Tick tock…here comes the Zero Lower Bound again

This week have brought even more confirmation that we are still basically in a deflationary world – particularly in Europe. Hence, inflation numbers for October in a number of European countries published this week confirm that that inflation is declining markedly and that we now very close to outright deflation in a number of countries. Just take the case of the Czech Republic where the so-called monetary policy relevant inflation dropped to 0.1% y/y in October or even worse Sweden where we now have outright deflation – Swedish consumer prices dropped by 0.1% in October compared to a year ago.

And the picture is the same everywhere – even a country like Hungary where inflation notoriously has been above the central bank’s 3% inflation target inflation is now inching dangerously close to zero.

Some might say that there is no reason to worry because the recent drop in inflation is largely driven by supply side factors. I would agree that we shouldn’t really worry about deflation or disinflation if it is driven by a positive supply shocks and central banks would not react to such shocks if they where targeting nominal GDP rather than headline consumer price inflation. In fact I think that we are presently seeing a rather large positive supply shock to the global economy and in that sense the recent drop in inflation is mostly positive. However, the fact is that the underlying trend in European prices is hugely deflationary even if we strip out supply side factors.

Just the fact that euro zone money supply growth have averaged 0-3% in the past five years tells us that there is a fundamental deflationary problem in the euro zone – and in other European countries. The fact is that inflation has been kept up by negative supply shocks in the past five years and in many countries higher indirect taxes have certainly also helped kept consumer price inflation higher than otherwise would have been the case.

So yes supply side factors help drag inflation down across Europe at the moment – however, some of this is due to the effect of earlier negative supply side shocks are “dropping out” of the numbers and because European governments are taking a break from the austerity measures and as a result is no longer increasing indirect taxes to the same extent as in earlier years in the crisis. Hence, what we are no seeing is to a large extent the real inflation picture in Europe and the fact is that Europe to a very large extent is caught in a quasi-deflatonary trap not unlike what we had in Japan for 15 years.

Here comes the Zero Lower Bound

Over the past five years it is not only the ECB that stubbornly has argued that monetary policy was easy, while it in fact was über tight. Other European central banks have failed in a similar manner. I could mention the Polish, the Czech central banks and the Swedish Riksbank. They have all to kept monetary policy too tight – and the result is that in all three countries inflation is now well-below the central bank’s inflation targets. Sweden already is in deflation and deflation might very soon also be the name of the game in the Czech Republic and Poland. It is monetary policy failure my friends!

In the case of Poland and Sweden the central banks have had plenty of room to cut interest rates, but both the Polish central bank and the Swedish Riksbank have been preoccupied with other issues. The Riksbank has been busy talking about macro prudential indicators and the risk of a property market bubble, while the economy has slowed and we now have deflation. In fact the Riksbank has consistently missed its 2% inflation target on the downside for years.

In Poland the central bank for mysteries reasons hiked interest rates in early 2012 and have ever since refused to acknowledged that the Polish economy has been slowing fairly dramatically and that inflation is likely to remain well-below its official 2.5% inflation target. In fact yesterday the Polish central bank published new forecasts for real GDP growth and inflation and the central bank forecasts inflation to stay well-below 2.5% in the next three years and real GDP is forecasted to growth much below potential growth.

If a central bank fails to hit its inflation target blame the central bank and if a central bank forecasts three years of failure to hit the target something is badly wrong. Polish monetary policy remains overly tight according to it own forecasts!

The stubbornly tight monetary stance of the Polish, the Czech and the Swedish central banks over the past couple of years have pushed these countries into a basically deflationary situation. That mean that these central banks now have to ease more than would have been the case had they not preoccupied themselves with property prices, the need for structural reforms and fiscal policy in recent years. However, as interest rates have been cut in all three countries – but too late and too little – we are now inching closer and closer to the Zero Lower Bound on interest rates.

In fact the Czech central bank has been there for some time and the Polish and the Swedish central bank might be there much earlier than policy makers presently realise. If we just get one “normal size” negative shock to the European economy and then the Polish and Swedish will have eventually to cut rates to zero. In fact with Sweden already in deflation one could argue that the Riksbank already should have cut rates to zero.

The Swedish and the Polish central banks are not unique in this sense. Most central banks in the developed world are very close to the ZLB or will get there if we get another negative shock to the global economy. However, most of them seem to be completely unprepared for this. Yes, the Federal Reserve now have a fairly well-defined framework for conducting monetary policy at the Zero Lower Bound, but it is still very imperfect. Bank of Japan is probably closer to having a operational framework at the ZLB. For the rest of the central banks you would have to say that they seem clueless about monetary policy at the Zero Lower Bound. In fact many central bankers seem to think that you cannot ease monetary policy more when you hit the ZLB. We of course know that is not the case, but few central bankers seem to be able to answer how to conduct monetary policy in a zero interest rate environment.

It is mysteries how central banks in apparently civilised and developed countries after five years of crisis have still not figured out how to combat deflation with interest rates at the Zero Lower Bound. It is a mental liquidity trap and it is telling of the serious institutional dysfunctionalities that dominate global central banking that central bankers are so badly prepared for dealing with the present situation.

