inflation is due to excess savings.

“We should not overestimate the central banks’ ability to fine-tune inflation,” Borio said. “In particular, raising inflation against powerful headwinds may prove harder than previously thought. It would also increase any collateral damage.”

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