The ECB must face the deflation risk
February 6, 2014 8:20 am
by Gavyn Davies
The governing council of the European Central Bank meets on Thursday amid rising expectations in the market that it will signal another easing in monetary policy, either in February or March. Most ECB watchers now expect the council to cut the refinance rate by around 15 basis points before quarter end (from 0.25 per cent to 0.10 per cent), and some expect the deposit rate to be reduced into negative territory for the first time. This action would be in response to recent volatility in money market rates, and an unexpectedly low inflation rate of 0.7 per cent for the euro area in January.
If the ECB was to follow this course of action in the next couple of months, it would represent another relatively minor adjustment in its policy stance in response to surprisingly low inflation data. It is still thinking in terms of incremental changes in policy, rather than anything more dramatic. This, of course, follows from the fact that the ECB has a pessimistic view of the growth in potential output since 2008, implying that the output gap is fairly small, and that inflation in the medium term will gradually return to the target of “below but close to” 2 per cent.
This view is, however, being increasingly challenged by the data. Some forecasters now see the 12-month inflation rate falling to only 0.5 per cent in the spring, depending on the behaviour of oil prices. More importantly, core inflation also continues to drop. After the next round of interest rate cuts, the central bank will genuinely be at the zero lower bound for the first time ever. The ECB will therefore face a major problem if the inflation data confound again, and head towards zero.
How likely is that to happen? My colleague Juan Antolin-Diaz (formerly at the ECB) has just released a research paper (available here), which examines the nature of the deflation threat, and discusses the ECB’s options for handling it. His analysis applies to the euro area a macro model described in a really interesting paper on the US and Japan by Jim Bullard, president of the Federal Reserve Bank of St Louis, in 2010 [1]. (Readers who do not like macroeconomic models should skip the next section, and just accept that the euro area might be sucked towards a deflationary outcome.)
Deflationary equilibria
The model is basically of the New Keynesian variety in use at all of the major central banks, but the novelty is that the economy does not necessarily head back to its normal equilibrium after a major shock. This, of course, is similar to results of an old Keynesian IS/LM model when interest rates are at the zero lower bound, but the Bullard results apply even when expectations are rational, and prices and wages are flexible in the long run. There are two equilibria in the model, one of which is in permanent deflation. The suggestion is that Japan found itself in this deflationary equilibrium for many years, and that the euro area might be headed in that direction now.
The mechanics of the model are fully explained in the paper, but the key graph is this one:
In order to be in equilibrium, the economy needs to satisfy two different criteria: the real interest rate has to be at the level needed for unemployment to be at the natural rate, and for inflation to be fully-anticipated (red line, showing the Fisher relation, which states that the nominal interest rate is equal to the equilibrium real rate plus expected inflation); and the central bank needs to be setting short rates at the level implied by its normal policy rule, assumed to be a Taylor rule (black line).
In normal circumstances, the economy tends to gravitate towards its familiar or targeted equilibrium. This is what happened in the eurozone from 1999 to 2008 (blue triangles). Imagine starting at the targeted equilibrium, with a small shock then taking the economy to point A, with inflation now only around 1 per cent. Interest rates are above the Taylor rule (black line), so the central bank cuts rates aggressively, reducing unemployment and causing a rise in inflation. Real rates are now well below the Fisher equilibrium for the economy (red line), so the economy expands. This process continues until the economy returns to equilibrium.
However, imagine that the shock is much larger, taking the economy to point B, with inflation below 0.5 per cent. The central bank now hits the zero lower bound for interest rates, so it cannot respond as aggressively as before, and the real rate of interest starts to rise. With policy tightening unintentionally, the economy in this model can be sucked into the second, deflationary equilibrium, from which it can be difficult to escape. Lawrence Summers and Paul Krugman might describe this as “secular stagnation”, especially if the equilibrium real rate is falling (say because of a drop in investment or a rise in precautionary savings), thus shifting the red line further down to the right.
Policy consequences
Is this just an abstract theoretical possibility, or could it happen in reality? Mario Draghi, the ECB president, has emphatically denied that the eurozone could fall into a deflationary trap, and does not seem minded to do anything about it now. He clearly believes that the normal equilibrating process in the economy is still intact, and will reassert itself with only a modest dose of assistance from the ECB.
In normal times most economists have also tended to ignore the second, deflationary equilibrium, regarding it as improbable and unstable. But it does seem to describe what has happened in Japan, and it could be explaining why the eurozone seems to be moving into dangerous territory, contrary to the ECB’s previous forecasts.
In 2010, Dr Bullard applied this model to the US, and (after considering many other policy options) concluded that:
Under current policy in the United States, the reaction to a negative shock is perceived to be a promise to stay low for longer [on short-term rates], which may be counterproductive because it may encourage a permanent, low nominal interest rate outcome. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.
That is what the Fed eventually did. Mr Antolin-Diaz, closer to the ECB tradition, argues that amendments to the central bank’s communications strategy – including a published path for intended interest rates, and a 2 per cent target for the price level instead of the inflation rate – should be tried before quantitative easing.
We may discover this week that the ECB is not willing to go anything like as far as that into unconventional territory, yet.
——————————————————————————————————
Footnote
[1] The first academic paper to outline this model is by Banhabib, Schmitt-Grohe and Uribe in 2001.
0 comments:
Publicar un comentario