As Deflation Stalks the World Economy, Leaders Cling to Outdated Thinking

The world’s finance ministers and central bankers have been making tracks for Lima, where the annual World Bank/IMF meetings are taking place.  Their mood is apprehensive.  While world GDP is far from shrinking, as it was in 2009, growth forecasts are continually being cut.  In estimates released last week, the IMF reduced its projected 2015 rate of expansion in global GDP to 3.1% from its 3.3% July forecast.  For 2016, the IMF now foresees 3.6% growth as against its July expectation of 3.8%.  This is not the first occasion in the post-2009 recovery that forecasters have felt obliged to lower their sights on growth.  It has been a regular tendency.  Furthermore, consumer price data in most of the advanced economies indicate there are strong disinflationary forces at work despite the fact that central banks are pursuing unprecedentedly loose monetary policies.  To policymakers who are steeped in the economic wisdom of the age, such as it is, the lack of buoyancy in consumer prices is a warning that an intractable economic depression may be a present danger.

For some years past, the standard response of policymakers to slow growth and disinflation has been to rely on ever-easier monetary policies to cure the economic malaise.  The scope for conventional monetary easing was more or less exhausted in 2009-10 when official short-term rates were taken down as near as was practical to zero.   That was when central bankers began to resort to ‘non-conventional’ measures, chief among which was their purchasing of large amounts of securities (mainly government bonds) in the market.  But even after these efforts, economic performance still appears unsatisfactory.  There are two possible conclusions to be drawn.  Either the measures taken did not address the root-problem and so were not effective, or else they were not applied with sufficient vigour, that is, monetary policy was still not stimulative enough.  Central bankers are reluctant to countenance the first of these possibilities because it might mean that they are powerless to deal with the problem confronting them.  However, they are cautious about adopting the second explanation because they are concerned that central bank asset purchases might already have damaged the financial markets and that expanding the asset-buying might have an even more severely distorting effect.  Hence, some central bankers are exploring possibilities for action that go beyond what has so far been regarded as non-conventional.

One approach would deny the reality of a zero lower bound on interest rates.  The reason why central bankers resorted to the non-conventional is that they believed the lower bound was, indeed, binding.  But if negative interest rates are admitted to be a practical policy-option, substantial scope for potential monetary easing opens up.  How banks might behave if the only rates available to them on a wide range of the assets they are wont to hold were negative is hard to predict.  Central banks might find that, in creating an environment inimical to bank profitability, they were reducing the banks’ willingness to incur the risks inherent in lending to customers.  Further, the extent to which banks would be willing to shift from assets with low risk-weights but carrying negative interest rates to loans with high risk-weights but earning positive rates might in any case be limited, given that banks must nowadays pay attention to meeting stiff capital requirements.  As for bank depositors, the imposition of negative interest rates would probably lead to a reduction in their propensity to hold funds with banks and other financial institutions, and an increase in their willingness to hold cash.  After all, the zero interest rate that cash earns would be relatively attractive if deposit rates were negative.

The most effective means a hostile power might employ to bring the country to its knees might be to launch a cyber-attack on the digital currencyThis potential problem with negative interest rates is leading a few central bankers to consider the radical step of abolishing cash.  If the circulation of cash stands in the way of their implementing a super-accommodative regime of negative interest rates, they argue, then cash must be eliminated from the monetary system.  It could be replaced by digital entries in a ledger maintained by the central bank, on which entries the central bank would be able to levy negative interest rates.  It should be clear that such a ‘reform’ could not be implemented with the freely-given assent of economic agents.  For why would they risk incurring negative interest rates on their liquid balances when currently they do not have to?  Further, enough of these agents have experienced problems as a result of relying on digital entries maintained by commercial banks for there to be a degree of distrust in any central bank’s e-money.  Finally, such a regime would be exposed to the risk of electronic breakdown and, more especially, sabotage.  The most effective means a hostile power might employ to bring the country to its knees might be to launch a cyber-attack on the digital currency.  That would not only paralyse day-to-day economic transactions; it would surely sap national morale.  This seems a serious risk to run merely so that central bankers might congratulate themselves that they are back in control of the economy (that is, assuming negative interest rates would turn out to be more effective than any of the other measures they have tried up to this point).

So desperate are some policymakers to do something that might be effective, they have suggested raising the consumer price (CPI) inflation target from the 2% or so that most central banks in the advanced economies currently have in their sights.  They maintain that declaring the inflation target is to be, say, 4% might jerk the economy out of its lethargy.  It is not at all clear why they should think this, however.  Why would economic agents regard 4% inflation as a credible prospect, when central banks have failed to meet existing targets around 2%?  There would be an even bigger gap between central bank objectives and reality than there is at present. But even if economic agents believed the central bank was going to achieve 4% inflation, that would probably not boost spending in the economy.  It might, indeed, depress it.  For if consumers doubted whether their own incomes would keep pace with so elevated a rate of inflation, they might be careful to curb current expenditures so as to be able to meet the cost of future necessities.  The theory says that consumers would rush out to buy in anticipation of higher prices later but they could not do this if they did not have the wherewithal to finance their purchases.  With stagnating wages and maxed out credit cards, they would be in no position to step up their spending.  For them, it is a mercy that prices are not rising because that means their meagre gains in income allow them just about to maintain their living standards.  Further, with little prospect of consumer spending picking up, companies have only weak incentives to raise their capital expenditures.

