Consider this: “Through the looking glass”

Consider this: “Through the looking glass”


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10 October 2017

This note summarises “Through the looking glass” by Claudio Borio, Head of the Bank of International Settlements’ Monetary and Economic Department, OMFIF City Lecture, 22 September 2017.

Borio starts by reflecting on the irony for central bankers that, having fought inflation for most of the past few decades, they are now trying hard to promote it by urging on wage increases and fiscal profligacy.

Understanding inflation has become increasingly difficult. Not only has the link between inflation and domestic slack become weak and elusive, but also, the Phillips curve has become flatter. A positive explanation is that central banks have become more credible so that inflation and expectations are strongly anchored around the official target. Alternative explanations have to do with real factors, primarily globalisation. First, inflation has become increasingly synchronised across the globe, giving more of a role to global slack as opposed to individual domestic market slack. Second, lower-cost producers have put downward pressure on inflation in advanced economies. In particular, global value chains have played an important role in diffusing global competition at all stages of production. Looking forward, technology could similarly become a real phenomenon durably weighing down on inflation. Overall, the idea that “inflation is always and everywhere a monetary phenomenon” needs to be nuanced.

While the impact of monetary policy on inflation may be overestimated, its impact on real interest rates may be underestimated. A prevailing view is that, currently, low interest rates are related to deep-seated forces such as secular stagnation (Summers 2014) or the savings glut (Bernanke 2005). In such a framework, the natural interest rate is determined by real factors and monetary policy is neutral over the long run. Market real interest rates tend to gravitate toward this natural interest rate and both converge over sufficiently long horizons.

But, as the natural interest rate is theoretical and unobserved, evidence that market rates indeed follow the natural interest rate is itself strongly theory-based. A first approach (e.g. Rachel and Smith 2015) is to simply assume this is the case and to tell plausible stories or build models that can produce results roughly consistent with observed changes in the theoretical determinants of the natural interest rate. The drawback is that this does not provide independent evidence that market rates actually track the natural rate, only that it can describe some features of the data. A second approach filters unobservable natural rates from market rates (e.g. Laubach and Williams 2003). This framework uses inflation as a key signal since it ultimately implies that whenever inflation rises, the market rate is too low and vice-versa. For example, in today’s world, since inflation is not rising despite full employment, the implication is that the natural rate must have fallen. The drawback is that having inflation as the key compass needle is at odds with the elusive Phillips curve relationship described above.

It is possible to break out of this theoretical circularity by examining much larger datasets to test the relationship between real interest rates and their usual determinants (GDP growth, dependency ratios, life expectancy, relative price of capital, inequality). Using a dataset starting in the 1870s and spanning 19 countries shows that while these variables appear to work reasonably well over the often-cited more recent period, the relationship breaks down when going back before 1980 (Exhibit 1) – a sign that the relationships may be spurious.

Conversely, there are economically and statistically significant differences in the level of interest rates across monetary policy regimes, implying a long-lasting influence of monetary policy on real interest rates. For example, during the classical gold standard, central banks tended to keep nominal interest rates constant through short-term variations in output and inflation. Still, over that period, inflation remained stable and range-bound. In the standard approach, this would imply that real interest rates were close to natural interest rates. And yet the usual determinants of the natural interest rate varied just as much as in the recent period. All this implies a different interpretation of the reasons for low real interest rates today, attributing a much more central role for the monetary policy regime. Three factors are worth mentioning. First is the gradual normalisation of interest rates after the Volcker shock. Second is an asymmetrical policy response to successive financial and business cycles in the 1990s-2000s in a context of globalisation-driven disinflation. Third are the ultra-accommodative policies implemented to lift inflation since the global financial crisis.

Exhibit 1: Real interest rate and saving/investment drivers: spot the correlation

Source: Borio et al. (2017)

These deliberately provocative thoughts lead to a number of implications for monetary policy:

  1. Basing policies on an unobservable concept such as the natural interest rate is risky, especially when evidence of its usefulness and reliability is weak.
  2. The impact of monetary policy on inflation is significant but should not be overestimated, while the influence of real factors on wage- and price-setting behaviours can be large and persistent.
  3. If the ability to understand inflation and fine-tune it are limited, central banks should lengthen the horizon over which it is desirable to bring inflation back towards target and tolerate greater deviations in the interim.
  4. The definition of the natural interest rate could include references to financial stability, which is at least as desirable an objective as inflation. After all, the large costs of financial busts are well documented while those of deflation are less clear-cut. Moreover, over longer horizons, any trade-off between price and financial stability tends to dissipate. At the current juncture, the risk is a ‘debt trap’ whereby raising interest rates is made difficult by the accumulation of debt. 


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