Deflation versus Inflation

This is just a short update with a few thoughts on interest rates, their effectiveness at very low levels, and inflationary expectations. We have argued that central bankers should not worry too much about the effectiveness of interest rate at low levels. We still believe that is the case, and also believe that the ECB will, and should, cut interest rates further, as this extraordinary economic downturn gets hold. We accept that the guiding principle should not be the stabilisation of GDP, but of inflation expectations. But our point is that the dynamic of the decline is so extreme that we are in a new situation that is probably not captured by the existing models.  We simply do not what happens to inflationary expecations if an economy collapses that fast. For that reason, a progressive cut in policy rates to 1% seems reasonable to us, and relatively risk-free.

But in making this call, we should also make three observations. First, at the long of the yield curve, there is at present no fundamental gap between US, UK and euro area interest rates. That means, in light of present inflationary expectations, it is not very likely that cuts in policy rates will lead to cuts in real world rates.

At the short of the curve, there is also surprisingly little difference in interest rates, see below.

 

 

And inflationary expectations have been rising.

 

And they have been rising a bit more lately. So, in terms of stabilising inflationary expectations, the case for going down to below 1% is actually not very strong, and if the inflation expectation continue to rise, the ECB might not after all cut rates much below 1.5%. Remember a ZIRP does not work magic by itself, but only if markets are persuaded that interest rates are going to stay low for a long time. Should inflation expectations suddenly rise, and the ECB were forced to raise interest rates in quick succession, one could expect a re-run of the 1994 bond market crash, or quite possibly worse. While we have no time for the argument that a central bank can avoid a liquidity trap by not cutting rates, there is a financial market stability argument for not taking rates down all the way zero, unless the central bank has definite information about a built-up of deflationary expectations. To us, that does not seem to be the case now, and investors seem to be more concerned about inflation in the future, than about deflation now.

So, it is important to continue to view the states of the future as a two-tailed risk. We see no danger of an inflationary overshoot until 2010, but we do see a danger of an inflationary overshoot beyond that period. That tempers our enthusiasm for rate cuts somewhat.

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