A Level Economics 86: Zero or Low Inflation?

Governments target low levels of inflation instead of aiming for zero inflation (no inflation) for several reasons:

1. Price Stability: Low levels of inflation provide a degree of price stability, allowing businesses and individuals to plan and make economic decisions with more certainty. Moderate inflation encourages spending and investment, as consumers and businesses are motivated to avoid holding onto cash that loses value over time.

2. Avoiding Deflationary Spirals: Targeting a low, positive rate of inflation helps prevent deflation, which can be harmful to the economy. Deflation can lead to falling demand, reduced business profits, and negative expectations about the future, triggering a deflationary spiral that can be difficult to reverse.

3. Interest Rate Management: Having a small positive inflation rate allows central banks to use interest rates more effectively to control economic conditions. When inflation is too low or negative, central banks may reach the "zero lower bound," limiting their ability to further lower interest rates during economic downturns.

4. Nominal Wage Flexibility: Moderate inflation helps facilitate nominal wage adjustments in the labor market. Wages are typically sticky downward, meaning that employees are reluctant to accept nominal wage cuts. With moderate inflation, real wages (wages adjusted for inflation) can adjust downward more smoothly without actual cuts in nominal wages, allowing labor markets to respond to changes in economic conditions.

5. Balancing Debt Burdens: Low inflation helps reduce the real burden of debt. In economies with significant public and private debt, moderate inflation allows debtors to pay back loans with money that has lower purchasing power, easing the overall debt burden.

Winners of Low Inflation:

1. Savers and Lenders: Savers and lenders benefit from low inflation as the real value of their savings and lending returns is better preserved. They avoid the erosion of purchasing power that occurs during periods of high inflation.

2. Debtors: Borrowers benefit from low inflation as it reduces the real burden of their debts. They can pay back loans with money that is worth less in real terms, effectively reducing the real cost of borrowing.

Losers of Low Inflation:

1. Fixed-Income Earners: Individuals with fixed incomes, such as retirees living off pension funds, may struggle to maintain their purchasing power during periods of low inflation. Their incomes do not keep pace with rising prices.

2. Central Banks in Deflationary Situations: When inflation is too low or negative, central banks may face challenges in stimulating the economy through conventional monetary policy tools. This can limit their ability to address economic downturns effectively.

3. Economies in Deflationary Spirals: Low inflation can increase the risk of deflationary spirals, which negatively affect businesses and consumers. Falling prices can lead to postponed spending and reduced investment, perpetuating economic stagnation.

In summary, governments target low levels of inflation to maintain price stability, avoid deflationary risks, and enable more effective monetary policy management. While low inflation benefits savers and lenders and reduces the real burden of debt, it may adversely affect fixed-income earners and pose challenges for central banks and economies experiencing deflationary pressures. Striking a balance between price stability and supporting economic growth is essential for achieving sustainable economic performance.

---

Yes,in theory, zero inflation would offer more price stability than a low level of inflation. With zero inflation, the general price level of goods and services would remain constant over time, providing the most stable prices for consumers and businesses. However, achieving and maintaining exactly zero inflation can be challenging and may not always be the most desirable target for central banks and governments. Here's why:

1. Deflation Risk: The pursuit of zero inflation can increase the risk of deflation, which is a sustained decrease in the general price level. Deflation can be harmful to the economy, as it can lead to falling demand, reduced business profits, and negative expectations about the future. Deflationary spirals can be challenging to reverse and can result in economic stagnation.

2. Nominal Wage Stickiness: Wages in the labor market are often sticky downward, meaning that employees are reluctant to accept nominal wage cuts. In a scenario of zero inflation, real wages (nominal wages adjusted for inflation) could be more rigid and unable to adjust downward. This may lead to higher unemployment, as businesses may not be able to adjust labor costs efficiently during economic downturns.

3. Interest Rate Management: In a low-inflation or deflationary environment, central banks may face difficulties in using interest rate policy effectively. Interest rates already near or at zero, known as the "zero lower bound," can limit the central bank's ability to further lower rates to stimulate economic activity during downturns.

4. Avoiding Economic Stagnation: A small positive rate of inflation, often targeted by central banks (e.g., 2% inflation target), can provide some buffer against deflation and help avoid stagnation. Moderate inflation encourages spending and investment, as consumers and businesses are motivated to avoid holding onto cash that loses value over time.

