The transition from an inflationary to a deflationary (or lowflationary) economic climate has brought with it a range of new expressions, economic jargon, preconceptions and misconceptions. To help you get to grips with the new paradigm, we provide brief explanations of a number of these concepts as well as the interaction between inflation and the economy, trade, consumers, central banks and governments.
What is quantitative easing? It’s a measure central banks can employ when conventional, nominal interest rate policy is constrained by the zero lower bound….
Central banks are charged by national governments with, among other things, the management of monetary policy to meet specific policy objectives with regard to criteria such as economic growth and the rate of inflation.
Raising and lowering interest rates is the main tool employed by a central bank to regulate the national economy. By lowering official interest rates (which provide the reference for banks in determining the ‘price’ at which they will offer credit to borrowers) a central bank can seek to stimulate economic conditions. Raising interest rates is, on the other hand, a means of slowing economic growth by restricting access to credit and potentially suppressing inflationary pressures.
But when interest rates reach zero (a.k.a. ‘the zero lower bound’), central banks have to resort to other, ‘non-conventional’, policies to restore growth and combat deflationary trends. These policies may include pumping money into the economy to stimulate consumption and investment.
This process, whereby the central bank buys assets such as government bonds, is known as quantitative easing or QE.
Central banks use money they have ‘printed’ (i.e. created electronically) to buy bonds from investors, thereby increasing the amount of liquidity in the financial system and encouraging financial institutions to lend more willingly to companies and individuals.
Exhibit 1: To increase the amount of liquidity in the financial system central banks expand their balance sheets. The graph below shows the increase in the sizes of the balance sheets of the ECB and the US Federal Reserve between 2005 and 16/01/15.
Source: BNP Paribas Asset Management, Bloomberg, as at 16 January 2015
Exhibit 2: Overview of the size of quantitative easing programmes undertaken by the US, UK, Japan and Sweden since 2008.
* The forecast for Euro assumes a rate of EUR 40bn per month of sovereign bonds only this year.
* Total purchases for US, UK and Japan are since 2008. Sweden’s Riksbank announced a QE programme on 12/02/15 (admittedly on a much smaller scale than other central banks) in reaction to downside risks to inflation.
Source: BNPP IP, JP Morgan, as at 12 February 2015
Negative interest rates are another unconventional policy measure…
Negative interest rates are another measure to which central banks can resort when seeking to combat deflationary risks. In June 2014 the ECB reduced the deposit rate to minus 0.10 percent from zero. A priori, it clearly is an unconventional idea that lenders should have to pay banks to hold their deposits. The ECB took this measure, amongst others, to ensure price stability (i.e. a rate of inflation close to but below 2%) over the medium term, which is considered to be a necessary condition for sustainable growth in the euro area.
Until recently there have been relatively few examples of central banks employing negative interest rates as a policy measure. The Riksbank and the Danish National Bank used negative interest rates in 2012 to discourage excessive appreciation of the Swedish krona and Danish krone. In the 1970s the Swiss central bank cut official interest rates to below zero to slow currency purchases of the Swiss franc by investors seeking a safe haven from the middle east oil crisis.
On 12 February 2015, negative rates returned to Sweden when the Riksbank (the world’s oldest central bank – the Riksbank has a 350 year history), announced asset purchases (i.e. quantitative easing) and reduced its benchmark repo lending rate (the rate at which it lends short-term money to commercial banks against securities) to minus 0.10%. The Riksbank has since cut made two more rate cuts taking its repo rate to minus 0.35% (and has avowed its “readiness to do more”).
According to the Riksbank, it expects the repo rate to remain at -0.10 per cent until the rate of inflation is close to 2%. In the Riskbank’s view it will not be appropriate to increase the repo rate until the second half of 2016.
The Danish central bank (Danish National Bank (DNB)) was also active earlier this year seeking to stem apprection of the Danish krone in order to maintain the exchange rate peg to the Euro. In January 2015 the DNB cut rates on four occasions to minus 0.75%. According to a statement on the DNB’s website “Following the decision by the Swiss National Bank to discontinue the minimum exchange rate and the decision by the European Central Bank to launch an expanded asset purchase programme, there has been a considerable inflow of foreign currency.“ Denmark has however tied its currency to neighbours’ for over 30 years — first to Germany’s deutsch mark and subsequently to the euro. In addition the Danish market is not large and liquid enough to fully fufil the role of a safe haven.
