Because the work of central banks is increasingly difficult. Report Ft
Why do central banks find their jobs so difficult to do? Questions and answers in an in-depth study by the Financial Times
Why do central banks find their jobs so difficult to do? A common opinion is that this is due to the fact that they are incapable. People who say this insist that central banks must keep interest rates in line with their historical norms. This is wrong, because historical norms are irrelevant. The questions are why and what this implies for our economies.
A paper by Atif Mian, Ludwig Straub and Amir Sufi at the Jackson Hole monetary conference on August 27 illuminates this issue. He comes to a conclusion, already suggested in their previous work: the main explanation for the decline in real interest rates was high and growing inequality and not demographic factors, such as the saving behavior of the "baby-boom" generation during the their lives, as some have argued.
The analysis starts with estimates of the real "natural rate" of interest, a concept that dates back to the Swedish economist Knut Wicksell. The natural rate, he explained, balances supply and demand in the economy, which manifests itself in stable prices. The modern doctrine of inflation targeting stems from this idea. Crucially, however, estimates of this rate for the United States show a decline from around 4% four decades ago to around zero now.
This decline is matched by other high-income countries, as one would expect: in an open world economy, equilibrium real interest rates should converge, the FT writes.
As the document also notes, the decline "raises concerns about secular stagnation, threatens asset price bubbles and complicates monetary policy." In fact, it's a big part of the reason central banks have had to make huge asset purchases in crisis situations, like now.
Their main point is that savings rates vary much more by income within age cohorts than they do among age cohorts. The differences are also huge: in the United States, the top 10 percent of households by income have savings rates between 10 and 20 percentage points higher than the lowest 90 percent. Given this divergence, the upward shift in income distribution inevitably increased the overall propensity to save. As an explanation for the increase in the propensity to save and the decline in the real interest rate, the shift of the baby-boom generation into middle age does not work, because the increase in saving has been continuous, while the impact of the demographic shift on the savings behavior it was not.
At the aggregate level, the savings must match the investment. So what happens when the rich get richer and then try to save more? Interest rates have to go down. It turns out that the impact of this on business investment is quite weak. Indeed, the propensity to invest has been chronically weak, partly for demographic reasons. So the offsets have come either from persistent fiscal deficits or from higher spending by the lower 90 percent. Both are fueled by debt, while the second is also fueled by asset price bubbles, especially in house prices. When central banks pursue the natural rate down, they drive both of these processes. But, as debt ratios rise, natural rates drop even further as highly indebted people become less and less creditworthy.
An objection to this argument is that it concerns only one country, however important it may be. But the trend towards greater income inequality is shared by almost all large economies, including China in particular. Indeed, the saving glut of the rest of the world has also manifested itself in the persistent current account deficits of the United States. The need to compensate the latter has made the Federal Reserve's task even more difficult.
The financial crisis of 2007-12 should be seen as a result of these processes, resolved at the time by saving the financial system, tightening regulation and doubling low rates along the yield curve. The Covid crisis was a bolt from the blue, but the response was more or less the same, but on an even greater scale. This time, too, the huge increases in central bank reserves actually increased the broader monetary aggregates. It's no big surprise, then, that the combination of supply-side disruptions with today's strong demand is generating "surprise" inflation.
So how could the story evolve? There is no valid reason to expect income inequality, the fundamental driver of today's excess savings, to reverse, even though it may stabilize. There is a very good reason for a huge investment boom, especially the climate transition. But this will not happen without a coherent, determined, intelligent and globally aware policy, which we cannot expect, even if we can hope. Thus, in the medium and long term, secular stagnation is likely to return unless income inequality decreases.
The short term is harder to read, but if it goes wrong, it's creepy, perhaps even for the medium term. In his Jackson Hole speech, Jay Powell, chairman of the Federal Reserve, insisted that everything is under control. But he would have said this. In fact, the surge in inflation surprised almost everyone. The concern must be that price shocks persist and then become bogged down in expectations, which will only be reversed by a period of significantly higher short-term rates. This would cause stagflation, which would create painful dilemmas for central banks and would certainly cause devastating problems for the weakest borrowers, particularly, but not exclusively, highly indebted emerging economies.
The exceptional policies of 2020 can no longer be justified. Given today's super-low short-term interest rates and supportive fiscal policies, it's hard to see why large asset purchases should continue. We have more than enough money today and bond yields should go up a bit. When the facts change, central banks should change their minds. That time is now.
(Extract from the foreign press review of Eprcomunicazione)
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/banche-centrali-lavoro/ on Sat, 25 Sep 2021 06:05:04 +0000.