The Dangerous Delusion of Price Stability
Since the high inflation of the 1970s, which central banks were right to combat by whatever means necessary, maintaining positive but low inflation has become a monetary-policy obsession. But, because the world economy has changed dramatically since then, central bankers have started to miss the monetary-policy forest for the trees.
BASEL – The major central banks’ vigilant pursuit of positive but low inflation has become a dangerous delusion. It is dangerous because the policies needed to achieve the objective could have unwanted side effects; and it is a delusion because there is currently no good reason to be pursuing the objective in the first place.
In the 1970s, when inflation in the advanced economies rose sharply, central banks rightly resisted it. The lesson central bankers took from that battle was that low inflation is a necessary condition for sustained growth. But, subtly and over time, this lesson has morphed into a belief that low inflation is also a sufficient condition for sustained growth.
That change may have been due to the benign economic conditions that accompanied the period of disinflation from the late 1980s to 2007, commonly referred to as the “Great Moderation.” For central bankers, it was comforting to believe that they had reduced inflation by controlling demand, and that their policies had many beneficial side effects for the economy. After all, this was the demand-oriented narrative they had used to justify tight money to begin with.
But then the world changed. From the late 1980s onward, low inflation was largely due to positive supply-side shocks – such as the Baby Boomer-fueled expansion of the labor force and the integration of many emerging countries into the global trading system. These forces boosted growth while lowering inflation. And monetary policy, far from restricting demand, was generally focused on preventing below-target inflation.
As we now know, that led to a period of easy monetary conditions, which, together with financial deregulation and technological developments, sowed the seeds of the 2007 financial crisis and the ensuing recession. The fundamental analytical error then – as it still is today – was a failure to distinguish between alternative sources of disinflation.
The end of the Great Moderation should have disabused policymakers of their belief that low inflation guarantees future economic stability. If anything, the opposite has been true. Having doubled down on their inflation targets, central banks have had to rely on an unprecedented array of untested policy instruments to achieve their goals.
For example, many central bankers are now recommending the use of “macroprudential” instruments to manage systemic risks in the economy – which, in turn, will allow them to keep interest rates “lower for longer.” The problem with this approach is that there is little, if any, empirical evidence to suggest that such policies will work as intended.
Central bankers sometimes rationalize their current policies not by extolling the benefits of low inflation, but by underscoring the heavy costs of even mild deflation. Yet while there is ample evidence showing that high inflation is more costly than low inflation, it is hard to find similar evidence that mild deflation is all that costly.
In fact, the widely held assumption that consumers and corporate investors will extrapolate from past price declines and hold off on making purchases as a result of deflation has essentially no empirical support behind it. Recent consumer responses to sectoral price declines in various countries, not least Japan, all suggest the very opposite.
True, as a matter of arithmetic, deflation increases the real (inflation-adjusted) burden of debt service. But if debt levels are at onerous heights as a result of easy-money monetary policies, it is not obvious that the solution to the problem is still more easy money.
Central banks’ fixation on positive but low inflation under today’s prevailing economic conditions is also increasingly dangerous. Global debt ratios have risen sharply since the financial crisis began, while traditional lenders’ margins have been squeezed, raising questions about their overall health. And as lending has continued to migrate further into the “shadows,” price discovery in financial markets has become severely compromised, to the point that many assets now seem to be overvalued.
These developments constitute a threat not just to financial stability, but also to the workings of the real economy. Moreover, one could argue that easy money itself has contributed to the unexpectedly strong disinflationary forces seen in recent years. Owing to easy financing and regulatory forbearance, aggregate supply has risen as “zombie” companies have proliferated. Meanwhile, aggregate demand has been restrained by the debt headwinds – yet another result of easy monetary conditions.
In view of these conditions, continuing to insist on monetary easing seems particularly ill advised. With so many potential dangers on the horizon, central bankers should at least consider rethinking the fundamental assumptions underlying their policies.
So, what should policymakers do? In the immediate future, governments must stop relying so much on central bank policies to restore sustainable growth. Rather than obsesses over inflation targets, policymakers should (belatedly) start asking themselves what practical measures they can take to prevent another crisis from erupting. Equally important, they need to ensure that they have done everything they can to prepare for such a scenario, in case their preventive measures prove inadequate.
Looking even further into the future, when some semblance of “normality” has been restored, central banks should focus less on hitting near-term inflation targets, and more on avoiding “boom-bust” credit cycles. Unlike slight deviations from inflation targets, or even slight deflation, the latter actually are costly.
