As I have stated before, (here and here), for the U.S., the current policy stance is a trap. The Fed clearly intends to maintain its policy interest rate target at essentially zero, possibly well into 2016. But, particularly as the economy continues to strengthen, most forces are pushing short-term real rates of return up. With short-term nominal rates of return pegged at zero by the central bank, the inflation rate has nowhere to go but down. But central bankers appear only to understand the short-term liquidity effects of central bank actions. They seem to think that a low short-term nominal interest rate must mean high inflation, even if the nominal interest rate is persistently low. Though real rates of interest are certainly not constant, and there can be persistence in deviations of real rates of interest from long-run averages, if the short term nominal interest rate is low for a long period of time, then the inflation rate is guaranteed to be low.
The most recent FOMC statement contains exactly that confusion between the short-run and long-run effects of monetary policy:
The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.So, if inflation continues to be low, the policy interest rate will continue to be low, which implies a low inflation rate...
The ECB President seems to suffer from the same confusion. See this story on how he has pledged to keep nominal interest rates low in the face of low inflation:
Draghi reiterated his commitment to keeping borrowing costs low “for an extended period of time” as policy makers continue their deliberations over whether they have done enough to prevent deflation...This is not exactly a quote from Mark Carney, the Governor of the Bank of England, but he seems to think the same thing:
Low inflation also meant that raising interest rates became less urgent even though the economy is growing.With Carney, we'll have to see what he says if the inflation rate falls below his 2% target. My guess is that he'll fall into line with Yellen and Draghi.
Finally, this comes from a speech by Steve Poloz, the Governor of the Bank of Canada, who discussed current risks in Canadian central banking, including the possibility of deflation:
Let’s switch gears and look at the risk of outright deflation. Like out-of-control inflation, deflation can become a spiral, but a downward one. Expectations become unanchored on the downside, and people put off their purchases because they expect things to be less expensive later. Demand declines with prices, while the weight of debt on the economy grows.The first part is a standard story one hears about deflation. As the story goes, the economy can enter a "deflationary trap" in which expenditure is indefinitely postponed, and things get generally awful. As far as I know, there is no sound theory that actually delivers such a phenomenon. We certainly have multiple equilibrium models in which the economy can be stuck forever in a Pareto-dominated equlibrium, but I don't know of a model like that in which a bad equilibrium is associated with deflation (maybe you do?). Indeed, in a wide class of models, deflation can be associated with Pareto optima - that's the logic of the Friedman rule (not that I'm endorsing that).
In the Great Depression, consumer prices in Canada fell 25 per cent, and national output dropped by almost a third. The human cost was staggering, with unemployment reaching 20 per cent. A milder form of deflationary trap has nagged Japan for the past 20 years.
What I am describing is an economy-wide process of deflation, which is quite different from individual prices falling because of improved competitiveness in an economy that is still growing strongly.
Today, the concern is that even though policy-makers were successful in avoiding global deflation in the wake of the 2008 crisis, there is still a risk that inflation could creep down into deflationary territory as the aftershocks of this crisis persist. It is, at least in part, to counter that risk that central banks in a number of countries have kept interest rates very low and used unconventional monetary policies, such as quantitative easing, to provide additional stimulus to their economies.
History has taught us that deflation usually comes in the wake of a financial crisis. This was true of the Great Depression, and of the Japanese deflation of the 1990s. Perhaps the most important lesson of the crisis, then, is that a stable financial system is necessary to keep inflation low, stable and predictable - and limit the risk of falling into a deflationary trap.
Poloz goes on to discuss the empirical relationship between deflation and poor performance on the real side of the economy. But it's quite possible that we associate low inflation, or deflation, with bad outcomes on the real side because those outcomes make the central bank respond with zero short-term nominal interest rates at zero for long periods of time, which in turn produces low inflation. But that wouldn't entirely explain the behavior of a Poloz central bank, as he also thinks good insurance against low inflation is a low policy interest rate for the central bank - sustained, apparently.
We can find a related type of argument in the minutes of the December FOMC meeting:
A few participants raised the possibility that recent declines in inflation might suggest that the economic recovery was not as strong as some thought.We could call this the "hidden output gap argument." These FOMC participants are hardcore Phillips curve adherents. In the face of what appears to be a declining output gap, by any measure, they insist that the output gap must be rising, because inflation is falling.
One feature that sticks out in the chart at the top of the page is the behavior of inflation in Japan - obviously it's very different from the inflation behavior in the other countries. Part of what's interesting about this is that the increase in the inflation rate in Japan, by about two percentage points, coincides with the Bank of Japan's "Qualitative and Quantitative Monetary Easing" policy, which commenced in April 2013. Details of this program are in the April 2013 policy statement of the Bank of Japan. Basically, the B of J intends to double the size of its balance sheet over a period of about two years, by purchasing longer-maturity Japanese government bonds and private assets (exchange-traded funds). A curious part of the policy is the following:
With a view to pursuing quantitative monetary easing, the main operating target for money market operations is changed from the uncollateralized overnight call rate to the monetary base.The B of J pays interest on excess reserves and, under this policy, the interest rate on reserves (IROR), is a key part of its policy. It's not clear whether the officials at the B of J understand this or not. Though rules for how the IROR should be set are not addressed in any policy statements of the B of J post-April 2013, as far as I can tell, arbitrage tells us that the overnight call rate is equal to the IROR. Here's the overnight rate:
My advice to the B of J would be the following. The QE policy is just foreplay. Get to the main event. The B of J cannot sustain 2% inflation if it keeps the IROR at .07% for the next two years. That policy will make it likely that the B of J will fall short of its 2% inflation target, just as is happening in the Euro zone, the U.S., Canada, and - shortly - the U.K.
Here's the same scatter plot I constructed in this post for the U.S., but in this case for Japan, using data from 1985-2013, plotting the overnight call rate vs. the CPI inflation rate.
If inflation in Europe, North America, Japan, and elsewhere stays low - or falls into negative territory, that's not a disaster, I think. I don't think there is any serious economics that supports the conventional deflationary-trap-as-black-hole idea. But the policy trap that exists at the zero lower bound is a genuine trap, and it even has some genuine theory behind it, as Jim Bullard pointed out. I'm interested in watching how central bankers dig themselves out.