davies70_XinhuaLiu Jie via Getty Images_jerome powell Xinhua/Liu Jie via Getty Images

Central Banking’s Next Act

Central banking seemed to have reached an “end of history” moment in the mid-1990s, when inflation targeting spread round the world after its success in New Zealand. A generation later, history has started again, with unpredictable consequences.

LONDON – When US Federal Reserve Chair Jay Powell delivered his major speech at the Jackson Hole conference of central bankers last month, setting out the results of a yearlong review of the Fed’s monetary policy framework, he had stars in his eyes. Not the twinkly kind, but rather the notation that encapsulates the Fed’s views of interest rates, and unemployment.

R-star is the equilibrium real interest rate, while u-star is the natural rate of unemployment. Both stars seem to have been falling in recent years, and, unlike in the old song, the Fed has had trouble catching them. Since 2012, when the Fed last restated its policy objectives, the Federal Open Market Committee’s members believe, on average, that r-star has fallen from 4.25% to 2.5%, while the median estimate of u-star has dropped from 5.5% to 4.1%.

These declines have been associated with what Powell himself calls a “persistent undershoot of inflation from our 2% longer-term objective.” They have found that lower inflation expectations and lower interest rates have meant that the Fed has found itself at the effective lower bound for interest rates for long periods, implying less flexibility to stimulate demand when necessary. One consequence is that annual inflation in the United States has averaged only 1.75% over the last decade, and has undershot the target 63% of the time.

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