Low interest rates and low inflation at full employment
How low can you go? No… this is not a post about Limbo. It is a post about low interest rates, low inflation, and economic growth.
The question is… Can low inflation stay low as the economy heats up around full employment?
Let’s look at Europe. Low interest rates and falling inflation are not stopping economic growth. Brian Blackstone from the Wall Street Journal wrote about this yesterday. Here are some selected quotes from his article…
“The super-low inflation rates (in Europe) are the average for the euro zone and are propped up some by higher inflation in Germany (1.04%). Five euro members—Greece, Spain, Cyprus, Portugal and Slovakia—have negative rates.”
“Yet the euro zone’s economic recovery is proceeding faster than expected… And it raises a key question for European policymakers: can economic growth coincide with weak prices? In a recent speech, Jaime Caruana, general manager of the Bank of International Settlements, a consortium of central banks, suggested it can.”
“Still, recent economic reports suggest the euro zone is showing little if any ill effects from low inflation, which has been driven to a large extent by softer food and energy prices. This adds to disposable income and may help consumption…”
” Euro members outside of France and Germany posted their strongest output gain in more than three years, according to the PMI report, despite ultra-low inflation or falling prices.”
The European economy is heating up and inflation is actually still falling. Will inflation keep falling? The long run Fisher effect states…
- when a central bank’s nominal interest rate is held steady, whether deliberately or not (such as against the zero lower bond), eventually inflation adjusts to the nominal rate in the long run so that the real interest rate returns to its natural level.
Currently, the long run nominal interest rates set by central banks in Europe are below 1% with many at the zero lower bound. According to the Fisher effect, inflation would like to move lower so that the real interest rate rises higher towards its natural level of 1% to 2%.
The long run Fisher equation could look like this when Europe reaches full employment…
Natural real rate of interest (1.0%) = nominal interest rate (0.5%) – expected deflation (-0.5%)
So yes, inflation can keep falling according to the long run Fisher effect. The combination of quickening economic growth and falling inflation makes sense as the Fisher equation finds its long run equilibrium toward the end of a business cycle. The central banks only need to keep their nominal interest rates low.
But there is a risk hiding in the shadows. Again from the article by Brian Blackstone…
“With inflation already so low, an economic shock could push the bloc into more punishing deflation.”
I suppose central bankers will cross that bridge when they get there. In the meantime, low interest rates and falling inflation don’t seem to be a problem, as long as the economy is growing.
“So yes, inflation can keep falling according to the long run Fisher effect”
But there is a limit to how much prices can actually fall. Prices deflate until limits of labor productivity, and profit margins are squeezed. Since deflation is normally associated with low or negative growth negative externalities from slow economy may increase prices due to UE, crime, health, declining environment, regional conflicts etc…
I think in the long term price deflation is limited, not continual which wont allow the natural interest rate to manifest if rates are held too low. I don’t think its right to assume constant increases in productivity.
What is the presumed mechanism that causes deflation/inflation to adjust in the Fisher effect?
Investor/management behaviors? Buyer behaviors?
i would be willing to speculate that prices are currently set at monopoly levels. That is, far above the “cost to produce”. Prices can fall reducing, perhaps, the “return to capital.” until that return is closer to the “natural rate of interest” ? or something like that.
what interests me in all this is that it looks like another law of economics is about to turn out to be no law at all when those other things refuse to be equal.
“The European economy is heating up and inflation is actually still falling. Will inflation keep falling?”
I guess I don’t understand what you mean by ‘heating up’.
Here are Real GDP statistics for Europe and the US, from the European Commission:
Looking at the top entries in the table. (EU27, EU28, EU 18, and EU 17) The recent EU annual Real GDP numbers are lower than the US toward the bottom of the table. The EU numbers for Real GDP for 2012 and 2013 look especially low.
Real GDP growth rate – volume (volume seems to mean chained by their definition)
Percentage change from previous year:
2008- 2009– 2010– 2011– 2012– 2013
EU27— 0.4— -4.5—- 2.0—- 1.6—- -0.4—- 0.1
EU28— 0.4— -4.5—- 2.0—- 1.7—- -0.4—- 0.1
EU18— 0.4— -4.5—- 1.9—- 1.6—- -0.7— -0.4
EU17— 0.4— -4.4—- 2.0—- 1.6—- -0.7— -0.4
U. S.— -0.3— -2.8—- 2.5—- 1.8—- 2.8—– 1.9
Am I missing something?
The references to ‘Real GDP’ in the fourth paragraph should be ‘Real GDP growth rate’.
Goodwin & Coberly,
What are the mechanisms? yes, monopoly pricing, investor behavior, loaning & borrowing behavior, price setting, wage setting, contracts,
But there is so much more to the issue of the long run Fisher effect…
You have to look at the economic structure. For example, monetary expansion that is not bifurcated will change how the Fisher effect manifests.
Demand for loans is another. Compare an economy coming out of war that has to re-build, to the economy we have now that invests overseas where operating expenses are lower.
The long run Fisher effect is not a cut and dried law. It itself can manifest in many different ways.
Very good point. The article referenced says that output growth is the strongest it has been for 3 years in many countries. But you are correct that overall the real GDP growth rate is still low, but it is improving fast.
There are projections that growth will keep on increasing.
Some say that the natural real interest rate in Europe has fallen from slow labor force growth. So there may be a lower standard for Europe than there is for the US. 0.5% growth there might be considered close to normal, but here in the US, it is considered very low.