Central Bank Dilemma: Tie Between Money And Inflation Appears Broken

Central Bank Dilemma: Tie Between Money And Inflation Appears Broken

Right now, the Federal Reserve System and the European Central Bank have a dilemma.

Last week the value of the Euro reached $1.2000 for a short time, although the price dropped off to $1.1842 at the close of the week.

The general market feeling is that, if anything, the price of the Euro should rise further.

But, this thought is bringing pressure on Christine Lagarde, the ECB president, to “talk down” the Euro so that the currency does not become too strong and hurt the economy of the European Union and possibly hold down inflation.

Yet, to some, to do this also carries risks.

Stephen Gallo, European head of FX strategy at BMO, has argued,

But at the same time she has to be careful. If they fire that bullet and it only has limited impact, that could be even worse.”

The value of the Euro could grow even stronger.

The ECB has a meeting this Thursday.

The Problem Is Inflation

The problem right now, in the European Union and in the United States is that inflation is rather tepid.

In August, annual core inflation in the eurozone hit an all-time low of 0.4 percent. The last time the core rate of inflation in the eurozone was above 2 per cent was in 2008.

In the United States, the Federal Reserve expects that inflation will only be 0.8 percent this year. Next year, maybe the inflation rate will hit 1.6 percent.

The so-called core consumer prices, an underlying measure that strips out volatile items such as food and energy, are expected to climb 0.3 percent month-on-month, following a 0.6 percent gain in July – the sharpest increase in almost three decades. The year-on-year number is expected to be 1.7 percent.

Inflation, according to the Nobel prize-winning economist Milton Friedman, is everywhere and every time, a monetary phenomenon. But, that doesn’t seem to be the case at this time.

Well, both the European Central Bank and the Federal Reserve System have produced rapid rates of monetary expansion and yet inflation has not responded.

That is one reason why the Federal Reserve set out new guidelines for the conduct of monetary policy. This new set of guidelines allows the Fed to keep interest rates lower for a longer period of time than did the previous set of guidelines the Fed was working from.

But, criticism is also placed upon fiscal policy efforts for not being strong enough to help.

The failure of the price statistics to respond to these monetary efforts has created an environment where the leaders of the central bank feel they must “talk down” market prices. Nothing else seems to be working.

Going Forward

Inflation targeting has been a vital part of the conduct of modern monetary policy.

Built up on the assumptions of the Phillips Curve, the statistical relationship between the unemployment rate and the rate of inflation, modern monetary policy has targeted inflation rates that seem to be consistent with a lower rate of unemployment without forcing excessive inflation on the economy.

But. inflation targeting must have credibility.

Wolfgang Münchau writes in the Financial Times that

In the past, inflation targeting did have greater credibility and, in the European Union, trade unions and employers did use the ECB’s target as the basis for their wage negotiations. “

But,

“Nobody does that now.”

Neither the European Central Bank nor the Federal Reserve System seems to have any control over their inflation rate. Credibility with respect to central bank policy over prices is weak and seems to actually be declining.

The result is the uncertainty with how the central banks should act.

The European Central Bank To Meet

This whole discussion centers around the meeting of the ECB scheduled for Thursday. What should investors be expecting from Ms. Lagarde? Will she try and “talk down” the Euro? Will she ease around the subject, hoping that the markets will not over-react to the situation?

If the inflation targeting has lost its credibility, both in the EU and in the US, maybe the central banks should be looking for a new “model” for narrating its policy decisions, rather than try to explain things in the same old way.

The Phillips Curve, to me, is legacy. It doesn’t work and needs to be replaced. Policy makers need a better tool to set policy with and a better tool with which to explain their decisions.

Mr. Münchau ends up his piece with the following message:

The ECB needs to be brutally honest both with itself and with EU leaders about what it can and cannot achieve. It would be wrong to say that monetary policy is ineffective. But it would also be wrong to state the opposite: that a central bank can do, and achieve, whatever it takes.”

The same needs to be said about the Federal Reserve as well. In this age of radical uncertainty we must be prudent about what we can expect our policy makers to achieve and understanding that things have changed and we need to adjust our thinking to all that is happening.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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