Wolfgang Munchau of the Financial Times provides an excellent and from what I can tell, overlooked argument against central banks’ eagerness to cut interest rates to shore up wobbly financial markets.
His point is simple, and I am annoyed that I didn’t think of it. The reason that monetary authorities are so quick to lower rates when a bubble bursts is that if an economy slips into deflation, it is very difficult to pull it out, as the last decade plus of stagnation attest. Yet as Munchau illustrates, there is no sign of a rapid fall in inflation, such as took place in Japan in the early 1990s and the US in the 1930s. Au contraire, inflation expectations are rising, particularly in Europe. That suggests that by using the wrong remedy, central bankers will merely be replacing one set of problems with another.
From the Financial Times:
“If stupidity got us into this mess, then why can’t it get us out?”
– Will Rogers, late US writer and actor
We are certainly trying very hard.
The stupidity that got us into our financial mess was low, and occasionally negative, real interest rates over long periods of time. Now that the bubble has burst, central banks are responding by cutting interest rates yet again.
By the end of this year, if market expectations prove correct, the US Federal Reserve will have cut short-term rates by a full percentage point from their peak. It has become the policy orthodoxy of the early 21st century that central banks must overreact to asset-price induced economic downturns.
This orthodoxy has its intellectual roots in past recessions. Burst asset price bubbles triggered the Great Depression in the 1930s and more recently cost Japan a decade of economic growth. What turned these crises into calamities was a string of policy mistakes. In both cases, central banks failed to respond to a sharp fall in inflation.
Once deflation descended on the US and Europe in the 1930s and on Japan in the 1990s, the zero nominal interest rate rendered monetary policy toothless: since nominal rates cannot go below zero, negative inflation implies positive real interest rates. In such an environment, central banks lose their ability to provide sufficient stimulus. The lesson the current generation of policymakers has drawn is that the monetary policy has to react fast and decisively when an asset-price bubble bursts and threatens a recession.
But that conclusion does not follow logically from historical observation. The mistake central banks made during those periods was to disregard a strong fall in inflation. It is our consensus today – and rightly so – that the ultimate purpose of monetary policy is to keep consumer price expectations anchored at some mildly positive inflation rate. Should those expectations fall dramatically, history has taught us that a central bank must act decisively to bring inflation back into target.
But we are living in a very different environment. On the contrary, inflation expectations are rising everywhere, and this is not a statistical argument about the price of oil and food. US core inflation has been above the central bank’s comfort level for some time. And in the eurozone, even a strong euro has not stopped inflation from rising to 3 per cent in November. This year’s price increases may fall out of next year’s inflation indices, but what about next year’s price increases? We are already seeing evidence of those dreaded second-round effects. Whether it is Finnish nurses or German train drivers, Europeans are asking for wage increases to compensate for a loss of purchasing power. Some of these negotiated wage increases are no longer consistent with the inflation target and productivity developments.
Just witness the furious debate on purchasing power that is raging in the French media. A perceived loss of purchasing power is often a first step towards a persistent increase in inflationary expectations. Long-term inflation expectations in the eurozone, as measured by interest rate futures, are running at nearly 2.5 per cent, which is not consistent with an official target of “close to but below 2 per cent”. While some forecasters expect eurozone inflation to slow next year, nobody predicts that it will fall below target, let alone turn negative.
So the inflation outlook would justify a neutral policy stance at best. I agree that there is a non-trivial risk of a substantial slowdown in the US economy and maybe even a recession. But it is not clear to me that monetary policy is the right tool to deal with a slowdown that is not accompanied or caused by a decline in inflationary expectations.
This is not a moral point. It is about what a central banker’s toolkit can realistically achieve. If a financial market generates a bubble, one would expect that asset prices would eventually fall back after the bubble has burst. Over long periods asset prices are self-correcting. If a central bank does not care about asset prices on the way up, but starts to target them on the way down, it risks stoking up inflationary expectations.
Look at it in terms of insurance. Lower interest rates insure us against the risk of a slowdown, but we are paying a price by accepting new risks. Among the biggest are moral hazard and higher inflation in the future.
The moral hazard argument is well known: banks reap the profits in the good times and beg for central bank support during bad times.
Higher inflation is a more immediate concern. If it is tolerated, expect serious convulsions in global bond markets and serious disruption to the global flows of funds. If it is not tolerated, expect a policy shift in the opposite direction and at greater magnitude. Neither scenario is appealing.
On balance, the benefits of a loose monetary policy are not nearly as one-sided as its advocates claim. A bias towards low interest rates got us into this mess. Low interest rates will not get us out of it. Central banks should keep their cool.