The global economy

The perils of falling inflation

In both America and Europe central bankers should be pushing prices upwards

Nov 9th 2013
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WHAT is a central banker’s main job? Ask the man on the street and the chances are he will say something likekeeping a lid on inflation”. In popular perception, and in their own minds, central bankers are the technicians who squeezed high inflation out of the rich world’s economies in the 1980s; whose credibility is based on keeping it down; and who must therefore always be on guard lest prices start to soar. Yet this view is dangerously outdated. The biggest problem facing the rich world’s central banks today is that inflation is too low.

The average inflation rate in the mostly rich-world OECD is 1.5%, down from 2.2% in 2012 and well below central banks’ official targets (typically 2% or just under). The drop is most perilous in the euro area: annual consumer-price inflation was only 0.7% in October, down from 2.5% a year ago.

That is partly because commodity prices have been falling, but even if you strip out volatile food and fuel prices, the euro zone’s underlying or “coreinflation is 0.8%, as low as it has ever been since the single currency began. In America the headline rate in September was 1.2%, down from 2% in July—and the core rate, as defined by the Federal Reserve, has stubbornly stayed at 1.2%, close to its low point. There were inklings this week that some at the Fed want even looser monetary policy.

True, things are improving in Japan, which seems finally to have escaped 15 years of falling prices, but even there underlying inflation is still only zero. The only big, rich economy where prices are rising at a clip is Britain, where overall inflation is 2.7%.

That sinking feeling
These are depressing numbers (see article). The most obvious danger of too-low inflation is the risk of slipping into outright deflation, when prices persistently fall. As Japan’s experience shows, deflation is both deeply damaging and hard to escape in weak economies with high debts. Since loans are fixed in nominal terms, falling wages and prices increase the burden of paying them. And once people expect prices to keep falling, they put off buying things, weakening the economy further.

There is a real danger that this may happen in southern Europe. Greece’s consumer prices are now falling, as are Spain’s if you exclude the effect of one-off tax increases.

In America and northern Europe deflation is less of an immediate risk. Most economies are growing, albeit slowly. And surveys show consumers still expect medium-term inflation to be at or above the central banks’ target of 2%. But if an economy with high unemployment grows too slowly for too long, prices and wages are eventually likely to fall. In Japan deflation did not set in until seven years after the asset bubble burst.

Even without reaching that critical level, ultra-low inflation has costly side-effects. It tends to go with a weaker economy and higher-than-necessary joblessness: America’s unemployment rate is 7.2%, France’s 11.1% and Spain’s 26.6%. It also means that nominal incomes grow more slowly than they would if prices were rising faster. This makes both government and household debts harder to pay off.

And low inflation makes it tougher for uncompetitive countries within a single currency to adjust their relative wages. With Germany’s inflation rate at 1.3%, Italian or Spanish firms need outright wage cuts to compete with German factories.

What’s more, too little inflation will undermine central bankers’ ability to combat another recession. Normally, during a period of growth bankers would raise rates. But policy rates are close to zero, and central bankers are reliant on “unconventionalmeasures to loosen monetary conditions, particularly “quantitative easing” (printing money to buy bonds) and “forward guidance” (promising to keep rates low for longer in a bid to prop up people’s expectations of future inflation). Should the economy slip back into recession, the central bankers will find themselves unusually impotent.

An attitude for altitude
Most rich countries, then, would be better off if consumer prices were rising a bit faster. But what isa bit”, and how should central bankers go about nudging prices upwards without losing control of them? Too often in the past a bit of inflation has turned into a lot—with nasty consequences. And it is not as if central bankers have been doing nothing: from the Federal Reserve to the Bank of Japan, their balance-sheets have exploded. That has pumped up asset prices, and leads many to fret that dangerously higher consumer-price inflation will eventually appear too.

One response might be to raise official inflation targets, say from 2% to 4%. But changing what has been the cornerstone of central banking for decades could easily prove counter-productive, by unnerving financial markets. Nor is such radicalism yet necessary. Central bankers’ first step should be to work harder at reaching their existing inflation goals.

The European Central Bank, which cut its main policy rate from 0.5% to 0.25% on November 7th, still has the most work to do. Bolder moves to loosen financial conditions, including broad bond-buying and a new cheap financing facility for banks, are needed. The ECB must also stress that its target is an inflation rate close to 2% for the euro zone as a whole, even if that means higher inflation in Germany.

