The FOMC’s reluctance to raise interest rates in the face of uncertainties radiating from the Far East reflects the dilemma many central banks face in attempting to retain a domestic prioritization. To raise rates or to firm policy guidance (to that end) is to be rewarded with a strengthening currency (the “offside trap” as we like to call it) at a time when trade shares globally are at a premium. Essentially this is the basis for ‘currency wars’ and few central banks have been able to remain disengaged. On Thursday, the BOE once more made mention of GBP’s inflation-dampening strength in a comment that echoed Mark Carney’s recent assertion that “the importance of the exchange rate for UK inflation [means that] …. Monetary policy must be carefully calibrated” (that’s central bank speak for ‘we can’t outdo other central banks with talk of higher rates if it means a much stronger pound’.) and Martin Floden was perhaps the most noted commentator on FX this week: the Riksbank official called the recent strengthening of the SEK “worrying”. Last year, Riksbank famously turned its back on preceding efforts to rein in the country’s debt mountain and focused instead on fighting deflation; and with consumer prices still falling by 0.2% year-on-year, Mr. Floden presumably feels that the Bank has had a poor return on its venture into radicalism (Riksbank was the first modern central bank to implement negative interest rates). Hence, a stronger SEK is the last thing this Bank needs.
Actually, Mr. Floden is also scheduled to speak this coming week at a breakfast meeting in which he will deliver a speech entitled “Sweden needs its inflation target”. Whilst we look forward to hearing what Mr. Floden has to say on the matter, we would like to pre-empt it with our own penny’s worth. Indeed, we have long argued that the one agenda item conspicuously absent from the “truth and reconciliation” of this Crisis era has been the role of central banks and the merits of plain-vanilla inflation targeting. For a central bank solely mandated to meet an inflation target, asset prices only matter in as far as they can be expected to impact upon goods and services prices over a specific time frame; but if, for whatever reason, the two series diverge, then identifying the moment when associated leverage adopts a destabilizing trajectory is simply inscrutable, a matter of pure conjecture and hence open to political influences. We could have learnt from Japan’s seminal experiences in the late 1980s during which time CPI inflation barely rose above 1%; but two decades later, and the West’s predicament could be attributed to the same delusion of ‘price stability.’ In short, stable CPI inflation is a necessary but, in itself, insufficient condition to ensure macroeconomic stability, and appearing on the stand for the prosecution is none other than the biggest financial crisis in history.
The only way forward, we suspect, is for a more concerted focus on financial stability as part of central bank mandates: a number of banks, such as the RBNZ and BOE, have recognized this need, and we recall the RBA’s Glenn Stevens stating in 2013 that central banks ‘should be prepared to take the heat out of asset price booms, rather than relying on low rates to clean up the mess after the bubbles burst.’ The comments were remarkable in that they could very easily have been borrowed directly from a speech made by former ECB chief economist Otmar Issing at an IMF conference earlier that year. Issing said, “… if [it] is your position, that monetary policy should deal with asset prices only on the way down, it is a totally asymmetric approach … Price stability and financial stability must not be seen as a trade-off. We have to deal with financial stability in the context of monetary policy that is geared to maintain price stability.” Of course, focusing on financial stability is one thing, but we have yet to see some sort of nominal target that can in some way quantify risks, say, associated with house price inflation and corresponding indebtedness. Political will notwithstanding, whether this could ever be formulated in a meaningful way is another matter; but we live in hope.