The Big Macroeconomic Puzzle
Why decade-long low interest rate is not resulting into higher inflation?
Inflation
Inflation essentially means increase of price level and/or decrease of purchasing power of money. The central banks generally ‘target’ inflation around 2% annually. When I was studying Macroeconomics 101, I asked my Professor where we got that 2% target from. Why is it not 1% or 3%? The answer is- it is arbitrary. But the main gist is to keep inflation low but positive. The second question I had was- how does a central bank ‘target’ inflation? Can they change the inflation rate when they want to? The answer is- no. Central banks do not have direct control of inflation rate. However, there are several fiscal and monetary mechanisms, through which they aim to control inflation. Sometimes it works, sometimes it doesn’t. Our big macroeconomic puzzle is regarding one of these mechanisms, perhaps the most important tool central banks have to control inflation.
When there is inflation, the prices of most things rise. It begs the question, why do we need low inflation, a.k.a. why is stable or even lower prices bad?
Back in 1970s and 80s, when economy wasn’t doing well due to external shocks (like the Oil shock in 1973), prices going down was interpreted by economists as that economy was in trouble. The reasoning went like this: prices are going down because people are not spending and thus there is excess supply (aggregate demand going down, while supply remains constant in short term). People fear a coming economic crisis and thus, decide to save more instead of spending to consume (your income can simply be used 2 ways- spending or saving). Lower aggregate demand also means that businesses will decrease their supply; which will result into less jobs and more unemployment. Hence, the opposite of declining prices- inflation was seen to be a good sign,- that economy is consuming more, producing high demand and employing more people.
What is the “Interest-rate Lever”?
Interest rates are central banks’ main economic control lever which is used to control inflation. The interest rate lever works (more accurately, is believed to work) like this: low interest rates stimulate spending and higher spending results to higher inflation.
When the interest rate is low, it means that borrowing is less costly. Thus, it encourages interest-sensitive spending like construction, investment, purchase of durable goods (housing, automobile); for both individuals and companies. Think about yourself- when you see very low interest rate, you might start thinking about buying a house with mortgage and low interest payments. Hence, with higher spending, inflation can go up (simple model: higher spending -> higher demand -> rising prices (inflation!) -> increased supply -> higher employment and production).
Low interest rate can also stimulate the economy through decreasing currency value and thus increase inflation (although more indirectly). Reduction in domestic interest rate make domestic assets less attractive (many foreign buyers buy assets to get interest payments), reducing the demand for dollars in foreign exchange markets and thus lowering currency exchange rate. Lower currency value makes the currency more export competitive, hence resulting into decrease of imports and increase of exports, raising domestic production and employment. Thus, the stimulated economy can encourage higher spending by consumers and trigger inflation.
It is important to remember that the economy is an incredibly complex, inter-related machine. Hence, to explain all the linkages is almost impossible and to predict all the consequences (intended and unintended) of an intervention is extremely difficult. The truth is, even economists do not really know how the economy works. The mechanisms of how interest-rate lever works is debated and perhaps changes in each context.
The Puzzle
The big question for most macroeconomists and central bankers is: why is the interest-rate lever not working?
Despite having decade long low interest rate, inflation remains very low (figure 1). But low interest rate for very long period (figure:2), accompanied by very low unemployment (in US context), should have triggered higher inflation. In the aftermath of the financial crisis, inflation rate remained below 2% most of the time.
Possible Explanations
Planet Money’s episode: “The Central (Bankers’) Question” provides a possible explanation, where they interview economist John Van Reenen.
Reenen argues that the ineffectiveness of the interest-rate lever has a lot to do with a new economic phenomenon: increase in concentration in all industries, not just the tech industry. Across industries, consolidation (merging of different companies) is taking place. This increasing concentration has three main ways to make the interest-rate lever ineffective:
Pricing: All of these big, new consolidated companies do one thing really well,- offering low prices. Think about Walmart & Amazon; people use them more because they offer cheaper prices. Cheaper prices means that there are deflationary (or anti-inflationary) or downward pressure on prices, which makes inflation harder to occur.
