With the Federal Reserve pondering how they can unscrew themselves from the corner that their experiments have screwed them quite firmly into (i.e Operation Twist), I thought it was time to look at a paper by James Bullard, President and CEO of the Federal Reserve Bank of St. Louis. This paper, entitled "Seven Faces of "The Peril" (a rather ominous sounding title, don't you think?) was released in late July 2010 and looks at the deflationary issues facing Japan's economy and how the actions taken by the Federal Reserve’s Federal Open Market Committee (FOMC) could help avoid this economic nightmare (for central bankers) with their program of quantitative easing or how they could mimic Japan’s problem by implementing a long period of near zero interest rates. Let's delve more deeply than we ever have into the mind of a central banker.
Mr. Bullard opens with the rather frightening "...most worrisomely, current monetary policies in the U.S. (and possibly Europe as well) appear to be poised to head straight toward the problematic outcome described in the paper.". The paper he refers to was written by three academic economists in 2001 and is entitled "The Perils of Taylor Rules". For those of you who aren't aware of Taylor-type economic policy, it occurs when central bankers change nominal interest rates at a more than one-for-one ratio when inflation deviates from a given target. Taylor Rules are basically a guideline for interest rate manipulation where changes in interest rates are used to both stabilize the economy in the short-term and maintain long-term growth. Central banks will raise interest rates in times of high inflation and lower rates when inflation is low. In general, Taylor Rules are followed by many of the world's central banks today on either a formal or informal basis. As well, in the “Perils of Taylor” paper, the authors emphasize that a combination of Taylor Rules and a zero limit on interest rates will create a new outcome for a given economy that will result in very low interest rates and a deflationary environment. One need look no further than Japan to see Taylor rules and deflation in action as we will see.
To open, and for your information, here are two graphs showing the benchmark interest rates for the United States and Japan since the very early 1970s:
Notice that while Japan’s benchmark rate has been low since the mid-1990s, the U.S. interest rate pattern is quite similar and could well replicate what has been experienced in Japan.
Now let's look at a graph from Mr. Bullard’s research showing both monthly short-term interest rates and inflation for Japan (round green data points) and the United States (square blue data points) from 2002 to 2010 with inflation on the horizontal axis (with the negative numbers showing deflation) and nominal interest rates on the vertical axis:
Please bear with me while I attempt to explain what this graph is telling us. The red dashed line is called the Fisher relation or Fisher hypothesis. In the Fisher hypothesis, the real interest rate is equal to the nominal interest rate (the rate you see posted at your local bank for example) minus the expected rate of inflation. In this case, Mr. Bullard has taken the real component of the interest rate and fixed it at one-half percent or 50 basis points. In Main Street speak, if nominal interest rates are 1 percent, then the Fisher relation will bring real interest rates up to 1.0 plus 0.5 or 1.5 percent. Looking at the curved black line, we see the Taylor Rule in action. This line describes what central bankers do as inflation rises, that is, they raise interest rates. When inflation is above their preferred target, they raise interest rates at a more than one-for-one ratio. When inflation is below their preferred target, central bankers raise interest rates at less than a one-for-one basis. Notice on the graph that the straight red line (the Fisher line for lack of a better label) crosses the curved black line. This is called the steady state where the central bank no longer wishes to raise or lower interest rates. This is the point where central bankers have to raise interest rates at more than the rate of inflation, that is, where inflation is greater than 2.3 percent and nominal interest rates are greater than 2.8 percent, interest rate increases are greater than one-to-one. Thus, the black line becomes steeper because it takes greater increases in interest rates to keep inflation within the central bank's target zone.
Now, if you look at the far left side of the graph, you'll notice that the red dashed line and black curved line intersect once again in amongst the green Japanese circles. This second or unintended low interest rate steady state occurs where inflation (or in this case, deflation) is negative one-half percent (-50 basis points) and interest rates are nearly zero. In this case, the policy rate cannot be lowered below zero but it is not really necessary (or possible for that matter) since inflation is non-existent. That's most fortunate since the Bank of Japan has absolutely no "wiggle room" left. Unfortunately, deflation is the stuff made of nightmares for central bankers and is exactly the outcome that they do not want from messing with interest rates. Central bankers, particularly the Fed, are trying desperately to avoid ending up with the blue squares representing the U.S. experience with inflation and interest rates overlying the area on the graph covered with little green circles.
Note that the little solid coloured blue data point labeled "May 2010" lies very close to the horizontal axis of the graph along with a whole collection of other similar data points. These data points are showing us that American interest rates are nearly zero but that there is still inflation within the system, unlike in the case of Japan. The "May 2010" point does, however, show a potential slide toward the Japanese model discussed above. With the Federal Reserve recently announcing that it was committing to a long-term policy of near zero rates, it would appear that they have boxed themselves into a corner. The Fed wants and needs at least some level of inflation but, from the example of Japan's green data points, we can see that the ultimate outcome of extremely low interest rates could be the much dreaded negative inflation. Here's a quote from Mr. Bullard's paper:
"Both policymakers (the world's central bankers) and private sector players continue to communicate in terms of interest rate adjustment as the main tool for the implementation of monetary policy. This is increasing the risk of a Japanese-style outcome for the U.S."
What he's saying is that the use of interest rates as a means to control the level of inflation (i.e. Taylor Rules) by central bankers around the world do not always work. Deflation can and may well occur because of the Federal Reserve's long-term pledge to keep interest rates at a near zero level.
Through the remainder of the article, Mr. Bullard goes on to suggest that divisions among economists about his findings range from denial to tinkering with the minimum interest rate level that should be allowed. He also discusses the policy of quantitative easing and how it is expected (hoped) to be inflationary. Here's a quote:
"...The experience in the U.K. seems to suggest that appropriately state contingent purchases of Treasury securities are a good tool to use when inflation and inflation expectations are too low. Not that one would want to overdo it, mind you, as such measures should only be undertaken in an effort to move inflation closer to target." (my bold)
One question: how do central bankers know when they have overdone quantitative easing? Is it possible that QE 3, if implemented, could be the straw that breaks the camel’s back?
Basically, those of us who live on Main Street are the subjects of a gigantic fiscal experiment by central bankers, most particularly the Federal Reserve. They have no precedent which will allow them to predict the long-term outcome of their policy of ultra-low interest rates other than Japan and that is exactly the outcome they desperately need to avoid. Interestingly enough, according to the Bank of England, in 314 years, interest rates never fell below 2.0 percent until recently. That is most telling.
Here are Mr. Bullard's concluding remarks:
"The global economy continues to recover from the very sharp recession of 2008 and 2009. During the recovery, the U.S. economy is susceptible to negative shocks which may dampen inflation expectations. This could possibly push the economy into an unintended, low nominal interest rate steady state. Escape from such an outcome is problematic. Of course, we can hope that we do not encounter such shocks, and that further recovery turns out to be robust but hope is not a strategy. The U.S. is closer to a Japanese-style outcome today than at any time in recent history." (my bold)
The recent debt issues facing the Eurozone make it less and less likely that the world will return to a normal interest rate environment anytime soon. Inflation, as shown on the graph at the beginning of this posting can move one of two ways. Should it move toward the green circles, the United States could well experience Japan's "lost decade".
Remember this rule of thumb: economics is not a science, rather, it’s more akin to medieval alchemy. The actions of today’s central bankers are all the proof that we need.