The Fed, which is still buying $85 billion-worth of bonds a month, does not need to expand quantitative easing. But it can change its forward guidance. This week’s kerfuffle was based on the idea that the Fed should reduce the “threshold below which unemployment must fall before rates are raised, lowering it from 6.5% to 6% or below. That looks a good idea. The Fed’s boss-in-waiting, Janet Yellen, could introduce an inflation threshold of, say, 1.75%: prices would have to rise faster than that for her to raise rates.

None of this means that inflation will not one day be a risk. But it is not today’s problem. All the “sound moneyfanatics who issued dire warnings about rampant inflation when central bankers began their unconventional measures might usefully reconsider whether Western policymakers did too little, not too much. Be afraid of inflation, by all means; but life can be even scarier when it sinks.


The price is a blight

The rich world, and especially the euro zone, risks harmfully low inflation

Nov 9th 2013

WHEN central banks adoptedquantitative easing” (printing money to buy financial assets) and other unorthodox means to buoy economies holed by the financial crisis, many feared that the result would be out-of-control inflation. Asset prices have certainly soared. But consumer prices have not. Indeed, the growing fear is that rich countries may be entering a twilight zone of ultra-low inflation.

A downward lurch has been most notable in the euro area, where annual inflation dropped from an already low 1.1% in September to 0.7% in October; a year ago it stood at 2.5%. It is now a percentage point lower than the European Central Bank’s inflation target of “below but close to 2%”. The ECB lowered its main policy rate to 0.5% in May; on November 7th its governing council, responding to the weak inflation figures, reduced the interest rate further, to 0.25%.

Elsewhere, too, inflation is low and falling. Almost five years after the Federal Reserve led the way with quantitative easing, inflation is well below the Fed’s 2% target (which relates to a somewhat broader measure of consumer prices than the better-known consumer-price index). In August this wider measure stood at little more than 1%. Across the G7 economies, inflation has been weak this year and has recently fallen back to 1.3%; a year ago it was 1.8%. Even in Britain, which has the highest inflation (2.7%) in both the G7 and the European Union, the rate has been broadly stable this year.

Slack energy prices have contributed to recent declines in overall inflation. That is a welcome development, boosting the purchasing power of both businesses and households. But core inflation, which by excluding the more volatile elements of energy and food offers a surer guide to underlying price pressures, tells a less heartening story. Across the G7 core consumer-price inflation has been stuck over the past year at 1.4% (see chart). On the Fed’s measure it is just 1.2%. And in the euro zone, core inflation has fallen over the past year from 1.5% to 0.8%, matching the record low of early 2010.

One bright spot that has helped to keep G7 inflation from falling further is Japan, where the reflationary drive of Shinzo Abe, the prime minister, is stoking hopes that the past decade and a half of deflation may at last be coming to an end. Overall inflation has risen to 1.1%higher than in the euro area—and core inflation is now at zero. But the immense difficulty that successive Japanese governments have encountered in trying to escape the shackles of deflation serves as a warning of the danger of letting inflation fall too low. Once people start to anticipate declining rather than rising prices, it can be very hard to reverse their expectations.

Abandoning reserve
That danger is less acute in America than in the euro area largely because the Fed is more proactive than the ECB. It surprised the markets in September by sustaining quantitative easing at its present pace of $85 billion of asset-purchases a month, rather than starting to curb it. A study by economists at the Federal Reserve, published this week, has fuelled speculation that it may keep interest rates at rock bottom even longer by lowering the level of unemployment at which it will consider rate increases from the current 6.5%.

By contrast, the euro area looks increasingly vulnerable to a slide into deflation. Although the region emerged this spring from a painfully protracted double-dip recession, the recovery is expected to be a feeble one. GDP will fall by 0.4% this year and rise by only 1.1% in 2014, according to forecasts from the European Commission published on November 5th.

Such weak growth is unlikely to overcome the forces pushing inflation down. Output will remain well below its full potential next year, estimates the commission; all that idle capacity acts as a drag on prices. Unemployment across the euro area will stay stuck at a woefully high 12.2%, which will keep wages down. The strength of the euro will also exert a downward pull. It has been trading this week at $1.35, more than 5% higher than a year ago; on a trade-weighted basis it is 8% higher.

Very low inflation in the euro zone makes it much more difficult for uncompetitive countries, predominantly in southern Europe, to regain lost ground. Workers tend to resist nominal cuts in pay more fiercely than they do the subtler erosion of their income through inflation. If inflation in the countries with which the weak economies trade is high, they can improve their competitiveness simply by keeping their rate lower. That is in essence how Germany gained a big edge in the first decade of the euro.

