Disinflation, interest rates and risks to monetary policy

Maybe the FED is uncapable of raising the inflation rhythm as promised; or maybe it is on purpose, as Mr. Avent suspects. He believes that the fear of a possible bubble, which destabilizes the financial system once more, is responsible for the FED’s attitude.

Jeremy C. Stein points the following in his article about the influence of the monetary policy:

 “[S]hould financial stability concerns, in principle, influence monetary policy decisions? To be specific, are there cases in which one might tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level than one would otherwise, because of a concern that a more accommodative policy might entail a heightened risk of some sort of adverse financial market outcome? This question is about theory, not empirical magnitudes, and, in my view, the theoretical answer is a clear “yes.”

On the other hand, Mr. Avent believes that an excessively low inflation may be financially destabilizing due to its impact on debt. How much low is it then?

In the chart below, the green line is the index of inflation expectations, which is calculated by the difference between the nominal interest rate at 10 years and the real interest rate.

monetary policy 2

According to Mr. Avent, the expectations depended on the FED’s mood swings: when it has begun to reverse the QE, expectations plummeted significantly –below 2%. Those same expectations have increased the yield of the 10-year debt (which corresponds to the blue line in the chart) –even though the monetary rate or FED’s target (red line) remains at zero.

The problem comes when the nominal and real yields pick up due to a sound recovery in the activity, or because people have accepted that the FED has hardened its position without an authentic steady consolidation.

Be that as it may, this analysis shows that practicing economics is quite imprecise. The FED is skating on very thin ice, among risks that are very difficult to calculate and could increase even if they do something to avoid them.

Mr. Avent says that if the inflation is too low, the rhythm of growth and employment may be reduced, thus making the debt reduction more difficult. On the other hand, if the target was a higher inflation, the markets might react with too much optimism (which would lead to indebtedness and speculation).

After all, a bubble –once initiated- is really difficult to stop if you don’t dramatically increase interest rates or carry out more effective cutting policies.

About the Author

Miguel Navascués
Miguel Navascués has worked as an economist at the Bank of Spain for 30 years, and focuses on international and monetary economics. He blogs in Spanish at: http://http://www.miguelnavascues.com/

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