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Borio to central bankers: the “secular stagnation” is coming from inside the house

Summary:
One of the most significant changes in the world economy in the past couple of decades has been the decline in real interest rates and the commensurate rise in indebtedness:The chart above comes from a recent speech by Claudio Borio of the Bank for International Settlements. The question is why it happened.According to Larry Summers and other exponents of the “secular stagnation” hypothesis, the downward slope of the red line reflects deep changes in the balance between the supply and demand for credit. If market interest rates — and central banks — hadn’t responded to these underlying fundamental changes, the rich world would have been plagued with decades of underemployment and slow growth in the decades before the crisis.The corollary is that rich countries must either depend on

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One of the most significant changes in the world economy in the past couple of decades has been the decline in real interest rates and the commensurate rise in indebtedness:

Borio to central bankers: the “secular stagnation” is coming from inside the house

The chart above comes from a recent speech by Claudio Borio of the Bank for International Settlements. The question is why it happened.

According to Larry Summers and other exponents of the “secular stagnation” hypothesis, the downward slope of the red line reflects deep changes in the balance between the supply and demand for credit. If market interest rates — and central banks — hadn’t responded to these underlying fundamental changes, the rich world would have been plagued with decades of underemployment and slow growth in the decades before the crisis.

The corollary is that rich countries must either depend on continuously falling interest rates and continuously rising indebtedness to sustain spending, or address the underlying causes of the supply-demand imbalance. Interest rates can only fall so far, however, which might explain the inability of many rich countries to return to what had previously been considered “normal” after the crisis.

Borio recognises the unsustainability of continuously falling interest rates, but wonders whether the “secular stagnation” explanation makes sense. He suspects interest rates dropped because central banks bungled their response to global disinflationary forces:

As long as inflation does not rise much during booms, partly held back by the tailwinds of globalisation and by central bank credibility, a monetary policy focused on near-term price stability has little incentive to tighten to restrain the build-up of financial imbalances. But then it has every reason to ease aggressively and persistently if the economy weakens and inflation declines further.

Recall that the standard argument for why central banks should target consumer price inflation is that this is the number that best reflects whether “aggregate demand” is in line with the economy’s underlying productive capacity. If inflation is slower than its target, it means there is room for more spending by households, businesses, and the government. Central banks should therefore, according to theory, encourage these entities to save less and spend more by lowering interest rates.

The question is whether consumer price inflation is actually that useful a signal, especially during a period when so many of the goods in the basket are either produced abroad or produced by domestic companies competing in global markets. Borio’s argument is that the weak inflationary pressures in the 1990s and 2000s fooled monetary policymakers into running things looser than they should have.

The problem is that the resulting borrowing binges tend to encourage unproductive construction booms at the expense of competitive manufacturing sectors. That in turn suppresses the longer-term growth trend after the boom ends:

Borio to central bankers: the “secular stagnation” is coming from inside the house

As if that weren’t bad enough, the end of the boom usually means a big cyclical hit to growth, so it’s only natural for textbook central banks to loosen policy even further. While this may make sense at the time, it reinforces the underlying problem by driving rates even further down.

After all, if you only cut rates when the economy weakens but you fail to raise them symmetrically when the real economy recovers, it shouldn’t be too surprising that traders will respond by continuously lowering long-term interest rates, which, after all, are just supposed to be the geometric average of expected future short-term interest rates plus a risk premium:

Over long horizons, asymmetrical policies across successive financial cycles – failing to constrain their expansion but easing aggressively and persistently during busts, with monetary and, to some extent, fiscal policy – could lead to a sequence of episodes of serious financial stress, a loss of policy ammunition and a debt trap.

Such a sequence imparts a downward bias to interest rates and an upward bias to (private and public) debt that at some point makes it hard to raise interest rates without damaging the economy. The accumulation of debt and the distortions in production and investment patterns induced by persistently low interest rates hinder the return of those rates to more normal levels.

In other words, the “secular stagnation” observed by central banks is actually the cumulative result of monetary policy mistakes. But even if you agree with that controversial claim, the implications for future policymakers are unclear.

Borio thinks the solution is to abandon simplistic inflation targeting and instead attempt to keep credit growing in line with incomes:

Defining the natural or equilibrium rate without reference to its financial stability implications is arguably too narrow. It has encouraged the view, sometimes put forward by proponents of the secular stagnation hypothesis, that the interest rate could be at its equilibrium value and yet cause damaging financial and macroeconomic instability down the road.

I take this not so much as pointing to an inherent tension between financial stability and macroeconomic stability – there cannot be – but as reflecting what is missing in the standard models, ie the incorporation of financial instability in the first place. In models that did so, a more useful definition of the natural interest rate would also call for the financial side of the economy to be on an even keel – in equilibrium – so that financial imbalances do not build up.

Figuring out how to set policy under this framework won’t be easy. That doesn’t mean central bankers shouldn’t try.

Related links:
Secular stagnation or financial cycle drag?Full Borio speech
Claudio’s presentation slides — BIS
The Fed’s gradual embrace of “secular stagnation” — FT Alphaville
The Bank of Canada admits easy money can inflate debt bubbles — FT Alphaville
Some Fed thoughts: QE4 and all that — FT Alphaville
What’s the right rate? Or, the case for monetary policy nihilism — FT Alphaville
Is the only choice bubbles or recession? — Bloomberg View

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Matthew C Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist. I have worked at the world’s largest hedge fund and read every FOMC transcript since May, 1987

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