A version of this piece originally appeared in the Financial Times on 19 June 2019.
Central banks around the world are pivoting toward easier monetary policy. In some countries this means rates are falling below previous record lows, and in the U.S. the Federal Reserve has paused a rate-hiking campaign and now appears more likely to lower rates than raise them further. Unfortunately, there is little evidence to suggest that lower and lower policy rates are successfully generating either better real growth outcomes or higher inflation.
Yet in pursuit of their 2% inflation target, major central banks seem willing to exhaust monetary policy “ammunition” at a time when economic output is at – or above – potential. In some countries, this policy stance has the potential to reduce monetary policy effectiveness, create imbalances that may sow the seeds for the next crisis, and leave central banks powerless to respond to that crisis. Perhaps it’s time to ask whether the 2% inflation target has outlived its usefulness.
The picture today: lower for longer
Despite largely maintaining policy rates below their own estimated “neutral” levels for more than a decade, the central banks of the U.S., the eurozone, and Australia, among others, have been guiding markets to expect lower rates for longer. This is happening even as many economies are operating with negative output gaps, meaning that employment rates are already above full capacity estimates and economic growth rates have been higher than what is deemed to be achievable in the steady state.
Over the past few decades, most of the world’s major central banks have adopted inflation targets that specify achieving an average inflation rate of around 2%. In many cases, such as with the U.S. Federal Reserve, 2% is not a legally required target but rather an adopted one. With inflation stubbornly below 2% across most of the developed world, central banks have felt compelled to keep interest rates low as well.
Why inflation targeting?
The main concern of today’s inflation-targeting central banks is that if inflation remains too low, it risks drifting into negative territory. The concern about a deflationary world is that it may cause the value of the assets or activity behind the world’s mountains of debt to decline, thus increasing the debt burden in real terms. Additionally, individuals and businesses may delay consumption and investment in a situation where prices are falling, eventually leading to a recession.
Environments like the Great Depression or the 2007/2008 crisis or other periods of large asset deflation (most usually housing deflations) are often cited as proof positive that the dangers of deflation should overwhelm other costs and risks born of artificially depressed rates.
The focus on the risks of deflation may be misguided
Yet one should be careful about confusing cause and effect when examining recessions and deflation. Although economic recessions are typically accompanied by disinflationary forces, it is far from clear that disinflation or small negative rates of deflation actually cause economic crises. Japan has had such an environment for much of the past two decades, and yet its real economic growth per capita looks very similar to that of the U.S. or Europe over the same time period.
By contrast, a primary cause of most large deflations in housing or other areas is overinvestment, or a misallocation of capital. Ironically, many of those situations can be traced back to monetary policy that, in hindsight, may have been too easy. The U.S. housing bubble that was the chief catalyst of the global financial crisis would not have been as severe had policy rates not been kept far below what was thought to be neutral for such an extended period of time. Similarly, an extended period of below-neutral rates has been a prime driver of the high housing prices cited by many of today’s central banks (Australia, Canada, the Nordics, etc.) as a key risk to the economic outlook.
The risks of lower for longer
In addition to contributing to market imbalances, near-zero policy rates have exhausted central banks’ flexibility to react to future shocks or recessions, thus increasing the risks of an extended downturn. Low policy rates may also be creating frictions that lower potential growth via “zombification,” where marginally profitable (at best) companies still remain in business given the ease of access to cheap capital created by repressed interest rates. Suboptimal business behavior, investment, and consumption may be occurring due to the persistence of subsidized borrowing rates.
And while likely fueling these risks and distortions, low rates are clearly not delivering targeted inflation, and they may even be having the opposite effect: It has recently been observed that low rates correlate to low inflation outcomes, perhaps because they cause inflation expectations to fall rather than rise. After all, many real economy actors look to the level of interest rates to form their expectations about future inflation.
The “natural” rate of inflation may fluctuate over time because of the forces of technology, globalization, demographics, and so on. With potential growth rates that are barely positive and falling in places like Europe and Japan (owing much to challenging demographics), 2% may also not be the natural inflation rate for every region. If this is the case, then inflation targets should be looser, more variable over time, and differ across countries with different economic structures. What’s clear is that a new approach should be considered since the existing framework is not only failing to deliver its promised inflation goal, but also exhausting monetary policy flexibility while creating worrying distortions in the real economy.
For more of PIMCO’s views on developments driving global economies, see our recent Secular Outlook, “Dealing With Disruption.”