The Fed, in
nostalgia...
Inflation and/or
deflation affect the value of money and therefore demand and supply in the
economy by the way of increasing or decreasing real wages and/or real interest
rate, both as a tool to achieve full-employment. Inflation reduces the real
interest rate which pushes investment by lowering the value of money and debt,
and also reduces the real wages and demand which decreases the cost of labour
and capital and increase investment; however disinflation or deflation
increases the real interest rate and real wages which increases the cost of
investment by increasing the value of money which might not be true. Inflation
is often used to induce investment and supply by increasing the price-level,
and disinflation or deflation increase demand and investment by decreasing the
prices. Of the two, it is clear from the above lines, that inflation reduces
demand, and disinflation or deflation
increases demand, and, investment and supply, both, by reducing prices and
increasing the value of money and, real interest rate and real wages.
Therefore, we might also get closer to the point that during a slowdown i.e. in
a period of high unemployment and low demand, an increase in real interest rate
and real wages by lowering prices or inflation would incentivize demand and
investment and supply when the money-supply is loose. Nonetheless, inflation
and slowdown is hard to happen at the same time because during slowdown there
is a pressure on the price-level to go down in the presence of higher
unemployment. Nevertheless, inflation coincides with boom and low unemployment.
Thus, it is futile to expect inflation during low growth and higher
unemployment. Then, it is not worth to expect that inflation would cut real
interest and real wages to promote supply and investment, but lower prices and
more money-supply is expected to increase real wages and real interest rate
which would also increase savings and investment by increasing the value of
money. A recent study shows that prices significantly affect the economic
growth rate and the relationship between the two is negative, i.e. lower prices
increase economic growth. Among the major factors affecting prices and economic
growth are money-supply, current account deficit and house-price-index.
Therefore, the Fed’s targeting of higher income, demand and inflation failed to
increase real wage expectations and spending, and lower real interest rate
never happened during the slowdown. Notwithstanding if the Fed had committed
higher real wage expectations it would have increased spending, and, savings
and investment too by increasing the real interest by committing a lower
price-level.
Shaping
Expectations, an Awkward Observation...
Shaping expectations is
important, though, difficult by the way of targeting variables... It is really
an irony that if we target a variable and try to carve expectations it works in
the opposite direction... For example, if we target inflation and shape
inflation expectations it takes us in the opposite direction, deflation...
because inflation would make things costly which means less purchasing power
and spending, moreover it increases savings because of higher future
inflation-expectations, people would demand less and save more... Nonetheless,
if we could try to target lower-prices or inflation people would spend more and
save less because of lower prices and price-expectations, they would feel
richer, spend more and increase inflation in the future... For further
understanding we could take example of targeting higher interest-rate and
expectation, it would again lead to lower spending and lower interest-rate...
Moreover, if we try to target lower exchange-rate, lower demand for imports and
foreign-exchange would make foreign currency cheap and increase imports in
future... It looks we should try to target variables other-way if we want them
to work better.....
Two quantity
theories for two Worlds...
A common observation of
the everyday life is that the value of money is assumed to go down or decrease
as the time pass, which means the value of one-rupee or one-dollar falls as we
go ahead with time that they buy less and less as we go through time and we use
higher denomination of a currency to increase demand and growth, but we suppose
inflation also do increase which lowers the purchasing-power or the real-value
of money and that depends upon the both, demand and supply. If we take demand
into consideration, an increase in money-supply would increase inflation and
inflation expectations with supply-side constraints and full-employment, which
is the old-quantity theory of money and is true for a less developed or
developing economy with protectionary policies, but when seen from the
supply-side perspective, an increase in the money-supply is likely to lower the
borrowing-cost and prices, and improve supply when population growth-rate and
demand is going down through time, in short supply may outpace demand. The
supply-side argument, increasing-returns and lower prices may be called the
special-quantity-theory of money observed in most of more-open-Western-countries
Japan, Europe and the US. This might also be explained with the help of returns
to the scale experiencing the economy. The old quantity theory of money has
presumed the decreasing returns to scale in the economy which means prices
would increase as a result of expansionary monetary-and–fiscal policies; more
money-supply would increase the price-level, since demand would exceed supply.
On the other hand, the special-quantity-theory of money and increasing returns
may lower the general-price-level as a result of more money supply and
expansion because supply may increase more than demand. By comparing the above
two we find that the old-quantity-theory-of-money may lead to money-illusion
and inflation, and may lower demand by lowering the value of money, whereas the
special-quantity-theory-of-money and increasing-returns would compensate for
the lower population growth-rate and low demand by increasing the value of
money.
Neutral or
Natural real-interest-rate...
