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E.C.B. Holds Benchmark Interest Rate Steady
Some analysts expect the bank president, Mario Draghi, to signal that large-scale purchases of government bonds will probably start early next year.You searched for lowflation
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Already in the Lowflation Trap
Dean Baker, reacting to Neil Irwin,
feels that he needs to make the perennial point that zero inflation is
not some kind of economic Rubicon. Below-target inflation is already a
problem, and a very serious problem if you don’t have an easy way to
provide economic stimulus.
Think about it.
Suppose that you have a 2 percent inflation target, but you’ve cut
interest rates close to zero and the inflation rate is 1 percent and
falling. Then you’re already experiencing a cumulative process that will
pull you deeper into the trap unless you get lucky.
How so? Actually, a
couple of mechanisms. As inflation falls, real interest rates will rise,
tending to depress the economy further. Also, debtors will find their
debt growing because inflation isn’t as high as they expected, so that
you have a debt-deflation cycle even if you don’t yet have deflation.
So Europe’s low and
falling inflation isn’t a problem because it might turn into deflation —
it’s a problem because of what it’s doing right now.
Oh, and a word on
Sweden, where the central bank is indeed on the edge of deflation but
say never mind because output is currently growing. Um, does the bank
have an inflation target or doesn’t it? Yes, the economy can expand some
of the time even if inflation is below target — but because the
inflation rate is low, there isn’t as much room to respond to adverse
shocks. So missing the target is a policy failure whatever the current
output indicators.
Anyway, back to Europe: it’s not that something could go wrong, but the fact that it already has gone wrong.
And remember, above
all, that the risks aren’t symmetric. Controlling inflation may be
painful, but we do know how to do it. Exiting deflation or lowflation is
really, really hard, which is why you never want to go there.
Lowflation and the Two Zeroes
Via the always invaluable Mark Thoma, the IMF blog — yes, the IMF has in effect become an econblogger — has a terrific piece on the problem with low inflation in Europe.
It’s the perfect antidote to the do-nothing voices insisting that
there’s no problem, because we don’t see actual deflation yet.
Part of the IMF
analysis concerns debt dynamics. They don’t put it quite this way, but
I’d say that to have debt deflation — in which falling prices due to a
weak economy increase the real burden of debt, which depresses the
economy further, and so on — you don’t need to have literal deflation.
The process begins as soon as you have lower inflation than expected
when interest rates were set. It’s also noteworthy that inflation rates
in the highly indebted countries are all well below the eurozone average (pdf), with actual deflation in Greece and near-deflation in the rest. So the debt deflation spiral is in fact well underway.
Beyond that, the trouble with low inflation is that it exacerbates the problem posed by the two zeroes — the impossibility of cutting interest rates below zero and the great difficulty of cutting nominal wages.
Is ECB policy
constrained by the zero lower bound? You could argue that it isn’t,
since it could cut a bit further than it has but hasn’t. I’d argue,
however, that if nominal interest rates were much higher — say, 4
percent — but the overall euro macro situation were what it is, with
inflation clearly below target and unemployment very high, the ECB
wouldn’t (and certainly shouldn’t) hesitate at all about cutting rates
substantially. It’s only the fact that zero is already so close that
makes cutting rates seem like a big deal, an admission that things are
looking dangerous (which they are).
Meanwhile, the zero on
wages is hugely important now. The fundamental issue here is that Spain
(and other debtors) needs to reduce its wages relative to Germany,
reversing the runup in relative wages during the bubble years. The
argument some of us have been making
for a long time is that it’s vastly easier if this adjustment takes
place via rising German wages rather than falling Spanish wages — partly
because of the debt dynamics, but also and crucially because it’s very
hard to cut nominal wages.
What would you look
for if downward nominal wage rigidity were a seriously binding
constraint? A spike in the distribution of actual wage changes at zero.
And sure enough:
To be technical about it: Yowza. This is prima facie evidence that excessively low European inflation is already a huge problem.
The point is that
there is no red line at zero inflation; excessively low inflation is
still a very severe problem, especially given the European situation,
even if the number is positive.
So when people warn about Europe’s potential Japanification,
they’re way behind the curve. Europe is already experiencing all the
woes one associates with deflation, even though it’s only low inflation
so far; and the human and social costs are, of course, far worse than
Japan ever experienced.
This need not lead to a
breakup of the euro: Pessimists on that front, me very much included,
misjudged the strength of European elites’ commitment to the project.
But the euro might yet survive — and be a continuing disaster.
