Photo: Reuters
Photo: Reuters

ZIRP, NIRP and RIRP

Tighter monetary policy is effective in reining in inflation, but looser monetary policy isn't in stoking inflation

Just last week, the Bank of England brought out its monetary policy bazooka. It lowered interest rates; committed itself to lowering them further; resumed quantitative easing (QE); extended it to corporate bonds and got sanction for another £100 billion of QE to be kept in reserve, literally. All this based on a gross domestic product growth forecast that may or may not materialize. Even if it materializes, it may well be due to the inevitable bursting of the asset bubbles that policies such as this fuel. In other words, the policy meant to stave off a growth slowdown might very well be the cause of it, eventually.

Pushing interest rates down to zero or negative and unleashing a quantitative response has become the unthinking Pavlovian response of central banks to a real or imagined economic slowdown or low inflation. On their part, financial markets with their Pavlovian response to such policies send asset prices to new highs. Both financial markets and central banks are defying logic and the former is defying gravity as well.

The belief that low rates would stave off an economic slowdown, disinflation and even deflation is almost religious because it ignores evidence to the contrary. In a recent interview, Alberto Gallo told Bloomberg that Zero Interest Rate Policies (ZIRP) and Negative Interest Rate Policies (NIRP) are actually deflationary. When interest rates fall so low or go negative, savers find that their targeted savings for retirement or other needs grow more distant and end up saving even more, rather than less. That drags down the economic growth rate.

There is another way negative interest rates have the opposite effect than the one intended by policymakers. Interest rates are positive because of time value of money. Money loses its value over time. In other words, over time, goods will be scarce relative to money. The relatively ‘plentiful’ money would have lower purchasing power and hence, lenders who postpone consumption need to be compensated and ‘made whole’. In contrast, ZIRP and NIRP signal to the market that there is no time value of money. Money will not be ‘plenty’ relative to goods and hence there is no loss of purchasing power. There won’t be relative scarcity of goods to money. That signal obviously is a deterrent for investments. Investing is all about producing goods and services to relieve the scarcity. But, ZIRP and NIRP signal the opposite.

The failure of ZIRP and NIRP to achieve their objectives has given rise to some spurious theories. One is the Neo-Fisherian theory of interest rates. This theory draws equivalence between NIRP and ZIRP stoking deflation and rising rates being useful in stoking inflation. In other words, according to this new theory, if ZIRP and NIRP generate disinflation or deflation, Restrictive Interest Rate Policies (RIRP) will generate inflation! This symmetry is ill thought through because life is nothing if not asymmetric.

Behaviour of savers: Savers save more because target savings are harder to achieve in an ultra-low rate environment. Interestingly, they also save more when interest rates are high and/or rising. Positive rates incentivize the public to save while ZIRP and NIRP frighten them to save more. The behavioural motivations are different.

Firms raise their hurdle rates when rates go up. That reduces investments. But firms do not bring down their hurdle rates when rates go down. They are downward sticky. That makes the case for more effectiveness from tighter monetary policy on reining in spending and inflation than from looser monetary policy in stoking spending and inflation.

Central banks themselves are asymmetric in their behaviour. The public trusts and wants them to fight rising prices of goods and services rather than falling prices (which people feel good about). Similarly, people do not approve of them working to pop bubbles but when they prop bubbles with lower rates, investors, markets and the public cheer. There is asymmetry there too. Evidently, central banks have taken the latter to their heart but not the former. Even their response to public preferences is asymmetric!

Lastly, policymakers resort to ZIRP and NIRP when the economy is already saddled with high debt. That is, the economy is balance sheet-constrained when low interest rates are deployed. That robs monetary policy of its effectiveness. Even with low interest rates, prospective borrowers already suffering from debt indigestion won’t be tempted by a loan feast. In contrast, rates go up when balance sheets are not bloated (if not downright lean) and are ready to take on more debt. In that situation, central banks raising rates will have the effect of reining in enthusiasm for debt. At least, it can slow it down. So, RIRP can be effective in reining in animal spirits whereas ZIRP and NIRP are not effective in stoking animal spirits in the economy. They succeed spectacularly with asset markets, for sure! That is actually part of the problem with ZIRP and NIRP.

In sum, RIRP will not lead to higher inflation even though ZIRP and NIRP generate and entrench deflation. Certainly, that is no argument for lowering interest rates in India. The relationship between economic variables is non-linear and asymmetric. One should be careful about linear and symmetric extrapolations.

V. Anantha Nageswaran is an independent financial markets consultant based in Singapore.

Comments are welcome at baretalk@livemint.com. Read V. Anantha Nageswaran’s previous columns at www.livemint.com/baretalk

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