Financial markets, and perhaps the global economy, seem to be reaching a crossroads where it appears that central banks have exhausted their abilities to support real growth with the toolkit currently being used.
The most recent example of unconventional monetary policy not doing what was expected is the move of the European Central Bank (ECB) and now the Bank of Japan (BOJ) to enact negative nominal interest rates. Financial markets have responded to negative interest rates with destruction in bank equity and debt valuations, a drop in global inflation expectations and no particular depreciation of the respective currencies versus the U.S. dollar (USD). It is hard for any monetary policy to be effective if it destroys the profitability and credit-expanding abilities of banks, as negative interest rates are doing.
In the U.S., the Federal Reserve hiked rates last December and indicated the possibility of more hikes this year under the base expectation that the U.S. economy was growing (albeit slowly) and operating near full employment. While this remains PIMCO’s base case, a consequence of the Fed’s guidance has been a strengthening of the USD, the world’s reserve currency, and a resultant tightening of global financial conditions. Persistently tighter financial conditions may force the Fed to abandon its guidance and look for ways to weaken the USD and lower real interest rates.
The Fed has traditionally dismissed the possibility of negative nominal interest rates due to concerns about unintended consequences related to the plumbing around the U.S. money market system. Recently, however, it started considering this option given the precedent set by the ECB, the BOJ and other smaller central banks. Seeing the adverse effects that negative interest rates are having in Europe and Japan, we believe it is clear that the problem with negative interest rates is not related to the plumbing of the financial system, but rather that they have an adverse impact on the real economy! We believe it would be a mistake for the Fed to go down this path in the event of an unexpected slowdown in the U.S. economy, especially when there is a logically and practically simpler approach that the Fed, so far, refuses to consider – explicitly raising the 2.0% inflation target, even if just temporarily (which is essentially price level targeting, or allowing inflation to run hot in order to compensate for the sustained miss on the downside).
There are both near-term and longer-term reasons why this may be effective. In the near term, announcing a higher inflation target is likely to accomplish what central banks are attempting (but not achieving) with negative nominal rates. It could raise inflation expectations, lower real interest rates and weaken the currency, all without the deleterious effect on bank profitability and credit creation that negative interest rates entail.
In the longer term, a higher inflation target could make it easier for the Fed to support the economy with more conventional monetary policy. The Fed agrees, in line with PIMCO’s New Neutral hypothesis, that the neutral real interest rate is probably lower than it has been in the past and possibly close to 0%. In this world, operating with the established inflation target of 2.0% would mean hitting the zero bound of nominal interest rates fairly frequently, and then having to resort to unconventional monetary policy more often than not. Going forward, if the Fed wants to stick with conventional monetary policy, first it may have to take the unconventional step of raising the inflation target.
So why is the Fed so loath to take this relatively simple step? We believe it is because much of the global central bank leadership (not just at the Fed) came of age when high and rising inflation was a problem undermining their credibility and negatively affecting global economies. Currently we have the opposite situation, but the Fed is so worried about unleashing the “inflation genie” that it is unwittingly feeding the “deflation demon” instead.