But with overall inflation so low, peripheral countries must instead adjust through outright deflation or something close to it, meaning a freeze or absolute cuts in wages. Already, in September, when euro-wide inflation was 1.1%, prices were falling by 1% in Greece. They were flat in Ireland and rising by just 0.3% in Portugal.

A sustained period of deflation would be particularly hard on the euro zone’s periphery, weighed down by debt. Cyprus, Ireland, Portugal and Spain have high public and private debt; Greece and Italy have high public debt. When prices are falling, debt, which is fixed in nominal terms, becomes more onerous in real terms. Higher inflation, in contrast, makes escaping heavy debt much less burdensome.

Central banks have had to move beyond past orthodoxies in order to coax a modest recovery from the ruins of the financial crisis. Now, to avoid the blight of stagnating or falling prices, they may have to venture still further into unconventional territory.

Who Will Run the World’s Deficits?

Sanjeev Sanyal

NOV 7, 2013

Newsart for Who Will Run the World’s Deficits?

SINGAPORE These days everyone seems to want to run a current-account surplus. China has long run large surpluses. The eurozone is now running even larger ones, with swings in southern Europe augmenting Germany’s longstanding surpluses. Indeed, countries from Singapore to Russia are running large surpluses.
Meanwhile, America’s external deficit – which for decades has helped to sustain surpluses elsewhere – is now smaller tan it was before 2008, with many economists arguing that it should never revert to its previous levels (they argue that the shale-gas boom makes this unlikely, anyway). Financial markets have also made clear that the ability of other major deficit countries, like Brazil and India, to absorb capital flows is reaching its limit. Since the world is a closed system, this raises the question: Who will run the world’s deficits?
Mainstream economists believe that the global economy should function as a balanced mechanical arrangement in which external surpluses and deficits are smoothed out over time. But periods of global economic expansion have virtually always been characterized by symbiotic imbalances.
One part of the world runs large deficits for a prolonged period, creating demand; another part of the world runs surpluses, financing its counterparts’ deficits. This was true of Roman-Indian trade in the first and second centuries, and of the age of European exploration in the sixteenth century. It was also true of the two Bretton Woods arrangements, in which the US ran the necessary deficits.
Admittedly, imbalanced systems create distortions. The Romans had to debase their coins, owing to the continuous loss of gold to India. The Spanish empire flooded the world with silver coins as it paid for its many wars. Bretton Woods I collapsed in 1971, when the dollar’s peg to gold became untenable, and Bretton Woods II ended in 2008, owing to the misallocation of capital. But these distortions did not prevent unbalanced systems from enduring for long periods.
The only significant period of “balancedeconomic expansion was in the early nineteenth century. The British East India Company deliberately imposed a triangular trade arrangement whereby Britain sold manufactured goods to India in order to buy opium, which it subsequently sold in China to finance the purchase of tea and other products. In other words, balanced global economic growth required war, colonization, and large-scale drug trafficking.
So, what symbiotic imbalance will underpin the next round of global economic growth? Given that the current account is the difference between a country’s saving and investment rates, both of which are heavily influenced by demographics, we need to consider rapid changes in population dynamics.
China currently saves and invests half of its GDP, but, as its workforce shrinks in the coming years, its investment rate is likely to fall sharply. However, aging will keep the saving rate from falling at the same pace. This differential will generate large external surpluses that will transform China from the “world’s factory” into the “world’s investor.”
It would be convenient if global demographics were distributed in such a way that aging countries could run surpluses just when younger countries needed the capital. In reality, many major economies will be trying to save for retirement at the same time. Moreover, the younger countries are typically emerging markets, which have neither the scale nor the capacity to absorb the world’s excess savings efficiently.
The US is the main exception: it has both the required scale and the youngest population of any major developed country. Given this, it will once again fall to the US to run the world’s largest external deficit, in what could be dubbed Bretton Woods III.
It may seem appalling to expect such a highly indebted country to continue to run deficits; but the world is willing to finance the US at negative real interest rates. Indeed, the main international concern has been US policymakers’ reluctance to raise the government’s debt ceiling!
If the US is unable or unwilling to run the required deficits, the global economy will flounder in a savings glut of low demand and cheap capital until another alternative emerges. Or perhaps the low cost of international capital will entice the US to absorb some of the world’s excess savings, triggering a new period of global expansion.
While a Bretton Woods III arrangement would inevitably generate its own distortions, it could last for years if the capital is invested sensibly. The prospect of its eventual demise is not a good reason to wait for some theoretical ideal of global balance to materialize. If history is any indication, we will be waiting for a long time.

