Introduction

The “Lost Decades” of Japan has been cited by economists and policymakers as an allegory to warn against heedless reduction in interest rates in the face of a worsening economic climate. During this period of economic stagflation triggered by its 1990 stock market crash and thus suffering from immense debt, the country was in desperate need to recover the economy from rapid deflation. As a result, the nominal interest rate fell from 8 per cent in 1990 to around 1 per cent in 1995, culminating in the Zero Interest Rate Policy in the Spring of 1999. However, such efforts were not rewarded with increased consumer spending. Not only does this demonstrate the detriments of economic collapse, it also – and perhaps more importantly – serves as a cautionary tale of the threat of disinflation toppling into deflation and the inefficacy of relying on customary monetary policies in such situations. This raises the question of whether monetary policies such as interest rates should be used in the first place to address disinflation.

The Model

This article will use the Three-Equation Model, comprising the investment-saving curve (IS), the Philips curve (PC), and the central bank monetary rule (MR), to simulate the effect of interest rates on disinflation. The model will be set out to show how theoretically a fall in inflation below target invites interest rate cuts, before exploring the various specific reasons why this is rarely exercised.

The IS curve illustrates a negative relationship between the interest rates and national output. Increased interest rates discourages further consumption and investment from consumers and investors due to the rise in cost of borrowing: financing purchases through bank loans are made more expensive which comes with the more appealing opportunity cost of the higher returns in savings. A lower national output hence occurs through a fall in total demand. The reverse happens when interest rates are decreased. In this instance, the PC displays the positive relationship between output and inflation: higher output – thus higher GDP – increases profit for firms which translate to higher wages and disposable income for consumers. Consequent rises in spending engender demand-pull inflation. Lastly, the MR refers to a general rule for the central bank’s monetary policymaking by suggesting the optimal interest rate for the central bank to implement for any given inflation rate.

As shown in Figure 1 (top), the PC shifts from A to B following a decrease in inflation from π^T to π^1. This, ceteris paribus, corresponds to a decrease in interest rate from r^s to r^1 as A moves to B on the IS. Hence, it is economically sound, according to the three-equation model, to lower interest rate when there is a falling inflation below target; this is especially the case when this fall is not due to a change in vertical PC which is caused by productivity growth but rather a demand-deficiency shock, assuming adaptive expectation (speculating future happenings based on past events) in the private sector.

The Economy at the Zero Lower Bound

Despite the normative notion established by the Three Equation Model aforementioned, there are a few circumstances in which this norm becomes untenable. As a central bank implements vigorous interest rate cuts, the macro economy may reach the zero lower bound (ZLB) where nominal interest rates are near or become zero.

An IS curve adapted for the ZLB can be seen in Figure 1 (bottom); a decrease in inflation when the economy is at the ZLB – where IS intersects the x-axis – can drive the nominal interest rate to a negative value (r^s to r^1 corresponding an extension from A to B along the IS curve). In this case, any monetary policies that stimulate economic growth become in vain since r cannot be lowered below zero: doing so would mean a cost on savings which depletes the central bank’s monetary stock as consumer withdrawls the savings in cash.

Meanwhile, the Fisher’s equation (1), linking nominal (i) and real (r) interest rate with inflation (π^E), suggests that a non-negative nominal rate can lead to a positive and higher real interest rate when expected disinflation downturns to deflation (2). Since the real rates directly affect investment and consumption activities, reducing nominal rates to zero to boost growth can become an ineffective, self-destructive exercise in such extreme situations: investors and consumers lose money as they save.

Moreover, the impact of a widened risk premium during crisis arguably renders interest cuts even more obsolete. Given such economic distress and uncertainty, the risk of investments, either given to the central banks or assets in general, increases. As the investment risk aggravates, the incentive to face this risk reduces and investors demand higher risk premia to forestall this uncertainty. Because the normal real interest rate is derived from the calculated interest plus risk premium, the borrower must still pay this premium, notwithstanding the interest rate being zero. 

Overcoming the Zero Lower Bound

However, while this is true for short-term interest rates, the same may not be true for long-term interest rates which is calculated as follows:

Where i_t, i_0, and 〖E(i〗_t) represents the long-term rate, the rate at present, and the expected rates in subsequent periods respectively. Thus, the government can promise a lower rate of nominal interest for a prolonged period to decrease the expected rate, thereby lowering the overall long-term rate.

In addition, the central bank can announce a high inflation target to increase the private sector’s expected inflation, lowering the real interest rate. If the private sector has a large component of rational expectation speculators, then promising to keep the real interest rate for an extended period out of the crisis can also increase the expected inflation of future periods and thus help reduce the real interest rate today. These factors help the government in addressing the Keynesian liquidity trap the economy faces as it approaches the ZLB.

Yet, the central bank might be disadvantaged by a lack of credibility from the private sector due to time inconsistency. That is, when the time has come for the central bank to deliver on its promises, the action may no longer serve its optimal interest. To solve this mutual reluctance for the private sector to change due to time inconsistency, the central bank can adopt price level targeting rather than inflation targeting.

As compared to inflation-targeting where the economy will continue with a path which is parallel to the expected price with disinflation unaccounted for (Fig 2.1), a price level targeting central bank will seek to eliminate this gap to return to the expected price level (Fig 2.2). Hence, a period of disinflation will be compensated by increased inflation in the following period through a lower interest rate. This makes the central bank’s promise of a low interest rate target more convincing

Alternatively, the central bank can use quantitative easing (QE) as a last resort to stimulate inflation when manipulating short-term interest rate deems ineffectual. One of the merits of QE is that it allows more liquidity to be injected into the economy through the purchase of government bonds by the central banks. The further purchase of bank assets provides a greater monetary reserve and gives banks the power and incentive to lend, consequently leading to greater consumption and investment while partially offsetting the liquidity drain following the crisis. Withal, the increased demand can bring forth higher prices in stock and bonds, thereby augmenting aggregate demand through the wealth effect. Coupled with expansionary fiscal policies financed by a budget deficit, the government can engender a multiplier effect to fuel the economy further until it escapes the disinflation crisis.

Discussion

In all, our conventional economic understanding dictates us to exercise a lowering in interest rate during disinflation. Yet, due to the risk of facing the ZLB, such a monetary policy is not so generously applied, owing to possible limitations aforementioned and the possible increase in risk premium in the midst of economic uncertainty. Hence, in place of the more ineffectual, physical methods of alleviating disinflation and low interest rate, governments and central banks should instead opt for means which bolster economic certainty and motivate consumer confidence. This approach should ameliorate the long-term economic forecast and rebuild stability.