Walking a tightrope

Is a low-inflation, low-growth environment the new normal?

Globally, policy circles are now debating the reducing efficacy of unconventional monetary policies being used by global central banks to support growth and the need for other levers, including counter-cyclical fiscal policies. The rise in such activism is on account of the fact that these unconventional policies have not been able to generate inflation despite very low rates across the yield curve, often moving to negative territory. This limits the space of monetary policy to deal with a future slowdown. ‘

Proponents of counter-cyclical fiscal policies advocate putting money into the hands of those who would spend it, thus improving aggregate demand and in turn leading to improved inflationary impulses, through tools like tax cuts. However, any such policy needs to be implemented within the contours of maintaining central bank independence without relying on excessive debt monetisation, through close coordination with the central bank and a well-defined exit strategy when inflation returns to medium-term trend levels. Moreover, one needs to understand that reliance on fiscal policy would possibly offset to some extent the work done by monetary policy in lowering interest rates. Rates could rise as expansionary fiscal policies could lead to reducing the global savings glut along with an increased risk perception of government bonds, which could lead to an outflow of funds from debt instruments. 

Another school of thought gaining ground is the approach supported by modern monetary theorists (MMT), which radicalises policy making by transferring the burden of economic stabilisation to fiscal policy alone. This could be done by reducing the role of monetary policy to fund the government through debt monetisation with taxation taking a secondary role. While quantitative easing (QE) in part does defer to debt monetisation, it is only temporary as the QE debt is not rolled over but needs to be repaid by the government on maturity. In contrast, the MMTs propose rolling the debt in perpetuity to a point where markets move beyond the liquidity trap (an environment of low interest rates and high savings rate). Proponents of modern monetary theory would theorise this to be non-inflationary under the premise that governments would roll back this “helicopter money” as economies reach full potential by increasing taxes. In practice, however, this could be misleading as governments might not have the ability or the political willingness to retract, eventually leading to the unintended consequences of overheating of the economy. 

Other tools to improve inflation and inflationary expectations include raising the inflation target, price level targeting or through raising the average inflation targeting. These policies, if considered credible, could eventually lead to an increase in inflation levels, providing more ammunition to central banks during downturns. However, these policies might lead to increased costs through higher inflation, increased transaction costs and redistribution of wealth from holders of cash (mostly the poor) which cannot be ignored. 

These discussions lead us to think that the policy prescription for this low-inflation, low-growth environment might be more esoteric than one would like to believe. However, one might need to step back and assess the need or the urgency to move out of this milieu. Neutral rates have come down on account of changing demographics, technology and globalisation. These are structural changes that could be considered outside the purview of influence of monetary policy. One could argue that the low-inflation, low-growth environment is the new normal and any attempts to distort this could lead to unhealthy pressures on credit and asset price increases. Moreover, should we concentrate on growth rates, when in most of the developed world, metrics of per capita income levels and social and human development indicators are robust? The jury is still out there, in our view.  

The author is group head, global markets, sales, trading and research, ICICI Bank