Why Deflation May Yet Destabilise the Monetary Policy Regime

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IF YOU want a robust defence of current central bank practices, you could always help yourself to a few choice paragraphs from Christopher Allsopp's speech ("Macroeconomic Policy Rules in Theory and in Practice") presented to the conference on Policy Rules - the Next Steps at Cambridge University last week. Mr Allsopp, a member of the Monetary Policy Committee of the Bank of England, provides a series of powerful academic arguments in favour of current practices in Threadneedle Street.

At this point, I should warn you about the perils of cronyism. Chris Allsopp was my economics tutor at Oxford a couple of decades ago. So you might think that I'm going to be rather too sympathetic to Mr Allsopp's views. Well, I do have a lot of sympathy with what he has to say. But I also think that there are quite a few things that he has left unsaid. These could prove to be rather more challenging for policy makers in the years ahead.

Central to his argument, and, indeed, to the consensus within the economics community, is his observation that there is no long run trade-off between nominal developments (inflation) and the real economy. There appears to be nothing particularly controversial about this view. However, this observation may be more relevant for inflation than deflation. Deflation, after all, tends to leave the monetary authority a bit powerless for the simple reason that real interest rates tend to rise (in other words, that nominal interest rates cannot fall below zero). If those increases are beyond the control of the central bank, it would seem reasonable to argue that they could have an impact on the real economy.

Of course, deflation might be considered to be a peculiar special case that has little relevance in the real world. However, given Japan's recent experience and concerns about the relationship between asset price deflation and deflation for an economy more broadly, this seems to me to be an increasingly important issue. The underlying assumption throughout Mr Allsopp's speech is that monetary policy works. Maybe it's worth thinking about how to spot - and, hence, steer away from, situations where monetary policy is in danger of failing. To be fair, Mr Allsopp does mention this issue in passing, but I suspect that we're going to see a lot more attention paid to it in the years ahead.

Mr Allsopp puts in a stout defence of inflation-targeting regimes. He argues that an appropriate, transparent and credible policy will lead to "the anticipation of longer-term economic growth at potential rates and the understanding that deviations of output from potential and inflation from target will ... be as small as possible given the shocks hitting the economy".

Nothing wrong with all this and Mr Allsopp provides plenty of encouraging evidence to support these views. Although he admits that it may be too soon to tell, Mr Allsopp demonstrates that inflation has been remarkably stable and close to target since the MPC was brought into existence in 1997. He notes that, at the same time, financial market expectations of inflation have stabilised, suggesting that the regime carries a lot of credibility. In a later section of the speech, Mr Allsopp goes even further, suggesting that markets anticipate potential changes in monetary policy to such a degree that monetary conditions are altered even without the central banks doing anything themselves. He argues that the recent decline in market interest rates, across the yield curve, should be interpreted as an easing of monetary policy "despite no change in policy rates".

I'm not so sure about these conclusions. It's true that inflation has been remarkably well-behaved in recent years and I think the shift in financial market expectations is a particularly convincing vote of confidence in the new monetary arrangements. It is less obvious, however, that the low rate of inflation is solely the work of the MPC. …