Raghuram Rajan recently offered advice on monetary policy regimes:
[T]The balance of risks suggests that central banks should reaffirm their mandate to fight high inflation, using standard tools such as interest rate policy. What if inflation is too low? Perhaps, as with COVID-19, we should learn to live with it and avoid tools like quantitative easing that have dubious positive effects on real activity; distort credit, asset prices and liquidity; and are hard to leave. Arguably, as long as low inflation doesn’t collapse into a deflationary spiral, central banks shouldn’t worry too much about it. It is not decades of low inflation that have slowed growth and labor productivity in Japan. The aging and shrinking workforce are more to blame.
I think it is a mistake to adopt an asymmetric targeting policy, where you fight above-target inflation and tolerate below-target inflation. Better to define a target path (preferably NGDP) and eliminate gaps in both directions.
But here I would like to focus on another issue. Although Rajan does not say so explicitly, his comment implies that tolerating low inflation is an alternative to quantitative easing (QE). In my view, tolerating very low inflation is a cause of EQ. To understand why, let’s review some concepts in monetary economics:
1. The demand for base money (as a percentage of GDP) is negatively related to the trend rate of inflation/growth of GDPN. Prior to 2008, most developed countries had monetary bases of around 5% to 10% of GDP. In extreme cases of very high inflation, basic demand can fall to 1% or 2% of GDP. Conversely, countries with very low inflation (such as Japan and Switzerland) have base/GDP ratios above 100% of GDP.
2. From a technical point of view, central banks do not have to meet high basic demand with QE policies. But if they don’t, a country can slide into severe deflation, as we saw in the early 1930s in the United States. So, from a political point of view, a high basic demand as a percentage of GDP almost forces central banks to engage in a lot of QE. The central banks of Switzerland and Japan are not left organizations. They are (small c) conservative. They have built up large balance sheets to meet strong demand for base money and thus avoid outright deflation.
Rajan is correct that Japan adjusted to a low inflation regime (although the initial adjustment process of the 1990s was somewhat painful). But I don’t think the example of Japan shows what Rajan seems to think he shows. Over the long term, Japan’s success in maintaining a very low inflation environment has required far more extensive QE policies than those adopted by the Fed or the ECB.
Tolerating very low inflation is not an alternative to QE; long-term this is the primary cause of EQ. There is a close analogy with monetary policy and interest rates. On a given day, a cut in the central bank’s interest rate target is expansionary (for a given natural interest rate). But in the longer term, a central bank with a restrictive policy regime that leads to low inflation will end up with lower nominal interest rates than a central bank that tolerates high trend inflation.
In the long run, there are three regimes central bankers can choose from:
Regime A: Very weak core inflation. Very low nominal interest rates. Lots of QE and a big central bank balance sheet. (Japan and Switzerland are examples.)
Regime B: Moderate trend inflation. Moderate nominal interest rates. Very little QE and a moderate size balance sheet. (The United States before 2008.)
Regime C: High core inflation. High nominal interest rates. Substantial QE (financing budget deficits), but small central bank balance sheets as a percentage of GDP. (Argentina and Turkey.)
PS. Yes, paying interest on reserves complicates this picture somewhat, leading to larger CB balance sheets for a given trend inflation rate. But the IOR is a political choice. (Not wise, in my opinion.)