The Fed has constantly
said that Core-CPE (Consumer-Price-Expenditure) at 1.5% is near the inflation
target which is in line with the unemployment rate close to 4.9 % although the
growth rate is tepid. However, it is yet unclear that the bank has shifted its
official inflation index the CPE to the Core-CPE which might show the increase
in the price-level due to full-employment and wage-hike since inflation from
other sources like transport or oil and food show no price-pressures and loss
in the domestic value or purchasing power of the dollar. Currency debasing is
debated widely in the Political-circles. The Fed’s Fund-rate path demonstrates
that it would be near 2-2.25% by 2018 and if we assume the same inflation
target we arrive at a real interest rate of 0.25% which means that the
real-interest-rate would increase and not fall compared to the present
condition when nominal Fed’s fund rate is 0.25-0.5% and inflation is 1.5%,
therefore, the real-rate would be 0.5% - 1.5% equals -1% lower than the real
rate in 2018. Hence, 3 years down the line we could expect real rates to be
higher than today at which the investment-spending would decrease and not
escalate and inflation would go down because real rates would be higher than
the natural-rate today when spending is low. The current scene explains lower
natural real rates when inflation is low and stable little above zero at 1%
which might need slight tightening to bring complete price-stability by
increasing real-rates and nominal interest rate. Nonetheless, lowering demand
to lower the price-level is different from increasing supply and lower the
price-level because the former lowers employment and demand, whereas the supply
increases employment and vice-versa and lower the price-level. Therefore, the
Fed is expected to find or achieve the natural real interest-rate by keeping
money-supply loose, and increase supply and lower the price-level than by
keeping demand and the price-level low by increasing the real-rates and
unemployment.
The natural rate
theory…
The natural rate theory
says that interest-rate should not produce inflation or deflation so as to make
the economy stable because inflation fosters inflationary expectation that is
neither good for consumption because aggregate demand would go down, nor for
investment because the value of capital-stock would go down. However, deflation
would increase deflationary expectations, but since lower prices would also
discourage supply people would rush to buy the inventories. The expectation
that people would delay spending is not acceptable. In addition lower-prices
would again lower interest-rate and interest-rate expectations which would
increase supply in the future which further means price correction or lower
prices. Lower borrowing cost is a larger part of the overall cost which is
likely to increase supply and lower prices. The Fed is targeting inflation and
has increased inflation expectations which have made the economy costly when
there is already a long-term marginal-productivity and real-wages gap. Nonetheless,
Janet Yellen has conveyed to the government to increase productivity by
investing in education, skills and innovation. But, what would be the use of
increasing productivity when there is already a big gap in real-wages and
productivity since 1970s. Paul Krugman supports the stagnant-wages theory.
Nonetheless, the Fed too might help increase real-wages by increasing deflation
and deflation expectations by keeping the money-supply little tight… Or by
increasing nominal wages by continuing with lose money-supply and increase
inflation and inflation expectation which actually reduce demand. Milton
Friedman in his optimal-monetary-policy envisaged deflation as the right
strategy and maintained that nominal interest-rate should be sufficiently down.
Therefore, the Fed might increase rates again after a complete year to keep the
prices lower and lower inflation expectations in the future, but there might be
a trade-off between inflation and unemployment, a little higher unemployment at
which prices and wages support a higher or increasing real wages which also
means lower prices is the right thing to desire for. Wages or real wages should
increase to keep demand intact in the face of lower population and
labour-force-participation rate. Revival in the lagging demand due to low real
wages compared to the productivity might also help to increase domestic-demand
and spending and economic-growth…. Nevertheless, in the next five years we
could expect natural interest-rate not above 2% which is currently negative… By
increasing nominal rates the Fed would also increase real-interest rate because
inflation and inflation expectations would also go down… But, sharp tightening
is not expected because that would also lower growth and growth expectations…
Inflation-targeting
in the US...
The Fed could raise
inflation either by increasing demand, higher demand would increase the
price-level, or reduce supply, lower supply would increase prices, relative to
each other. Demand-side would work when employment and real wages would go up
and supply-side would work for inflation targeting if supply goes down. Both,
together, mean that demand should go up in comparison to supply, i.e., demand
should go up relative to supply or supply should go down. Moreover, low prices
and expectations show that supply is abundant and demand is low. In this
situation inflation targeting would lower real wages and demand, supply would
outpace demand, prices further would go down. On the opposite, if we lower
inflation expectation, lose money-supply would also increase real wage
expectations which means more spending and less wage demand due to lower prices
could also increase export competitiveness. If prices would fall it would do
the both increase demand and also reduce some supply due to lower prices which
might help the inflation targeting. However, if the Fed tries to increase
inflation by inflation targeting it would reduce real wages expectations and
demand and spending and higher prices would further improve supply in the event
of low demand and lower prices could fail inflation targeting. Higher inflation
expectations would not let inflation targeting work because demand would go
down and supply would increase means lower prices, however lower inflation
expectations might increase inflation in the future by increasing real wages
demand and limiting supply due to low prices...
Inflation-targeting
would lower demand...
