MNI INTERVIEW:Less Inflation Fine-Tuning As R* Climbs-Schembri

Central banks will move away from overly precise fine-tuning of inflation as the upheaval of Covid and geopolitical tensions push neutral interest rates higher, former Bank of Canada deputy Larry Schembri told MNI.

“Before the pandemic, there was this mindset among central banks that we had to worry about small deviations from 2%. That if the average was 1.7 or something, that was significant,” Schembri said. “Given what we’ve gone through in the pandemic, a 0.3 or 0.2 deviation didn’t really matter.”

Central banks such as the Fed may be satisfied with inflation close to 2% given the global restructuring, Schembri said. He noted debate between Olivier Blanchard and Larry Summers about a potential rise in neutral rates amid an aging global workforce and fraying free trade, adding that higher spending on defense and climate change will further boost government debts.

“The restructuring... I think will show up in potentially a higher neutral real interest rate than we experienced before the pandemic,” Schembri said. (See: MNI INTERVIEW: Era of Shortages To Force Rates Up - Bill White)

A GOOD CASE

“There’s a good case to be made that interest rates will not come back to a neutral policy rate of 2.5% over the next five years or so,” Schembri said.

The Bank of Canada is in the club of central banks that will return inflation to target said Schembri, a deputy governor from 2013 until June of last year. Governor Tiff Macklem said Thursday that it may be more difficult to make up the last bit of ground to 2% next year and he's prepared to hike a ninth time if inflation becomes stuck materially above target.

“There’s a lot of economic restructuring that’s going on globally, which often entails more public sector debt because the public sector is involved in a lot of restructuring, especially with respect to climate change,” Schembri said. “That’s more demand than otherwise, so inflation may take longer to get back to 2%, though I think the Bank’s projection of inflation returning to 2% at the end of 2024 is reasonable, because I think inflation expectations will come down as actual inflation declines.”

More concerning than global imprecision on inflation targets is the shrinking of central bank balance sheets bloated by QE, Schembri said. “The U.S. experience is the balance sheet is ratcheting up over time and can we get it back to what we might think of as a more normal level,” he said.

LIQUIDITY AND MARKET TENSIONS

“The financial system itself adjusts to having more liquidity in the system with higher settlement balances. And so there’s an endogenous process there, and I worry that as you try to shrink the central bank balance sheet and remove the liquidity in the system, that could create some tensions in financial markets.”

Since stepping down from the BOC last June, Schembri has been researching increased central bank transparency over the last 50 years and whether there are lessons following the pandemic for fiscal policy.

“Fiscal policy could be a little bit clearer about what the objectives are, what tools are used, how effective they are, and really what’s the strategy involved,” he said. “Whether you have sort of more constrained fiscal rules I think is something useful.”