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Finally, monetary policy normalization?

March 8, 2021

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Imagine a world where multiple equilibria happen (for non-technical readers: this is when something happens just because people believe that it will happen, like a financial crisis). In such a world, interest rates may be low because central banks make them low and promise to keep them low. And inflation is low because people believe that it will stay low. Why would they believe that? Because people see low interest rates and conclude that central banks cannot lower them any further in order to try and bring inflation up.

 

Smart economists who observe this situation of low interests and low inflation but do not think about multiple equilibria, have imagined another explanation: the natural real interest rates (the rate that central banks aim at on average) is now close to zero or even negative because the world has entered a long-lasting period of secular stagnation. This phenomenon is the consequence of excess world savings, the demographic transition and diminished productivity gains. This is a fascinating hypothesis. But hypotheses cry out for empirical validation and, unfortunately, it will take a lot of time to be able to seriously test such long-run evolutions. Meanwhile, researchers use fancy techniques to estimate natural real interest rates, but these techniques do not allow for multiple equilibria.

 

So, here we are, the conventional wisdom accepts this hypothesis as a fact. It implies that central banks have lost the ability to raise inflation because they cannot lower their interest rates enough. Maybe, for once, the conventional wisdom is right. Maybe it is not. How do we know? Well, a titillating possibility is that we will know soon.

 

 President Biden’s American Rescue Plan has just been voted upon the Congress. Public spending will increase in 2021 by some 9% of GDP, coming on top a massive increase of close to 20% of GDP in 2020. You have to go back to World War II to find anything that huge. Current knowledge suggests that the US economy should be booming by year end and that inflation will then rise. The Chairman of the Federal Reserve, Jay Powell, does not seem intimidated, which has triggered anguished discussions in the financial markets about quickly rising inflation. If indeed inflation significantly rises, the Federal Reserve will do what central banks do when inflation is rising, it will jack interest rates up, which is already spooking financial markets. This all will spread around the world, because the US dollar will appreciate spontaneously once capital, attracted by the higher interest rate, flows into the US. Other currencies will depreciate, mechanically. Current knowledge suggests that a depreciation pushes inflation up. So other central banks will raise their interest rates to contain inflation.

 

This is when we will find out which is the right hypothesis. If inflation quickly declines back to present minute levels, central banks will lower their interest rates and the current conventional wisdom will be comforted. However, if inflation remains higher, say around 2% or 3%, in spite of higher interest rates, we will be back in familiar territory, the pre-2009 equilibrium.

 

Why did we get stuck in the current equilibrium? It goes back to the Global Financial Crisis. The financial sector (markets, banks) was shaken to its core. Central banks slashed their interest rates to zero, or even negative, while inflation declined because of the recession. Unable to push the interest rates further down, they adopted new tools. In particular, through quantitative easing (QE). The old conventional wisdom predicted that flooding economies with cheap cash would rekindle inflation. It did not happen, because the financial sector absorbed most the cash. Most of the QE money never reached the real sector, private spending remained weak and inflation did not materialize. This, in turn, alarmed central banks and they kept interest rates low, much longer than they had initially anticipated. Actually, the Fed did raise its interest rates a bit since US banks had done a lot of cleaning up, in contrast with Europe and Japan. But the pandemic came while the Fed was still super cautious, and it promptly lowered the interest rate down to zero and promised to keep it there for a long time again.

 

This time, with the pandemic, the big difference is that fiscal policies were extensively used and President Biden just made sure that the expansion will not be cut prematurely as in 2010. It is this misguided fiscal policy retrenchment that moved us into the low inflation-low interest rate equilibrium of the last decade. Will fiscal policy exuberance, so far only in the US for sure, move us back to the old normal equilibrium? We will find out, but there is an important precedent. The world already slid into the sad equilibrium of the Great Depression. It lingered there until President Roosevelt made his move (and World War II spending completed the shift). Back then, like now, most of the conventional-wisdom holders warned about impending disaster and, guess what, they were proven wrong.

 

Of course, all of this is just one hypothesis, and it could be as wrong as many others. The testing has already started so we should have the answer some time soon, well in two or three years.