Economists think that
deflation or lower prices make people delay spending which is against the sales
logic that lower prices would help clear the market… During a sale or low price
period the seller is expected to sell more. That is equivalent to say that
higher prices or their expectation in the future would decrease demand and it
might also increase savings which is against the spending reason. Higher
inflation or inflation expectations in the future could also make people spend
less, purchasing power goes down, number of goods and services relative to the
money-quantity or amount in the hand goes down, and they also save more for the
future. Economists say that the relative comparison between two nominal
variables makes a real variable. Inflation hurts demand is very simple to
understand when it can reduce demand by increasing the price-level. Simply, we
know that lower prices increase demand and higher price reduce it (Tobin) which
is true for both, the domestic economy and the external economy. Lower prices
make you competitive in the market. Moreover, Pigou has also put his theory in
a similar way that lower prices would increase real-wages thereby increasing
demand. Ordinary people talk about nominal variables but an economist likes to
look at the real picture, real-wages, real interest-rate, real-prices of
assets, real GDP and so on, i.e., inflation adjusted values of variables. The
central banks are trying to reduce unemployment by cutting on real wages,
external devaluation to increase exports, and real interest rate through
inflation to make businesses and investors spend more in order to clear the
market but inflation targeting has also failed to increase domestic demand by
reducing real wages and income to increase external demand at the expanse of
the former at a time of global headwinds and slow recovery in the US.
Inflation-targeting by the central-banks has reduced domestic demand by
lowering real wage expectations and also increase savings, in the face of
higher inflation, for the future.
The Opposites...
This discussion between
the Fed and the government over the use of fiscal-spending to increase demand
and growth within the economy has turned out to be the point of contention. The
Fed Chair’s view is that the spending is not opportune as the economy is near
full-employment and more spending would increase over-heating and probably
would force it to increase nominal interest-rate before than expected which
might be true because at this time it would mean debasing of the currency which
is a pet issue amongst the policy-makers, higher inflation is seen as negative
for the value of money and demand. But,
the economists favour lower real-interest-rate or natural-rate which means
lower value of debt, however they forget that lower prices would increase that
value of money and more savings due to lower-prices could help maintain lower
nominal-rates and real-interest-rate if the economy is below full-employment
and price-level is low. Fiscal-spending at this level would increase expected
inflation because we have signs of wages firming up because of full-employment.
Nonetheless, higher inflation and inflation expectation could increase
export-competitiveness in the short-run, but at the cost of lower domestic
real-wages and higher nominal exchange rate and lower-imports which may
increase exports, but is not suggestible since domestic demand could go down.
Lower consumption means lower domestic-welfare and depreciation would increase
capital outflows that means domestically less investment could lower inflation and interest-rate expectations
which is the opposite of what the policy-makers want. They want higher
inflation and interest-rate to come-out of the liquidity-trap, the opposite.
However, if the Fed targets lower-prices and interest-rates it might increase expected
inflation and interest rate and expectations by increasing demand. They are
targeting higher inflation, but inflation would increase when demand increase
and that is dependent on real-wages and income which higher inflation might
push down. Keynesians too believe that effective-demand during slowdowns would
increase if employment and wages increase. The Fed has committed a higher
inflation target and has also target higher real-GDP, but other things
constant, if inflation increases, it would reduce real-GDP because of a higher
deflator. Higher inflation would increase the value of deflator when GDP is
constant. So both, the signals to target higher inflation and higher GDP are
half conflicting. Notwithstanding, if we try to keep inflation constant or lower
with a higher real-GDP target that might increase the GDP when the
money-supply, demand, output and income increase… If we commit higher inflation
it would also lower real-GDP expectations if other things remain constant…
Helicopter-money,
and, Fiscal and Monetary Policies...
The idea of
“Helicopter-Money” has its origin in the Keynes famous advice to a President of
a country of digging and levelling pits and pay for labour and wages which
would create effective demand in the economy during recessions, i.e.,
advocating fiscal-policy during low growth. Some continued this argument with a
difference that since this public investment has not actually created a
public-asset to justify time and labour spent on the project so it may take
another forms like helicopter-money or money under the ground or money in
bottles in an attempt to simplify the procedure. Keynes prescribed
fiscal-policy during recessions and liquidity-trap to increase demand, spending
and growth. Nonetheless, he never added that spending should target inflation
which the central-banks are doing rather he assumed that more spending would
increase demand and prices by increasing employment and wages during recession.
If the central-banks
would target inflation people’s views about real wages might change and they
would save more for the future which means less spending. Whenever, wages or
incomes increase the money is divided between consumption and saving. Poor
people’s marginal propensity to consume is higher than other classes who have a
higher propensity to save. Developed economies have fewer poor people and the
majority is well-off and they spend less and save more out of a given rise in
income as far as helicopter money is concerned. A part of this rise an amount
would also be saved and that depends upon inflation expectations. Higher
inflation expectations would increase savings and it is undeniable that some
people might save all. The helicopter money’s multiplier would be lower than a
fiscal-multiplier because this would increase wages and poor people’s incomes
with no employment and with a higher propensity to consume. Poor people would
spend more. Therefore, fiscal-policy to create public-assets and spending on
wages look more enticing.
