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UNTIL recently, China was widely accused of exporting deflation to the rest of the world. Massive overcapacity in China, it was argued, was depressing the prices of manufactured goods. This year, however, the charge against China has been turned on its head. It is now being blamed for exporting inflation to the rest of the world as its insatiable demand for raw materials pushes up the price of oil and other commodities. Amidst this confusion, one thing is clear: the entry of China and other emerging economies into the global economy may affect monetary policy in ways that central banks do not yet fully understand.
To the extent that China adds to the world's productive capacity and strengthens competition, it should, on balance, help to reduce inflation for a period. A purist would argue that in the long run, inflation is determined entirely by monetary policy, but in the short to medium run cheaper imports from China will reduce inflation. A study by economists at America's Federal Reserve estimates that cheaper imports from China have lowered inflation in America by an annual average of 0.1-0.3 percentage points in recent years. Another study by Dresdner Kleinwort Wasserstein, which allows for the price-reducing effects of Chinese competition on all producers, reckons that China may have brought down America's inflation rate by almost a full percentage point. So what should central bankers do?
Last year, prompted by fears about deflation, America's Federal Reserve reduced short-term interest rates to a 45-year low of 1%. America's underlying rate of consumer-price inflation fell to only 1% at the end of last year, a bit too low for comfort. The experience of America in the 1930s and Japan over the past decade shows that deflation can be much more harmful than inflation: falling prices increase real debt burdens, depress demand and so push prices even lower. Deflation also emasculates monetary policy, because interest rates cannot fall below zero.
The right sort of deflation
The Fed is now celebrating its success in avoiding deflation. But Stephen King, chief economist at HSBC, argues that with hindsight some of the deflation that the Fed was fretting about last year was in fact “good deflation”, caused by structural changes in the global economy. Historically, benign deflation, of the sort experienced in the late 19th century at a time of rapid growth, has actually been more common than malign deflation, when prices and output spiral downwards. In recent years, cheaper imports from China and other emerging economies, along with the IT revolution (which has boosted productivity growth), have cut the prices of many goods and so, for a period, brought down inflation.
Mr King suggests that last year the Fed and some other central banks, fearing the bad sort of deflation, may have cut interest rates by too much and then left them low for too long. Instead, he says, they should have accepted this “good” deflation.
This is an echo of a lively debate in the 1920s, when some economists suggested that when rapid productivity growth is bringing down the cost of production, overall price stability may be the wrong goal. Instead, average prices should be allowed to fall to pass productivity gains on to workers in the form of higher real incomes. But just like today, monetary policy prevented prices from falling. Because nominal wage rises lagged behind productivity growth, profits surged. The mistaken belief that profits could continue to grow at this pace helped to inflate the late-1920s stockmarket bubble.
In retrospect, it is clear that the risk of deflation in America last year was exaggerated. Even so, it is hard to criticise the Fed's rate cuts in 2001-03. Even if some of the threatened deflation was of the good sort, there was a high risk of bad deflation after the bursting of the stockmarket bubble. At a time of weak growth, it was understandable that the Fed did not want to run the risk of any sort of deflation; it was desperate not to repeat the mistakes of the Bank of Japan in the 1990s.
This does not mean that the Fed is blameless. The best concept for understanding the forces at work is the “natural rate of interest”, which goes back to Knut Wicksell, a Swedish economist working at the start of the 20th century. The idea was developed further by Austrian economists such as Friedrich Hayek. The natural rate of interest is the rate at which the supply of saving from households equals the demand for investment funds by firms. If the rate set by the central bank (the cost of capital) is lower than the natural rate, there will be excessive investment and borrowing, and households will not save enough. At the natural rate of interest, policy neither stimulates nor reins in the economy.
To make life tricky for central bankers, the natural rate can vary over time, in line with changes in the return on capital or households' desire to save. And there is good reason to think that the natural rate has risen in recent years. The entry of China's army of cheap, unskilled labour into the global economy has increased the ratio of labour to capital, which in turn lifts the worldwide return on capital. The spurt in productivity growth from IT has also increased expectations about future profits and investment opportunities, further lifting the natural interest rate. In other words, the very same forces that have caused central banks to cut interest rates to prevent inflation falling have actually increased the required equilibrium real rate of interest.
Meanwhile, households in many countries have decided that they need to save less than they used to, because they think rising share or house prices are likely to provide the assets to finance their retirement. In the economic jargon, the supply curve for saving has shifted backwards, whereas the demand curve for investment funds has shifted outwards. This implies a higher natural rate of interest.
Capital on the cheap
China has also caused the cost of capital to fall below its natural rate in another way. China and other Asian countries have been big buyers of American Treasury bonds, through heavy foreign-exchange intervention to hold down their currencies against the dollar. According to some estimates, that may have reduced bond yields by anything from half a percentage point to a full point. This “subsidy” has artificially lowered the cost of capital for homebuyers and companies, at precisely the time when the return on capital and hence the natural rate of interest has increased.