The ECB’s announcement of its QE programme on 21 January 2015 had had the effect of weakening the Euro versus a number of currencies including the Danish krone. Rather than purchasing Denmark’s sovereign debt the DNB has also taken the unusual step of suspending all issuance of Danish government bonds.
The DNB is battling to defend the peg to the Euro having spent Danish krone 106,3 bn (equivalent to EUR 14,24 bn) in January intervening in the exchange markets to defend its euro peg in the Exchange Rate Mechanism (ERM).
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Quantitative easing in Japan is on a different dimension to the QE programmes that other central banks have put in place (see Exhibit 3 below). QE has been significantly expanded in Japan as part of “Abenomics”, the three-part plan of Shinzo Abe, Japan’s prime minister, to shake the country from its economic torpor. On 31/10/14 the Bank of Japan (BoJ) announced a major expansion of its programme of quantitative easing (the bank’s previous measures were already very bold). The BOJ is now swelling Japan’s monetary base at an even faster pace, by around ¥80 trillion ($712 billion) each year, up from ¥60 trillion-70 trillion previously. To do so, it will purchases larger quantities of Japanese government bonds (JGBs) and other assets. According to Haruhiko Kuroda, the governor of the BoJ, this “shows our unwavering determination to end deflation”.
The BOJ’s action is also a recognition that QE has so far, not had the desired effect in Japan. Its bond-buying has succeeded in sparking some inflation, but the objective of achieving price rises of 2% a year by around April 2015 is some way off. Both the BOJ and the Japanese government, underestimated the dampening effect of a hike in the consumption tax in April 2014. This caused the economy to shrink by 1.7% in the second quarter of 2014. Due to faltering consumer and corporate demand, and falling oil prices, the rate of inflation in Japan has been heading in the wrong direction.
Exhibit 3: Japan is undertaking a massive programme of quantitative easing
Source : BNP Paribas Asset Management, BoJ, Bloomberg, Dec 2014
Inflation, deflation, reflation, disinflation, stagflation
Total or headline inflation refers to the change in prices of all products and services consumers buy. To measure this, prices of all products and services are monitored on the basis of a “basket” of goods and services that is intended to measure what a consumer buys. This forms the basis for an index of weighted prices. Inflation is the year-on-year change in this index. Perceived inflation may differ from the actual number (i.e. the basket of goods may not accurately reflect what individuals consume). If, for example, prices of discretionary, frequently purchased goods such as personal services or drinks in a bar rise by more than rents or utility costs, consumers may feel inflation is higher than the official numbers suggest. The sentiment among consumers about trends in inflation is reflected in expected inflation as measured in consumer surveys.
Gauging expectations of futures interest rates depends on understanding how the pace of inflation is lkely to evolve. Central banks and investors monitor developments using market-based inflation expectations measures— typically via breakevens in Treasury Inflation-Protected Securities (TIPS) and inflation swaps. Movements in both measures provide valuable information but readings should always be interpreted with care. The recent decline in market-based inflation measures (see exhibit 3) is one of the factors that may have convinced central banks to pursue unconventional, reflationary policies to ward off deflationary risks.
Exhibit 3: Market-based inflation measures suggest that future rates of inflation in the US and eurozone may so low that corrective action (i.e. reflationary policy measures) is required from central banks. As interest rates are already at multi-year lows, central banks have resorted to unconventional policy measures (e.g. quantitative easing).
Source: BNP Paribas Asset Management, Multi Asset Solutions, as of 31/12/14
To get a better view of underlying trends in the rate of inflation, economists often strip out volatile food and energy prices to arrive at core inflation.
Inflation goes up and down with the economic cycle. The long-term trend of falling inflation since the early 1980s is referred to as disinflation. If the rate of inflation falls below zero it is called deflation.
If inflation falls by too much, central banks can stimulate the economy by lowering interest rates or by additional stimulus measures. Such policy action is some times referred to as “reflationary.” Should inflation rise due to these measures, we have reflation. Stagflation refers to low or negative economic growth and high inflation. This is an unlikely combination since sluggish growth tends to be accompanied by a low rate of inflation, but the 1970s provided a graphic demonstration of stagflation in developed economies.
The key task of most central banks is to control inflation. The Federal Reserve is an exception: it has a dual mandate – being tasked with keeping both the rate of inflation and unemployment low. The Fed does not have explicit targets for inflation or unemployment, but several other banks do. The ECB aims to keep inflation below, but close to 2%. The Bank of England’s target is also 2%. The BoE has some room for error. If inflation falls below 1% or rises above 3%, its governor must write an open letter to the Chancellor explaining why this happened. The Reserve Bank of Australia was the earliest adopter of inflation targeting. Since 1993, the RBA has had an inflation target of 2-3%.
