The US Federal Reserve (Fed) is considering raising rates. Is the “normalization” of interest rates about to happen which savers and investors have been yearning for? Most likely not. Policymakers are merely realizing that the policy of zero rates — or even negative rates as in the euro area or Switzerland — doesn’t work as intended.
The wider public is very much against it. Banks, for instance, run into trouble because their profits come under severe pressure in an environment of zero, let alone negative, interest rates. Bank clients start protesting as their bank deposits no longer earn a positive return. They even start redeeming their deposits in cash, thereby causing bank refinancing gaps.
Negative Rates Under Another Name
However, central banks are quite unlikely to abandon the idea of pushing real — that is inflation-adjusted — interest rates into the negative. What they might have in mind is allowing for “somewhat higher” nominal interest rates, accompanied by “somewhat higher” inflation, making sure that real interest rates remain in, or fall into, negative territory.
In this vein, the Federal Reserve of San Francisco suggested in a paper published on 15 August 2016 that monetary policy should rethink and possibly allow for an inflation of more than 2 percent.[1] The debate about higher inflation — say, 4 rather than 2 percent — is actually an old one; in academic circles it comes and goes in waves.
The central argument is that a somewhat higher inflation would “grease the wheel” of the economy, thereby supporting production and employment. Another argument has it that higher inflation would make it easier for the Fed to pull the economy out of recession, especially so if and when the “neutral interest rate” has come down considerably.
The truth is, however, that inflation — be it 2, 4, or more percent — doesn’t make a society better off. On the contrary. For instance, inflation corrupts economic calculation, thereby causing entrepreneurs to make the wrong decisions. The stimulus inflation initially is due to the errors which it produces.
What is more, inflation only works if and when it comes unexpectedly, thereby benefiting some at the expense of others. “Surprise inflation,” however, can never be more than a temporary incentive. Sooner or later, people will discover that they have been tricked and adjust their behavior accordingly.
Consider a case in which the central bank promises an inflation rate of 2 percent. After people have entered into their contracts, the central bank increases inflation to 4 percent. People will learn and expect future inflation to be 4 or even 5 percent. The central bank, if it wants to stimulate again the economy, has to bring inflation further up.
This kind of policy would ultimately lead to high or even hyperinflation — which has been observed in many countries around the world. However, if the central bank succeeds in (1) raising inflation from, say, 2 to 4 percent on a one-off basis and (2) simultaneously controlling nominal yields, it potentially deleverages the economy, bringing down debt-to-income ratios.
If, for instance, the Fed fixes interest rates at, say, 2 percent and pushes inflation to 5 percent, real interest rates fall tominus 3 percent. Moneyholders would be ripped off. The same holds true for investors in debt, issued by states, banks, and corporates. Debtors, in turn, would presumably welcome a policy of negative real rates that come with somewhat higher inflation.
It therefore doesn’t take much to expect that in particular politically powerful and highly indebted borrowers would do their very best to push the central bank to bring up inflation and, at the same time, put a lid on nominal interest rates. To press their case, they will make sure that an economic theory in support of inflation and negative interest rates is propagated to the public at large.
How to Drive Up Price Inflation
But can a central bank really ramp up inflation? It sure can. Inflation — in the sense of higher prices — is ultimately a monetary phenomenon. Technically speaking, the central bank can expand the quantity of money at any time and any amount politically desired, as the central bank has a monopoly on money production.
For instance, the central bank can purchase debt in the market against issuing newly created money. Or, in extremis, it can also issue “helicopter money.” The central bank hands out money for free to governments, consumers, and entrepreneurs in the amount deemed necessary to push inflation upward.
Central banks are highly politicized, and they will act in a way that is politically expedient. Once the debt burden has become unsustainable and growth disappointing, it becomes increasingly difficult to prevent an inflation policy. It was Ludwig von Mises who clearly understood the political dimension of inflation:
We have seen that if a government is not in a position to negotiate loans and does not dare levy additional taxation for fear that the financial and general economic effects will be revealed too clearly too soon, so that it will lose support for its program, it always considers it necessary to undertake inflationary measures. Thus inflation becomes one of the most important psychological aids to an economic policy which tries to camouflage its effects. In this sense, it may be described as a tool of antidemocratic policy. By deceiving public opinion, it permits a system of government to continue which would have no hope of receiving the approval of the people if conditions were frankly explained to them.[2]
Against this backdrop it would be surprising if governments and their central banks will not opt at some stage for higher inflation in an attempt to escape the problems their policies and the issuance of unbacked paper money has caused in the first place. Alas, it wouldn’t be the first time in monetary history that unbacked paper money would be deliberately debased.