However, a permanent
increase in wages and incomes would increase spending more. This is called by
Paul Krugman as the credibility problem. The central-banks could not commit for
a forever increase in money-supply because inflation would push them to
tighten, but that would rest on the supply-side and, open and free-trade might
help to overcome the problem of full-employment and more-supply. Nevertheless,
if the central-banks could commit a permanent increase people might spend more.
Inflation and inflation expectation would make them save more and lower prices
might make them feel richer and spend more. A commitment to increase real wages
in the long-run would increase demand. In the short-run, if we commit higher
wages and lower prices that might also increase spending in the short-run. Also
true for the long-run as mentioned before.
Therefore, if
fiscal-policy commits full-employment and wages, and, monetary-policy
lower-prices it is likely to increase spending and growth at a higher pace.
Both, policies might do their bit to recover fast.
Lower real-wages
lead to lower demand and growth...
All the countries are
trying to increase their per capita income and living-standard according to the
increase in productivity while maintaining their competitiveness with
innovations because labour is relatively scarcer which might restrict the
economy’s capacity absorb capital without increasing wages and the general
price-level, as found in the general quantity theory of money.
Productivity is
measured by output per labor (Y/L) and output per capital (Y/K). If these
increase over time, we can say that productivity has increased and vice-versa.
Productivity can be measured. We need productivity growth-rate to decide growth
of returns to factors of production. We are here talking about productivity
that increases supply capacity to sell more at lower prices. In the market
there is a competition to sell at low price. A direct factor that drives
productivity is knowledge or innovation.
More money-supply has
reduced the cost of capital with low wages increasing supply despite of low
demand which has lowered the general price-level and interest rates pushing the
economy at the zero lower bound or liquidity-trap for a longer period. At the zero
lower bound cash hoarding increases, not necessarily in banks, because the
value of money goes up in the face of lower prices, moreover everybody expects
higher inflation in the future because it is the our basic observation that
prices increase with time and the will to hold unlimited money also increase
savings.
The zero lower bound
also trims the possibility of increasing investment and employment by reducing
the borrowing cost or nominal interest rate, but the central banks are trying
to reduce real interest rate and wages with inflation to incentivize the
supply-side and profits which would also increase the relative international
competitiveness to survive in the market-place.
A higher
current-account-deficit (CAD) in the most of the developed -world means you
have to devalue, either by cutting on nominal wages, interest-rate and prices
(internal-devaluation) or by cutting real wages, interest-rate and prices
(external-devaluation) by increasing inflation. In internal devaluation
money-supply is tightened to lower inflation, to cut down nominal wages and
interest rate. In external, money-supply is loosened to increase inflation and
cut down real wages and interest-rate. But, we have evidences of
downward-nominal-wage-and-price-rigidity after a point. In most of the
developed world there has been a cut on real-wages despite increasing
productivity. There has been a real-wages and productivity gap since few
decades.
Nonetheless, when real
wages are going down demand too is likely to remain subdued resulting in lower
growth rate. But, if, we pay equal to the marginal-product or productivity,
there would be no inequality-issue. Economists favour reward to factors of
production according to their product which is the purpose of Economics
(explaining income-distribution). It is among the stylized-facts that share of
labor and capital should be equal in GDP and real-wages would rise in the
long-run. Labor-saving technological progress and higher productivity may be
the reason for higher capitalists’ profits, but real-wages-productivity-gap is
observable in the charts.
The US might
target higher real-wages....
The Fed could try to
moderate long-run interest-rate and interest-rate expectations that the economy
can weather rate-hikes in the long-run one its current growth... without
decelerating.... A little higher unemployment rate may save the economy from
overheating... When the neutral real interest-rate has some positive bias so
that the downward pressure on the price-level to make savings worthwhile...
Capitalists earn profits, save and invest; they have a low propensity to
consume... they demand less compared to income... The value of multiplier would
be low... The economy is demand deficient... Since 1970s real wages have
stagnated low even after increase in the economy’s productivity... Higher real
wages would increase domestic demand and income and growth…
The central-bank could
commit higher real-wages through tighter labour market and low inflation and
inflation expectations through low interest-rate when unemployment is below the
natural-rate and there is an upward pressure on the real wages by lowering the
borrowing cost, increasing supply and lowering the general-price-level because
lower prices would increase the value of money and demand and lower
unemployment and higher growth. Higher real-wages could increase investment in
people skills and reduce voluntary unemployment and increase the supply of
labour and productivity too, it would increase demand and growth...