Surveying the Damage of Low Interest Rates
Few would disagree that it was necessary to slash interest rates in the immediate aftermath of the 2008 global financial crisis. But after a decade of ultra-loose monetary policies across advanced economies, growth remains tepid, financial risks have proliferated, and middle-class savers have lost out.
WASHINGTON, DC – For years after the 2008 financial crisis, policymakers congratulated themselves for having averted a second Great Depression. They had responded to the global recession with the kind of Keynesian fiscal and monetary stimulus that the moment required.
But nine years have passed, and official interest rates are still hovering around zero, while growth has been mediocre. Since 2008, the European Union has grown at a dismal average annual rate of just 0.9%.
The broad Keynesian consensus that emerged immediately after the crisis has become today’s prevailing economic dogma: as long as growth remains substandard and annual inflation remains below 2%, more stimulus is deemed not just appropriate, but necessary.
The arguments underlying this dogma do not hold water. For starters, measures of inflation are so poor as to be arbitrary. As Harvard’s Martin Feldstein notes, governments have no good way to measure price inflation for services and new technologies, which account for an ever greater share of advanced economies’ GDP, because quality in these sectors varies substantially over time. Moreover, real estate and other assets are not even included in the accounting.
The dictate that inflation must rise at an annual rate of 2% is also arbitrary. Swedish economist Knut Wicksell’s century-old concept of a “natural” interest rate – at which real (inflation-adjusted) GDP growth follows a long-term average while inflation remains stable – makes sense. But why should the inflation rate always be 2%? And why aren’t services, new technologies, or, say, Chinese manufactured goods excluded from the measure of core inflation, alongside energy and food?
Given these shortcomings, it is worth asking if central banks’ doctrine of “inflation targeting” will suffer the same fate as monetarism in the 1980s, when policymakers obsessed over the supply of money. As with inflation today, central bankers then had no credible way even to measure the quantity of money, let alone deliver desired monetary-policy outcomes.
We should consider the effects of large budget deficits as another dubious form of stimulus. In 2017, economic growth in the EU swung up to an annual rate of 2.3%, after member states had finally reduced their budget deficits to an average 1.5% of GDP, down from 6.4% of GDP in 2010. Apparently, the fiscal stimulus after the crisis was not all that stimulating. By contrast, tighter fiscal policies in recent years seem to have had a positive effect.
Usually, a financial crisis gives rise to major structural reforms. But neither the 2008 crisis nor the subsequent euro crisis, which was caused by excessive public debt, led to significant deleveraging or Schumpeterian creative destruction in the affected countries. Clearly, the flood of government spending alleviated the need for difficult reforms, and allowed incumbent enterprises to shore up their positions with cheap finance. Any chance at structural renewal was smothered in the crib.
Among EU countries, average public debt increased from 73% of GDP in 2009 to 86% of GDP in 2016, far above the ceiling of 60% of GDP set by the Maastricht criteria. In Southern Europe, public debts are so large that they will depress growth for years to come.
And yet the past decade of ultra-low interest rates will likely prove even more pernicious than the years of deficit spending. There is no telling when or where the next financial bubble will burst. But we would do well to heed the findings of economists such as the late Charles Kindleberger and Harvard’s Kenneth Rogoff and Carmen Reinhart, and tread carefully.
After all, one can spot potential bubbles all over the place. Real-estate and other asset prices are at record highs in much of the world. And the value of bitcoin in circulation has increased tenfold just this year, to $170 billion, although the cryptocurrency’s underlying value remains dubious at best.
Ultra-low interest rates have also created such a scramble for higher yields that even a poor, mismanaged country like Tajikistan can sell Eurobonds. For Tajik President Emomali Rahmon, that certainly beats seeking help from the International Monetary Fund, which would demand substantial reforms. Thanks to low interest rates, Rahmon can continue to misrule his former Soviet republic as he sees fit.
The many other victims of ultra-low interest rates should be all too apparent. Middle-class savers have watched the real value of their bank deposits decline annually at a rate of about 2%, and many retirees have suffered a real decline in their pensions, which are invested in safe assets and thus yield minimal returns.
The same is also true for many forms of insurance. Insurers themselves seem to be doing fine, but that is because they have been cutting benefits to the point that their customers will soon wonder why they bothered to take out policies in the first place.
Even banks are beleaguered. In advanced economies, traditional lenders are now subject to such a mass of regulation that they have had to withdraw from foreign activities. Not surprisingly, less regulated intermediaries in the shadow banking system have stepped in to seize much of their business.
Traditionally, the banking business centered around attracting deposits and issuing loans. But as a result of “low-for-long” interest rates, that share of banking has become ever smaller, and banks have had to charge ever-higher fees for various other financial services.