5. Monetary Policy Flexibility: A low, positive rate of inflation allows central banks to use interest rates more effectively to manage economic conditions. They can implement conventional monetary policy tools to adjust interest rates in response to changes in the economy.

In practice, many central banks aim for a low, positive rate of inflation rather than zero inflation. They typically target inflation rates around 2%, which allows for some price stability while providing a buffer against deflationary risks. A moderate and stable rate of inflation can facilitate nominal wage adjustments, allow for more flexible interest rate management, and avoid the adverse effects of deflation. Striking a balance between price stability and supporting economic growth is a key consideration for monetary policy and inflation targeting.

---

The definition of "low inflation" is not fixed and can vary depending on the context and the specific economic conditions of a country. It is not a scientific term with a standard numerical value universally applicable to all economies. Instead, what constitutes "low inflation" is often a normative judgment made by policymakers and economists based on the desired economic outcomes and the prevailing economic circumstances.

Subjectivity of Low Inflation: What may be considered low inflation in one country or at a particular time may not be deemed as such in another context. Policymakers, central banks, and economists typically consider various factors, such as historical inflation trends, long-term economic growth objectives, and the overall stability of prices, when determining the target level of inflation.

Examples of Target Inflation Rates:

1. United States: The Federal Reserve, the central bank of the United States, has a dual mandate of promoting maximum employment and stable prices. It has typically targeted an inflation rate of around 2% as conducive to economic growth and stability.

2. European Central Bank (ECB): The ECB, responsible for monetary policy in the Eurozone, aims to maintain inflation below, but close to, 2% over the medium term. This target is based on the belief that a moderate level of inflation is beneficial for economic activity and helps avoid deflationary risks.

3. Japan: The Bank of Japan (BOJ) has had difficulty achieving its target of 2% inflation amid decades of deflationary pressures. In response, the BOJ has implemented aggressive monetary policies to combat deflation and boost inflation expectations.

Evaluating the Normative Nature of Low Inflation: The normative nature of low inflation means that there is ongoing debate and differing viewpoints on what the ideal inflation rate should be. Some arguments in favor of low inflation include:

1. Price Stability: Low inflation contributes to price stability, making it easier for households and businesses to plan and make economic decisions without significant concerns about rapidly changing prices.

2. Wage and Price Stability: A moderate and stable inflation rate allows for nominal wages and prices to adjust more smoothly, facilitating labor market flexibility and resource allocation.

3. Avoiding Deflation: A target for low inflation helps avoid deflationary pressures, which can be harmful to economic growth and can lead to negative expectations and delayed spending.

On the other hand, some economists and policymakers argue that there are potential drawbacks to persistently low inflation:

1. Deflationary Risks: If inflation consistently falls too close to zero or turns negative, it can increase the risk of deflationary spirals, leading to economic stagnation and challenges in policymaking.

2. Monetary Policy Constraints: Extremely low inflation can reduce the effectiveness of conventional monetary policy tools, such as lowering interest rates, especially when interest rates are already close to zero (zero lower bound).

3. Real Debt Burden: Very low inflation can increase the real burden of debt, making it more challenging for borrowers to service their debts.

In conclusion, the definition of "low inflation" is subjective and varies across countries and economic circumstances. It is typically a normative judgment based on the desired economic outcomes and the prevailing economic conditions. While low inflation is generally viewed as conducive to economic stability, there are ongoing debates on the ideal inflation rate and the potential drawbacks of persistently low inflation, such as deflationary risks and limitations in monetary policy effectiveness. Striking the right balance between price stability and supporting economic growth remains a key challenge for policymakers.

Economics Essay 48: Central Banks and Exchange Rates

Discuss the extent to which it is desirable for a central bank to use foreign currency reserves to support its exchange rate.

Central banks use foreign currency reserves as a tool to manage their exchange rates and support their domestic currencies. By intervening in the foreign exchange market, central banks buy or sell currencies, utilizing their reserves to influence the supply and demand dynamics. This intervention can help stabilize or influence the exchange rate.

The use of reserves by central banks for exchange rate support has both benefits and drawbacks. On the positive side, it can contribute to exchange rate stability, providing certainty for businesses engaged in international trade and reducing exchange rate risk. Stable exchange rates can also attract foreign investment, promote price stability, and foster confidence in the domestic economy.

