United States: Permazero rates rise
News: Low interest rates favor easier financing conditions, which support a gradual economic recovery. The concept of Permazero describes a situation where this mechanism no longer works and paradoxically contributes to a further decline in prices. The monetary policy response to this situation should therefore be to raise rates in order to stimulate upward inflation expectations. This is one of the arguments put forward by the most hawkish ( pro-rate hike) members of the Fed.
· Fisher’s equation (nominal interest rate = real interest rate + inflation) shows that keeping the nominal interest rate low over a long period of time implies a decline in inflation with the real interest rate unchanged. A nominal rate kept low for a prolonged period would encourage a sharp rise in the price of risky assets, which would inevitably have to be corrected at a later date, thereby affecting savers’ net income and reducing their spending. This latter adjustment would limit economic recovery and thus limit wage and price increases.
· Conversely, the Fed’s minutes refer to a gradual decline in the neutral real interest rate(the rate that is sustainable with inflation and production), which supports either a decline in the nominal interest rate or its maintenance at the same level combined with a decline in the inflation rate. This decline in the neutral rate is justified by:
o (1) excessive savings (savings glut), which keeps bond yields low;
o (2) private sector deleveraging, due to favorable financial conditions;
o (3) and a rise in the dollar, linked to negative interest rates in Japan and the Eurozone.
· In the current US economic climate, base effects on the WTI barrel could appear as early as July and support a recovery in year-on-year inflation, which recently slowed in 2016 (1.4% in January, 1.0% in February, 0.9% in March). The slowdown in the appreciation of the dollar and private deleveraging would favor the stabilization or even recovery of the neutral real interest rate. This situation would favor a further rise in rates and would fit into a moderate model known as neo-Fisher (Cochrane 2015): the nominal interest rate rises modestly and inflation reacts by falling before gradually picking up again.
· If this recovery were too sluggish, several increases in the key interest rate could boost inflation. This is the second type of model proposed by Cochrane (2015): the nominal interest rate rises sharply and inflation reacts immediately with an increase (extreme neo-Fisher model). This situation would support a more hawkish view among certain members of the Fed if the expected effects (weaker dollar and end of deleveraging) prove to be weak.