Moreover, low interest rates have diverted money toward less transparent and more speculative financial institutions, such as private-equity and hedge funds. Such institutions thrive on cheap credit, which enjoys more favorable treatment than equity financing under most Western tax regimes.
The benefits of low interest rates have accrued not to the population at large, and certainly not to the middle class, but to billionaires – the top 0.1%. The global wealth gap has widened significantly in the past decade alone, and especially in the US, where billionaires pay little to nothing in taxes thanks to special rules such as “carried interest.” And under the new Republican tax plan, they will pay even less.
The question now is whether Western institutions are strong enough to contain the global plutocracy that low interest rates have wrought.
Rewriting the Monetary-Policy Script
Many central bankers, intoxicated by rigid neo-Keynesian models of the effects of interest rates on demand and inflation, are ignoring a major lesson from decades of experimentation: the impact of monetary policy cannot be predicted with a high degree of certainty or accuracy. To manage risk, flexibility is key.
MUNICH – How long will major central banks blindly rely on rigid rules to control inflation and stimulate growth? Given the clear benefits of nimble monetary policy, central bankers need to open their eyes to the possibilities that flexibility affords.
The rule of thumb for monetary policymakers has long been that if inflation is below official target ranges, short-term interest rates should be set at a level that spurs spending and investment. This approach has meant that once interest rates reach or approach zero, central banks have little choice but to activate large asset-purchase programs that are supposed to stimulate demand. When circumstances call for it, policymakers default to the predetermined scripts of neo-Keynesian economic models.
But in too many cases, those scripts have led us astray, because they assume that monetary policy has a measurable and foreseeable impact on demand and inflation. There is plenty of reason to question this assumption.
For starters, households have not responded to ultra-low interest rates by saving less and spending more. If savings no longer yield a return, people can’t afford big-ticket items or pay for retirement down the road. Likewise, companies today are faced with so much uncertainty and so many risks that ever-lower costs of capital have not enticed them to invest more.
It’s easy to see why, despite the data, predetermined formulas are attractive to monetary policymakers. The prevailing wisdom holds that in order to return the inflation rate to a preferred level, any slack in the economy must be eliminated. This requires pushing interest rates as low as possible, and when these policies have run their course (such as when rates dip toward the negative), unconventional instruments like “quantitative easing” must be deployed to revive growth and inflation. The paradigm has become so universally accepted – and the model simulations underpinning central banks’ decisions have become so complex – that few are willing to question it. For individual central banks or economists, to do so would be sacrilege.
Central banks do not completely deny the economic costs that these policies imply: exuberance in financial markets, financing gaps in funded pension systems, and deeper wealth inequality, to name just a few. But these costs are deemed an acceptable price to pay to reach the clearly defined inflation level.
Yet the policies pursued in recent years have given no room for the intangibles – unstable political environments, geopolitical tremors, or rising risks on financial markets – that can send models off course. As the 2008 financial crisis illustrated, the normal distribution of risk was useless for predictions.
Keynes never tired of arguing that monetary policy becomes ineffective if uncertainty is sufficient to destabilize the expectations of consumers and investors. Unfortunately, many central banks have forgotten this. The Bank of Japan, the Bank of England, and the European Central Bank all hone to rather rigid policy rules. If expansionary policies fail to have the desired effect of lifting inflation to the predefined level of around 2%, they do not question their models; they simply increase the policy dosage – which is just what markets expect.
For now, the US Federal Reserve has the most flexible toolkit among the major central banks. In addition to inflationary pressure, the Fed’s monetary policy must also take into account employment statistics, growth data, and the stability of financial markets. But even the Fed’s flexibility is under siege. Republican lawmakers are discussing how to bind the Fed to more scripted policy rules to manage inflation (using a formula known as the Taylor rule, which predetermines changes in the federal funds rate in relation to inflation and an output gap). Needless to say, such a move would be a mistake.
Central banks (not to mention lawmakers), with their strong attachment to neo-Keynesian theory, are ignoring a major lesson from decades of monetary-policy experimentation: the impact of monetary policy cannot be predicted with a high degree of certainty or accuracy. But the belief that it can is essential to the credibility of the now-standard inflation targets. If central banks keep missing these rather narrow marks (“below, but close to 2%”), they end up in an expectations trap, whereby markets expect them to dispense ever higher doses of monetary medicine in a frantic attempt to reach their target.
Clearly, such monetary policies create soaring costs and risks for the economy. And central banks themselves are coming dangerously close to looking like fiscal agents, which could undermine their legitimacy.