Nonetheless, lower interest rate due to higher supply and lower price-level
could increase real-wages-expectations and increase spending and lower prices
may help increase savings and investment and the economic-growth rate... Higher
real interest-rate, since of lower-prices, would also increase return on
capital...A little higher real-interest-rate would save both little, labour and
capital and would help lower demand and
prices with a downward bias to make the money strong and valuable to increase
demand in the long-run when population growth rate is going down... Higher
real-wages in this scenario would help maintain demand/supply and the
price-level and the real- GDP... Too much expansionary and too much
contractionary policy would increase volatility and in the attempt to control
the swings during booms and busts, either we slow too much or grow too much...
If the FED tries to stabilize the value of money at the current-level of the
prices or increase disinflation or little deflated expectations is would
increase the wealth expectations and demand and the economic-growth-rate...
Borrowed from the Milton Friedman’s OPTIMAL MONETARY POLICY... The government too may contribute by
increasing the real wages expectations by demanding more labour and help
achieve wage-gains... Nevertheless, if the budget increases on infrastructure
and skills-development or reduce taxes on the lower and middle-class it could
also increase real-wages and expectations and spending – consumption and
investment... When the value of money
increases in the economy it affects everybody in the same way by the way of
inflation/disinflation/deflation...
Disinflation or Slow
Deflation Trajectory...
In Economics we
generally assume that the value of money falls in the long-run because
inflation increases as the money-supply is increased, the Monetarism. One of
its principal proponents Milton Friedman based his models on the Irving
Fisher’s Quantity-Theory-of- Money which states that as the money-supply is
increased, either by the monetary and/or the fiscal policy it increases
inflation which also forms the core of the inflation-expectations theory
because it assumes that when money-supply is increased it also increases
inflation -expectations. This is what the Fed in the US is trying to do to come
out of the liquidity-trap, since only higher inflation and
inflation-expectations make case for rate-hikes and hike-expectations the short
and the long-run. Inflation and interest-rate expectation may influence
spending decisions.
In the liquidity-trap,
Keynes advocated government intervention during recessions... He probably
prescribed counter-cyclical economic-policy to stabilize trade-cycles for
full-employment and stable-price, too...
The Fed thinks that
neutral real rates could go up... Currently, it is negative when the nominal
rates are still close to zero and lower than 1... It is expecting that neutral
rate might go up probably because higher nominal rate may lower
economic-activity and inflation... Lower prices and higher real rates could
increase savings in banks... Money value would increase and more savings would
lower loans-rate which means more investment in the future... Lower price or
prices expectations are more expansionary, both consumption and savings and
investment increase... The Fed might commit a lower price and
price-expectations trajectory in the long-run to increase demand when demand
from population growth-rate is going down which determines the employment,
production and economic-growth...
Lower cost of supply -
lower real interest rate and lower real wages – because of lower-prices and
lower population growth-rate has made supply outpace demand and also lower the
price-level, and lower oil prices have all contributed to low inflation and low
inflation expectation... Fundamentally we are in a lower price regime…
(Deflation)...
They never let it materialize...
Higher real-rates or
lower prices or deflation makes money more valuable in terms of banks deposits
and bonds owing zero nominal interest rates. Money becomes more valuable. But,
some economists say that lower-price expectations make people delay spending. I
think lower prices increase the value of money therefore people accumulate
reserves not because they expect lower prices ahead especially in the
liquidity-trap. People always think that prices would go up and they need to
save more for the future. Banks also keep the long-rates higher than the
short-run rates which also depend upon expectations of inflation besides just
inflation. The central-banks conduct monetary easing to lower long-term rates
first and then it lowers short term rates. Banks have kept long-term real
interest rates higher than the short-term rates. Since zero-lower bound,
nominal rates are zero we also do need to lower long term interest rates which
also depend upon inflation/deflation expectations. Lower price expectation
would lower long-run interest rates and inflation would increase the long-run
interest-rates. Expectations depend upon right information and more on economic
policy.
Keynes is right upto
the zero lower bound or liquidity-trap for which he advocates fiscal policy
because interest-rates are zero. Fisher talked about real interest rate i.e.
inflation adjusted rates and Wicksell natural or equilibrium interest-rates at
which there is neither inflation nor deflation which means constant real
interest rate. The economists still say that there is no unique set of nominal
and real interest rates which might be true. Non-economists people rarely think
about real interest rate... they are occupied with nominal interest rate. The
Fed says it is Wicksellian economy...
Japan might also target
real wages to increase demand and supply and inflation by increasing
consumption, and when demand goes up supply is increased to earn profits by
investing more at lower prices. The forecast about the real GDP growth may
influence investment decisions... Lower price increase demand and supply and
consumption and investment... In the stocks lower prices are an opportunity to
buy at low and sell at high... Lower inflation might lower cost and increase
profits... Labour demand less wages and interest rate/cost also goes down in a
low price regime... Lower prices too reduce inflation expectations and may
increase spending... Lower prices help demand...
Most of the economists
argue that deflation is unending and unlasting which might be wrong, because
when prices fall too much demand increases and supply also goes down which may
push the price-level up in the future... People know that supply is limited so
they must spend now... Moreover, if they expect lower -prices they would also
save less which again increase spending... Deflation might not last too long,
but may help increase real-wages and demand and inflation in the time ahead, if
other things are constant...