In theory, if central banks hold interest rates below the natural rate, credit and investment will rise too rapidly and households will save less and spend more. This is what has happened in America in recent years. Austrian-school economists would say that in the late 1990s interest rates were held too low in relation to the higher expected return on capital, which caused excessive investment, falling saving and the biggest stockmarket bubble in American history. Since the bubble burst, the expected return on capital may have fallen, but real interest rates have been cut by more, leaving them even further below their natural rate.
Holding interest rates too low for a prolonged period has created a whole series of excesses: a global housing bubble (of which more in the next article), rampant consumer borrowing and spending, and an unhealthy amount of investment in highly risky assets, such as emerging-market bonds, as investors searched for higher yield amid falling interest rates.
The exceptionally low cost of capital may also have distorted economies by encouraging firms to invest in labour-saving machinery rather than hire new workers. Thus, ironically, China may be indirectly to blame for America's jobless recovery. Workers are being priced out not by cheap Chinese labour, but by low-cost capital investment subsidised by the Fed's incorrect response to the downward pressure on inflation exerted by China.
As inflation has started to edge up, the Fed and other central banks have started to lift interest rates. But the risk now is that pushing real rates back to where they should have been in the first place will reveal the fragility of the recent economic recovery. Decisions taken on the basis of unsustainably low interest rates, such as borrowing to the hilt to buy an overpriced house, will suddenly look unwise. Aware of this risk, the Fed is lifting interest rates gradually. But a gentle rise may fail to halt the borrowing binge if expectations of future gains in house prices are entrenched, so the bubble may continue to inflate.
On the other hand, bigger rate increases (which may be unavoidable if inflation continues to rise) could cause a hard landing, triggering the bad deflation that central bankers have been so keen to avoid. Awkwardly, there would then be much less room for interest-rate cuts or fiscal stimuli than after the stockmarket bubble burst, because most of the ammunition has been spent already.
A pinch of Basel
In its latest annual report, the Bank for International Settlements (BIS), the central bankers' central bank based in Basel, Switzerland, also expresses concern that monetary policy around the world has been too loose in recent years. The BIS frets that even if inflation is subdued in the short term, very low interest rates could either increase the risk of higher inflation in future or feed into financial imbalances such as excessive growth in credit and rising asset prices. Competition from China, deregulation and faster productivity growth have helped to hold down inflation, says the BIS, at the same time as financial liberalisation has increased the risk of booms and busts in asset prices.
Not only are structural forces such as globalisation helping to hold down prices, but central banks' success in the battle against inflation has also enhanced their credibility and reduced inflationary expectations. This has meant that they need not tighten policy by as much as previously in response to rapid growth in demand. Conversely, so long as inflation is subdued, they can afford to ease policy more freely to deal with economic downturns or during bouts of financial instability. The Fed has been doing exactly that in recent years, which has resulted in record low interest rates. This has reduced economic volatility in the short term (America's recession after the stockmarket bubble burst was the mildest in history), but the asymmetric policy could cause long-term problems by allowing bigger financial imbalances to build up. Rescuing investors each time a bubble bursts also encourages even more risk-taking.
The bottom line is that the extra liquidity created by lower interest rates is now more likely to spill over into asset prices and excess credit growth than into old-fashioned inflation. Liquidity has certainly been flowing freely in recent years. Monetary policy in the big developed economies has been looser than at any time for three decades. The Fed not only reduced short-term interest rates to a 45-year low, but it also made huge efforts to convince the bond market that rates would be kept low for a considerable period, thereby bringing down bond yields. Real short-term rates have been negative for the first sustained period since the 1970s (see chart 10). If the Fed sticks to its current slow tightening, real interest rates will remain negative well into next year.
The European Central Bank has been much criticised for running an overly tight monetary policy and thereby cramping growth in the euro area. Yet in fact, although interest rates in the euro area did not come down by as much as in America in 2001-03, real rates are also negative, and are at their lowest for over 25 years.
Another useful gauge of monetary policy is to look at the gap between interest rates and growth in nominal GDP. Nominal GDP growth can be seen as a proxy for the average rate of return on investment in America Inc, so this is a very crude estimate of the gap between actual interest rates and the natural rate. In both America and the G7economies as a whole, the negative gap between interest rates and nominal GDP growth is currently at its widest since the 1970s (see chart 11).
America's lax monetary policy has spilled over beyond its borders. Low American interest rates have encouraged capital to flood into emerging economies. For those countries that try to peg their currencies against the dollar, notably China and the rest of Asia, this has caused a large build-up in foreign-exchange reserves and excessive domestic liquidity. When central banks buy dollars to hold down their currencies, they amplify the Fed's loose monetary policy. All this means that, arguably, the Fed has not only caused the Americans to save too little, but also the Chinese to invest too much. Ed Yardeni, an economist until recently at Prudential Equity Group, tracks the growth of what he calls “supermoney” (the sum of America's cash and banks' reserve holdings at the Fed, plus foreign reserves held by central banks around the world). He found that earlier this year supermoney was expanding at an annual rate of almost 25%.
In August 1977 The Economist published a signed article by Alan Greenspan, then a private-sector economist, which contained a list of five economic “don'ts”. One of them was: “Don't allow money-supply growth to spiral out of hand.” In recent years, Mr Greenspan seems to have inadvertently broken his own rule. As a result, America's economic recovery is built on wobbly foundations.