In Front Of Your Macroeconomic Nose
Simon Wren-Lewis says most of what needs to be said about Tyler Cowen’s attempted riposte to my post about Keynes rising.
I’d add that Cowen seems to have missed my point; I wasn’t talking
about the merits of the Keynesian case, which I believe have always been
overwhelming, but about the way macroeconomics is discussed in the
media and among VSPs in general. My sense is that this is shifting in a
Keynesian direction, while Cowen is arguing (wrongly, I’d say) that it
shouldn’t shift because of Osborne or something. Wrong answer to the
wrong question.
But I’d like to hone
in on something else Simon notices: the reference to the “so-called
liquidity trap.” This is something I still find, although less so:
assertions that there is something odd or suspect about claims that the
rules of economics change when policy interest rates hit the zero lower
bound.
I can see how someone
could have had that attitude in 2008 or even 2009, although not if he or
she had paid any attention to Japan. But at this point we’ve been at
the zero lower bound for six years; we’ve seen a 400 percent rise in the
monetary base without a takeoff in inflation; we’ve seen record
peacetime deficits go along with record low long-term interest rates.
Liquidity trap economics aren’t a speculative hypothesis at this point,
they’re the world we’ve been living in for years. How can that go
unnoticed?
But there’s a lot of denial out there. Recently David Glasner
deconstructed a WSJ op-ed calling for a return to the gold standard,
which was as out of touch as you might expect. But what got me was the
approving citation of Robert Mundell from 1971 (!) declaring that the
Keynesian model was irrelevant to modern economies because it assumed
pessimistic expectations and rigid wages. Right: no pessimism out there
these days. And no sticky wages; oh, wait:
I mean, seriously, at
this point even long-time skeptics about short-run wage and price
stickiness are coming around in the face of overwhelming evidence.
Oh, and treating the
monetary approach to the balance of payments as the epitome of modern
macroeconomics is just hilarious. That was the new thing when I was an
undergraduate econ major; to the extent that it was any use at all, its
usefulness was restricted to countries with independent currencies but
fixed exchange rates. It has been pretty much irrelevant since the
collapse of Bretton Woods and is almost completely forgotten among
serious international economists.
The resistance of much
economic discussion to the facts of the world around us — the facts in
front of our noses — is quite extraordinary, particularly if you compare
it with what happened in the 1970s. The 70s of legend — the era of
stagflation and all that — lasted maybe 7 years, from around 1973 to
1979 or 1980. Yet that stretch of time is constantly cited to this day
as having refuted everything we supposedly knew about macroeconomics. So
here we are, 40 years later, after six-plus years at the ZLB, with
sticky prices and wages all around, etc., etc., and a large number of
economic commentators haven’t noticed a thing.
Why To Worry About Deflation
David Wessel
has a very nice explainer in the WSJ — although I wonder how the editor
allowed his citation of a particular expert under point #2 to slip
through. One thing he doesn’t do, however, is make it clear that zero is
not a magic red line here — as even the IMF has made a point of emphasizing, too-low inflation has all the adverse effects of outright deflation, just to a lesser degree.
Most notably, the euro area currently has 0.8 percent core inflation, far below its 2 percent target, which is itself too low. This means that Europe is already in a lowflationary trap, qualitatively the same as a deflationary trap.
Asymmetric Misinformation
A followup to my post about Jaime Caruana at the BIS. One other thing that struck me was his claim that
policymakers respond asymmetrically over successive business and financial cycles, hardly tightening or even easing during booms and easing aggressively and persistently during busts
Is this true? Anyway, is symmetry in policy responses inherently desirable?
The claim that policymakers have an easy-money bias is one of those things usually said with an air of worldy wisdom; of course
people don’t want to take away the punchbowl when everyone is having
fun. But the reality doesn’t look at all like that. After all, if policy
were consistently doing too much to fight slumps and not enough to curb
booms, what you would expect is a steady ratcheting up of inflation —
which isn’t at all what has happened over the past 35 years. This
supposed piece of wisdom is actually a cliche from the 1970s, which
hasn’t been remotely true for a generation.
And look at the ECB in
particular. Twice since the crisis hit it has raised rates at the
merest hint of above-target inflation, despite good reason to believe
that these were just blips driven by commodity prices. But as inflation
slides ever further below target, what we get is equivocation and persistent failure to act.
If there’s an asymmetry here, it’s in the opposite direction: hasty
action against dubious inflation threats, inaction against deflationary
threats.
