Inflation is a fundamental nature of the economy

The specification of the inflation target - a way out of the low interest rate policy?

After the outbreak of the financial crisis, central banks around the world not only drastically lowered their key interest rates, they also tried out a large number of completely unconventional measures with undreamt-of creativity - starting with the massive expansion of central bank balance sheets (by buying up mostly government bonds, but also some corporate bonds and share packages) via targeted communication strategies (forward guidance) of the future planned policy path to experiments with negative key interest rates. Despite the unusually long period of loose monetary policy, economic growth has so far hardly recovered; The inflation rate also remains at historically low levels in most industrialized countries.

Criticism of the ECB policy

The policy of the European Central Bank (ECB) in particular is now facing increasing criticism, especially from the German public. Many accuse it of the low interest rate policy "expropriating" German savers. They vehemently demand a quick exit from the low interest rate policy and warn of the negative effects of the ultra low interest rate policy on the entire financial system. Some argue that only by raising interest rates quickly can the necessary leeway to be able to lower interest rates again in the event of a downturn in the future.

The critics overlook the fact that interest rates worldwide have fallen to unimagined lows. Low interest rates are by no means a special route taken by the ECB, but rather the “new normal” in industrialized countries. At the end of 2015, the US central bank, the Fed, began a series of small rate hikes in an attempt to normalize - it slowly increased the key rate from 0.25% to 2.5% in December 2018. But as early as August 2019 the Fed initiated another round of rate cuts. The Fed's research departments are also currently conducting an intensive discussion to review their monetary policy strategy, instruments and communication policy in order to be better equipped if interest rates hit the lower limit again.

While the US central bank as well as the Bank of England deliberately refrained from making the key interest rate negative out of concern for the stability of the financial sector, others (initially Denmark, from the beginning of 2015 then the ECB - with a negative deposit rate - dared the Switzerland as well as Sweden and finally Japan) the experiment to test how low the lower limit of the interest rate could be below zero. The Swiss National Bank went the furthest. Its key rate has remained unchanged since January 2015 at -0.75%. At the moment, it does not rule out the possibility that further easing itself may be necessary under certain circumstances. On the other hand, the Swedish Reichsbank said goodbye to the phase of negative key interest rates last month: on December 19, 2019 - despite the slowdown in the Swedish economy - it raised its key interest rate back to 0% after having set it negative for several years. She justified this step with the fear that too long negative interest rates could trigger undesired behavioral changes with negative consequences. At the same time, the Swedish Reichsbank emphasized that the key interest rate would probably remain at zero for years and by no means ruled out a future easing.

Limits to the low interest rate policy

The central banks around the world are clearly reaching the limits that have been characterized in detail by macroeconomic theory since John Maynard Keynes: By adjusting the short-term base rate over the course of the business cycle, monetary policy can normally successfully help stabilize inflation and fluctuations in output. Over the past few decades, central banks have cut their key interest rates by an average of around 5 percentage points in the course of an economic downturn. However, the scope for such interest rate cuts is limited by the fact that the nominal interest rate cannot fall well below zero without triggering a flight into hoarding cash and thereby endangering the stability of the banking sector. As soon as monetary policy reaches this effective lower limit, the traditional instruments no longer work as usual. A lack of overall economic demand is then ultimately reflected in an underutilization of resources, unless the loss of demand is compensated for by supporting active fiscal policy.

Keynes was already aware that, given the hoarding costs, this lower limit of interest is by no means zero, but slightly below it. The incentive to hoard can also be mitigated if only additional bank deposits are charged with a marginal negative interest rate, while existing deposits are excluded from this. This has been done in Switzerland and Japan since the introduction of negative interest rates; in the euro area only since September 2019. If the aim is - as in the case of Switzerland - to make investments in one's own country unattractive for international investors, the lower limit may be even lower. As long as there is cash, however, it cannot be removed by magic. Modern approaches1 model this situation more elegantly as the “reversal rate” below which lending declines in the face of declining profitability in the banking sector, thus increasing the loss of demand. The basic mechanism remains unaffected.

Rather, the new insight from the experience of the financial crisis is that the problem of insufficient demand can last a very long time unless resolute countermeasures are taken from the start. The threat of secular stagnation has become a frighteningly realistic scenario. This aspect is likely to play an important role in the review of the ECB's monetary policy strategy, which was recently initiated by its new head Christine Lagarde.

A reflection of real long-term developments?

