RIRP, NIRP and ZIRP
Just last week, the Bank of England brought out its monetary policy bazooka. It lowered interest rates; committed itself to lowering it further; resumed quantitative easing; extended it to corporate bonds and got sanction for another GBP100bn of QE to be kept in reserve, literally. All this based on a GDP growth forecast that may or may not materialise. Even if it materialises, it may well be due to the eventual and inevitable bursting of the asset bubbles that policies such as this fuel. In other words, the policy meant to stave off a growth slowdown might very well be the cause of it, eventually.
The Bank of England (Willem Buiter noted recently that soon it may find its name truly reflect its domain) did not appear to have taken into account the fact that stock and bond markets have rallied since the Brexit vote in the UK in June. Had asset prices collapsed and stayed low, there would be some justification for the Bank to have acted to forestall an economic recession. That too is not the case. Hence, pushing interest rates down to zero or negative and unleashing quantitative response has become the unthinking pavlovian response of central banks to real or imagined economic slowdown or low inflation. On their part, financial markets with their pavlovian response to such policies, send asset prices to new highs. Both financial markets and central banks are defying logic and the former is defying gravity as well.
The belief that low rates would stave off economic slowdown, disinflation and even disinflation is almost religious because it ignores evidence to the contrary. In a recent interview, Alberto Gallo told Bloomberg that Zero Interest Rate Policies (ZIRP) or Negative Interest Rate Policies (NIRP) are actually deflationary. When interest rates fall so low or go negative, savers find that their targeted savings for retirement or other needs grow more distant and end up saving even more, rather than less. That drags down economic growth rate.
There is another way negative interest rates have the opposite effect than the one intended by policymakers. Interest rates are positive because of time value of money. Money loses its value over time. In other words, over time, goods will be scarce relative to money. The relatively ‘plentiful’ money would have lower purchasing power and hence, lenders who postpone consumption need to be compensated and ‘made whole’. In contrast, ZIRP and NIRP signal to the market that there is no time value of money. Money will not be ‘plenty’ relative to goods and hence there is no loss of purchasing power. There won’t be relative scarcity of goods to money. That signal obviously is a deterrent for investments. Investing is all about producing goods and services to relieve the scarcity. ZIRP and NIRP thus end up deterring real investment. That is why they have not only failed to arrest economic slowdown and declining inflation rates but have also reinforced them.
For example, this news story in Financial Times notes that inflation expectations in Europe had hit a record low in March this year, despite negative interest rates and the European Central Bank buying sub-investment grade corporate bonds. The only thing ZIRP and NIRP have done is to boost asset prices causing them to decouple (once more as in 2005–2007 and as on many earlier occasions) from economic fundamentals, setting up a very painful climax. If rational expectations theory is all about economic agents not making systematic and persistent errors, central bankers are proving the theory wrong spectacularly.
The failure of ZIRP and NIRP to achieve their economic objectives has given rise to some spurious theories. One of them is called a Neo-Fisherian theory of interest rates. This theory draws an equivalence between NIRP and ZIRP stoking deflation and rising rates being useful in stoking inflation. In other words, if ZIRP and NIRP generate disinflation or deflation, Restrictive Interest Rate Policies (RIRP) will generate inflation! This symmetry is ill thought-through because life is nothing if not asymmetric.
More than a year ago, celebrated author Stephen King had tweeted the following:
“Comcast down all day. When the network crashes, everyone pisses and moans. When it works, everyone takes it for granted. Human nature, man.”
He has captured an enduring phenomenon that is pervasive not just among humans but in nature too. Life is all about asymmetries. In motivation theory, there are hygiene factors and motivating factors. Hygiene factors matter in their absence but their presence does not motivate workers. Most relationships in economics are asymmetric or non-linear. Examples abound.
Behaviour of savers: Savers save more because target savings are harder to achieve in ultra-low rate environment. But, they do not save less in higher rate environment because rates are positive and will deliver returns because borrowing rates simultaneously rise. Positive rates induce higher savings for motivational reasons. Negative rates induce even higher savings for precautionary reasons.
Wages and prices go up more easily than they come down. Their behaviour is asymmetric too. Firms raise their hurdle rates when rates go up. That reduces investments. But, firms do not bring down their hurdle rates when rates go down. They are downward sticky. That makes the case for more effectiveness from tighter monetary policy on reining in spending and inflation than from looser monetary policy in stoking spending and inflation.
Central banks themselves are asymmetric in their behaviour. Perhaps, people prefer it that way. Central banks trusted only when they fight rising prices of goods and services rather than falling prices (which people feel good about).
Similarly, people do not approve of central banks working to pop bubbles but when they prop bubbles with lower rates, investors, markets and the public cheer. There is asymmetry there too. Evidently, central banks have taken this to their heart. Even their response to public preferences is asymmetric!
Lastly, policymakers resort to ZIRP and NIRP when the economy is already saddled with high debt. That is, the economy is balance sheet constrained when low interest rates are deployed. That robs monetary policy of its effectiveness. No matter what the loan feast is, arising out of low interest rates, if prospective borrowers are already suffering from debt indigestion, no amount of feast would tempt them.
In contrast, rates go up when balance sheets are not bloated (if not downright lean) and are ready to take on more debt. In that situation, central banks raising rates will have the effect of reining in enthusiasm for debt. At least, it can slow it down. So, RIRP can be effective in reining in animal spirits whereas ZIRP and NIRP are not effective in stoking animal spirits in the economy. They succeed spectacularly with asset markets, for sure! That is actually, part of the problems with ZIRP and NIRP.
In sum, RIRP will not lead to higher inflation even though ZIRP and NIRP generate and entrench deflation. The relationship between economic variables are non-linear and asymmetric. One should be careful about linear and symmetric extrapolations.
(This is an expanded version of my piece in MINT published on 9th August, 2016)