Adopting an inflation target serves several purposes. It gives the central bank a clear target for its main policy objective and makes policymakers accountable for policy actions. An inflation target is also an anchor for inflation expectations. If a central bank is successful in meeting its goal, in other words if it can keep inflation close to its target, consumers and producers will expect future inflation to be close to that target. As a result, actual inflation usually fluctuates around the target. Monetary policy is simply not able to keep inflation exactly at target due to time lags and uncertainties. Moreover, keeping inflation always close to the target would require an overly activist monetary policy.
Competitive devaluation and inflation
Currency movements affect inflation, especially in small open economies. A falling currency makes exports cheaper for foreign customers and imports more expensive for the domestic market. The positive effect of a falling currency is therefore more exports and less imports. However, higher import prices also boost domestic inflation. Which is the dominant effect depends among others on the structure of the economy and the value of imports relative to exports. If an economy slows, its policymakers may try to revive growth by weakening their currency actively. They may do so by selling the local currency in the foreign exchange markets and buying foreign currencies.
Governments may also take measures to limit imports. This is called protectionism. If only one country pursues such policies, it would support its economy without hurting the rest of the world too much. Nevertheless, the country involved would lean on foreign countries to revive growth, often referred to as a beggar-thy-neighbour policy. If other countries would react with similar policies, a downward spiral would emerge. Competitive devaluation would only lead to lower currencies, without the benefits of higher exports. The negative inflation effect would prevail in this case.
Consumers and inflation
Complaints about rising prices have been around since the introduction of money as a means of exchange. The reason is that inflation hurts consumer spending power. If prices rise faster than incomes, households can purchase fewer goods and services. This is why consumers dislike inflation. Even if wages keep up fully with inflation, the increase in nominal wages is eaten up by inflation. Real, or inflation-adjusted, wages would not increase in such a case and consumer may still feel worse-off. Following this logic, consumers should benefit from deflation (falling prices), since they could purchase ever more goods and services with a given amount of income.
However, inflation also affects debtors and creditors. If prices and wages increase and debts remain constant, the ratio of debt to incomes falls. Debts are never adjusted to the rate of inflation. Thus, inflation tends to reduce debt burdens. This is positive for debtors and negative for creditors. In a long period of deflation, if nominal wages start falling, debt burdens increase. This process of debt deflation can be hard to turn around. If debt deflation takes hold, consumers will cut their spending in an attempt to pay off debts. This would slow economic growth and increase the downward pressure on prices.
Economies need some inflation, to avoid deflation
In theory, zero inflation would be no problem at all. Nevertheless, every central bank that has adopted an inflation target has set this target at above zero. Apparently, zero inflation is not desirable in practice. The main reason is that deflation has such severe negative effects and if central banks aimed to keep inflation at zero, deflation would quickly emerge when economic growth slowed.
Why is deflation considered to be so dangerous?
1) It coincides with serious economic distress. Sharp declines in demand and production tend to presage periods of deflation.
2) If consumers expect prices to keep falling, they may postpone purchases. This would slow demand further.
3) As described above, a longer period of deflation may lead to falling wages and rising debt burdens. If consumers decide to pay off debt and thus cut spending, this would be another blow to demand. Deflation becomes dangerous when it grips the mind of an economy prompting consumers to postpone spending and companies to cancel investments.
4) Real or inflation-adjusted interest rates matter more in economic decisions than nominal rates. If an economy slows, central banks cut nominal interest rates to revive growth. If they cut nominal rates to zero and deflation emerges, real rates would actually be positive, or higher than the central banks target. In such a case, additional monetary stimulus measures would be needed.
Governments and inflation
Governments traditionally prefer some inflation. There is a trade-off between inflation and unemployment: raising interest rates to lower inflation slows the economy and leads to higher unemployment, while cutting rates would support growth and help create jobs. However, this trade-off is mostly temporary. Attempts to exploit it actively have had adverse effects in the past. The main reason why this does not work is that producers and consumers would adjust their expectations, making such as policy less effective.
Another reason why governments may prefer some inflation is that it reduces the debt burden, as described above. Most governments have realised that low and stable inflation is a sensible target, although politicians from time to time try to persuade central bankers to cut rates. The governments’ preference for some inflation has been the prime driving force for central bank independence. Some central banks such as the ECB have specific inflation targets to prevent them from succumbing to political pressures.