Sanjeev Sanyal is Deutsche Bank's Global Strategist. Named "Young Global Leader 2010" by the World Economic Forum, he is the author of The Indian Renaissance: India's Rise After a Thousand Years of Decline (Penguin 2008) and Land of the Seven Rivers: A Brief History of India's Geography (Penguin 2012).

What Fed economists are telling the FOMC

by Gavyn Davies

November 7, 2013 6:17 am

While the markets have become obsessively focused on the date at which the Fed will start to taper its asset purchases, the Fed itself, in the shape of its senior economics staff, has been thinking deeply about what the stance of monetary policy should be after tapering has ended. This is reflected in two papers to be presented to the annual IMF research conference this week by William English and David Wilcox, who have been described as two of the most important macro-economists working for the FOMC at present. At the very least, these papers warn us what the FOMC will be hearing from their staff economists in forthcoming meetings.

Jan Hatzius of Goldman Sachs goes further, arguing that the papers would only have been published if their content had been broadly approved by both Chairman Ben Bernanke and by Janet Yellen. The new works take the Fed’s mainstream thinking into controversial areas which have certainly not been formally approved by the majority of the FOMC.

The English paper extends the conclusions of Janet Yellen’soptimal control speeches” in 2012, which argued for pre-committing to keep short rateslower-for-longer” than standard monetary rules would imply. The Wilcox paper dives into the murky waters of “endogenous supply”, whereby the Fed needs to act aggressively to prevent temporary damage to US supply potential from becoming permanent. The overall message implicitly seems to accept that tapering will happen broadly on schedule, but this is offset by super-dovishness on the forward path for short rates.

The papers are long and complex, and deserve to be read in full by anyone seriously interested in the Fed’s thought processes. They are, of course, full of caveats and they acknowledge that huge uncertainties are involved. But they seem to point to three main conclusions that are very important for investors.

1. They have moved on from the tapering decision

Both papers give a few nods in the direction of the tapering debate, but they are written with the unspoken assumption that the expansion of the balance sheet is no longer the main issue. I think we can conclude from this that they believe with a fairly high degree of certainty that the start and end dates for tapering will not be altered by more than a few months either way, and that the end point for the total size of the balance sheet is therefore also known fairly accurately. From now on, the key decision from their point of view is how long to delay the initial hike in short rates, and exactly how the central bank should pre-commit on this question. By omission, the details of tapering are revealed to be secondary.

2. They think that “optimal” monetary policy is very dovish indeed on the path for rates

Both papers conduct optimal control exercises of the Yellen-type. These involve using macro-economic models to derive the path for forward short rates that optimise the behaviour of inflation and unemployment in coming years. The message is familiar: the Fed should pre-commit today to keep short rates at zero for a much longer period than would be implied by normal Taylor Rules, even though inflation would temporarily exceed 2 per cent, and unemployment would drop below the structural rate. This induces the economy to recover more quickly now, since real expected short rates are reduced.

Compared to previously published simulations, the new ones in the English paper are even more dovish. They imply that the first hike in short rates should be in 2017, a year later than before.

More interestingly, they experiment with various thresholds that could be used to persuade the markets that the Fed really, really will keep short rates at zero, even if the economy recovers and inflation exceeds target. They conclude that the best way of doing this may be to set an unemployment threshold at 5.5 per cent, which is 1 per cent lower than the threshold currently in place, since this would produce the best mix of inflation and unemployment in the next few years. Such a low unemployment threshold has not been contemplated in the market up to now.

3. They think aggressively easy monetary policy is needed to prevent permanent supply side deterioration

This theme has been mentioned briefly in previous Bernanke speeches, but the Wilcox paper elevates it to centre stage. The paper concludes that the level of potential output has been reduced by about 7 per cent in recent years, largely because the rate of productivity growth has fallen sharply. In normal circumstances, this would carry a hawkish message for monetary policy, because it significantly reduces the amount of spare capacity available in the economy in the near term.

However, the key is that Wilcox thinks that much of the loss in productive potential has been caused by (or is “endogenous to”) the weakness in demand. For example, the paper says that the low levels of capital investment would be reversed if demand were to recover more rapidly, as would part of the decline in the labour participation rate. In a reversal of Say’s Law, and also a reversal of most US macro-economic thinking since Friedman, demand creates its own supply.

This new belief in endogenous supply clearly reinforces the “lower for longercase on short rates, since aggressively easy monetary policy would be more likely to lead to permanent gains in real output, with only temporary costs in higher inflation. Whether or not any of this analysis turns out to be justified in the long run, it is surely important that it is now being argued so strongly in an important piece of Fed research.