In the past, low inflation might have meant that economy is not performing well. But this may have changed now. Low inflation might not mean that economy is not doing well. It may simply mean, these giant companies are getting more and more efficient. Thus, their products/ services are getting cheaper (or, prices are stable).
Borrowing: In the past, to become a giant company, the company needed to build the best factories, expand existing factory space and buy the newest machines. Hence, when interest rate was kept low, companies would borrow money and invest to build new factories, buy new machines, which would have made interest-rate lever work. But these days, the way you win as a company is by owning the best version of what economists call intangible capital — things like patents and software.
Think about Walmart in retail. Many think that retail is more low-tech type of sector. But Walmart’s comparative advantage does not just lie in having the biggest network, most number of trucks and warehouses.Rather, what Walmart’s done is that it invested huge amounts of money in building up better software. The software and data helps Walmart move its delivery trucks more and more efficiently. So, it’s not about how many trucks you have; it’s about how you move the trucks. More more tech-heavy sectors, there is even less of a need for borrowing and investing huge capital to expand and grow. Instead, network externalities and virtuous cycle of data collection, make the existing big companies ever more efficient and powerful.
Wages: One of the biggest puzzles in economics is to explain the decreasing labour share of income. A bigger and bigger share of profits has been going to all these big companies, and a smaller and smaller share has been going to workers.
One possible explanation can be declining power of labour unions who can bargain with employers for wage increase. But a more important reason is perhaps what economists call monopsony power (a less famous cousin of monopoly). Monopsony means a market situation where there is only one buyer. Think about the labour market; if you are in a town where there is only one firm which can employ you (you and many others are trying to sell your labour; while the company is buying your labour and paying you wages), then that firm holds the monopsony power. Hence, that single buyer has substantial control of the market and in labour market’s case, the big companies can control the wage. Hence, due to their interest, these big companies are keeping wages from rising, as their profits increase.
This phenomenon also explains part of our interest-rate lever puzzle. Decade long low interest rate with very low unemployment should have caused wage growth according to economists, which would have triggered inflation resulting from higher purchasing power (from higher wages). But because of monopsony power, wages are not rising and hence interest rate lever is not working.
Thus, increasing concentration across industries might explain at least part of the puzzle. One important implication is that interest-rate lever might not be effective like the past anymore.
Other Explanations
One explanation might just be psychological. In the aftermath of a crisis, as the memory of the crisis remains fresh, people become more cautious and save more. In this case, lower interest rates will not deter many people from saving more (instead of borrowing and spending more).
Another factor can be about longer life expectancy. Economies need increasing consumption for the lever to work, as companies will only expand if they see higher aggregate demand. But people are saving more because they now have to save more for longer to buy their first home, or to have a reasonable retirement as they expect to live longer, instead of consuming more now. It is prudent on their part. But for the economy, if most people are saving more than spending, it can be ominous.
For younger generation, a gradual shift in mindset from consumerism to voluntary-simplicity/ minimalism/ anti-consumerism can also be observed. Younger people are more environmentally conscious and less materialistic, given their concerns about climate change and increasing focus on finding fulfillment from simplistic living. In the future, if this trend continues, we will see lower consumption and spending. I do not think this should be cause for concern, specially given the fact that addressing climate change requires drastic action and less consumerism.
Conclusion
Central banks have traditionally used interest rate lever for controlling the inflation rate; taking the inflation rate as a signal for overall economy’s performance. But inflation is probably not the right signal for an economy’s health, for the new economic reality described above. In a changing economy, a better signal for the health of the economy is perhaps the unemployment rate and the debt level. Economists increasingly point out the ills of very high public and private debt. Hence, interest-rate lever can be used to control the private debt level;- increase interest rate when there is high private debt; decrease interest rate when very low private debt. This use of the lever will be politically challenging because temporary increases in debt can enable people to buy things like homes, which can make them happy and thus create a more satisfied voter base. But in the long run, high private debt can result into crisis, as we saw during the 2008 financial crisis.
