Why interest rates are losing their worldwide relevance | Instant News

File photo of the Swiss National Bank building in Bern | Wikimedia Commons

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For thousands of years, interest rates have been the primary means of setting the price of money. They have determined how medieval empires financed distant conquests and modern nations went to war. They affect everything from the cost of food, shelter and transportation to health care and government spending. Even the slightest adjustment is closely watched by investors, home buyers, business owners, presidents and kings. However, the 21st century may mark the end of its use.

Inflation has long been the main driver in setting interest rates. But rising prices, once seen as a curse, have been overcome in recent decades. We didn’t see meaningful inflation as trillions of dollars in stimulus flooded the economy after the global financial crisis, nor were we seen after a surge in fiscal and monetary aid amid the Covid-19 pandemic.

On the other hand, the world is in a prolonged period of zero or low inflation. It began after attempts by central banks in the 1980s to crack down on uncontrolled price increases of the previous decade, and was met with a confluence of deflationary pressures: a shift in manufacturing to low-cost destinations, technological advances, and demographic changes. Even negative interest rates, a radical move adopted years ago in Japan, Switzerland and the eurozone, have been largely ineffective in spurring inflation.

That’s why worrying about official interest rates isn’t productive, according to three economists urged the Swiss National Bank to change its approach. “It is time for the SNB to recognize that the policy rate has been stuck at -0.75% for more than six years and has ceased to serve as a policy instrument,” wrote Stefan Gerlach, Yvan Lengwiler and Charles Wyplosz in their paper on February 17th “Too Much of a Good Thing: Lowflation in Switzerland.” Their recommendations include embracing faster public inflation, an idea once considered heretical, and steering the economy through exchange rates. This approach would emulate the Monetary Authority of Singapore, which uses what is called a crawling peg that manages the local dollar against a basket of currencies.

Singapore’s method predates the global financial crisis and pandemic – and its appeal is understandable. Like Switzerland, the city-state is a small, wealthy exporter and financial center. Singapore views the exchange rate as the most effective tool managing monetary policy and keeping inflation under control, given the size of the economy. Many of the items sold here come from outside. For its part, the SNB has also tried to greatly influence the Swiss franc level, even limiting it for three years. It also maintains a very negative interest rate, which is the lowest in the world. But the central bank has to admit that currency is the main game, Lengwiler, a professor at the University of Basel, said in a telephone interview.

Even if inflation increases in the next few years, the prospect of the benchmark interest rate returning to its early 2008 levels is still small. This means that we need something better to regulate today’s economic life. In the case of Switzerland, currency is already an available tool. Why not make full use of it? If your main fare will remain for more than a decade, in the middle deepest global slump since the Great Depression, What is the point?

There are lessons here for the larger economies, too, even if they cannot migrate to currency-focused policies. (Can you imagine global market chaos if the Federal Reserve suddenly told the world to ignore federal funds rates and instead focus on the greenback?) The most realistic option is for central banks to fine-tune their approach to inflation. The SNB, for example, currently defines price stability as a positive rate of below 2%, but actual inflation has been below zero for over a year. Gerlach, Lengwiler and Wyplosz argue that they should set the target at 2%, which will be achieved on average in the medium term. The downsides on the downside should be taken as serious as overshoot.

This advice resonates from Washington to Wellington. The Federal Reserve last year completed a lengthy review of its monetary framework. It’s now comfortable with inflation that is above the target for a while, if that’s what it takes to anchor it at 2%. The Bank of Japan is reviewing its very lax policy and will for three months release its findings next month. The Reserve Bank of India is considering its own changes in how prices should go up. “It’s dangerous not to review your strategy every now and then,” says Lengwiler. “When the strategy fails, you have to do it.”

The authors favor the Reserve Bank of Australia’s goal of averaging 2% to 3% inflation in the medium term. That will leave plenty of room to move around. The RBA does not expect tariff increases for at least several years. Even so, officials want to see evidence of higher inflation, not just forecasts. But the Reserve Bank has had vocal critics, including former Prime Minister Paul Keating, who has called it “Upside Down Bank” and criticized it for being too conservative. The central bank must be more stimulative, he said.

If the old model of monetary management is reversed, it is still not entirely clear what to replace it. But the need for creative thinking shouldn’t come as a surprise – quantitative easing and volatile price increases existed long before the coronavirus. “There is a generation that has not experienced inflation,” said Lengwiler. “They have no conception of that, apart from intellectually.”

For overly cautious monetary policymakers, now is a good time for inspiration. – Bloomberg

Also read: The Indian economy needs to increase consumer confidence to emerge from stagnation

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