Central banks also utilize reserves to intervene during periods of excessive volatility or speculative attacks. By buying or selling currencies, they can mitigate disruptions to the economy and financial markets. Additionally, reserves can be used to support international trade by ensuring competitive exchange rates, making a country's exports more affordable and attractive in foreign markets.

However, the use of reserves for exchange rate support has limitations. Depletion of reserves over time can leave a country vulnerable to external shocks and reduce its ability to respond to future crises. Holding reserves also incurs an opportunity cost as these resources could have been invested in other productive areas. Furthermore, continuous intervention in the foreign exchange market can create a moral hazard and undermine market dynamics if market participants become overly reliant on central bank support.

In considering the desirability of using reserves for exchange rate support, central banks need to carefully manage their reserves, communicate their policies clearly, and take a comprehensive approach to economic development. While maintaining exchange rate stability is important, central banks should also prioritize long-term economic growth, sustainable development, and policy credibility.

In conclusion, central banks utilize foreign currency reserves by intervening in the foreign exchange market to manage exchange rates and support their domestic currencies. The use of reserves can contribute to exchange rate stability, trade support, and policy autonomy. However, careful reserve management is necessary to strike a balance between short-term stability and long-term economic development. Prudent policies, effective communication, and a comprehensive approach to economic management are essential to ensure that the use of reserves for exchange rate support is beneficial to the overall economy.

After the easy money: a giant stress test for the financial system

John Plender in The FT 

Five weeks after the collapse of Silicon Valley Bank, there is no consensus on whether the ensuing financial stress in North America and Europe has run its course or is a foretaste of worse to come. 

Equally pressing is the question of whether, against the backdrop of still high inflation, central banks in advanced economies will soon row back from monetary tightening and pivot towards easing. 

These questions, which are of overwhelming importance for investors, savers and mortgage borrowers, are closely related. For if banks and other financial institutions face liquidity crises when inflation is substantially above the central banks’ target, usually of about 2 per cent, acute tension arises between their twin objectives of price stability and financial stability. In the case of the US Federal Reserve, the price stability objective also conflicts with the goal of maximum employment. 

The choices made by central banks will have a far-reaching impact on our personal finances. If inflation stays higher for longer, there will be further pain for those who have invested in supposedly safe bonds for their retirement. If the central banks fail to engineer a soft landing for the economy, investors in risk assets such as equities will be on the rack. And for homeowners looking to refinance their loans over the coming months, any further tightening by the Bank of England will feed into mortgage costs. 

The bubble bursts 

SVB, the 16th largest bank in the US, perfectly illustrates how the central banks’ inflation and financial stability objectives are potentially in conflict. It had been deluged with mainly uninsured deposits — deposits above the official $250,000 insurance ceiling — that far exceeded lending opportunities in its tech industry stamping ground. So it invested the money in medium and long-dated Treasury and agency securities. It did so without hedging against interest rate risk in what was the greatest bond market bubble in history. 

The very sharp rise in policy rates over the past year pricked the bubble, so depressing the value of long-dated bonds. This would not have been a problem if depositors retained confidence in the bank so that it could hold the securities to maturity. Yet, in practice, rich but nervous uninsured depositors worried that SVB was potentially insolvent if the securities were marked to market. 

 An inept speech by chief executive Greg Becker on March 9 quickly spread across the internet, causing a quarter of the bank’s deposit base to flee in less than a day and pushing SVB into forced sales of bonds at huge losses. The collapse of confidence soon extended to Signature Bank in New York, which was overextended in property and increasingly involved in crypto assets. Some 90 per cent of its deposits were uninsured, compared with 88 per cent at SVB. 

Fear spread to Europe, where failures of risk management and a series of scandals at Credit Suisse caused deposits to ebb away. The Swiss authorities quickly brokered a takeover by arch rival UBS, while in the UK the Bank of England secured a takeover of SVB’s troubled UK subsidiary by HSBC for £1. 

These banks do not appear to constitute a homogeneous group. Yet, in their different ways, they demonstrate how the long period of super-low interest rates since the great financial crisis of 2007-09 introduced fragilities into the financial system while creating asset bubbles. As Jon Danielsson and Charles Goodhart of the London School of Economics point out, the longer monetary policy stayed lax, the more systemic risk increased, along with a growing dependence on money creation and low rates. 

