The intersection that occurs within the Japanese data suggests a more challenging situation for policymakers. Here their efforts become ineffective. This area of the graph is sometimes called the “unintended” steady state. As Bullard puts it, “in this unintended steady state, policy is no longer active: It has instead switched to being passive. When inflation decreases, the policy rate is not lowered more than one-for-one because of the zero lower bound. And when inflation increases, the policy rate is not increased more than one-for-one because inflation is well below its target.” He concludes that in this state, “the private sector has come to expect the rate of deflation consistent with the Fisher relation accompanied by very little policy response, and so nothing changes with respect to nominal interest rates or inflation.”
In effect, Bullard is saying that a policy that makes a promise to investors that rates will stay low for long periods of time backfires. While the Fed may intend to fan inflation concerns in order to motivate aggregate demand, the private sector begins to assume a semi-permanent state of very little change in inflation, and a growing inability for the Federal Reserve to do anything about it.
On Friday, Kansas City Fed President Thomas Hoenig expanded on the reasons why he has dissented from the current policy in place. “If an attempt to add further fuel to the recovery, a zero interest rate is continued, it is as likely to be a negative as a positive in that it brings its own unintended consequences and uncertainty”, Hoenig said in a speech. “A zero rate after a year of recovery gives legitimacy to questions about the sustainability of the recovery.” While Hoenig believes a deflationary outcome has low odds, his argument is the same. A Zero Bound strategy locks market participants into thinking inflation and growth are not likely near-term outcomes.
Promising low rates for long periods of time is particularly pernicious following periods of credit crises, points our Arun Motianey, now with Roubini Global Economics, in his book SuperCycles. In a discussion of Japan's low policy rates over the last 15 years, Motianey points out that deflation became worse the longer Japan's equivalent Fed Funds rate stayed at zero.
Motianey argues a slightly different transition mechanism that pushes the economy into deflation, mainly through lending markets. He argues that after a credit crisis, government-supported banks are borrowing at close to government rates and at the same time being coerced to lend at rates lower than they would otherwise demand for the risk of default. The result is that they demand higher credit standards (typically higher operating cash flow) of their borrowers. Borrowers, mostly companies, oblige by halting the growth in or cutting the nominal wages of workers. Generalized price deflation typically follows wage deflation.
Motianey sums up his argument up this way, “Very low nominal rates cannot be used to fight deflation, since they are, in these conditions – the condition of banking system distress – the cause of deflation.” He calls this the Paradox of the Zero Bound.
This is an important topic because it's clear that investors still believe that the Fed is engaged in active monetary policy (whether that might be setting the Fed Funds Rate, quantitative easing, or adjusting the interest rate paid on reserves) and that active monetary policy will play an important role in the outcome of the recovery. And this faith in the Fed that investors have, although unquantifiable, has certainly played an important role in the performance of stock markets over the last few years. After more than a decade of Greenspan's Put, and Bernanke's do-what-ever-it-takes attitude in protecting investors from taking appropriate losses, investors have been conditioned to believe that the Fed has their back. This faith in the Fed also must be playing a role in the valuation of the stock market, considering that investors are pricing stocks nearly 40 percent above long-term valuation levels (using normalized earnings) during an economic recovery that is by almost any measure lagging far behind the typical post war recovery.
