econintersect.com
       
  

FREE NEWSLETTER: Econintersect sends a nightly newsletter highlighting news events of the day, and providing a summary of new articles posted on the website. Econintersect will not sell or pass your email address to others per our privacy policy. You can cancel this subscription at any time by selecting the unsubscribing link in the footer of each email.



posted on 11 June 2016

Why Don't Low, Zero Or Negative Interest Rates Create Inflation?

Written by

The Federal Reserve and other major central banks around the world have set reference rates near zero, at zero or below zero for some time with the objective of increasing inflation. This, combined with central bank purchases of financial securities from the public (also with an increased inflation target), has failed to produce significant increases in inflation. How can this possibly be?

pumping.a.balloon

It has been a base tenet in economics that higher interest rates will "tamp down" inflation and lower rates will enable inflation to increase. The most notable example of the former was the early 1980s regime of Paul Volcker's Federal Reserve which raised the effective Fed Funds rate to 19% to end an oil-crisis induced inflation spiral which peaked at 15% CPI in 1980.

It is this relationship which has been the thinking behind the high liquidity and very low interest rate policies that have attempted to fend off deflation and promote a low rate of inflation during the years following the Great Financial Crisis of 2008. And immediately upon the initiation of the extraordinary monetary policy of the past 7 years, there were many respected financial and economic authorities who started warning that serious inflation would soon be the result from ZIRP and QE (quantitative easing - the creation of excess reserves in the banking system to pay for asset purchases by the Fed).

The inflation warnings came because it was feared that creating trillions of dollars of excess reserves would induce banks to increase lending in an imprudent manner. And the very low interest rates resulting from ZIRP (zero interest rate policy) would encourage unwise borrowing. The resulting increased liquidity would create a much larger surge of inflation than targeted, or so the critics thought.

But, inflation didn't happen.

The reason why these warnings were wrong are many. A few:

  1. Inflation is produced by increasing liquidity when an economy is operating near its output capacity - that has not been the case. There is far more capacity in the global economy than there is demand for goods and services.

  2. With high levels of private debt there has not been an excessive demand for additional credit from creditworthy borrowers.

  3. Many inaccurate predictions were based on an incorrect model of banking.

It is the third item above on which I will elaborate.

The incorrect model of banking is the so-called "loanable funds theory". This is theory still found in many textbooks which states that the interest rate is determined by the demand for and supply of loanable funds. The term loanable funds includes all forms of credit, such as loans, bonds, or savings deposits. It is often referred to as the theory of endogenous money. This inaccurate characterization of banking has poisoned many a mind. The poison is the idea that deposits and reserves limit credit.

The actual operation of banks today uses what is called an exogenous money model: Credit is extended based on perceived ability of the borrower to repay interest and principle. The banker doesn't look at deposits and/or reserves before making a loan - he extends credit based on evaluation of the return. It is said that bank credit "creates money out of thin air".


An aside: Of course, it is temporary money because when the loan is repaid the money is removed from the economy. And the interest paid actually decreases money in the economy below what existed before the loan. That means as money grows in the financial sector is will decrease in the "real economy". Thus if an increase in money is needed for increased output, that can only come from an expansion of credit.


So new temporary money is created through credit secured by the ability of the borrower to repay, not in any way by the amount of reserves or deposits in the banking system. Any imbalance created in reserve requirements across the entire banking system is corrected by the Fed, with increases in aggregate reserves when necessary.

So let's go back to QE and ZIRP? That does create money but in an ineffectual way for a credit economy. The impact is on reserves which, as discussed above, has no significant relationship to issuance of new loans. And some think ZIRP may actually discourage new loans because low interest does not adequately compensate for risk involved in issuing new credit.

So, as Steven Hansen suggested this week (and he is not the first), raising interest rates may indeed increase credit issuance because banks will be able to be compensated for the risk assumed in making loans.


