At first glance, rich-world central banks are going their separate ways. Cheered by sturdy growth figures, the Bank of England and the Federal Reserve are shuffling toward an exit from easy monetary policy; markets found Janet Yellen’s first Fed statement unexpectedly hawkish. The European Central Bank, in contrast, is tacking looser. On March 25 Jens Weidmann, president of the Bundesbank, suggested that the ECB might need to be more forceful in order to keep the euro-area economy out of the grips of deflation.
Look again, however, and the path forward appears similar across the rich world: low interest rates stretch off into the visible distance. The outlook is clearest in Europe, where the ECB may toy with negative rates as a means to fend off deflation. But even in America and Britain “normal” rates are a distant prospect. In February Mark Carney, the Bank of England’s governor, promised that eventual rate rises would happen gradually, and would level off below the pre-crisis norm. On March 19 Ms Yellen offered similar guidance. Markets project that short-term rates in both economies will still be just 2 percent in early 2017 (see chart 1), a level the euro zone will not hit until 2020.
As normalization recedes toward the horizon, central bankers moan publicly about the costs of low rates. In February Daniel Tarullo, a Fed governor, said that they might encourage investors to take dangerous risks as they “reach for yield.” Even more worrying, low rates leave little cushion against future shocks. The Fed’s main policy rate was just 2 percent when Lehman Brothers failed in 2008, compared with 5 percent at the start of the 2001 recession and 8 percent when the downturn of 1990 began.
Yet rates are low for good reason: economies cannot withstand dearer credit. Central banks are battling against two sources of downward pressure on their main policy rates. One is the rock-bottom level of the real (i.e., inflation-adjusted) interest rate needed to keep economies running at full tilt. This “natural” rate has been dragged down by long-term structural trends. A global savings glut is partly to blame: export powerhouses like the OPEC countries and China buy vast quantities of rich-world debt, depressing borrowing costs in the process. Rising inequality also adds to the pool of underused savings, since the rich save more of their income. Leaden real rates were reinforced by the financial crisis. Tumbling asset prices forced households to repay debts rapidly. As they struggled to deleverage, their interest in new borrowing and spending evaporated.
Central banks bear more responsibility for the second complication: low inflation. Since besting the double-digit price rises of the 1970s, most central banks have set inflation targets of around 2 percent per year. But though stable prices are a true central-bank achievement, they have not been won without cost: headline interest rates fell alongside inflation, as borrowers required less compensation for erosion of the value of their principal by rising prices (see chart 2, below). That raised the odds of a bump against near-zero rates — a collision that has forced central banks to use unfamiliar and untrusted tools to combat slow growth.
Though central banks are in a tight spot, stuck between the economy’s need for cheap credit and the mounting costs of low rates, they are not without options. Some of the pressure could be eased by higher inflation. This would let central banks cut effective borrowing costs despite the zero bound on interest rates, since inflation reduces the burden of repaying a given loan. Just as important, higher inflation would speed up interest-rate normalization.
Last November Fed economists published a paper arguing that lifting the inflation target to 3 percent would rapidly lower unemployment while allowing the Fed’s policy rate to rise higher, faster. The argument does not seem to have swayed the Fed’s monetary-policymaking committee, which continues to project inflation of at most 2 percent until the end of 2016. Markets reckon prices will rise even more slowly.
A rise in the inflation target would not be an easy step to take. The ECB would need permission from its political masters. The Fed only established an official target of 2 percent in January 2012; its officials would no doubt worry that so great a change after so little time would undermine its credibility.
But it is still hard to explain central banks’ nonchalance in the face of below-target inflation. Since declaring its 2 percent target the Fed has undershot almost 90 percent of the time; American inflation is now just 1.2 percent. Elsewhere low inflation is becoming more entrenched. Euro-area inflation is 0.7 percent and falling. In Britain, where above-target inflation was the norm for much of the recovery, consumer prices rose at just 1.7 percent in the year to February.
Central banks could do a world of good simply by promising not to tighten until inflation is back on target. Seizing on better economic conditions to begin preparing for rate rises may seem like good sense. But tightening policy while inflation is no threat will make fighting the next recession much more difficult.
© The Economist Newspaper Limited, London (March 29, 2014)