They never let it
materialize... Japan always used policies to increase inflation and
inflationary expectations through loose money-supply and communication... They
never accepted deflation as a tool to increase demand; real-wages has been
low... Although the economy is near full-employment, but lower rate of
population growth is also responsible for low demand and inflation...
Nevertheless, Core-inflation has shown improvement (more inflation)...
Improvement in wages in yen-terms is very slow or low compared to the size of
the money-economy in the yen terms... It would need a very-very big stimulus to
reach the threshold that could increase wages and spending... Japan could
communicate deflation and increase money-supply in order to increase real-wages
and demand... Probably, 10% of the money-base...
Negative
interest-rates...
Negative interest rates
these days in Europe and then in Japan is the latest unconventional tool of the
monetary-policy to increase demand and growth with a persistent deflationary
bias in the general price-level attributed to low demand and spending,
consumption or investment. Deflation is a prime cause of low interest-rate and
the central-banks are trying to reduce real interest rate in order to adjust to
natural interest-rate which would keep unemployment and inflation at the
targeted or NAIRU-level while increasing the growth-rate to catch the potential.
In their efforts to converge interest-rate to the natural rate the central-bank
has adopted the negative interest path when inflation has failed to materialize
to cut-down the real-rates. The banks as negative rates sound are charging its
savers and customers for their deposits in order to dis-incentivize savings and
incentivize consumption and investment. The negative interest-rate used by the
central banks has charged on deposits but we have not heard banks paying for
loans. Negative interest also means
reversal of incentives to invest or spend from the creditor to the debtor. It
also means that the banks might have to pay more for spending or investment.
Only then it is consistent with the outcome we want, more consumption more
investment (or spending)... Is it happening...?
More on
negative-nominal-interest-rate...
The negative interest
rate adopted by some of the World’s developed countries’ central-banks has
started a new discussion among analysts and economists as what would be the
interest-rate trajectory for the economies reeling under recession, several
rounds, when they have cut down nominal-interest-rate below zero in an attempt
to boost consumption and investment spending to increase demand and growth
keeping inflation and unemployment low. It is true that several important
central-banks of the developed-world has cut down nominal-interest-rate below
zero and are receiving money from deposits opposite of the usual practice of
paying interest rate for their deposits which is primarily intended to boost
consumption instead of savings during recession. But, these banks have missed
to reconcile consumption and investment, both. They are trying to increase
consumption by dis-incentivizing savings, but, have made no effort to increase
investment by also reducing the borrowing cost in the negative which means
banks should literally pay for new loans, means interest-rate payment for
availing loans when they are getting money from deposits. The banks are now
earning from deposits, but they must also try to increase loan demand by
incentivizing through interest-payment, and that’s what negative interest rate
should do in order to increase employment, demand and growth. Only then
negative interest would make a complete sense to increase economic-activity
because the Capitalist must also be incentivized to increase employment through
more investment when the households are encouraged for more consumption.
However, if the banks manage to increase consumption without investment that
would create inflation and unemployment, in the place of deflation and
unemployment, which is again an awkward position from the view-point of
stability. Nonetheless, the objective of the monetary-policy and interest-rate
management is to shoot for the natural interest rate at which the economy is on
full-employment and there is neither inflation nor deflation.
Synthesize...
In the context of the
2008 Financial-Crisis in the US economy that send jitters to the rest of the
global economies, the long divide between the “freshwater” and “saltwater”
economists also known as “the neo-Classicals” and “the neo-Keynesians”,
respectively, over the rigidity or sticky or no-rigidity of the key
economic-variables, could be brought to the light of evidences to understand
the view-point of the two schools of thought. The neo-Classicals maintain that
the economy in the long-run could self-equilibrate with the help of change in
the real economic variables like, real-wages, real-interest rate and real
exchange rate, i.e. inflation adjusted variables, while the neo-Keynesians
believe in government intervention and sticky or rigid prices to converge the
economy to stability. In the earnest efforts to tackle the recession that
followed the Lehman-brothers, an investment bank, collapse the Federal Reserve
Bank of the US embarked on massive monetary-easing and set inflation target to
achieve economic-activity, full-employment and growth-rate. Nevertheless, the
economy after these seven–years showed recovery in terms of employment and
economic growth, but inflation remained below the target. Even after so much of
easing the economy failed to increase demand and inflation and the discussion
is still on to raise the inflation target, but as we know inflation is also a
kind of tax and it reduces demand and growth by increasing the price-level and
the interest rate. Thus, inflation reduces demand. The Fed initially thought
that more money-supply would increase inflation and inflation expectation, but
this did not happen as oil-prices, that have constrained the growth many times,
have gone down due to innovation in crude oil by shale. “Targeting” and
“expectations” have been the buzzwords in Economics, now the countries target
economic variables like prices or inflation, wages, interest-rate, exchange
rate and economic-growth, and also try to shape expectations about the future-
values of economic variables. There has been a tradition among the major
economies to target higher GDP projections to increase investment. Nonetheless,
inflation targeting and exchange rate targeting are also not uncommon. However,
the question is still there that which variables to target, nominal or real and
if there is a need for government-intervention (?). The neo-Classicals favour
the real economic-variables, but not government-intervention; however, it is
still unclear that the central-bank is a part of the government although
independent. Keynes’ prescribed fiscal-policy in the liquidity-trap to increase
nominal-wages and effective-demand whereas Pigou recommended to increase real-wages
and, probably, the same effective-demand. Notwithstanding, if we target real
variables with the help of monetary and fiscal policy we might get results or
outcomes soon. We might try to affect real-variables since nominal variables
confuse the agents. For example, the Fed has committed inflation and also
income which might send contradictory signals about real wages and real-wages
expectation which reflect the real position. In this situation spending would
be low and people would also save more due to higher inflation expectation
which during recessions may negatively affect demand/supply and
economic-growth. Conversely, if people see and expect lower prices they would
increase spending because real-wages and real-wage-expectations would go-up.
