The lower bound of central bank effectiveness
I have a bit of time on my hands at the moment to read stuff that I otherwise wouldn’t have time to read. For example I am currently reading Michael Lewis’ new book Flash Boys about the ins and outs of high frequency trading. I will probably have more to say about that one in a few weeks, but for now I want to point to this recent BIS speech by former BOJ governor Masaaki Shirakawa.
I recommend you to read it in its entirety, it is worth the effort. Two points in particular are worth highlighting.
Firstly, Shirakawa provides a non-consensus yet apt narrative on the interaction between central bank’s noble quest for price stability and the formation of asset bubbles. Drawing on the experienced of relative price stability that prevailed in Japan in the late 1980s an important link is drawn between the traditional pursuit of key central banking objective and sowing the seeds of financial instability.
During the bubble period of the mid- and late 1980s, the rate of inflation of the consumer price index (CPI) was quite subdued at about 1% (Figure 3). This was followed, as we all know, by a period of sub-par growth, financial crisis and deflation. This bears striking similarities with the Great Moderation experienced by many industrial economies in the mid-2000s; namely, a period of benign price developments that was followed by severe economic downturn and financial crisis.
I don’t mean to say that price stability itself creates problems or bubbles, but there exists a subtle link between the two.12 A prolonged period of high growth coupled with low inflation gives rise to optimistic sentiment, which is at least partly responsible for fostering financial bubbles. In addition, low inflation tends to justify prolonged monetary easing, which in turn can become one of factors contributing to the formation of bubbles.13 We should not treat these experiences lightly.
We have to start by recognising this odd reality of bubbles being accompanied by price stability, yet then followed by instability of the financial system, subsequently bringing about low growth and often inflation that is lower than desired. From such a long-run perspective, we have to admit that central banks that have accommodated asset price bubbles failed to achieve economic stability, given that both financial and price stability are essential elements of economic stability. We also cannot separate the bubble period from its damaging aftermath, intertwined as they are through leverage and deleverage and through overly optimistic pricing followed by its correction. We certainly cannot say that problems can be solved by focusing solely on the latter period. We have to think deeply about how best to relate the price stability mandate to financial stability when the central bank conducts monetary policy.
What is interesting about the account above is that it takes a structural view on what unintended consequences that modern monetary policy might entail. Price stability may then be an imminently reasonable cyclical yardstick for monetary policy but the underlying effects on the economy might no be benign on a net basis. The obvious counterargument is then what monetary policy makers should do instead. However, I think the train of thought above deserves mention even without answering that question.
The second point that I think is worth mentioning from the speech is the following on the link between the natural rate of interest and demographics.
Japan is now experiencing rapid ageing, at a pace that is unprecedented in modern economic history. Rapid ageing or, more precisely, the rapid rise in the “dependency rate”, is one of factors lowering potential growth and hence the natural rate of interest.18 It is noteworthy that there is a clear correlation between the potential growth rate and the long-term expected inflation rate in Japan (Figure 11). I can only say that we cannot fully understand Japanese macroeconomic performance without understanding its demography, and how it interacts with the economy and society.
I have argued a similar point on many occasions and while I am not completely in agreement with the Summers/Krugman notion of a secular stagnation, I think it is important to develop the idea further. In short, a rapidly ageing population may be one the key reasons that a central bank (and an economy) stuck in ZIRP may find it nearly impossible to escape. While this may represent nothing but an interesting theoretical issue for economic modelers it takes on a grave practical in the context of the large and growing debt burdens that modern societies find themselves with at exactly the wrong time in their economic life cycle. Larry Summers may have inadvertently stumbled across the crux of the issue in today’s FT;
“We do not have a strong basis for supposing that reductions in interest rates from very low levels have a big impact on spending decisions. Any spending they do induce tends to represent a pulling forward rather than an augmentation of demand.”
I think this is very good representation of our current malaise. Through the lens of someone looking at economies with rapidly ageing populations we can simply say that this problem arises because there isn’t any consumption to pull forward! Fisher’s interest theory was always valid, it is merely that in the context of a rapidly ageing population the consumption smoothing mechanism breaks for obvious and quite logical reasons. Quite simply, even in ZIRP you are not stealing a sufficient amount of “future” growth to kick-start the recovery because such future growth is not there.