The ultimate consequence was to undermine financial stability. Putting that right would require an increase in the capital base of the banking system. Yet, as Danielsson and Goodhart indicate, increasing capital requirements when the economy is doing poorly, as it is now, is conducive to recession because it reduces banks’ lending capacity. So we are back to the policy tensions outlined earlier. 

Part of the problem of such protracted lax policy was that it bred complacency. Many banks that are now struggling with rising interest rates had assumed, like SVB, that interest rates would remain low indefinitely and that central banks would always come to the rescue. The Federal Deposit Insurance Corporation estimates that US banks’ unrealised losses on securities were $620bn at the end of 2022. 

A more direct consequence, noted by academics Raghuram Rajan and Viral Acharya, respectively former governor and deputy governor of the Reserve Bank of India, is that the central banks’ quantitative easing since the financial crisis, whereby they bought securities in bulk from the markets, drove an expansion of banks’ balance sheets and stuffed them with flighty uninsured deposits. 

Rajan and Acharya add that supervisors in the US did not subject all banks to the same level of scrutiny and stress testing that they applied to the largest institutions. So these differential standards may have caused a migration of risky commercial real estate loans from larger, better-capitalised banks to weakly capitalised small and midsized banks. There are grounds for thinking that this may be less of an issue in the UK, as we shall see. 

A further vulnerability in the system relates to the grotesque misallocation of capital arising not only from the bubble-creating propensity of lax monetary policy but from ultra-low interest rates keeping unprofitable “zombie” companies alive. The extra production capacity that this kept in place exerted downward pressure on prices. 

Today’s tighter policy, the most draconian tightening in four decades in the advanced economies with the notable exception of Japan, will wipe out much of the zombie population, thereby restricting supply and adding to inflationary impetus. Note that the total number of company insolvencies registered in the UK in 2022 was the highest since 2009 and 57 per cent higher than 2021. 

A system under strain  

In effect, the shift from quantitative easing to quantitative tightening and sharply increased interest rates has imposed a gigantic stress test on both the financial system and the wider economy. What makes the test especially stressful is the huge increase in debt that was encouraged by years of easy money. 

William White, former chief economist at the Bank for International Settlements and one of the few premier league economists to foresee the great financial crisis, says ultra easy money “encouraged people to take out debt to do dumb things”. The result is that the combined debt of households, companies and governments in relation to gross domestic product has risen to levels never before seen in peacetime. 

All this suggests a huge increase in the scope for accidents in the financial system. And while the upsets of the past few weeks have raised serious questions about the effectiveness of bank regulation and supervision, there is one respect in which the regulatory response to the great financial crisis has been highly effective. It has caused much traditional banking activity to migrate to the non-bank financial sector, including hedge funds, money market funds, pensions funds and other institutions that are much less transparent than the regulated banking sector and thus capable of springing nasty systemic surprises. 

An illustration of this came in the UK last September following the announcement by Liz Truss’s government of unfunded tax cuts in its “mini” Budget. It sparked a rapid and unprecedented increase in long-dated gilt yields and a consequent fall in prices. This exposed vulnerabilities in liability-driven investment funds in which many pension funds had invested in order to hedge interest rate risk and inflation risk. 

Such LDI funds invested in assets, mainly gilts and derivatives, that generated cash flows that were timed to match the incidence of pension outgoings. Much of the activity was fuelled by borrowing. 

UK defined-benefit pension funds, where pensions are related to final or career average pay, have a near-uniform commitment to liability matching. This led to overconcentration at the long end of both the fixed-interest and index-linked gilt market, thereby exacerbating the severe repricing in gilts after the announcement. There followed a savage spiral of collateral calls and forced gilt sales that destabilised a market at the core of the British financial system, posing a devastating risk to financial stability and the retirement savings of millions. 

This was not entirely unforeseen by the regulators, who had run stress tests to see whether the LDI funds could secure enough liquidity from their pension fund clients to meet margin calls in difficult circumstances. But they did not allow for such an extreme swing in gilt yields. 

Worried that this could lead to an unwarranted tightening of financing conditions and a reduction in the flow of credit to households and businesses, the BoE stepped in to the market with a temporary programme of gilt purchases. The purpose was to give LDI funds time to build their resilience and encourage stronger buffers to cope with future volatility in the gilts market. 

The intervention was highly successful in terms of stabilising the market. Yet, by expanding its balance sheet when it was committed to balance sheet shrinkage in the interest of normalising interest rates and curbing inflation, the BoE planted seeds of doubt in the minds of some market participants. Would financial stability always trump the central bank’s commitment to deliver on price stability? And what further dramatic repricing incidents could prompt dangerous systemic shocks? 