The implication of these papers is that these Fed economists have largely accepted in their own minds that tapering will take place sometime fairly soon, but that they simultaneously believe that rates should be held at zero until (say) 2017. They will clearly have a problem in convincing markets of this. After the events of the summer, bond traders have drawn the conclusion that tapering is a robust signal that higher interest rates are on the way.

The FOMC will need to work very hard indeed to convince the markets, through its new thresholds and public pronouncements, that tapering and forward short rates really do need to be divorced this time. It could be a long struggle.

November 6, 2013

Taking Aim at the Wrong Deficit



WASHINGTONASK most people in this city what the most important step is to increasing economic growth and job creation, and they’ll reply, “Reduce the budget deficit!”
They’re wrong. So-called austerity measureslowering budget déficits while the economy is still weak — have been shown both here and in Europe to be precisely the wrong medicine. But they could be on to something important if they popped the wordtrade” into that sentence.
Simply put, lowering the budget deficit right now leads to slower growth. But reducing the trade deficit would have the opposite effect. Not only that, but by increasing growth and getting more people back to work in higher-than-average value-added jobs, a lower trade deficit would itself help to reduce the budget deficit.
Running a trade deficit means that income generated in the United States is being spent elsewhere. In that situation, labor demandjobs to produce imported goodsshifts from here to there.
When we run a trade deficit, as we have since 1976, we are spending more than we are producing.
When that happens, the national savings rate goes into the red. Either private savings (by households and businesses) or government savings, or both, must be negative.
Private savings are usually near zero, with companies net borrowers and households net lenders. The exceptions came during the stock and housing bubbles, when bubble-generated wealth caused household consumption to soar and savings to drop. The housing bubble also led to a surge in home building.
That rise in investment, coupled with the fall in savings, filled the gap in demand created by the trade deficit. But after the housing bubble burst, consumption fell back to more normal levels and construction tanked as a result of overbuilding. The government stepped up and at least partially filled the gap in demand, leading to large negative savings in the public sector, or budget deficits.
In other words, we’ve been bouncing from investment bubble to deficit spending to offset the income that is being drained out of the economy by trade deficits. And now, with the bubble behind us and politicians obsessively focused on lowering the budget deficit, we’ve lost our offsets. Meanwhile, the trade deficit remains a hefty 3 percent of gross domestic product, about $500 billion a year.
Still, many critics argue that the budget deficit is a “policy variable” — something policy makers can controlwhereas the trade deficit is set by free markets. But that view is naïve.
Many countries target the value of their currency, buying up dollars to keep their currency from rising against the dollar. This prevents normal market adjustment, as a country with a trade deficit would expect to see its currency fall in value, making its goods and services more competitive. China is the most visible and important currencymanager,” but there are many others.
These actions can be countered in at least three ways. First, we could pass legislation that gave the government the right to treat currency management as a violation of international trading rules, leading to offsetting tariffs.
We could also tax foreign holdings of United States Treasuries, making the usual tactic of currency managers more expensive. And we could institute reciprocity into the process of currency management: If a country wants to buy our Treasuries, we must be able to buy theirs (which is not always the case now).
The Obama administration, however, has not taken such measures, preferring instead to try to meet its goal of doubling exports by 2015. But there’s a key word missing from that formulation: “net.”
If you asked me how my basketball team did last night, and I told you, “Great — they scored 92 points!” you’d presumably want to know how many points the other team scored. Unless we’re targeting net exports, or exports minus imports, we’re not in the game.
The administration has other helpful measures in play, including tax credits to incentivize domestic production. But unless we’re willing to go after exchange rates — the value of our currency relative to that of our trading partners — we will not be able to significantly lower the trade deficit.
The impact of doing so would be striking. Suppose the reduction in the value of the dollar cut the trade deficit by two percentage points of G.D.P. This would directly create close to 2.8 million jobs, a disproportionate number of which would be relatively high-paying manufacturing jobs. And that’s not counting the fact that a factory job has a high multiplier effect, creating more work in other sectors to support it.
If we continue to run large, persistent trade deficits, we have no good choices. We can offset that exported demand with either bubbles or budget deficits. Or we can go austere and slog along with unacceptably high levels of unemployment and weak growth.
But if we shift our focus from reducing the budget deficit to the trade deficit, we could make a big difference, not just in the national accounts, but in the lives of people for whom that unfavorable math has meant hardship for far too long.
Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities. Dean Baker is a co-director of the Center for Economic and Policy Research. They are the authors of the forthcoming book “Getting Back to Full Employment: A Better Bargain for Working People.”