Incidentally, the fake
wisdom on monetary policy resembles a corresponding piece of fake
wisdom on fiscal policy — the claim that fiscal stimulus inevitably
turns into a permanent rise in government spending, because the programs
never go away. That didn’t happen this time:
And in fact it has
never happened in the United States, as far as I can tell — the WPA and
the CCC did not, in fact, become permanent fixtures.
Beyond that, there are
in fact good reasons for asymmetry in the response to booms and slumps,
even if central banks don’t actually do that. Suppose that central
banks wait too long to raise rates in a boom, so that the inflation rate
rises above target. Well, we have the tools to reduce inflation: just
raise rates enough to create a recession. It’s not nice, and you might
worry a bit about the political economy — but see above on how little of
a problem that has posed in practice.
On the other hand,
suppose you wait too long to fight a slump, and the economy develops a
case of deflation or at least lowflation. Turning that around is really
hard — it depends on either fiscal policy (which tends not to happen) or
unconventional monetary policy of uncertain effectiveness.
So there are good
reasons to believe that it’s much more crucial to act quickly and
forcefully to head off deflation than it is to head off inflation.
Symmetry is not a virtue.
Wages of Fear (Somewhat Wonkish)
Conventional wisdom
can be a terrible thing. In 2009-10 all the serious people started
telling each other that public debt was the number one threat facing
advanced economies, and that austerity policies were needed immediately.
We know how that turned out. Well, over the past few months I’ve been
watching a new conventional wisdom take hold – among a narrower and more
technical set of people, but still. According to this view, economic
slack is vanishing fast; even though we still have huge unemployment,
we’re actually running out of employable workers, and a dangerous
acceleration in the pace of wage increases is already underway. Time to
raise interest rates!
The trouble is that this emerging consensus is all wrong. In fact, it’s wrongheaded in at least four ways.
First, the widespread
impression, after the latest job report, that we’re seeing a surge in
wages is probably a snow job. Literally. The team at Goldman Sachs (no
link) points out that average hourly wages normally spike after a spell
of cold weather. Why? It’s a compositional effect: the workers idled by
bad weather tend to be hourly workers, who are paid less than salaried
workers. So the average worker in a snow-ridden month is better-educated
and better-paid than in a normal month, because the lower-paid workers
aren’t working. The blip in measured wages is a statistical artifact,
not a sign of tight labor markets.
Second, almost all the
talk about rising wages is driven by just one labor market indicator,
the average wage of nonsupervisory workers. Other wage indicators, like
the average of all employees and the Employment Cost Index, are telling a
different story. Here are three measures; you do get an impression of
rising wages:
But take out the nonsupervisory workers, and that impression mostly though not entirely vanishes:
Goldman Sachs has a
composite indicator, which is the first principal component of several
measures; it shows at best a slight hint of acceleration:
Third, what’s so bad
about rising wages? Wage increases are running far below their
pre-crisis levels, and everything we’ve learned in this crisis –
basically about the dangers of the two zeroes
– says that pre-crisis wage increases, and inflation in general, was
too low. And to get wage gains up to where they should be, we need a
period of overfull employment.
Fourth, there’s good
reason to believe that everyone is working with the wrong paradigm here.
Ever since the 1970s, textbook macroeconomics – reflecting the
experience of the 1970s — has assumed an “accelerationist” framework, in
which low unemployment leads not just to rising wages but to an
ever-rising rate of wage increase. But the actual data haven’t looked
like that for a long time. Since the mid-1990s, in fact, they have
looked much more like an old-fashioned Phillips curve, with a
relationship between the unemployment rate and the level of wage
increase, not the rate of change of wage increase. Here’s annual data
since 1995 comparing unemployment with the percentage rise in
nonsupervisory wages over the next year:
Why might an
old-fashioned Phillips curve have reappeared? Partly, perhaps, thanks to
anchored inflation expectations; partly because at low inflation rates
downward nominal wage rigidity comes into play. The point, in any case,
is that tightening because wage increases have gone up a bit may end up
condemning the economy to permanently higher unemployment than it could
have had if the Fed were willing to let wages rise.
Could I be wrong about
all this, and the conventional wisdom right? Yes, such things have
happened. But consider the relative risks. If the Fed stays calm about
rising wages and lets the economy grow, the worst that could happen
would be a modest rise in inflation by the time it becomes clear that
the natural rate really is 6 percent or higher – and remember, a modest
rise in inflation would arguably be a good thing. On the other hand, if
the Fed tightens prematurely, it could end up trapping us in lowflation;
essentially, it would have completed the Japanification of the US
economy, putting us into a trap that’s very hard to exit.
So let’s not panic over rising wages, OK? The only thing we have to fear is fear of full employment itself.
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