Another aside: if QE and ZIRP do not positively effect creation of new credit and therefore growth in the "real economy" what does it do? As many have pointed out it merely provides means of inflating the value of existing assets rather than supporting the creation of new assets.


I find the lack of recognition of these relationships by policy makers to be extremely distressful. ZIRP and QE have limited effect on the "real economy" of goods and services. A larger impact is seen in the inflation of financial asset values. And though people in the "real economy" got little benefit from the asset inflation, when the bubble bursts they will definitely feel the blast.

>>>>> Scroll down to view and make comments <<<<<<

Click here for Historical Opinion Post Listing










Make a Comment

Econintersect wants your comments, data and opinion on the articles posted.  As the internet is a "war zone" of trolls, hackers and spammers - Econintersect must balance its defences against ease of commenting.  We have joined with Livefyre to manage our comment streams.

To comment, using Livefyre just click the "Sign In" button at the top-left corner of the comment box below. You can create a commenting account using your favorite social network such as Twitter, Facebook, Google+, LinkedIn or Open ID - or open a Livefyre account using your email address.



You can also comment using Facebook directly using he comment block below.





Econintersect Opinion


search_box

Print this page or create a PDF file of this page
Print Friendly and PDF


The growing use of ad blocking software is creating a shortfall in covering our fixed expenses. Please consider a donation to Econintersect to allow continuing output of quality and balanced financial and economic news and analysis.


Take a look at what is going on inside of Econintersect.com
Main Home
Analysis Blog
The Truth About Trade Agreements - and Why We Need Them
Big Mess in Italy
News Blog
Defence Budgets Are Surging In The Baltic States
It's Been A Turbulent Start, But Juno Is Now Delivering Spectacular Insights Into Jupiter
The World's Most Reputable Cities
What We Read Today 07 December 2016
October 2016 Consumer Credit Headlines Say Year-Over-Year Growth Rate Declined
Disabled Veteran And His Service Dog Get Job At Hardware Store
October 2016 JOLTS Job Openings Rate Shows Insignificant Year-over-Year Growth
Do Rises In Oil Prices Mean Rises In Food Prices?
Are Mobile Phone Payments Secure?
Infographic Of The Day: 12 Reasons To Let Your Employees Play Games
Early Headlines: Asia Stocks Up, Oil Down, House Has Stopgap $ Bill, Trump Sold All Stock, Euro Holding On, May Doubles Down, India Economy Struggles, Oz GDP Contraction And More
President Trump Must Be One-Term, Voluntarily!
Documentary Of The Week: Untold History Of The United States, 1890s To 1920
Investing Blog
The Real 401k Plan Manager 07 May 2016
Exuberance Returns
Opinion Blog
The US Government Needs To Spend More
Trump And Modi: Birds Of The Same Feather, But With Different World Views
Precious Metals Blog
Silver Prices Rebounded Today: Where They Are Headed
Live Markets
07Dec2016 Market Close: Wall Street Records New Highs, Health-Care Stocks Tumble, Crude Prices Stall At $50 Handle, New Fears Of A Correction Are Looming
Amazon Books & More






.... and keep up with economic news using our dynamic economic newspapers with the largest international coverage on the internet
Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government



Crowdfunding ....






























 navigate econintersect.com

Blogs

Analysis Blog
News Blog
Investing Blog
Opinion Blog
Precious Metals Blog
Markets Blog
Video of the Day
Weather

Newspapers

Asia / Pacific
Europe
Middle East / Africa
Americas
USA Government
     

RSS Feeds / Social Media

Combined Econintersect Feed
Google+
Facebook
Twitter
Digg

Free Newsletter

Marketplace - Books & More

Economic Forecast

Content Contribution

Contact

About

  Top Economics Site

Investing.com Contributor TalkMarkets Contributor Finance Blogs Free PageRank Checker Active Search Results Google+

This Web Page by Steven Hansen ---- Copyright 2010 - 2016 Econintersect LLC - all rights reserved