But it is nonetheless a fact and it is hard not to think that we could be heading for decades of deflation in Europe if something revolutionary does not happen to the way monetary policy is conducted in Europe – not only by the ECB, but also by other central banks in Europe. In that sense the track record of the Swedish Riksbank or the Polish and Czech central banks is not much better than that of the ECB.

We can avoid deflation – it is easy!

Luckily there is a way out of deflation even when interest rates are stuck at zero. Anybody reading the Market Monetarists blogs know this and luckily some central bankers know it as well. BoJ chief Kuroda obviously knows what it takes to take Japan out of deflation and he is working on it. As do Czech central bank chief Miroslav Singer who last week – finally  – moved to use the exchange rate as policy instrument and devalued the Czech kurona by introducing a floor on EUR/CZK of 27. By doing this he copied the actions of the Swiss central bank. So there is hope.

Some central bankers do understand that there might be an Zero Lower Bound, but there is no liquidity trap. You can always avoid deflation. It is insanely easy, but mentally it seems to be a big challenge for central bankers in most countries in the world.

I am pretty optimistic that the Fed’s actions over the past year is taking the US economy out of the crisis. I am optimistic that the Bank of Japan will win the fight against deflation. I am totally convinced that the Swiss central bank is doing the right thing and I am hopeful that Miroslav Singer in the Czech Republic is winning the battle to take the Czech economy out of the deflationary trap. And I am even optimistic that the recent global positive supply shock will help lift global growth.

However, the ECB is still caught in its own calvinist logic and seems unable to realise what needs to be done to avoid a repeat of the past failures of the Bank of Japan. The Swedish central bank remains preoccupied with macro prudential stuff and imaginary fears of a property market bubble, while the Swedish economy now caught is in a deflationary state. The Polish central bank continues to forecast that it will fail to meet its own inflation target, while we are inching closer and closer to deflation. I could mention a number of other central banks in the world which seem trapped in the same kind of failed policies.

Ben Bernanke once argued that the Bank of Japan should show Rooseveltian resolve to bring Japan out of the deflationary trap. Unfortunately very few central bankers in the world today are willing to show any resolve at all despite the fact that we at least Europe is sinking deeper and deeper into a deflationary trap.


Update: Former Riksbank deputy governor Lars E. O. Svensson comments on the Swedish deflation. See here.

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  1. Inflation targeting with no floor is not price stability; and I am sure you agree with me that the ECB has consistently failed its mandate since 2008. I am curious though, what sort of mechanisms does the ECB have to do a QE-like operation if it wanted to… wouldn’t it need some sort of common capital market? I’ve heard, and don’t know if it’s true, that there isn’t any central place for the ECB to buy stuff that wouldn’t arouse serious jealousy among EZ members.

  2. Cristi C

     /  November 15, 2013

    Sorry but I find the starting point of the Sweden banker totally annoying and so I am frustrated that such lies are spread by former leads. What is leadership today, anyway!

    He starts by saying that the mild deflation experienced in Sweden is bad for borrowers. Sorry, I do not agree. Every durable asset (because that is what matter to the debt to value) has a depreciation duration. Really, even the simple citizen should do this math. Not buying a house thinking that its price will grow in value. You don’t buy a TV, a furniture knowing that it will grow in value. You buy them because you need them and because renting is a bit more expensive. Renting a place cannot be less than 7-10% p.a. of the value of the asset. That is your gain as owner. A mild deflation (-0.x% to -1.x% p.a) does not significantly decrease your gain and cannot increase your debt to value ratio that much (as it is implied in that position) to prevent you from further borrowing, spending (unless you were already massively overleveraged, of course caused by extended periods of low interest rates). That is the main silly point of inflationists: deflation reduces consumption. That is not true for the mild deflation (or mixed periods of very small de or inflation).

    The point being that the commercial agents know that when they invest money into an asset, they must deal with depreciation or amortization so it is a matter of arithmetic and business sense to make the asset profitable. Only speculators hope that the asset value will increase just because of monetary events (like inflation).

    The only way the inflation can be thought useful is to escape from debt, transferring wealth from creditors (that did not hike enough the rates) to borrowers. Otherwise, anything >2% is an evil to the real and sustainable economy.

    • Cristi C

       /  November 21, 2013

      Well done. At last, a Nobel economist is not in favor of inflation. Even the 2% one. Thomas Sargent to the Wirtschafts Woche.

      “Countries with falling prices include crisis countries such as Greece. These countries must restore their price competitiveness which they have lost over the past years. To do this requires either reduced wages or increased productivity. Wage unit costs would be thereby reduced and businesses could reduce their prices. This is not dangerous deflation but part of a necessary correction whereby these countries would again become competitive.

      Furthermore, according to Sargent, “there is from the historical perspective no reason to fear deflation” To the contrary, “We all profit if technological progress causes prices to be reduced, such as with computers. The fact that Central Banks target an inflation rate of about 2 percent is, according to Sargent, because they see it as their job “to make good debts from bad debts”. Sargent: Inflation is a big redistribution machine that reduces the real value of debt owed by debtors and reduces the wealth of creditors”,

      In order to avoid this, one could think about returning to the gold standard. “I would not necessarily say that it would be the best solution, but it also should not be feared. Up until WWI we had the gold standard to prevent central banks and governments from printing unlimited amounts of money. During this time prices fluctuated heavily, but this worked itself out over the years.”

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