By Willem Verhagen
The time when central banks need only be concerned with price stability is definitely over. The main problems in the developed economies are now persistent high unemployment and debt sustainability. In the past two years, monetary policy makers have become much more aware of these factors. We therefore picture a scenario in the years ahead in which the gradual closure of the output gaps in the developed economies goes hand in hand with an ongoing easy monetary policy stance.
Despite this, it is likely that the interests of price inflation on the one hand and those of debt sustainability and unemployment on the other will eventually conflict and create major dilemmas for the central banks. Although we expect that inflation will remain moderate in the near future, it has not ruled out a rise in inflation expectations in the longer run.
Inflation could be moderately higher than targeted in the long term because the central banks will be late to start withdrawing their stimulatory measures as their exit strategy, as they want to be certain that the recovery is on-going. Another possibility is that they will balance the inflation objective against the target for sovereign debt sustainability. The latter option may imply that interest rates will be lower than optimal from the perspective of meeting the inflation target.
Looking at central bank policies, the discussion about the ECB’s exit strategy is not an issue at the moment. The ECB recently cut interest rates to 0.5% and said that it would continue with its easy monetary policy and possibly relax it further. Furthermore, unemployment is still on an upward trend and ING IM estimates a 0.7% GDP contraction in 2013.
Out of all the developed regions, discussion on a possible exit strategy is still being aired the most in the US. Despite recent disappointing macro-economic figures, the steady upturn in the housing and labour markets are providing an important undercurrent to the US economic recovery.
Lastly, the special situation in Japan is certainly worth mentioning. Whereas the previously mentioned trade-offs may start to bite in the other developed economies when inflation expectations begin to rise. The case is different in Japan on account of the on-going deflationary psychology in the country; price stability, unemployment and debt sustainability all justify even further monetary easing by the Bank of Japan. It is therefore reasonable to assume that the monetary policy of the Bank of Japan will structurally loosen relative to that of the other central banks in the G4.
Willem Verhagen is chief economist at ING Investment Management
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