Modern macroeconomic theoretical approaches provide a clear answer to the demand for a quick exit from the low interest rate policy: The current low interest rates are by no means the result of the negligent policies of irresponsible central bankers; Rather, they are a reflection of real long-term developments - the steady decline in real growth rates (and thus the “natural” real interest rate) and the steady decline in inflation (and thus also inflation expectations) in most industrialized countries. Exiting too quickly would exacerbate the risk of remaining in a scenario of long-term secular stagnation. A simple look at the development of the nominal yields of government bonds with a term of ten years over the last 40 years (see Figure 1) illustrates the basic mechanism. Yields fell sharply over the entire period under review.

illustration 1
Ten-year government bond yield

The global decline can hardly be interpreted as the result of manipulation by conspiratorial central banks; it is rather easy to explain in economic terms: in the medium to long term, the arbitrage equation i = r + πe formulated by Irving Fisher as early as 1930 must be fulfilled for the nominal interest rate. In the long term, the equilibrium nominal interest rate in = rn + πe is determined as the sum of the expected inflation rate πe and the “natural” real interest rate rn of the economy.

The decline in inflation expectations can be directly attributed to the success of the central banks in combating high inflation rates since the 1970s of the last century (see Figure 2). It shows up directly in lower surcharges on the required real interest rate as compensation for the inflation risk. In Germany and France, the nominal interest rate on ten-year government bonds is currently slightly negative. If the financial markets were to expect sharply rising inflation rates over the next ten years, this would have to be reflected in rising yields on long-term nominal bonds.

Figure 2
Decline in inflation rates since the 1970s

Source: OECD Economic Outlook.

The natural real interest rate

The “natural” real interest rate has also fallen over the past few decades. A wide variety of factors contribute to the decline in real interest rates, such as declining trend growth in productivity, an increase in the propensity to save due to the demographic structure of the population, increasing risk aversion that goes hand in hand with increasing demand for safe government bonds, and an increase in private debt and inequality when poorer people are in debt Sections of the population save less than rich people who seek to accumulate wealth on the basis of status preferences or hereditary motives.2 Other contributions to the current talk of the day (especially by Weizsäcker) 3 analyze some of these factors in more detail.

The concept is (analogous to the structurally determined unemployment rate and the growth rate of the production potential) a theoretical construct and therefore difficult to measure empirically. Figure 3 shows the range of current estimates by Brand and Mazelis on the course of the natural real interest rate in the euro area. 4 Estimates of the true rate are always subject to a high degree of uncertainty. But the downward trend that can be seen in Figure 3 proves to be astonishingly robust across very different estimation methods.

Figure 3
Decline in the natural real interest rate in the euro area
Range of estimates

Source: C. Brand, F. Mazelis: Taylor-rule consistent estimates of the natural rate of interest, ECB, Working Paper Series, No. 2257, 2019.

Monetary policy has no direct influence on the natural real interest rate. Rather, their task is to adjust the short-term nominal interest rate in the course of the business cycle to ensure that the current real interest rate corresponds to the natural interest rate and thus to ensure that actual inflation is in line with inflation expectations. If, for example, the real interest rate is too high (r> rn), the desired savings are also too high compared to the planned investments. Then an interest rate cut would be appropriate in order to bring too low aggregate demand back into line with potential output. Conversely, in the case of r

Raising the inflation target?

For a long time, the prevailing view was that the lower limit of interest rates only seldom acted as a serious restriction, and then only for a short time. This assessment was based primarily on simulations based on the historically quiet times of the "great moderation" in the 1980s and 1990s. However, the experience after the financial crisis has led to a drastic rethink here. The Fed's research department now assumes that the lower limit of interest rates could almost always become binding in the course of future recessions - with the possible long-term consequences of costly underutilization of resources.

In the current review of its monetary policy strategy, the Fed is focusing on the discussion of how the problem of the lower limit of interest rates can be alleviated through various options.5 One obvious way would be to raise the inflation target. The higher πe, the less often the lower limit of the interest rate becomes binding. Standard models of secular stagnation show that multiple equilibria often occur: If inflation expectations are high enough, a steady state can be achieved without underutilizing resources. If, on the other hand, inflation expectations are too low, the economy can remain permanently in a state of underutilization.6 However, as the experience of the Bank of Japan shows, it is hardly possible to move the expectations of private economic actors in the desired direction simply by announcing a higher inflation target to steer.

The current discussion within the Fed is therefore concentrating on making the public's willingness to achieve the desired inflation rate more credible by specifying the current inflation target. Conceivable options for this are switching to a price path or nominal GDP target, emphasizing a symmetrical range around the target value, or the obligation to aim at at least temporarily overshooting inflation rates above the target value in the future in order to ensure that the target value will remain the same for longer persistent deviations on average will ultimately be achieved.