Inflation before all? 

The most obvious scope for sharp repricing relates to market expectations about inflation. In the short term, inflation is set to fall as global price pressures fall back and supply chain disruption is easing, especially now China continues to reopen after Covid-19 lockdowns. The BoE Monetary Policy Committee’s central projection is for consumer price inflation to fall from 9.7 per cent in the first quarter of 2023 to just under 4 per cent in the fourth quarter. 

The support offered by the Fed and other central banks to ailing financial institutions leaves room for a little more policy tightening and the strong possibility that this will pave the way for disinflation and recession. The point was underlined this week by the IMF, which warned that “the chances of a hard landing” for the global economy had risen sharply if high inflation persists. 

Yet, in addition to the question mark over central banks’ readiness to prioritise fighting inflation over financial stability, there are longer-run concerns about negative supply shocks that could keep upward pressure on inflation beyond current market expectations, according to White. For a start, Covid-19 and geopolitical friction are forcing companies to restructure supply lines, increasing resilience but reducing efficiency. The supply of workers has been hit by deaths and long Covid. 

White expects the production of fossil fuels and metals to suffer from recently low levels of investment, especially given the long lags in bringing new production on stream. He also argues that markets underestimate the inflationary impact of climate change and, most importantly, the global supply of workers is in sharp decline, pushing up wage costs everywhere. 

Where does the UK stand in all this? The resilience of the banking sector has been greatly strengthened since the financial crisis of 2007-08, with the loan-to-deposit ratios of big UK banks falling from 120 per cent in 2008 to 75 per cent in the fourth quarter of 2022. Much more of the UK banks’ bond portfolios are marked to market for regulatory and accounting purposes than in the US. 

The strength of sterling since the departure of the Truss government means the UK’s longstanding external balance sheet risk — its dependence on what former BoE governor Mark Carney called “the kindness of strangers” — has diminished somewhat. Yet huge uncertainties remain as interest rates look set to take one last upward step. 

Risks for borrowers and investors 

For mortgage borrowers, the picture is mixed. The BoE’s Financial Policy Committee estimates that half the UK’s 4mn owner-occupier mortgages will be exposed to rate rises in 2023. But, in its latest report in March, the BoE’s FPC says its worries about the affordability of mortgage payments have lessened because of falling energy prices and the better outlook for employment. 

The continuing high level of inflation is reducing the real value of mortgage debt. And, if financial stability concerns cause the BoE to stretch out the period over which it brings inflation back to its 2 per cent target, the real burden of debt will be further eroded. 

For investors, the possibility — I would say probability — that inflationary pressures are now greater than they have been for decades raises a red flag, at least over the medium and long term, for fixed-rate bonds. And, for private investors, index-linked bonds offer no protection unless held to maturity. 

That is a huge assumption given the unknown timing of mortality and the possibility of bills for care in old age that may require investments to be liquidated. Note that the return on index-linked gilts in 2022 was minus 38 per cent, according to consultants LCP. When fixed-rate bond yields rise and prices fall, index-linked yields are pulled up by the same powerful tide. 

Of course, in asset allocation there can be no absolute imperatives. It is worth recounting the experience in the 1970s of George Ross Goobey, founder of the so-called “cult of the equity” in the days when most pension funds invested exclusively in gilts. 

While running the Imperial Tobacco pension fund after the war he famously sold all the fund’s fixed-interest securities and invested exclusively in equities — with outstanding results. Yet, in 1974, he put a huge bet on “War Loan” when it was yielding 17 per cent and made a killing. If the price is right, even fixed-interest IOUs can be a bargain in a period of rip-roaring inflation. 

A final question raised by the banking stresses of recent weeks is whether it is ever worth investing in banks. In a recent FT Money article, Terry Smith, chief executive of Fundsmith and a former top-rated bank analyst, says not. He never invests in anything that requires leverage (or borrowing) to make an adequate return, as is true of banks. The returns in banking are poor, anyway. And, even when a bank is well run, it can be destroyed by a systemic panic. 

Smith adds that technology is supplanting traditional banking. And, he asks rhetorically, have you noticed that your local bank branch has become a PizzaExpress, in which role, by the way, it makes more money? 

 A salutary envoi to the tale of the latest spate of bank failures.