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2014-04-01 09:43:12
Higher inflation may be needed to leave extra-low interest rates behind
Mar 29th 2014
AT FIRST glance, rich-world central banks are going their separate ways.
Cheered by sturdy growth figures, the Bank of England and the Federal Reserve
are shuffling toward an exit from easy monetary policy; markets found Janet
Yellen s first Fed statement unexpectedly hawkish. The European Central Bank,
in contrast, is tacking looser. On March 25th Jens Weidmann, president of the
Bundesbank, suggested that the ECB might need to be more forceful in order to
keep the euro-area economy out of the grips of deflation.
Look again, however, and the path forward appears similar across the rich
world: low interest rates stretch off into the visible distance. The outlook is
clearest in Europe, where the ECB may toy with negative rates as a means to
fend off deflation. But even in America and Britain normal rates are a
distant prospect. In February Mark Carney, the Bank of England s governor,
promised that eventual rate rises would happen gradually, and would level off
below the pre-crisis norm. On March 19th Ms Yellen offered similar guidance.
Markets project that short-term rates in both economies will still be just 2%
in early 2017 (see chart 1), a level the euro zone will not hit until 2020.
As normalisation recedes toward the horizon, central bankers moan publicly
about the costs of low rates. In February Daniel Tarullo, a Fed governor, said
that they might encourage investors to take dangerous risks as they reach for
yield . Even more worrying, low rates leave little cushion against future
shocks. The Fed s main policy rate was just 2% when Lehman Brothers failed in
2008, compared with 5% at the start of the 2001 recession and 8% when the
downturn of 1990 began.
Yet rates are low for good reason: economies cannot withstand dearer credit.
Central banks are battling against two sources of downward pressure on their
main policy rates. One is the rock-bottom level of the real (ie,
inflation-adjusted) interest rate needed to keep economies running at full
tilt. This natural rate has been dragged down by long-term structural trends.
A global savings glut is partly to blame: export powerhouses like the OPEC
countries and China buy vast quantities of rich-world debt, depressing
borrowing costs in the process. Rising inequality also adds to the pool of
underused savings, since the rich save more of their income. Leaden real rates
were reinforced by the financial crisis. Tumbling asset prices forced
households to repay debts rapidly. As they struggled to deleverage, their
interest in new borrowing and spending evaporated.
Central banks bear more responsibility for the second complication: low
inflation. Since besting the double-digit price rises of the 1970s, most
central banks have set inflation targets of around 2% per year. But though
stable prices are a true central-bank achievement, they have not been won
without cost: headline interest rates fell alongside inflation, as borrowers
required less compensation for erosion of the value of their principal by
rising prices (see chart 2). That raised the odds of a bump against near-zero
rates a collision that has forced central banks to use unfamiliar and untrusted
tools to combat slow growth.
Though central banks are in a tight spot, stuck between the economy s need for
cheap credit and the mounting costs of low rates, they are not without options.
Some of the pressure could be eased by higher inflation. This would let central
banks cut effective borrowing costs despite the zero bound on interest rates,
since inflation reduces the burden of repaying a given loan. Just as important,
higher inflation would speed up interest-rate normalisation.
Last November Fed economists published a paper arguing that lifting the
inflation target to 3% would rapidly lower unemployment while allowing the Fed
s policy rate to rise higher, faster. The argument does not seem to have swayed
the Fed s monetary-policymaking committee, which continues to project inflation
of at most 2% until the end of 2016. Markets reckon prices will rise even more
slowly.
A rise in the inflation target would not be an easy step to take. The ECB would
need permission from its political masters. The Fed only established an
official target of 2% in January 2012; its officials would no doubt worry that
so great a change after so little time would undermine its credibility.
But it is still hard to explain central banks nonchalance in the face of
below-target inflation. Since declaring its 2% target the Fed has undershot
almost 90% of the time; American inflation is now just 1.2%. Elsewhere low
inflation is becoming more entrenched. Euro-area inflation is 0.7% and falling.
In Britain, where above-target inflation was the norm for much of the recovery,
consumer prices rose at just 1.7% in the year to February.
Central banks could do a world of good simply by promising not to tighten until
inflation is back on target. Seizing on better economic conditions to begin
preparing for rate rises may seem like good sense. But tightening policy while
inflation is no threat will make fighting the next recession much more
difficult.