“When interest rates are low central banks don’t have much room to maneuver to deal with a crisis”, The New York Fed President John Williams said on Wednesday June 6 2019. In addition, according to Williams “if inflation falls, central banks will have even less room to maneuver when faced with a slowdown”. Furthermore, said Williams, “while I will always be vigilant about inflation that’s too high, inflation that’s too low is now a more pressing problem”.
Note that this way of thinking is based on the equation that links nominal and real interest rates. On this way of thinking the real interest rate can be approximated as
Real interest rate = Nominal interest rate – Inflation rate
or we can say that,
Nominal interest rate = Real interest rate + Inflation rate
Price stability and deflation
The popular way of thinking maintains that the policy of price stability does not always imply that the central bank must fight inflation. It is also the role of the central bank to prevent large falls in the inflation rate, or an outright decline in the general price level. Why is that so? Because it is held that a fall in the price level i.e. deflation, postpones consumer and business expenditure thereby paralyzing economic activity. Moreover, a fall in inflation raises real interest rates thereby further weakening the economy. Additionally, as expenditure weakens this further raises unutilized capacity and puts further downward pressure on the price level.
Most economists are of the view that it is much harder for the central bank to handle deflation than inflation. When inflation rises, the central bank can always cool it off by tighter monetary policies, which weakens aggregate demand. There is no limit, so to speak, for the central bank as far as raising interest rates is concerned. This is, however, not so with regard to deflation. The lowest level that the central bank can go is the zero interest level.
For instance, let us assume that Fed policy makers have reached a conclusion that in order to revive the economy real interest rates must be lowered to a negative figure.
This, however, may not be always possible to accomplish, so the argument goes, when nominal or market interest rates are at a zero level. At negative interest rates, individuals are going to be reluctant to lend. (We are aware that some central banks such as the Sweden and the European central banks have lowered their policy rates to below zero mark. Thus in Sweden in July 2009 the rate was lowered to minus 0.25%, whilst in the Euro-zone to minus 0.1% by June 2014. We hold that Fed policy makers are going to be reluctant to experiment with negative interest rates given that this could generate market perception that policy makers are panicking).
For instance, when the inflation rate is minus 1% and nominal interest rate is 0% then the real interest rate following our equation is going to be 1%.
Let us say that central bank policy makers conclude that the real interest rate of minus 0.5% is required to prevent an economic deterioration. At an inflation rate of minus 1% this would require the central bank to lower nominal interest rates to minus 1.5%.
Likewise, when the inflation rate is very low it can also create problems. Suppose that inflation has fallen from 2% to 1%. At nominal rates at 0%, the central bank can only target a real interest rate of minus 1%. It cannot aim at a lower real interest rate since this would imply setting the nominal interest rate below zero.
Likewise, as the economy weakens further and inflation falls to 0.5% this will not allow the central bank to target real interest rates to below minus 0.5% i.e.
0%=minus 0.5% +0.5%
On this way of thinking deflation, or low inflation, reduces central bank’s flexibility in reviving the economy. Hence, the policy of price stability must aim at a certain level of inflation, which will give the central bank the flexibility to keep the economy moving along the growth path of economic prosperity and prevent it ever falling into a deflationary black hole.
The essence of all this is that a little bit of inflation is necessary in order to have economic prosperity and stability. The inflationary buffer must be large enough to enable the Fed to maneuver the economy away from the danger of deflation, or so it is held.
Mainstream economists believe that inflation at around 2% is not harmful to economic growth. By this framework of thinking, 2% inflation will allow the Fed to reach a real interest rate of minus 2% while still maintaining nominal interest rate at 0%, which clearly could stimulate economic growth or so it is held. Whilst most experts are of the view that the inflation rate of 2% seems to be good for the economy, a higher inflation rate say 10% could be actually bad.
Why should a rate of inflation of 10% or higher be regarded as a bad thing? If anything at an inflation rate of 10% it is likely that consumers are going to form rising inflation expectations, and according to popular thinking, in response to a high inflation rate, consumers will speed up their expenditure on goods at present, which should boost economic growth. Clearly, there is a problem with the popular way of thinking.
Inflation is not essentially a rise in prices
Inflation is not about general increases in prices as such, but about the increase in the money supply. As a rule, the increase in money supply sets in motion general increases in prices. This, however, need not always be the case.
The price of a good is the amount of money asked per unit of it. For a constant amount of money and an expanding quantity of goods, prices will actually fall. Prices will also fall when the rate of increase in the supply of goods exceeds the rate of increase in the money supply.
For instance, if the money supply increases by 5% and the quantity of goods increases by 10%, prices will fall by 5%. A fall in prices however, cannot conceal the fact that we have inflation of 5% here because of the increase in money supply.
The reason why inflation is bad news is not of increases in prices as such, but because of the damage inflation inflicts to the wealth-formation process. Here is why.
The chief role of money is to fulfill the role of the general medium of exchange. Money enables us to exchange something we have for something we want. Before an exchange can take place, individuals must have something useful that they can exchange for money. Once they secure the money, they can then exchange it for the goods they want.
Now, consider a situation in which money is created out of “thin air”. This new money is no different from counterfeit money. The counterfeiter exchanges the printed money for goods without producing anything useful. He in fact exchanges nothing for something. He takes from the pool of real goods without contributing to the pool.
The economic effect of money that was created out of thin air is the same as that of counterfeit money — it impoverishes wealth generators. The money created out of thin air diverts real wealth towards the holders of new money. This weakens wealth generators ability to generate wealth and this in turn leads to a weakening in economic growth. Note that as a result of the increase in the money supply what we have here is more money per unit of goods, and thus, higher prices.
What matters however is not price rises as such but the increase in money supply that sets in motion the exchange of nothing for something or “the counterfeit effect”. The exchange of nothing for something weakens the process of real wealth formation. Therefore, anything that promotes increases in the money supply can only make things much worse.
Since changes in prices are just a symptom as it were, and not the primary causative factor, obviously countering a falling growth momentum of the CPI by means of loose monetary policy i.e. by creating inflation, is bad news for the process of wealth generation and hence for the economy.
We also suggest that in order to maintain their lives and wellbeing, individuals must buy goods and services in the present. Therefore, from this perspective a fall in prices as such cannot be bad for the economy.
Furthermore, if a fall in the growth momentum of prices emerges on the back of the collapse of bubble activities in response to a softer monetary growth then this should be seen as good news. The less non-productive bubble activities there are the better it is for the wealth generators and hence for the overall pool of real wealth.
Likewise if a fall in the growth momentum of the CPI emerges because of the expansion in real wealth for a given stock of money obviously this is great news since more people could now benefit from the expanding pool of real wealth. We can thus conclude that contrary to the popular view, a fall in the growth momentum of prices is always good news for the wealth generating process and hence for the economy.
Given however that Fed policy makers are of the view that a decline in the annual growth of prices is bad for the economy they are most likely to embark on very easy monetary policy. Against the possibility of a visible decline in price inflation ahead we are of the view that it is quite likely that the market federal funds rate will likely to follow suit (see chart). This we suggest is going to weaken further the pool of real wealth and will make it much harder for the economy to stage a genuine recovery.