Perhaps central banks, far from raising their inflation targets, would be better advised to cut them.  It is not obvious why they equate 2% inflation with price stability.  While 2% may appear a modest rate of increase in prices, it does, in fact, mean a doubling in the general price-level every thirty-five years or so.  For a worker making provision for retirement that is no small matter. The reasons why, against common sense, central banks nevertheless regard 2% as an appropriate target for the inflation rate are twofold.  Long ago they assumed that the official consumer price data over-estimated the rate of inflation because they did not take full account of the degree to which price increases reflected quality improvements.  But with the ever more widespread deployment of hedonic adjustments to raw consumer price data, this argument against a zero inflation target is nowadays much weaker than it used to be.  Secondly, central banks have believed that the overall target for inflation needs to be set at a margin above zero because of the ‘stickiness’ of prices on the downside.  Since, in the post-1960s era, producers were resistant to cutting the prices of any of the goods and services they supplied, it was necessary to leave a margin above zero in the CPI target so as to accommodate price increases dictated by cost and demand developments where these were inflationary. However, price ‘stickiness’ on the downside is no longer a feature of the advanced economies.  The very fact that policymakers worry that deflation is a live risk shows they believe price movements are not necessarily all one-way.  In these circumstances there is a strong case to argue that zero inflation represents price stability.

Central Bankers appear to be in thrall to the tenets of an economic dogma fostered by a coterie of self-styled expertsThere is, of course, a question whether central banks should really be targeting CPI inflation.  After all, CPI measures capture only a fraction of the price changes in the economy that may be relevant to a monetary strategy with stability as its goal.  The world’s leading central bankers, though, seem to be locked into a mind-set that regards CPI inflation targeting as the only proper way of conducting policy.  The signs are that, as they continually fail to deliver positive results, impatience with their efforts is mounting.  For seven years, central bankers have been promising a return to normality but they are themselves reluctant to claim they are at all close to reaching their objective.  They appear to be in thrall to the tenets of an economic dogma fostered by a coterie of self-styled experts passing through the revolving-door linking the central banks to a narrow range of academic institutions.

The clearest indication of dissatisfaction with central banks’ performance has appeared in Japan.  There, Shinzo Abe seems to have abandoned hope of economic gains from more expansive monetary policy.  In a keynote economic statement last month, Japan’s prime minister outlined a plan to boost the economy that, like the original Abenomics programme, would comprise three ‘arrows’.  These were to increase Japan’s nominal GDP to ¥600trn by 2020, to reform the social security system and to improve care for the growing ranks of the elderly.  He made no specific mention of the contribution to be made by monetary policy.  Indeed, his assertion that Japan was no longer in deflation, even when the evidence for that view is far from compelling, seemed to be aimed at drawing a line under the first phase of Abenomics.  It could well be that Mr Abe has noticed that the chief consequence so far of the Bank of Japan’s monetary ease, and associated yen weakness, has been to push up import prices. to the detriment of consumers.  This is an inconvenient result when Mr Abe faces an Upper House election next year.  Haruhiko Kuroda at the BoJ is still saying that the central bank is ready to do whatever is needed to achieve its inflation target but he is not setting a timeframe on that.  He, too, is declaring he sees no problem in the broad trend in consumer prices and that Japan is no longer in deflation.  He has ruled out easing policy by cutting the interest rate the BoJ pays on bank reserves.  When the central bank’s policy council meets later this month, its members may feel they should make a small adjustment to the QQE asset purchase scheme to preserve BoJ credibility in the face of persistently weak CPI numbers but further substantial easing seems unlikely.

The initial impact of Mr Abe’s apparent reaction against ever-easier monetary policies has been to curb the yen’s weakness against the US dollar. If BoJ’s monetary policy actions this month turn out to be more limited than the markets currently expect, the yen might even gain against the US currency.  However, a shift in policy in Japan could have more profound and long-lasting implications.  It could lead political leaders elsewhere to question whether central banks are really serving broader economic interests by aiming, with dogged determination, to reach targets for CPI inflation that are no help in achieving smooth adjustment to post-crisis conditions.  Central bank actions may increasingly be seen as the problem rather than part of the solution. Central bankers were granted their political independence but they have abused the privilege, conducting experiments in a so far futile attempt to validate pet theories rather than consider broader economic welfare.

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About the author

Stephen’s career spanning five decades has made him one of the most respected and unique voices in the City of London. Disclaimer regularly publishes a selection of his elegant and thoughtful essays on the global economy, which he has been writing regularly since he founded Fifth Horseman Publications in the late 1980s. As well as an economist, Stephen serves as Treasurer of the Forum for European Philosophy and was elected to the Royal Institute of Philosophy.

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