Central banking like it’s 1989

Ashley Kindergan writes a great piece at The Financialist on the growing divergence between central banks, the likes of which we haven’t seen in 25 years.

In 2015, global monetary policy could look like a mirror image of its 1989 self. The Bank of Japan already expanded the scope of its asset purchases in October. The European Central Bank is expected to announce quantitative easing as early as the first quarter, while the U.S. and the U.K. are expected to start tightening monetary policy in mid-2015. That’s because policy makers’ concerns have been reversed as well, with deflation a bigger worry than inflation in Europe and Japan (a 40 percent drop in crude oil prices since June has exacerbated the deflationary dynamic), and inflation emerging as a potential concern of the Fed and the Bank of England.

One qualm: I’m a little skeptical that inflation fears will be the prime mover behind Fed policymaking in 2015. The economy may be looking up as equity values soar and unemployment continues to decline, but inflation itself remains low. Janet Yellen is a deflation hawk, anyway, having repeatedly dismissed inflation fears in the past. The collapse of oil prices adds deflationary pressures to the mix that, I think, will dissuade Fed officials from raising rates in 2015. Near-zero rates through 2016 is what Janet Yellen originally wanted, anyways.

But either way, how the world’s central banks respond to these contrasting inflationary and deflationary pressures will certainly be one of the coming months’ big stories. Here’s Barry Ritholtz saying as much at Bloomberg today:

The central bankers of the world are out of synch with each other. If the U.S. economy continues to accelerate, this disparity may become even more pronounced. How that plays out could be the big question facing central bankers in 2015.

The Fed especially has an interesting puzzle, as unemployment drops ever lower while inflation remains low—a situation The Economist calls “contradictory pressures” in it’s print edition this month. A working assumption behind the economics of the Fed’s dual mandate is that inflation and unemployment should move somewhat in tandem, and that the decision to ease off the monetary gas pedal should come when both indicators look good. But what happens when one indicator moves opposite the other—when inflation drops as job growth rises, as we’re seeing today? Can unemployment get “too low” as the Fed waits for inflation to pick up before raising interest rates? Will a rate hike spark deflationary fears if the Fed acts in response to strong jobs reports while inflation remains low?

(On that note, remember when 6.5 percent unemployment was supposed to trigger a rate hike? In retrospect, that was probably one of Ben Bernanke’s worst ideas. Pegging the end of easy money to a specific unemployment rate might have eased fears of a rate hike when unemployment was still well above 6.5 percent, but pegging the two events together like that created a perverse incentive—one I wrote about last year—that turned low unemployment into something stimulus-addicted markets didn’t like.)

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