For millennia, interest rates have been the primary tool for setting the price of money. They have determined how medieval kingdoms financed faraway conquests and modern nations fought wars. They affect everything from the cost of food, shelter and transportation to healthcare and government spending. Even the slightest adjustment is watched intently by investors, home buyers, business owners, presidents and monarchs. The 21st century, however, may mark the end of their usefulness.
Inflation has long been a key driver in setting the level of interest rates. Yet price increases, once considered a curse, have been contained in recent decades. We didn’t see meaningful inflation when trillions of dollars in stimulus flooded the economy after the global financial crisis, nor does it look likely after the gush of fiscal and monetary aid amid the Covid-19 pandemic.
Instead, the world is in for a prolonged period of zero or low inflation. This began after central banks’ efforts in the 1980s to crack down on the runaway price increases of the prior decade, and met a confluence of deflationary pressures: the shift of manufacturing to low-cost destinations, technological advances and demographic changes. Even negative rates, a radical step when imposed a few years ago in Japan, Switzerland and the euro zone, have been largely ineffective at spurring inflation.
That’s why fretting over official interest rates is unproductive, according to three economists urging the Swiss National Bank to change its approach. “It is time for the SNB to recognize that the policy rate has been stuck at -0.75% for more than six years and has ceased to play a role as a policy instrument,” wrote Stefan Gerlach, Yvan Lengwiler and Charles Wyplosz in their Feb. 17 paper “Too Much of a Good Thing: Lowflation in Switzerland.” Their recommendations include publicly embracing faster inflation, a notion once regarded as heretical, and steering the economy through the exchange rate. This approach would emulate the Monetary Authority of Singapore, which uses a so-called crawling peg that manages the local dollar against a basket of currencies.
Singapore’s method predates the pandemic and the global financial crisis — and the appeal is understandable. Like Switzerland, the city-state is a small, rich exporter and a financial center. Singapore views the exchange rate as the most effective tool to manage monetary policy and keep inflation in check, given the size of its economy. Many of the goods sold here come from outside. For its part, the SNB has also tried to heavily influence the level of the Swiss franc, even capping it for three years. It has also maintained its deeply negative interest rate, which is the lowest in the world. But the central bank should concede that currency is the main game, Lengwiler, a professor at University of Basel, said in a telephone interview.
Even if inflation picks up in the next few years, the prospect that benchmark interest rates will revisit the levels of early 2008 is slim. This means we need something better to regulate economic life today. In Switzerland’s case, the currency is already an available tool. Why not make full use of it? If your main rate is going to stay put for the better part of a decade, amid the deepest global slump since the Great Depression, what’s the point?
There’s a lesson here for larger economies, too, even if they can’t migrate to a currency-focused policy. (Can you imagine the global market tumult if the Federal Reserve suddenly told the world to ignore the federal funds rate and focus instead on the greenback?) The most realistic option is for central banks to refine their approach to inflation. The SNB, for example, currently defines price stability as positive rates below 2%, yet actual inflation has been sub-zero for more than a year. Gerlach, Lengwiler and Wyplosz argue it should set the target at 2%, to be achieved on average over the medium term. Misses on the downside should be taken as seriously as overshoots.
This advice resonates from Washington to Wellington. The Federal Reserve last year wrapped up a long review of its monetary framework. It’s now comfortable with inflation being above-target for a while, if that’s what’s needed to anchor it at 2%. The Bank of Japan is amid a three-month review of its ultra-loose policy and will release its findings next month. The Reserve Bank of India is mulling its own changes to what the ideal pace of price increases should be. “It’s dangerous not to review your strategy every once in a while,” said Lengwiler. “When the strategy is failing, you just have to.”
The authors view favorably the Reserve Bank of Australia’s goal of 2% to 3% inflation, on average, over the medium term. That should provide plenty of wriggle room. The RBA doesn’t foresee a rate increase for several years, at least. Even then, officials want to see evidence of higher inflation, not just forecasts for it. But the Reserve Bank has vocal critics, including former Prime Minister Paul Keating, who has called it the “Reverse Bank” and blasted it for being too conservative. The central bank should be even more stimulative, he says.
If old models of monetary management are getting overturned, it’s still not entirely clear what should replace them. Yet the need for creative thinking shouldn’t come as a surprise — quantitative easing and anemic price increases were around well before the coronavirus. “There is a whole generation that hasn’t experienced inflation,” noted Lengwiler. “They have no conception of it, other than intellectually.”
To monetary policy makers who have been too cautious, now would be a good time to get inspired.
Bloomberg
