Still No Exit: The Case for More Monetary Stimulus Remains Strong
Six months ago I wrote a policy brief in which I argued for large additional purchases of long-term bonds by the central banks of the four largest advanced economies—the United States, the euro area, Japan, and the United Kingdom—to reduce long-term interest rates. That advice remains relevant today for three of these economies. In the United Kingdom, however, policy should remain on hold pending further developments in inflation.
The European sovereign debt crisis is causing euro area and UK politicians to tighten fiscal policy faster than expected, which will weigh on economic growth, and the spillover effects also will be negative for growth in Japan and the United States. This fiscal retrenchment makes it all the more important for monetary policy to support economic recovery.
Over the past six months, forecasts of economic activity have improved noticeably in Japan, supported by exports to developing Asia. However, the improved outlook is still far below Japan's long-run sustainable economic path. Prices continue to fall in Japan so that, on balance, Japan needs monetary ease more urgently than any other economy.
Economic prospects in the euro area have been marked down from a level that was already far below potential. At the same time, core inflation fell to 0.7 percent in April,1 pointing to a dramatic undershooting of the European Central Bank's 2 percent inflation target over the next few months now that energy prices have stabilized. The need for monetary ease has greatly increased in the euro area.
Forecasts of US growth have been marked up a bit over the past six months, but this improvement is threatened by the strengthening dollar. Moreover, the Federal Reserve's latest forecast (compiled before the recent wave of bad news from Europe) continues to show unemployment far above its long-run level through the end of 2012. In addition, the news on inflation has been strikingly weak. The core consumer price index (CPI) rose only 0.9 percent in the 12 months to April and only 0.3 percent (annual rate) in the last six months. These rates are far below the Fed's desired inflation rate of around 2 percent. With both employment and inflation below desired levels over the foreseeable future, the case for more monetary ease is strong.
The United Kingdom is the exception. At 3.2 percent, the UK core inflation rate in April was higher than expected and above the Bank of England's target for headline inflation of 2 percent.2 With output still far below potential, inflation is likely to fall in coming months. Thus, the current low policy interest rate is appropriate, but the risk of a further unwelcome rise in inflation suggests that it may be prudent to wait for inflation to fall before easing policy further.
With short-term interest rates close to zero, the way to ease monetary policy now is by lowering longer-term interest rates. In a recent paper, my coauthors and I showed that Fed purchases of safe long-term bonds in 2009 lowered 10-year bond yields around 50 to 75 basis points. The latest inflation report of the Bank of England shows that similar purchases in the United Kingdom last year lowered long-term rates there, also. There is no reason to believe that such policies cannot work in the euro area and Japan. The Fed's actions last year spurred record issuance of corporate bonds in the United States, supporting business investment and employment. We need even more this year.
1. Core inflation is the 12-month change in the harmonized index of consumer prices (HICP) excluding energy and unprocessed food. Excluding volatile food and energy prices provides a better measure of where inflation is trending.
2. Core inflation is the 12-month change in the CPI excluding energy and unprocessed food. This rate includes the effect of a value-added tax increase in January that appears to have temporarily boosted inflation by at least 1 percentage point.