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2014-10-14 12:57:41
Oct 14th 2014, 9:40 by R.A. | LONDON
THE monetary economics of a world in which interest rates are close to zero are not especially mysterious. Stimulating the economy at that point requires central banks to raise expected inflation. Disinflation, by contrast, results in passive tightening, since the central bank can't lower its policy rate and since the real interest rate is the policy rate less expected inflation. In this world, the downside risks are much larger than those to the upside. There is infinite room to raise interest rates if inflation runs uncomfortably high (one might even welcome that opportunity to push rates up as that would reduce the probability that rates would fall to zero again in future). But there is no room to reduce interest rates if inflation is running to low. That, in turn, forces central banks to use unconventional policy or run psychological operations to try to boost expectations. Central banks are not very good at those sorts of things.
You need to overshoot, in other words, because undershooting feeds on itself. The zero lower bound is a heavy drag on an economy that must be thrown off by rapid growth. If a central bank is too cautious it will not simply fail to escape the ZLB; the effort of trying to provide stimulus through unconventional routes may lead to stimulus fatigue. The central bank may simply become less willing to take the necessary expansionary steps, creating an increased risk that the weight of the ZLB drags the economy beneath the waves.
Fatigue may be setting in at the Federal Reserve, which is expected to end its asset-purchase programme at its meeting later this month. Hawkish members of the Federal Open Market Committee are seizing on a relatively low and falling unemployment rate and on good hiring numbers as evidence that the economy can stand on its own. And if the Fed's main policy rate were at 4% rather than just above 0%, they might have a point. But the FOMC ought to have learned by now that an economy at the ZLB does not function like an economy in which interest rates are well above zero.
The threat is clear enough. Inflation in America is below the Fed's 2% target and looks to be falling again. The disinflationary winds blowing in from abroad are strengthening to a gale. Commodity prices are tumbling; cheaper resources will have a direct disinflationary impact in America but also signal a weakening global economy which should itself reduce inflationary pressures. Inflation in the euro zone has tumbled to 0.3%, and with many of the euro area's large economies in or near recession the downside economic risks in Europe are substantial. In Britain, which alongside America is the closest thing the rich world has to an economic success story, inflation has dropped sharply to just 1.2%, and markets are revising outward the date at which the Bank of England is expected to raise interest rates.
American markets are once again hunkering down for a bout of disinflation. Expectations for inflation over the next five years have fallen half a percentage point since July, to around 1.5%: a level at which the Fed has previously moved to begin new asset purchases. The yield on long-term Treasuries is tumbling again; the 10-year is down to around 2.2%, from nearly 3% earlier this year. Equity prices are sinking while the dollar is rising sharply. And futures markets now suggest the first increase in the Fed's main policy rate will not occur until January of 2016.
My question for the Fed is: what happens when disinflation continues in November and December after the Fed has termintated its asset purchase programme? Is it prepared to start purchases up right away, or will it wait to see whether things turn around? If so, how long is it prepared to wait? What is the plan here? Employment growth is not going to continue at current rates for very long if inflation expectations continue to behave this way while interest rates are at zero.
There are so many ways things around the rich world could go very badly in coming months. The euro zone, in particular, is entering a new and dangerous crisis phase, with Germany seemingly committed to fiscal tightening even as its economy falls into recession alongside France and Italy. A renewed dip into recession could lead to revolt, in markets or in the political systems of peripheral economies that have had enough of economic contraction forever.
The sensible course is what it has been for the last six years: keep pushing until the economy is well clear of danger. If inflation gets up to 3% or 4% or 5%, well, there are far worse things, and the response is simple enough: tighten policy. Erring in the opposite direction may end up far more costly, however. As, I fear, we all may learn.