In those distant days when world sharemarkets were still at or very near record highs – actually, on Monday – the Federal Reserve Bank of San Francisco released one of their short accessible Economic Letters summarising some research work done last year on the question “Is the Risk of the Lower Bound Reducing Inflation?“. The views expressed are those of the authors, not the FRBSF let alone the wider Federal Reserve system, but the authors aren’t just fresh out of college either: one is the executive vice-president and head of research (one of the most senior policy positions) at the FRBSF, and the two authors are senior managers on the research side of the Bank of Canada.
Here is their summary
U.S. inflation has remained below the Fed’s 2% goal for over 10 years, averaging about 1.5%. One contributing factor may be the impact from a higher probability of future monetary policy being constrained by the effective lower bound [ELB] on interest rates. Model simulations suggest that this higher risk of hitting the lower bound may lead to lower expectations for future inflation, which in turn reduces inflation compensation for investors. The higher risk may also change household and business spending and pricing behavior. Taken together, these effects contribute to weaker inflation.
How does this work? Here is their description
If monetary policymakers are constrained by the ELB in the future, recessions could be deeper and last longer because central banks may be unable to provide sufficient stimulus. The greater decline in economic activity in this case would translate into lower inflation during such downturns relative to recessions when the policy rate is not close to the lower bound.
In addition, greater risk of returning to the ELB could also affect inflation during good times, when the economy is performing well and interest rates are above the lower bound. Investors and households often care about the future when making long-term investment decisions that are difficult to reverse, such as setting up a new production plant or buying a house. The possibility that recessions might be more severe in the future because of the ELB can affect their economic decisions today, prompting them to be more cautious to guard against this risk. For instance, households could start saving more in anticipation of possible harder times ahead. Similarly, businesses could engage in precautionary pricing by setting lower prices today if they anticipate a greater likelihood of deeper recessions in the future and do not review their pricing strategy frequently.
As something for the future – perhaps the very near future – it all seems a plausible tale, and is consistent with a line I’ve been running here for years, that when the next severe downturn comes markets (and other economic agents) will quickly focus on the limitations of conventional monetary policy and adjust their behaviour (for the worse, in cyclical terms) accordingly, deepening and lengthening the downturn. But these authors go further and posit that people (real economy and financial markets) have already been factoring the ELB risks into their planning and decisionmaking, in turn directly contributing already to lower inflation and lower inflation expectations (than perhaps the current cyclical state of the economy might otherwise deliver).
I haven’t yet read their full working paper so can’t really evaluate the strength of their evidence on this point. But if they are capturing something important about actual behaviour in the last decade or so, presumably those effects would be expected to have become larger the closer to the present we come. Prior to 2007 the Fed (and other central banks other than Japan) had not reached the ELB at all. Immediately after the recession there was a pretty strong expectation that things would return to normal (including normal policy interest rates) before too long – a view typically shared by markets and by central banks. Only with the passage of time did those expectations gradually fade – and perhaps more completely in Europe (where policy rates are still often negative, and pretty consistently lower than those in the US).
For New Zealand, of course, if there is anything to this story, it must be even more recent, having started with higher policy rates, and with markets and the Reserve Bank mostly looking towards higher policy rates until just the last couple of years. The possibility of reaching the ELB in New Zealand has been a distinctly minority point (yours truly and perhaps a few others) for most of the last decade, in ways that leave me a little sceptical that the story will explain anything much of the inflation experience in New Zealand (or Australia) for the decade as a whole. In both countries, inflation has averaged materially below the respective target midpoints.
Whatever the case for the past, the FRBSF note ends with this point
These findings suggest that the puzzle of how to raise inflation to meet central bank goals may require new ways of addressing the risk of returning to the ELB and new ways of understanding how to set and meet inflation goals.
The problem is that there is a growing risk that it is now too late, and that central banks (and Ministries of Finance) have spent the last ten years not getting to grips with ensuring effective capacity for the next severe downturn, leaving things potentially almost paralysed when that severe downturn breaks upon us. Which it could be doing right now.