A new and more realistic monetary paradigm would discard overly rigid rules that embody the fallacy that monetary policy is always effective. It would give central banks more room to incorporate the risks and costs of monetary policies. With such a paradigm, central banks could move away from negative interest rates and large-scale asset purchases. They would define their inflation targets more flexibly, to avoid being forced into action whenever “uncertainties” such as declining oil prices or required wage adjustments cause inflation to move above or below 2%.
Perhaps most important, a new paradigm would acknowledge the limits of central banks’ power and foresight. That would remove an alibi that governments too often hide behind to avoid introducing the structural reforms that really matter for long-term growth.
The Inflation Target Trap
Central banks have a problem: economic growth is accelerating, but inflation has failed to take off. But perhaps the solution is not to continue trying to raise inflation – for most people, growth without inflation is ideal – but rather for central banks to end their preoccupation with inflation targeting.
BRUSSELS – Central banks have a problem: growth in much of the world is accelerating, but inflation has failed to take off. Of course, for most people, growth without inflation is the ideal combination. But central banks have set the goal of achieving an inflation rate of “below, but close to 2%,” as the European Central Bank puts it. And, at this point, it is hard to see how that can be achieved.
Central banks never pretended that they could steer inflation directly. But they thought that by providing rock-bottom interest rates and generous liquidity conditions in the wake of the 2008 global financial crisis, they could push investment and consumption upward. In 2009, when financial markets were in turmoil and the economy was in free-fall, the US Federal Reserve took matters a step further, initiating large-scale asset purchases, or quantitative easing (QE). The ECB followed suit in 2014-2015, when deflation appeared (wrongly, in hindsight) to threaten the eurozone.
The Fed’s actions certainly helped to stabilize financial markets. The ECB also claims that its bond purchases, after financial markets had already normalized, sparked economic growth and fostered employment. But the impact ended there.
The tightening of the labor market should have led to higher wages, which would ultimately translate into higher prices. But this mechanism, the so-called Phillips curve, seems to have broken down. In both the United States and Japan, despite low unemployment, wages are not increasing, at least not at the rate historical experience would indicate. And the wage increases that are occurring, such as in the US, are not having the impact on prices that one would expect.
The reasons for this are not well understood. Last year, low oil prices could be blamed; but, even when oil prices rebounded somewhat, inflation remained low. Another, more structural reason is that the prices of the goods comprising a large part of the consumer price index tend to fall over time, because they can be produced increasingly efficiently in low-wage countries, particularly in Asia. In addition, retailers’ margins are being squeezed, owing to competition from online shops.
This problem of “missing inflation” is especially acute in the eurozone and Japan. Because the Bank of Japan (BOJ) and the ECB have defined success exclusively in terms of achieving their inflation target, they are now in a quandary. The ECB, in particular, now has little choice but to continue its expansionary policies, including QE, until it sees some sustained increase in inflation.
For the Fed, the problem is less severe. The US is experiencing somewhat higher inflation than the eurozone and Japan are, and the Fed has a dual mandate: not just price stability, but also full employment. Having achieved the latter, it can declare at least half a victory and gradually start lifting rates.
But there is another reason why missing inflation is more of a problem for the eurozone. During the bubble years before the 2007 crisis, prices and wages increased sharply in the eurozone periphery, relative to Germany, which was plagued by high unemployment and stagnant wages. Over time, those economies became uncompetitive. When capital inflows suddenly stopped, they could not cope, requiring them to increase exports.
Now Germany is practically at full employment, but wages are not increasing at much more than 2% – far lower than the 5% rate that prevailed when Germany last had such low unemployment (below 4%), nearly 30 years ago. The resulting lack of inflation is not only contributing to Germany’s very high current-account surplus; it is also making it harder for the peripheral countries to improve their competitive position vis-à-vis Germany.
The ECB must set its monetary policy on the basis of the eurozone average. But it would clearly be more comfortable if the competitive imbalances that arose during the boom years were corrected more quickly, and most European policymakers would welcome some rebalancing as well.
But the real question is not whether inflation closer to 2% would be desirable. QE is a policy for desperate times. Today, the economic environment is totally different than it was just a few years ago: financial markets are buoyant, financing conditions are highly favorable, the economy is expanding satisfactorily, with no sign of deflation.
In a recent speech, ECB President Mario Draghi observed that reflationary dynamics are “slowly taking hold.” Taking him at his word, markets immediately traded the euro up, because investors concluded that, under these circumstances, negative rates and asset purchases would no longer be warranted. But the ECB quickly denied this interpretation.
That was a mistake. It makes no sense to continue with policies designed for a thunderstorm when the sun is shining again. The ECB need not reverse course completely, but it could declare victory in the fight against deflation and start exiting its emergency policies.