Instability and low interest rates

Deflating a boom can lead to a dangerous slump

Just as metallurgists have discovered that materials behave very differently at very low temperatures, so economists are finding that reactions of economic agents do not conform to their expected behaviour when interest rates are at low levels.

Technologists, particularly computer manufacturers, were pleased to have discovered that conductivity overcame resistance in surprising ways at super low temperatures and they then explored the Josephson junction for super conductivity.

Like them some economists are exploring the logical consequences of monetary reactions when nominal interest rates are at or around zero.

In a Federal Reserve research paper by James Clouse and others, the authors have considered monetary policy options available to the authorities when interest rates are so low that the rewards for parting with liquidity becomes marginal.

When short-term securities like Treasury Bills yield very low, almost negligible returns in comparison with cash in the bank, the outcome of the policy is unpredictable.

One tentative conclusion is that "In an environment of low inflation, the Federal Reserve faces the risk that it may not have provided enough monetary stimuli even when it has pushed the short-term nominal interest rate to its lower bound of zero."

It seems that when nominal interest rates are at zero, the continued injection of additional liquidity through open market operations fails to shift a bank's desired portfolio allocation towards loans and away from excess reserves.

Once banks have adjusted their loan portfolio, that is after they have loaned the appropriate sum after allowing for risk premiums for their advances, further additions to liquidity will not necessarily increase loans, particularly when nominal interest rates are so low that banks become indifferent as to whether they hold cash or securities.

This analysis, although not directly relevant to the Indian situation "" our nominal interest rates are still considerably above zero "" may however provide analogies to learn from.

Since the Indian authorities have been pushing additional liquidity into the markets, it is interesting to note that the extra money simply adds to the demand for government securities and does not make for opportunities to increase banks' loan portfolios; thus the relevance of the quoted research paper may be important even when interest rates, while not at zero levels, are sufficiently low to make banks indifferent between lending to government and increasing their loan portfolios. The deployment of additional liquidity mainly into government securities suggests some degree of trapped liquidity.

Essentially Clouse et al analyse some of the characteristics of markets when the liquidity trap is very much more evident. They particularly look at Japanese and American behaviour at a time when the authorities are relying upon stimulating the economy through monetary policies.

Two features are worth noting: First, that the normal method of borrowing in America and Japan through issue of Treasury Bills at the short-term interest rates does not influence the behaviour of the market. At low levels of interest rates banks are quite relaxed about adding to their liquidity.

Second, as more money is made available at the short end of the market the yield curve, that is the difference between short and long-term rates, only becomes steeper. The gap between excess liquidity at the short end does not seem to increase demand for the long end.

This has been a common feature of behaviour both in Japan and the United States in recent times; indeed it happened even at the time of the great depression in the thirties when, after initial errors, the authorities reduced interest rates in order to stimulate activity but this had little impact as longer term rates did not fall.

It would seem that markets do not believe that very low interest rates can last for long. They are therefore unwilling to lower the yield they seek on longer term bonds.

Further, the gap between government securities and commercial paper does not seem to change as short-term yields fall. Paradoxically the long-term interest rate, that is the bond rate, falls only after short-term rates begin to rise from their lowest levels.

This leads to problems for the authorities in creating stimulus. In fact the possibility of stabilising the economy by monetary policy is more difficult at low interest rates.

As Phelps points out "At low rates of inflation the trials of the stabilisers are made harder and their tools are made blunter and less reliable. In a world of uncertainty, a policy of moderately high inflation in order to contain liquidity somewhere below the otherwise ideal level imposes a cost which can be viewed as the premium charged for (limited!) insurance against economic instability." (Edmund Phelps 'Inflation Policy and Unemployment Theory' Mac Millan 1972).

Now it will seem perverse to warn Indian readers of the need for some inflation, particularly when it is a common theme of editors and writers to warn against an increase in inflation rates; but it is perhaps useful to point out that over a period of years we have traversed a long distance from inflationary to anti-inflationary policies and that we have now devised tools that are essentially only operative for countering inflation and do not cater for the possibilities of deflation, particularly the kind of deflation that destroyed Japanese growth and which must at least leave a question mark on the success of the present American growth.

In the case of each of these countries considerable additions to liquidity have not advanced the rate of growth on a firm footing. This was very much the outcome at the time of the Great Depression when it took American production 14 years after the initial drop of 25 per cent to recover back to 1929 levels. As for Japan, in spite of a dramatic increase in liquidity there are still only hesitant signs of any serious recovery.

We in India, do not yet suffer from the technical difficulties of zero nominal interest rates, but given the politics of economics we may have very little room to manoeuvre in further reducing interest rates to stimulate the economy.

Since analysis suggests that "there are many sectors" (apart it seems from steel) "that are not doing particularly well in terms of production growth", we should perhaps hesitate before leaping into deflation from our apprehensions of inflation.

It is only right to be aware that for forty years or more the leading economies of the world have been conscious of the damaging effects of rising prices; but that is no longer the full story. Whether somewhat dramatically in Japan or hesitantly in the US, the concern is that once a down-swing starts it is not easy to reverse it just by priming the pump.

We have to be careful to make sure that we do not prevent expenditure by shadows and fears of their inflationary consequences. For deflation is just as difficult to overcome as inflation is, once it takes a grip.

This is particularly true when certain instruments like public expenditure and low interest rates prove inefficacious. It is therefore beneficial that there are some research papers now in circulation which invite us to look at the sort of constraints to investment which are not overcome by even very low interest rates.

sjmulji@aol.com