Visiting Scholar John H. Makin

The Federal Reserve and the Bank of Japan, arguably the world's two premiere central banks, are each risking their credibility. The BoJ is tightening monetary policy while inflation there is falling, just as the Fed hints at easing while inflation here is rising. The result could be further deflation in Japan and further inflation in the U.S.--a classic recipe for a sharply weaker dollar that could jeopardize global growth.

At its February 2007 meeting, the BoJ raised its target interest rate by 25 basis points to a half a percent. Since then, year-over-year core inflation has dropped to minus 0.3% from minus 0.2% in January. This is no flash in the pan. Japan's core inflation rate has averaged minus 0.5% since 2001.

The only way a tighter monetary policy makes sense in a deflationary environment is the belief that a modest acceleration of growth will bring about a future increase of inflation. This is an odd notion. Japan's sustainable growth rate is probably somewhere around 2% to 2.5%. With growth still in that range, and nominal growth even lower, the markets have a hard time understanding why the BoJ thinks pre-emptive tightening is necessary.

The struggle of markets to understand the intentions of central banks shifted to the U.S. on March 21. Then, after a two-day meeting, the Fed left its target federal funds rate at 5.25%, but issued an ambiguous statement which markets widely interpreted to signal a possible easing of the rate in the future. While the Fed tried to hedge its bets by suggesting directly that it was more concerned about inflation than it had been, the removal of the "additional easing" words from the FOMC statement prompted a rally in financial markets that lowered interest rates, steepened the yield curve, weakened the dollar and boosted U.S. stocks.

Consequently, the Fed was left with a difficult outcome: a situation where broad financial conditions (stock prices, interest rates and exchange rates) were eased substantially to a level comparable to the level that had prevailed when the fed funds rate was just 2.5%. How, some in the marketplace asked, can the Fed suggest that it is more seriously concerned about inflation while issuing a policy directive that causes financial markets to ease, thereby stimulating more growth in spending that puts upward pressure on inflation? U.S. core inflation has been stuck firmly at about 2.5% for some time, and has not shown any sign of falling into the Fed's comfort zone of 1% to 2%. Why wouldn't the Fed want to hint at a tighter policy?

The answer may be that the Fed, like the Bank of Japan, is putting a heavier weight on growth. The Fed seems to have noted--though it has not acknowledged--a sharp drop in the U.S. growth outlook, which has led it to suggest the possibility that policy may be eased even while inflation has not abated. Such an interpretation cannot be pleasing to those at the Fed who have lectured markets on their determination to see core inflation at or below 2% before easing. The Fed's message had been that it would neither tighten nor ease for some time, but after the March 21 FOMC statement, markets reinforced the notion that an ease was coming, probably by midyear.

Central banks are supposed to worry primarily about inflation for a simple reason. The evidence of the last 30 years makes it unmistakably clear that low and stable inflation rates are the best way to promote sustained growth and prosperity.

One fears that the BoJ is overlooking the finding that an inflation rate of around 1%, given the upward bias in measured inflation rates, is probably the appropriate lower bound target for central banks to employ when setting their inflation comfort zones.

The Fed also seems to have forgotten an important lesson. Easing, for whatever reason, while the core inflation rate is stuck firmly at 2.5%, will result in financial market celebrations that, in turn, boost spending and growth. The next stop for U.S. inflation would, under such circumstances be 3%, instead of 2%. If that happens, the Fed will either have to relax its inflation comfort zone of 1% to 2%, or clamp down even harder on the economy to bring inflation all the way back down to 2% from 3%.

If U.S. growth continues to slow while inflation fails to come down, the stagflationary environment that emerges in the U.S. will sharply weaken the dollar and steepen the U.S. yield curve. A weaker dollar with slower growth in the U.S. will weaken Asian economies, including Japan's--perhaps forcing the BoJ to reverse, for a second time, a premature move toward tighter policy.

The best that we can hope for is that U.S. inflation starts to come down soon enough to permit the Fed to ease, thereby cushioning the emerging slowdown in the U.S. economy. But the Fed's assumption that this will happen does not guarantee that it will, any more than the BoJ's assumption that higher future inflation makes it the most likely outcome.

Whatever occurs, there are considerable uncertainties facing the world's central banks concerning the future path of inflation and growth. Perhaps the best policy stance for now would be for the Fed and the BoJ to remain firmly on hold until more inflation data provides some guidance regarding appropriate future policy moves.

John H. Makin is a visiting scholar at AEI.