Similarly, if the Capitalist see and expect lower prices of investment goods
and services, they would increase investment because real cost would go down
and real profits could increase. Moreover, if foreign importers see and expect
lower domestic prices they would import more because real exchange rate would
increase, exports would increase. All the three cases above might help increase
demand/supply, employment and the economic-growth, but with the help of low
inflation and inflationary-expectations and real economic-variables. However,
the Fed is trying to the same with the help of higher inflation and inflation
expectations and nominal variables which have given only limited results and
sub-par growth rate. The US has had been the home of many great economists of
which Milton Friedman is outstanding and widely celebrated. He himself proposed
“the optimal-monetary-policy” that says that monetary-policy might give better
outcomes in terms of demand/supply, employment and economic growth if the
nominal interest rate is set substantially low and there is little deflationary
bias in the economy (Aubhik Khan, Robert
G. King & Alexander L. Wolman, 2002). Moreover, the relationship between
deflation and depression is weak and there are periods of satisfactory growth
and deflation in the history (Andrew Atkeson, Patrick J. Kehoe, 2004). The Fed
is indirectly targeting nominal wages, interest-rate and exchange rate through
inflation which misses the outcome of more demand/supply, employment and
growth-rate, but if the Fed targets real wages, real-interest-rate and real
exchange rate by lowering inflation and inflationary expectations or through
little deflation it might be able to achieve better outcomes, demand and
growth. There has been a real-wage and productivity gap in the US since 1970’s
which the Fed and the government might try to level in order to increase
domestic demand and growth (Mark Setterfield, 2010). Committing a lower
inflation or little deflation path by the monetary-policy might help increase
real wages and domestic demand. Likewise it would also increase real-return on
investment and wealth thereby increasing supply and growth (Jonas Crews, Kevin
L. Kliesen and Christopher J. Waller, 2016), and, is also likely to increase
real-exchange-rate (real-exchange-rate equals nominal-exchange rate multiplied
by the foreign country price-level divided by the domestic price-level) and
exports, and growth. Friedman has clearly acknowledged that the
optimal-monetary-policy would entail dis-inflation or little deflation and
would require a sufficiently low nominal interest-rate. In the developed-world
the evidences show that price-levels in these countries have gone down even
with huge increases in the money-supply and lower interest-rates in the
long-run. In the long-run, perhaps lower borrowing cost has helped improve
supply and lower the price-level. The Fed may review Friedman’s
optimal-monetary-policy in respect to the relationship between lose
money-supply, lower borrowing cost, more supply, lower price-level or inflation
and real-variables – real-wages, real-interest-rate and real-exchange-rate -
for better guidance about the future monetary-policy.
Still, relevant...
Keynes predicted the
euthanasia of the creditor or rentier of the capital because he thought that land
and labour are scarce, but capital has no reason to be scarce, because the
central-bank can print money to stoke demand/supply to achieve full-employment.
