If interest rates stay high, central banks may need to rethink their approach: MAS chief economist
Annual monetary policy forum discusses competing theories of interest rates and growth
WITH interest rates perhaps staying higher for longer, central banks need to examine the parameters used in setting policy, said Edward Robinson, deputy managing director of economic policy and chief economist at the Monetary Authority of Singapore.
“A hard re-evaluation of several fundamental relationships in macroeconomics is under way,” said Robinson in his opening remarks at the 11th Asian Monetary Policy Forum on Friday (May 24).
These include the relationship between interest rates and growth, as well as that between inflation and unemployment.
Previously, the trend neutral real interest rate or r* – the rate expected at full employment and stable inflation – was thought to have permanently fallen, as demographic shifts lowered investment and raised savings.
This is under the “secular stagnation” hypothesis, popularised after the global financial crisis (GFC).
But long-run real interest rates have recently risen, and what will happen to r* seems less clear, said Robinson.
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Some economists think secular stagnation will persist, as there is little change to the long-term trends keeping rates low. Yet a low-rate world is “certainly not assured”, he added.
Instead, as inflation persists despite substantial rises in real interest rates, r* may have risen post-pandemic. This could be propped up by increased government spending that increases fiscal deficits and public debt.
Stagnation or supercycle?
This year’s commissioned paper dealt precisely with a comparison of secular stagnation and a competing theory on interest rates and growth, the debt supercycle.
In a discussion held under the Chatham House rule, one participant argued that the secular stagnation theory did not sufficiently consider the GFC’s own role in causing the sluggish growth and low interest rates that followed.
He added that much of the apparent evidence for secular stagnation could instead be attributed to the debt supercycle: the build-up of borrowing and debt by consumers and governments.
Another participant agreed that the debt supercycle is a plausible explanation for persistently low interest rates and growth, as debt problems are intrinsically slow to resolve.
Different understandings of what is causing the low interest rate and growth environment will result in different monetary policy moves, attendees agreed.
As Robinson noted, if r* settles higher, policy rates will need to be kept high – but this risks entrenching above-target inflation. Conversely, if r* actually remains low, monetary policy may be overly tight, putting “unnecessary strains” on employment and output.
In either scenario, central banks must carefully examine the parameters of their policy formula, Robinson said.
Trade-offs for inflation
Another macroeconomic relationship that requires a relook is the Phillips curve, which posits an inverse relationship between unemployment and inflation, said Robinson.
Before the era of low inflation ended three years ago, the Phillips curve was thought to have flattened in most advanced economies, implying a weaker relationship between unemployment and inflation.
But the negative correlation has since strengthened, and it is unclear if this is due to a temporary pandemic shock or structural supply-side changes, said Robinson.
If supply-side constraints bite, economies could “be operating on the steeper part of the aggregate supply curve more often”, meaning that production may not adjust much in response to price changes.
“This implies higher and more volatile inflation over the cycle, and more uncertainty around policy trade-offs.”
Finally, uncertainty over the level of r* affects not just monetary policy, but “has clear medium-term implications for fiscal policy”, said Robinson.
If r* stays above its pre-pandemic trend and trend growth faces challenges, the difference between real interest rates and growth may be smaller than expected.
This reduces the space available for strong counter-cyclical fiscal policies, and makes debt consolidation more urgent, Robinson said. “At the very least, it suggests that we need to be more aware of fiscal limits than we have been in the recent past.”
Held across two days at Pan Pacific Singapore and Conrad Centennial Singapore, the forum brought together policymakers and academics to discuss topics such as artificial intelligence’s impact on labour markets; China’s growth; and lessons from Credit Suisse’s restructuring.
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