‘Zeroflation’ baffles central bankers

The euro will celebrate its 20th anniversary in January 2019. [~ kyu/Flickr]

Discussions between central bankers often revolve around interest rates. But for the architects of the world’s monetary policy, who met in Paris on Tuesday (12 January), ultra-low interest rates were the order of the day. EURACTIV France reports

This is a burning issue in Europe: on 3 December 2015, the European Central Bank cut its deposit rate to -0.3%. This may be an interest rate floor, as Mario Draghi said, but it still poses certain problems.

Ultra-low interest rates can “lead to poor allocation of resources or bubbles, notably because they go hand in hand with long-term low inflation”, according to the new governor of the Bank of France, François Villeroy de Galhau.

Failure to convert low rates into economic growth

The Nobel Prize-winning economist and professor at the Toulouse School of Economics believes low interest rates not only lead to bubbles, but can also be responsible for financial instability and even crises. And they cause the involuntary transfer of assets from savers to borrowers.

Low interest rates are supposed to spark economic growth by encouraging consumers and companies to borrow.

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But the tendency to cut rates, as observed over the last 30 years, has led to the unprecedented situation we see today: negative interest rates. But in practice, negative interest rates can have perverse effects.

By eating into savings, they encourage would-be depositors to keep their money in cash, which can also lead to massive withdrawals. And for the banks, this represents an additional cost that could discourage them from lending.

Paying the bank to keep your money

“Some of our colleagues are in the historic position of facing sub-zero nominal interest rates,” said Stanley Fisher, the vice-president of the American Federal Reserve, in reference to some European countries like Denmark, Sweden and Switzerland. The central banks of these three countries charge their banks interest on deposits.

There are many explanations for this extreme situation. Denmark wants to protect its currency and Switzerland wants to discourage the use of the Swiss franc as a safe haven currency, which artificially boosts its value.

A similar situation occurred in Japan in the 1990s, where the central bank tried, unsuccessfully, to solve the problem of deflation with negative interest rates.

The eurozone in “zeroflation”?

But the central bankers were keen to avoid the term “deflation” in this unusual and depressed economic context. For Villeroy de Galhau, the operative word should be either “lowflation” or “zeroflation”.

This refers to a situation where prices stagnate under the effects of often contradictory forces: falling raw materials prices coupled with rising costs in other areas, for example. A set of potentially disruptive circumstances that central banks seem ill-equipped to deal with.

Another major weakness of ultra-low interest rates is that they end up depriving central banks of all room for manoeuvre: when a rate hits its floor level, there is nowhere else to go. When this happens, structural economic policies are the only tool left in the box.

Aiming for higher interest rates?

So should we change the course of monetary policy and go back on the generally accepted dogma that inflation in Western economies should be around 2%?

For some economists, like the American Paul Krugman or Olivier Blanchard from the OECD, this is the answer.

“The intense resistance of central bankers to regime change even after more than five years at the zero lower bound shows that the kind of policy stasis that afflicted Japan for almost two decades is a more or less universal phenomenon, Krugman told a European Central Bank Conference in Portugal in December 2015.

But the central bankers disagree. They fear the potential damage to their credibility, as well as the risk of a return to economic disorder. Christian Noyer, the former governor of the Bank of France, was especially hostile to the idea. “Revising the inflation target opens up far too many uncertainties,” he said.

Noyer had been an outspoken critic of Europe’s structural rigidities. “In the short term, price rigidity can protect the economy against deflationary shocks. […] But this rigidity can bring long-term costs, as it hampers the economic adjustment process and reduces the effectiveness of monetary policy,” he said.

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