Low inflation expectations

Despite the massive use of numerous unconventional monetary policy measures, not only inflation rates, but also inflation expectations over the coming years in many industrialized countries have remained below the desired target for years. For most central banks, this target is exactly 2%. In the euro area, things are a little more complicated. In October 1998 the Governing Council defined price stability as “an annual growth rate of the harmonized consumer price index for the euro area of ​​less than 2% in the medium term.” At the beginning of the new millennium, the fear of “Japanese” conditions with the risk of sustained deflation spread around the world , the ECB was increasingly confronted with the accusation of asymmetry: The original definition leaves open whether the ECB is also prepared to take decisive action against an inflation rate that is too low in order to prevent the development of a deflationary spiral. When the monetary policy strategy was revised, the Governing Council then refined the definition of price stability as inflation below, but close to, 2% in May 2003.

While most of the other central banks work with a symmetrical target, the specification at the time also left open what this definition might actually mean. When the revised strategy was presented on May 8, 2003, Otmar Issing, then chief economist at the ECB, explained that the aim was to anchor inflation expectations below 2% - roughly in a range between 1.7% and 1.9%.

In contrast, Mario Draghi emphasized several times in his last year as President of the ECB (for example in his speech “Twenty Years of the ECB's monetary policy” at the ECB research conference in Sintra in June 2019) 7 the target inflation rate of below, but close 2% is completely symmetrical; This symmetry not only means that the ECB will not accept an inflation rate that is persistently too low; Rather, the medium-term perspective also implies that the value of 2% does not represent an upper limit: Temporary deviations would be tolerated in both directions (i.e. also upwards) as long as inflation returns to the target of just under 2% in the medium term.

Figure 4
Decline in inflation expectations in the euro area

Source: ECB: Survey of Professional Forecasters (SPF); Thomson Reuters (inflation swaps).

At first glance, the difference between the two interpretations seems to be rather marginal. But which view is appropriate is decisive for the question of whether the current monetary policy stance of the ECB is adequate. In the course of 2019, not only did the inflation rate in the euro area fall again, the inflation rate expected over the next five years also fell (see Figure 4): According to the Survey of Professional Forecasters (SPF) carried out by the ECB, inflation expectations were in line 1.7% over the next five years in December 2019; Measured on the basis of market data from inflation-linked swaps, however, they were around 0.8% in September 2019, after having risen from 0.5% at the beginning of 2015 (the start of the ECB's quantitative easing program) to around 1.5% in the summer Increased in 2018. If one sees no cause for concern in the current decline (perhaps even the dawn of dreamy times of absolute price stability), there is no justification for the continuation of the loose monetary policy. If, on the other hand, the decline in inflation expectations is interpreted as an indication of the risk that the effective lower limit of the interest rate could soon become binding again in the next economic downturn, decisive countermeasures would be appropriate.

Specification of the target inflation rate

As in the USA, the specification of the target inflation rate is likely to play a central role in the renewed review of the ECB's monetary policy strategy planned for 2020. It is to be hoped that the insights gained by the Fed will also be taken seriously in the euro area. The clarification that the ECB is aiming for a completely symmetrical inflation target around the target value of 2% could send an important signal.It seems of secondary importance whether this is done by changing to a bandwidth or by obligating a temporary overshoot.

Ultimately, the point must be to expand the scope for action in the future so that sufficient ammunition is guaranteed for an active stabilization policy even in a low-interest environment. Few options remain: the increased use of unconventional monetary policy measures; the revitalization of active fiscal policy as an economic instrument or a credible strategy to tolerate, at least temporarily, an overshooting of the inflation rate above the target value.

It seems almost paradoxical that precisely the sharpest critics of unconventional monetary policy are precisely those who vehemently reject all obvious alternatives: the increased use of economic policy as well as temporarily higher inflation rates. If these options are discarded, all that remains is the continuation or even expansion of massive unconventional measures with the risk of unintended side effects; if this does not help, the pressure is likely to increase to seek refuge in far more unconventional measures such as printing helicopter money.

  • 1 For example by M. Brunnermeier, Y. Koby: The Reversal Interest Rate, mimeo, Princeton University, 2019, (9.1.2020 ).
  • 2 See G. Illing, Y. Ono, M. Schlegl: Credit Booms, Debt Overhang and Secular Stagnation, in: European Economic Review, 108th year (2018), pp. 78-104; A. Mian, L. Straub, A. Sufi: Indebted Demand, Working Paper, 2019, (9.1.2020).
  • 3 C. von Weizsäcker: End of the shortage of capital and new protectionism, contribution to the talk of the times in the business service, in: Business service, 100th year (2020), no. 1, pp. 25-28
  • 4 C. Brand, F. Mazelis: Taylor-rule consistent estimates of the natural rate of interest, ECB, Working Paper Series, No. 2257, 2019.
  • 5 See Federal Open Market Committee (FOCM): Minutes of the Federal Open Market Committee, September 17-18, 2019, (January 10th, 2020).
  • 6 Cf. for example G. Illing et al., Op. a. O.
  • 7 M. Draghi: Twenty Years of the ECB's monetary policy, Sintra 2019, (9.1. 2020).