Farewell to the ELB – whatever happens

  • As expected, inflation is coming down
  • Markets are beginning to look forward to central banks cutting interest rates
  • But interest rates will not return to ultra-low levels

Last autumn, I had occasion to look at the long-term future of interest rates. Specifically, would interest rates over the next ten years be higher or lower than in the ten years to 2020?

Intuitively, the answer was easy. In the years to 2020, interest rates in many countries were at all -time lows, with policy rates in a few cases even negative. How could interest rates going forward not be higher? 

But while intuition is important, it is of course equally important to look carefully at arguments both for and against any such forecast. Doing that made me think about a tangential topic.

Last year we were already seeing the collapse of broad money growth in the largest economies, more pronounced in the USA, less so in the EA, with the UK in the middle. For anyone who follows money trends (this excludes almost all central bankers!), it was clear that inflation would be coming down in 2023 and into 2024 even beyond the impact of the base effect from early 2022. This is of course now happening. The Fed has hinted that its rate increase shave come to an end, and markets are looking forward to the first cuts instead.

However, this leads to two other questions. First, will inflation drop below central banks’ targets again? And secondly, if it does, will interest rates go back to the ultra-low levels of the 2010s?

The answer to the first question is unclear. However, it does at the moment seem unlikely that inflation in the near term will even come down to, let alone go below, the 2% that is generally the central bank target in advanced economies. That might happen in due course, but perhaps not until late 2024 or in 2025. And it has to be assumed that central banks will do anything they can to avoid it.

This brings me to the second question. Central banks have seen the face of deflation or near-deflation, and they didn’t like it. More importantly, they have also seen policy interest rates at or near the Effective Lower Bound (ELB) and they certainly didn’t like that either. With interest rates around zero, they gave the impression of impotence and of flailing around for policies that would work – work, in the sense of bringing inflation back to the targets they were constantly undershooting and seemed incapable of reaching. Moreover, rock-bottom interest rates gave them almost no traditional ammunition to work with; and also raised the spectre of necessitating prolonged periods of monetary tightening if inflation for some reason would pick up – as indeed we have just seen. In addition, low and stable interest rates carry within them the power to destabilise the economy, as credit is cheap, thus encouraging ever more uptake of debt, and as the search for yield becomes ever more extreme and hence risky.

It is bad enough to fail at your task, certainly to fail consistently and spectacularly. It is probably even worse to fail like this if you are part of a group that only some years ago was seen as being practically omnipotent.

The likelihood is therefore that central banks and other monetary (and fiscal!) authorities will do their best to ensure that inflation doesn’t go below 2% on a sustained basis for the foreseeable future. But if it does, central banks are also likely to do almost anything except bring interest rates back towards the ELB. They can justify this by saying that the experience of the 2010s shows that ultra-low policy interest rates do little or nothing to stimulate inflation and that therefore it is better to keep their powder dry (although for what, one is tempted to ask).

What will they do instead, if inflation were to come down sharply and if deflation threatens? They will presumably do more of what we have already seen, once described as unconventional policies although by now very conventional indeed: forward guidance a l’outrance (to quote Keynes); more and larger quantitative easing; and possibly other measures as well, e.g., helicopter money in some shape. There may be other things they can do – and governments can ‘help’ by running large, unfunded budget deficits. But taking policy interest rates back to zero or below – not very likely if it can be at all avoided. One brush with the Effective Lower Bound in a central banker’s life is already felt to be one too many.

Gabriel Stein