By the brilliant Stephen King (HSBC's senior economic adviser), Why interest rate decisions are deliberately ambiguous - Central bankers do not know what determines inflation, though few will admit it
You are a budding economist about to take a macroeconomics multiple-choice examination. The clock hits the fateful hour. You turn to the first question: When should a central bank raise interest rates?
The choices are;
a) when inflation is below target;
b) when inflation is above target;
c) all of the above;
Naturally, your pencil hovers over the second answer. But then you pause to reflect. You know that, in the real world, life is not that simple.
The Federal Reserve has already raised interest rates on four separate occasions since the end of 2015. Investors expect another 25bp increase in December. Yet, although inflation picked up a bit during 2016, it has since dropped like a stone. The Fed's preferred "core" measure of inflation - the personal consumption expenditure deflator - has fallen from 1.9 per cent to 1.3 per cent over the past year or so, well below the 2 per cent target.
When the Bank of Canada raised interest rates in the summer, it did so in the knowledge that "the Bank's three measures of core inflation all remain below 2 per cent". Sweden's Riksbank, on the other hand, has watched inflation rise from of 0 per cent in March 2014 to 2.3 per cent in September. Yet, between 2014 and 2016 the Riksbank's key policy rate fell from 0.75 per cent to minus 0.5 per cent, where it remains.
The Bank of England, meanwhile, has stuck to the rule book much more closely, cutting interest rates in August 2016, shortly after the Brexit referendum inflation, when inflation was around l per cent, and raising them on Thursday when inflation was up at 3 per cent.
Based on the past couple of years, then, your answer to the multiple-choice question should ideally be "it depends" - a rather odd state of affairs given that inflation targeting was hailed as the ultimate in transparent monetary arrangements. How did we get here?
One answer is policymakers are not setting interest rates on the basis of the inflation rate, but on the outlook for inflation at some future date. That, however, turns one problem into another.
The Fed may have raised rates in 2015 and 2016 believing that inflation was heading back to target, but recent developments suggest that this belief was misplaced. And when the BoE cut rates last summer, in effect underwriting sterling's rapid decline, members of the Monetary Policy Committee knew full well the probable impact: the minutes stated that: "The fall in sterling is likely to push up on CPI inflation in the near term... probably causing it to rise above the target in the latter part of the MPC's forecast period."
Another answer is that central bankers no longer know what determines inflation, even though few of them will be comfortable admitting it. Phillips Curves have been next to useless in recent years: unemployment has mostly fallen faster than forecast but wage growth has been lower than expected. So labour market indicators offer inconsistent messages, perhaps reflecting the impact of technology and globalization on wage bargaining.
A third possibility is central bankers know full well the pursuit of an elusive inflation target may only help to engender greater financial instability. Inflation may have been low in Sweden for many years but, in the attempt to lift it, house prices have roared ahead. The Fed may be disappointed about its inability to push US inflation higher but it nevertheless increasingly frets about a sky-high US equity market.
And, if the policies of the Fed and European Central Bank help set global financial conditions, there is even more cause for concern: emerging economies with the weakest of prospects are increasingly able to access international capital markets at the lowest of rates.
All this suggests that central bankers are adopting what I would call "positive ambiguity", allowing inflation to stray well away from target because they are worried about broader economic and financial stability. This approach requires careful explanation. To date, central bankers have been overly vague, perhaps reflecting their growing fear that, in earlier attempts to hit inflation targets, monetary policy has been left too loose for too long (as, indeed, it was before the global financial crisis).
Or, to put it in terms of your exam paper, option three is correct, but should be amended to say, "all of the above, because central banks that focus on price stability alone may only be stoking the next financial bubble".