IMF warns central banks to watch inflation

The International Monetary Fund on Tuesday warned central banks to keep an eye on inflation and resist political pressure to focus policy only on lowering unemployment. With many governments desperate to find ways to generate jobs, the IMF said, it is ever more important for central banks to assert their independence to keep an eye on all potential problems in the economy -- whether growth, prices, or jobs. "In the wake of the Great Recession, there is political urgency to reduce unemployment," the IMF said in a section of its World Economic Outlook. "Instead, what our analysis underscores is that, whatever the source, limits on central banks' independence and operational restrictions that limit their flexibility in responding to evolving challenges can cause problems and must be avoided." While the IMF played down the immediate threat of a surge in inflation, many economists remain concerned that the exceptionally loose monetary policies pursued by major central banks will eventually spark runaway price increases. In the four years since the global financial crisis, advanced economies have unloaded massive monetary firepower to try to jump-start growth and create jobs. The US Federal Reserve and the Bank of England have employed large bond-purchase programs, or quantitative easing (QE), while the European Central Bank has focused on lending. Last week, the Bank of Japan announced an aggressive QE program and monetary policy to tackle deflation and end decades of tepid growth. So far the wave of easy money has not yet unhinged widespread expectations that prices will remain tame amid weak growth. The IMF noted broad evidence that, since the mid-1990s, inflation has become "better anchored around long-term expectations, which themselves have become more stable." But the IMF said that the nature of inflation in advanced economies has changed since the 1970s. In the past, inflation rose as unemployment fell, an inverse relationship known as the Phillips curve. That relationship has flattened out, according to IMF analysts, and they now warn that inflation can suddenly pick up without an improvement in joblessness if other aspects of the situation change -- particularly market and consumer expectations about inflation. "The greatest risk for inflation, just as in the 1970s, is the possibility that expectations will become disanchored," the IMF said. That underscores the need for central bankers currently pumping up their economies with easy money to not take their eyes off the threat of inflation. "Central banks are already making use of whatever flexibility they have in responding to the unprecedented circumstances following the Great Recession," the international lender said. "However, changes in the behavior of inflation and profound challenges in the aftermath of the Great Recession may mean there is need for even greater flexibility." Central banks would better serve their mission if they adopt a dual-mandate policy that would focus not only on inflation but on an explicit mandate to stabilize output, the IMF said. "Central banks would thus have more discretion to allow inflation fluctuations if addressing them would exacerbate cyclical downturns."