Big dan­ger at the lower bound

No room for rate cuts in re­ces­sion

Financial Mirror (Cyprus) - - FRONT PAGE -

Mar­kets nowa­days are fix­ated on how high the US Fed­eral Re­serve will raise in­ter­est rates in the next 12 months. This is dan­ger­ously short­sighted: the real con­cern ought to be how far it could cut rates in the next deep re­ces­sion. Given that the Fed may strug­gle just to get its base in­ter­est rate up to 2% over the com­ing year, there will be very lit­tle room to cut if a re­ces­sion hits.

Fed chair Janet Yellen tried to re­as­sure mar­kets in a speech at the end of Au­gust, sug­gest­ing that a com­bi­na­tion of mas­sive govern­ment bond pur­chases and for­ward guid­ance on in­ter­est-rate pol­icy could achieve the same stim­u­lus as cut­ting the overnight rate to mi­nus 6%, were neg­a­tive in­ter­est rates pos­si­ble. She might be right, but most econ­o­mists are skep­ti­cal that the Fed’s un­con­ven­tional pol­icy tools are nearly so ef­fec­tive.

There are other ideas that might be tried. For ex­am­ple, the Fed could fol­low the Bank of Ja­pan’s re­cent move to tar­get the ten-year in­ter­est rate in­stead of the very short-term one it usu­ally fo­cuses on. The idea is that even if very short-term in­ter­est rates are zero, longer-term rates are still pos­i­tive. The rate on ten-year US Trea­sury bonds was about 1.8% at the end of Oc­to­ber.

That ap­proach might work for a while. But there is also a sig­nif­i­cant risk that it might even­tu­ally blow up, just the way pegged ex­change rates tend to work for a while and then cause a catas­tro­phe. If the Fed could be highly cred­i­ble in its plan to hold down the ten-year in­ter­est rate, it could prob­a­bly get away with­out hav­ing to in­ter­vene too much in mar­kets, whose par­tic­i­pants would nor­mally be too scared to fight the world’s most pow­er­ful cen­tral bank.

But imag­ine that mar­kets started to have doubts, and that the Fed was forced to in­ter­vene mas­sively by pur­chas­ing a huge per­cent­age of to­tal govern­ment debt. This would leave the Fed ex­tremely vul­ner­a­ble to enor­mous losses should global forces sud­denly drive up equilib­rium in­ter­est rates, with the US govern­ment then com­pelled to pay much higher in­ter­est rates to roll over its debt.

The two best ideas for deal­ing with the zero bound on in­ter­est rates seem off-lim­its for the mo­ment. The op­ti­mal ap­proach would be to im­ple­ment all of the var­i­ous le­gal, tax, and in­sti­tu­tional changes needed to take in­ter­est rates sig­nif­i­cantly neg­a­tive, thereby elim­i­nat­ing the zero bound. This re­quires pre­vent­ing peo­ple from re­spond­ing by hoard­ing pa­per cur­rency; but, as I have ex­plained re­cently, this is not so dif­fi­cult. True, early ex­per­i­men­ta­tion with neg­a­tive in­ter­est-rate pol­icy in Ja­pan and Europe has caused some dis­en­chant­ment. But the short­com­ings there mostly re­flect the fact that cen­tral banks can­not by them­selves im­ple­ment the nec­es­sary poli­cies to make a neg­a­tive in­ter­est rate pol­icy fully ef­fec­tive.

The other ap­proach, first an­a­lysed by Fed econ­o­mists in the mid-1990s, would be to raise the tar­get in­fla­tion rate from 2% to 4%. The idea is that this would even­tu­ally raise the pro­file of all in­ter­est rates by two per­cent­age points, thereby leav­ing that much ex­tra room to cut.

Sev­eral cen­tral banks, in­clud­ing the Fed, have con­sid­ered mov­ing to a higher in­fla­tion tar­get. But such a move has sev­eral sig­nif­i­cant draw­backs.

The main prob­lem is that a shift of this mag­ni­tude risks un­der­min­ing hard-won cen­tral bank cred­i­bil­ity; af­ter all, cen­tral banks have been promis­ing to de­liver 2% in­fla­tion for a cou­ple of decades now, and that level is deeply em­bed­ded in long-term fi­nan­cial con­tracts.

More­over, as was true dur­ing the 2008 fi­nan­cial cri­sis, sim­ply be­ing able to take in­ter­est rates 2% lower prob­a­bly might not be enough. In fact, many es­ti­mates sug­gest that the Fed might well have liked to cut rates 4% or 5% more than it did, but could not go lower once the in­ter­est rate hit zero.

A third short­com­ing is that, af­ter an ad­just­ment pe­riod, wages and con­tracts are more likely to ad­just more fre­quently than they would with a 2% in­fla­tion tar­get, mak­ing mone­tary pol­icy less ef­fec­tive. And, fi­nally, higher in­fla­tion causes dis­tor­tions to rel­a­tive prices and to the tax sys­tem – dis­tor­tions that have po­ten­tially sig­nif­i­cant costs, and not just in re­ces­sions.

If ideas like neg­a­tive in­ter­est rates and higher in­fla­tion tar­gets sound dan­ger­ously rad­i­cal, well, rad­i­cal is rel­a­tive. Un­less cen­tral banks fig­ure out a con­vinc­ing way to ad­dress their paral­y­sis at the zero bound, there is likely to be a con­tin­u­ing bar­rage of out­side­the-box pro­pos­als that are far more rad­i­cal. For ex­am­ple, the Univer­sity of Cal­i­for­nia at Berke­ley econ­o­mist Barry Eichen­green has ar­gued that pro­tec­tion­ism can be a help­ful way to cre­ate in­fla­tion when cen­tral banks are stuck at the zero bound. Sev­eral econ­o­mists, in­clud­ing Lawrence Sum­mers and Paul Krug­man, have warned that struc­tural re­form to in­crease pro­duc­tiv­ity might be coun­ter­pro­duc­tive when cen­tral banks are paral­ysed, pre­cisely be­cause it low­ers prices.

Of course, there is al­ways fis­cal pol­icy to pro­vide eco­nomic stim­u­lus. But it is ex­tremely un­de­sir­able for govern­ment spend­ing to have to be as volatile as it would be if it had to cover for the in­ef­fec­tive­ness of mone­tary pol­icy.

There may not be enough time be­fore the next deep re­ces­sion to lay the ground­work for ef­fec­tive neg­a­tive-in­ter­est-rate pol­icy or to phase in a higher in­fla­tion tar­get. But that is no ex­cuse for not start­ing to look hard at these op­tions, es­pe­cially if the al­ter­na­tives are likely to be far more prob­lem­atic.

Newspapers in English

Newspapers from Cyprus

© PressReader. All rights reserved.