In the developed-world the central-banks have pumped so much money in the
system that has made money so cheap that pushed interest-rate rock-bottom
(Japan, US, Europe). In these countries, capital is cheap and not scare, at
all; interest rates are at zero-lower-bound. These economies are very close to
that (Keynes’ concept of) euthanasia, when interest rates are almost zero. If
we take Japan as an example which is reeling under recession for past two
decades and interest-rate near zero, euthanasia of the creditor seems very
plausible. In all the three economies interest-rate is near zero and they are also
probably in the famous Keynesian liquidity trap in which people accumulate
reserves, when nominal interest-rate is zero and cannot fall further and in the
expectation of lower prices forth they delay purchases. Prices reflect scarcity
and higher-prices reflect higher scarcity, even prices of labour (wages) and
capital (interest-rate). During downturns both are not scarce as there is a cut
down on investment and interest-rate (or increase in money-supply) and
employment and wages (or increase in unemployment and labour-force). In an
attempt to increase demand and growth, these banks failed to understand the
importance of savings which is also a function of real interest-rate (nominal
interest rate minus inflation). It has also led to capital-fight. Moreover, in
another attempt to make economy competitive we have also cut-down on real-wages
(nominal wages minus inflation). The continuous increase in money supply and
inflation has kept real-interest-rate-and-wages and demand low. Moreover,
slowing population growth rate has also affected demand negatively. The
central-banks are trying to push the economy through money-supply which is
supposed to increase spending and inflation, but this is even going to hurt
demand by lowering real-interest-rate-and-wages and might not work in the
liquidity-trap. Savings also do have a positive effect on demand through lower
interest rate and higher investment. Moreover, inflation will also lower
real-wages. These banks policies might have a negative effect on demand by increasing
inflation. The Fed is trying to push prices up which is opposite of the
argument that increase in real-wages will also increase demand, the
Pigou-Effect. The effect is also helpful in the liquidity-trap by increasing
real wages and demand. Growth-rate of the economy will increase. The Fed should
try to release the repressed demand by increasing real-wages and stop inflation
targeting and let the prices fall to increase demand. Lower interest rate, as
they are, will help increasing investment. The interest rate in these countries
might remain very low, probably zero, for an indefinite period of time (may be
forever) because in these capital rich countries, capital is not scarce
anymore... Japan is a good example...
Interest-rate depends
upon the money-supply, the price level and expectation of changes in it,
because of the price-stability objective of the monetary-policy or the
central-banks. They manage money-supply to adjust interest-rate and
demand/supply which jointly determines the price-level or inflation. But,
interest-rate in turn is also determined by inflation and inflationary
expectations, both short-run and long-run. Higher inflation and inflationary
expectations also make the central-banks fine-tune money-supply and
interest-rate. Normally central-banks job is to ensure price-stability, but
when growth-rate is tumbling it might set higher-inflation-targets, because it
is a sign of higher demand/supply and economic-activity. Generally, booms and
high growth-rates coincide with higher prices and interest-rate. Nonetheless,
busts and slow-downs in the economic-activity and growth-rate calls for lower
interest-rates, but to cut interest-rates during down-turn it is important to
tighten during higher inflation otherwise it would feed bubbles by increasing
the gap between nominal and real prices of assets because of inflation. The
fear that lose money-supply and interest-rate might create asset-price-bubbles
in the US is baseless since inflation is too low. Moreover, the fear of risky
investment because of too low rates is again overdone since banks lend only
after assuring feasibility of the project. Nevertheless, low interest-rate on
retirement-funds also depends on inflation and inflationary expectation, and,
low interest-rate would also mean that inflation in future could remain low
which means higher real-interest rates, and the argument that pension funds
might lose because of low rates may also be overblown because it would also
signal that inflation could remain low in the future so that less savings would
be needed. With oil from the Shale-revolution, which had put the expansion of
the US economy in shambles many times before. Lower oil-price expectations in
the economy has kept inflationary expectations and interest rate low, which is
likely to stay because the US is now a big oil producing country. Most of the
prior recessions in the US economy were associated with oil-price booms and
inflation. Lower oil-prices are a major contributor to low inflation and
inflationary expectations after Shale. Higher oil-prices in the future would
also make high-cost shale-exploration more viable, and, thereby more production
and supply leading to further low oil prices, inflation expectations and
interest-rate.
It is worth a thought
that economic-models assume zero inflation in the long-run. Inflation is a
short-run deviation from the equilibrium price-level. Economists think of the
long-run as self-correcting. But when deciding long-run rates expected
inflation plays an important role because the economy first consumes and then
saves for the future; if they expect higher inflation based on the current
situation they would also save more for the future too and more savings result
in lower spending means lower demand and prices. Interest rate would go down. On
the contrary, if they expect deflation based on the current condition they
would save less-spend more which might increase demand and prices and interest
rate. People expect higher interest rate if there is inflation because the
monetary-policy would work to control inflation. Generally, prices and interest
rate move in the same direction. Expected inflation would increase the long-run
rates, higher than the short-run rates. The long-run rates are higher than the
short –run rates which shows that depending on the economic –policy people
expect inflation in the long-run which is opposite of what the economic models
assume that inflation in the long-run would be lower or zero. Keynes long ago
accepted that labour and other factors of production might not be abundant but
capital has no reason to be scarce since the central bank can print money to
finance the economy. Gold-Standard off-load was a big move in that direction
which was later used to print notes, buy foreign exchange and devalue to gain
exports. Keynes foresees capital as not scarce in the long-run. Our zero
interest-rate regimes in much of the developed world do support Keynes view
that capital is not necessarily scarce. Higher long-run interest rate is
against Keynes argument of lower interest rate.
No comments:
Post a Comment