Central bankers are being forced to challenge their own conventional wisdom on the interplay between rates and inflation, and the next chair of the Federal Reserve will have a big say in what any new policy paradigm may look like.
The Fed, the Bank of Japan, the European Central Bank and the People's Bank of China may all have new bosses by 2019, which along with personnel changes at the Bank of England will lead to the departure of the generation of central bankers who steered the global economy through the crisis with an unprecedented era of easy money.
Despite the return of economic growth and tumbling unemployment, ultralow rates and trillions of dollars' worth of quantitative easing, or QE, have failed to push inflation back towards central banks' targets, raising the possibility that their conventional monetary policy tools are inadequate and some of their models broken.
"The frustration for all G7 central banks is that recoveries since 2009 have mainly been output-driven, and with output gaps slow to close and wage pressure still capped, they've yet to generate enough inflation to trigger central banks' usual reaction functions," said Neil Williams, chief economist at Hermes Investment Management.
"This — and hopefully the dawning realization that, by prolonging liquidity injections and ultralow rates, central banks may now be contributing to the problem — suggest newcomers may offer alternative paradigms."
As the custodian of the world's top reserve currency the Fed has an unequivocally global role, and the U.S. economy's advanced position in the post-crisis cycle means the next Fed chair may well set the tone for "post-QE" monetary policy.
Fight for the Fed
Kevin Warsh, one of the front-runners to succeed Janet Yellen as Fed chair in February 2018, has attacked what he sees as "groupthink" from global central banks post-crisis, and in a speech in June 2016 called for a "new paradigm" for monetary policy.
Warsh, who was a governor on the Federal Open Market Committee between 2006 and 2011, toward the end of which time he voiced criticism of then-Chair Ben Bernanke's second round of QE, has advocated a softer focus on the target of 2% inflation, arguing instead for a "comfort zone" of around 2%. He wants FOMC members to be happy for policy to "lean against the wind" and to be less reactive to data and market movements.
Jerome Powell, John Taylor, Gary Cohn and Yellen herself are all said to be still in the running, and while Warsh's stance has been dismissed by some analysts as self-promoting hyperbole, he is not alone in thinking central banks will need a new policy framework going forward.
Stanford economist Taylor, whose eponymous rule is used by many central banks to estimate how interest rates should respond to changes in the economy, has argued for the Fed to tie itself to stricter policy guidelines that would be published in detail, decreasing its capability to enact ad-hoc changes.
Yellen conceded last month that central banks' inflation models could be off "in some fundamental way." She has also pointed to forecasts showing the federal funds rate settling at about 3% in the longer run, a far cry from an average of more than 7% between 1965 and 2000, giving far less scope for rate cuts.
Bernanke, Yellen's predecessor, said this month he was not confident "the current monetary toolbox would prove sufficient to address a sharp downturn." He proposed "temporary price-level targeting" — a compromise between permanent price-level targeting and raising the inflation target above the current 2% level — as one response to a lower long-run equilibrium level of real interest rates.
Policymakers in Europe, the U.K. and Japan have also suggested rates may, for the foreseeable future, peak at lower levels than pre-crisis, and are discussing tweaks to their own models.
"Extending current inflation targets, broadening them to nominal GDP, and/or adopting, Fed-style, a dual mandate, are all being dusted off and may have their place," said Williams.
"None is perfect, but, if central banks truly want to get their power back, in terms of reclaiming their cherished policy rate, while demand inflation remains in the doldrums, an essence of the Fed's dual target may make sense for others too."
While Mario Draghi's term as ECB president runs until late 2019, investors are already wary of the "key man risk" attached to his departure, especially given Germany's Jens Weidmann — a serial dissenter on the governing council — has emerged as an early front-runner for the job.
"Draghi has drastically changed the ECB and molded it in his own image," said Claus Vistesen, eurozone economist at Pantheon Macroeconomics. "He has redefined the inflation target, and he has been key in gathering momentum behind the current policy tools."
Vistesen believes the ECB and the BoJ face the same kind of challenges in exiting their easy policy stance before running into the next recession, and that the Fed's attempt to do so could be instructive.
"The BoJ never managed to raise rates in a meaningful way before they had to start QE again," he said. "The Fed is keen to normalize policy, they want some bullets in the gun before the next recession happens. That should inform the ECB on QE and rates."
Whoever leads the G7 central banks through the next decade, they will be expected to answer the question to which "worryingly, no one really knows the answer," according to Claudio Borio, head of the monetary and economic department at the Bank for International Settlements.
Namely: Why inflation remains so stubbornly low despite developed economies approaching full employment and unprecedented central bank efforts to push it up.
In a speech last month, Borio said economists "should not take for granted even our strongest-held beliefs," and suggested that the impact of factors such as globalization, technology and even monetary policy itself on inflation and real interest rates was not properly understood.
Indeed, the new intake will also have to confront the possibility that the conundrum they are tackling has either been caused, or at least exacerbated, by the intervention of their predecessors, said Williams.
"I suspect we may be at the point where less will be more, and that part of the reason for wage sluggishness and low productivity is expectations of ticking along at ultralow rates," he said.
"With quantitative tightening offering a second lever to pull to take the weight off interest rate rises, this should not preclude rate rises, but help rates to eventually peak out at lower levels than we're used to."