The Swedish central bank just lowered interest rates to zero because of deflation risks. This action comes after ignoring repeated warnings from Lars Svensson who had joined the bank in 2007 and later resigned because of disagreements with monetary policy decisions. What it is interesting is the parallel between Riksbank decisions and ECB decisions. In both cases, these central banks went through a period of optimism that make them raise interest rates to deal with inflationary pressures. In the case of Sweden interest rates were raised from almost zero to 2% in 2012. In the case of the ECB interest rates were raised from 1% to 1.5% during 2011. Also, in both cases, after a significant expansion in their balance sheets following the 2008 crisis, there was a sharp reduction in the years that followed. During 2010 the balance sheet of the Riksbank was reduced by more than 50%. In the case of the ECB it was later in 2013 when the balance sheet shrank by about 1 Trillion Euros. Their policies stand in contrast with those of the US Federal Reserve and the Bank of England where interest rates still have to start going up after the initial actions taken during the crisis and where the expansion in their balance sheet has not started to being reversed.
The consequences of the policies of the ECB and Riksbank are clear: a continuous fall in their inflation rates that has raised the risk of either a deflationary period or a period of too-low inflation. What is more surprising about their policy actions is their low speed of reaction as the data was clearly signaling that their monetary policy stance was too tight for months or years. In both cases their decisions to bring down their interest rate or take further action has happened in very small steps. And every time a step is announced the reaction has always been asking what will be next. So the announcement of the Riksbank has now been met with questions about when they will have to start their own version of QE. Same as for the ECB where their latest announcements has led to expectations of future more aggressive actions.
What we learned from these two examples is that central banks are much less accountable than what we thought about inflation targets. And they make use of the lack of clarity on the exact definition of their targets to produce a policy that is clearly asymmetric in nature. Taking some time to go from 0% inflation to 2% inflation is ok but if inflation was 4% I am sure that their actions will be much more desperate. In the case of the ECB their argument is that the inflation target is defined as an asymmetric target ("close to but below 2%"). But this asymmetry, which was never an issue before the current crisis, has very clear consequences on the ability of central banks to react to deep crisis with deflationary risks.
What we have learned during the current crisis is that an asymmetric 2% inflation target is too low. Raising the target might be the right thing to do but in the absence of a higher target, at a minimum we should reverse the asymmetry implied by the ECB mandate. Inflation should be close to but above 2% and this should lead to very strong reaction when inflation is persistently below the 2% target.
Antonio Fatás
The consequences of the policies of the ECB and Riksbank are clear: a continuous fall in their inflation rates that has raised the risk of either a deflationary period or a period of too-low inflation. What is more surprising about their policy actions is their low speed of reaction as the data was clearly signaling that their monetary policy stance was too tight for months or years. In both cases their decisions to bring down their interest rate or take further action has happened in very small steps. And every time a step is announced the reaction has always been asking what will be next. So the announcement of the Riksbank has now been met with questions about when they will have to start their own version of QE. Same as for the ECB where their latest announcements has led to expectations of future more aggressive actions.
What we learned from these two examples is that central banks are much less accountable than what we thought about inflation targets. And they make use of the lack of clarity on the exact definition of their targets to produce a policy that is clearly asymmetric in nature. Taking some time to go from 0% inflation to 2% inflation is ok but if inflation was 4% I am sure that their actions will be much more desperate. In the case of the ECB their argument is that the inflation target is defined as an asymmetric target ("close to but below 2%"). But this asymmetry, which was never an issue before the current crisis, has very clear consequences on the ability of central banks to react to deep crisis with deflationary risks.
What we have learned during the current crisis is that an asymmetric 2% inflation target is too low. Raising the target might be the right thing to do but in the absence of a higher target, at a minimum we should reverse the asymmetry implied by the ECB mandate. Inflation should be close to but above 2% and this should lead to very strong reaction when inflation is persistently below the 2% target.
Antonio Fatás
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