Many advanced country central banks can now barely reduce the policy interest rate much at all – the biggest problem with former Fed governor Kevin Warsh’s call yesterday for a coordinated international rate cut is that it would immediately highlight the limits, especially in Europe. Even in a traditionally high interest rate country like New Zealand, there is perhaps 150 basis points of capacity, when the average recession in recent decades has involved 500+ basis points of cuts – a point our Minister of Finance rather glossed over yesterday in his talk of the advantage of starting with relatively high interest rates.
As the FRBSF authors note
To compensate for this lack of conventional firepower, central banks can rely on unconventional policy tools, such as forward guidance or quantitative easing. While these tools proved effective during and following the crisis, it remains unclear whether they can fully compensate for the diminished conventional policy space and the more frequent encounters with the ELB
That is fairly diplomatic speak, as befits senior officials. In reality, few really believe that unconventional tools under the control of central banks can adequately compensate for lack of conventional policy space.
In my view, those limits have not really been sufficiently focused on by markets, firms and households, or governments. There has been quite a lot of wishful thinking around – hankering for higher neutral rates, inability to spot an near-at-hand risk that might trigger an early severe downturn, or whatever. But when people look at the looming coronavirus risks – and markets will no doubt ebb and flow still, just as happened as the financial crisis unfolded a decade ago – and really begin to focus on what can, and will, be done, we are likely to see inflation expectations falling away much faster than in a normal downturn, in turn raising real interest rates and accentuating the problems, at a time when neutral interest rates are likely to be falling further (perhaps temporarily, but real enough for the time being).
To bring that back to the New Zealand situation, after ignoring the issue for a long time the Reserve Bank appears to have begun to take it more seriously in the last 18 months or so. But with little or no transparency and no apparent urgency. We keep being told they are about to reveal their thinking – I hope with a view to getting serious feedback etc – but they’ve already mentioned enough that we can be sure that what they’ve had in mind simply will not make up for the limits of conventional interest rate capacity, even allowing for the likelihood that in such a severe downturn our exchange rate will fall a long way (as it did in most of those previous 500 basis point rate cut episodes). There is also sadly little sign that the Minister of Finance has shown much leadership or urgency about seriously addressing this problem (again, nothing along those lines in yesterday’s speech – good enough as far as it went, but it stopped short of the really serious issues/risks).
It would be easy for me to suggest that the Governor has been too much occupied with his tree gods, his climate change interests, his views on infrastructure or the distribution of income, rather than driving action urgently in this area of monetary policy capacity (core day job). And that is no doubt true, but as a specific criticism it needs to be kept in perspective – his predecessors had let the issue drift, and his peers at the top of many other central banks have also seemed to prefer to believe things would come right than to seriously prepare for the constrained alternative. We risk paying the price now – including with central banks paralysed by their own limitations and reluctant to act early and decisively to lean against (do what they can to buffer) the economic downturn (and downside risks to inflation and inflation expectations).
Quite possibly there is a place for fiscal policy in responding to a serious downturn, even one amid the chaos of a potential pandemic, but there needs to be a lot more realism about the likely constraints on how much, and how longlasting, any discretionary stimulus is likely to last. There is no real excuse – even in a less fiscally constrained country like New Zealand – for authorities not to have moved to greatly alleviate or remove the effective lower bound before now, and to have used relatively settled times to have socialised the case for doing so.
And even if the FRBSF authors are wrong about the influence of the ELB on inflation over the last decade, if it very quickly now becomes even more binding – starting from a lower initial level – it will be front of brain for everyone through the next cycle. It really needs to be dealt with now. It isn’t technically hard – there are various workable options – but it needs leadership, will, and vision for something to happen, something which has the potential to limit the extremes (depth, duration) of that severe downturn whenever it finally strikes us.