Are central banks following the wrong policy and is this a risk for 2018?

The world’s major central banks are pursuing the wrong policy and the obsession with a 2% inflation target is a mistake, according to Charles Dumas, TS Lombard chief economist. He tells IGTV that this could have repercussions in the years to come.

2% inflation target

The US Federal Reserve (Fed), the Bank of Japan (BoJ) and the European Central Bank (ECB) each have a 2% inflation target and are concerned about low inflation within their economies. ‘Why create inflation in economies that do not have natural inflation?’ Mr. Dumas asks.

New paradigm?

Inflation was rampant in the 1970s with rates in the developed world in the teens. This led to central banks targeting inflation. But since the financial crisis, is there a new paradigm meaning economies no longer have a natural tendency to inflate thanks to the deflationary effects of technology? Low unemployment levels empirically result in climbing inflation, according to the Phillips Curve, but this is notably absent in the US. 

Dumas tells IGTV’s Jeremy Naylor that focusing on a 2% inflation target, when economies are growing above trend, risks them overheating. This would then trigger a clampdown by the same central banks and then a recession in the US, particularly, and the eurozone - what he describes as “go stop” policies, harking back to the stop-go policies of the 1970s used to tackle inflation.

Inflation chart

Three economic engines

For the first time this century, Dumas adds, there are three locomotives driving global expansion - China, the US and north central Europe. This is not based on debt as was the case before the crisis.

Rosy outlook in Europe

Back in 2012, the Organization for Economic Cooperation and Development (OECD) forecast that European employment would fall in the coming years. The reverse has in fact happened. 

Employment chart

Immigration climbed but was absorbed as employment rose. This has led to a drive to build more housing, working facilities and infrastructure. The influx of people has held down wages in Germany and the expected climb in inflation has not happened. 

In Europe, the strong euro has been keeping inflation in check, allowing the ECB to pursue its easy money strategy in defence of Italy for longer than it should, argues Dumas. But this simply pushes the risk of a meltdown into 2019.

This risk is that this is also the case in the US. Even with the three expected interest rate rises to come in 2018, the Fed will still be running an easy money policy and risking overheating.

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