MONEY The Economy

Think the Fed Should Raise Rates Quickly? Ask Sweden How That Worked Out

Raising interest rates brought the Swedish economy toward deflation Ewa Ahlin—Corbis

Some investors are impatient for the Fed to raise interest rates. They may want to be a little more patient after hearing what happened to Sweden.

If you’re a saver, or if bonds make up a sizable portion of your portfolio, chances are you’re not the biggest fan of the Federal Reserve these days.

That’s because ever since the financial crisis, the nation’s central bank has kept short-term interest rates at practically zero, meaning your savings accounts and bonds are yielding next to nothing. The Fed has also added trillions of dollars to its balance sheet by buying up longer-term bonds and other assets in an effort to lower long-term interest rates.

Thanks to some positive economic news — like the recent jobs report — lots of people (investors, not workers) think the Fed has done enough to get the economy on its feet and worry inflation could spike if monetary policy stays “loose,” as Dallas Fed President Richard Fisher recently put it.

If you want to know why the argument Fisher and other inflation hawks are pushing hasn’t carried the day, you may want to look to Sweden.

Like most developed nations, Sweden fell into a recession in the global financial crisis. But unlike its counterparts, it rebounded rather quickly. Or at least, that’s how it looked.

As Neil Irwin wrote in the Washington Post back in 2011, “unlike other countries, (Sweden) is bouncing back. Its 5.5 percent growth rate last year trounces the 2.8 percent expansion in the United States and was stronger than any other developed nation in Europe.”

Even though the Swedish economy showed few signs of inflation and still suffered from relatively high unemployment, central bankers in Stockholm worried that low interest rates over time would lead to a real estate bubble. So board members of the Riksbank, Sweden’s central bank, decided to raise interest rates (from 0.25% to eventually 2%) believing that the threat posed by asset bubbles (housing) inflated by easy money outweighed the negative side effects caused by tightening the spigot in a depressed economy.

What happened? Well…

Per Nobel Prize-winning economist Paul Krugman in the New York Times:

“Swedish unemployment stopped falling soon after the rate hikes began. Deflation took a little longer, but it eventually arrived. The rock star of the recovery has turned itself into Japan.”

And deflation is a particularly nasty sort of business. When deflation hits, the real amount of money that you owe increases since the value of that debt is now larger than it was when you incurred it.

It also takes time to wring deflation out of the economy. Indeed, Swedish prices have floated around 0% for a while now, despite the Riksbank’s inflation goal of 2%. Plus, as former Riksbank board member Lars E. O. Svensson notes, “Lower inflation than anticipated in wage negotiations leads to higher real wages than anticipated. This in turns leads to many people without safe jobs losing their jobs and becoming unemployed.” Svensson, it should be noted, opposed the rate hike.

image (8)
Sweden

Moreover, economic growth has stagnated. After growing so strongly in 2010, Sweden’s gross domestic product began expanding more slowly in recent years and contracted in the first quarter of 2014 by 0.1% thanks in large part to falling exports.

As a result, Sweden reversed policy at the end of 2011 and started to pare its interest rate. The central bank recently cut the so-called “repo” rate by half a percentage point to 0.25%, more than analysts estimated. The hope is that out-and-out deflation will be avoided.

So the next time you’re inclined to ask the heavens why rates in America are still so low, remember Sweden and the scourge of deflation. Ask yourself if you want to take the risk that your debts (think mortgage) will become even more onerous.

MONEY The Economy

Europe’s Central Bank Is Paying Negative Interest Rates. What Does That Mean?

Mario Draghi, President of the European Central Bank (ECB)
Mario Draghi, President of the European Central Bank (ECB). On June 5, the ECB introduced negative interest rates on deposits held by banks. Kai Pfaffenbach—Reuters

The European Central Bank tests out the radical idea of interest rates that are less than zero. Will this keep the Eurozone from slipping back into deflation?

At least we’re not Europe.

While Americans are starting to shift their attention to the next economic war — against inflation, as MONEY’s Pat Regnier notes – European policymakers are still frantically trying to fight the last one against deflation.

Toward that end, the European Central Bank on Thursday took the extraordinary step of going negative — that is, it cut the interest rate that it offers banks for holding excess reserves from 0% to -0.10%. It was part of a broader stimulus plan that also included a cut in another key European benchmark rate from 0.25% to 0.15%.

The extreme measures indicate just how worried European policymakers are about the threat of deflation.

But how do negative interest rates actually work?

Well, banks in the region will now be punished for keeping excess reserves at the ECB rather than deploying that money in the economy.

In the U.S., for instance, our central bank — the Federal Reserve — pays banks 0.25% on excess reserves that they keep on deposit. (In turn, banks pay you interest for parking your money in their CDs and money market accounts). By contrast, European banks who want to deposit their excess reserves will now be dinged 0.10%.

The move is designed to encourage banks to deploy their excess cash by investing it and loaning it out to spur economic growth, rather than just sitting on it.

Maybe encourage isn’t the right word. As David Kotok, chief investment officer at Cumberland Advisors, described it last year: Negative rates “employ only a stick and no carrot. Their use tends to progress from disincentive through penalty to punishment.”

What is the European Central Bank’s real goal?

ECB president Mario Draghi took this radical step in hopes of accomplishing a few things in the short term:

1) Weaken the euro. By lowering its rates just as the U.S. Fed Reserve is debating when to start raising rates, the ECB is trying to send a loud signal to the global currency markets. The message: Don’t park your cash in our currency. That message was received loud and clear, as the euro has weakened in recent weeks in anticipation of Draghi’s moves.

Euro to US Dollar Exchange Rate Chart

Euro to US Dollar Exchange Rate data by YCharts

You can debate whether it’s good in the long run for a country (or in this case, region) to promote a weak currency. However, in the short run, a falling euro would help European exporters compete on price with their U.S. and Asian counterparts.

2) Promote borrowing and investment by European companies. By prodding banks to deploy their capital while simultaneously lowering other interest rates, Draghi wants to juice economic activity by making it cheap and attractive for European companies to borrow funds. At least more attractive than their American competitors are finding. This is important as the U.S. recovery is on much firmer footing than Europe’s.

Eurozone Industrial Production Chart

Eurozone Industrial Production data by YCharts

3) Introduce more inflation to the region. Right now, the year-over-year inflation rate in the Eurozone has slipped below 1%, which is well below the near-2% goal that the ECB is targeting. Isn’t low inflation good? Yes, but a growing economy needs some inflation, and deflation is distinctly bad. If Europe were to slip into deflation, it would be that much harder for the region’s companies and consumers to pay down their debt.

Eurozone Inflation Rate Chart

Eurozone Inflation Rate data by YCharts

What could go wrong?

A lot of things. Obviously, there could be unintended consequences of such a move. For instance if banks don’t feel it is safe to put this capital to work, a -0.10% rate may not be punitive enough to persuade them to free up capital in a meaningful way. At the same time, the punishment may be steep enough for banks to start raising fees and rates on their customers, which would actually curtail economic activity.

Also, what happens if banks go beyond what the ECB wants and start making investments that are too risky, threatening the economy in another way?

Critics of negative interest rate policies point out that the problem with Europe’s economy isn’t necessarily the lack of supply of investment capital. There’s simply a demand problem in an economy where GDP is essentially flat.

How radical an idea is this?

This isn’t the first time that a central bank has deployed negative rates, but it’s the first time that a central bank this big and important has done so in such a calculated way.

Two years ago, for instance, Denmark tried negative rates on CDs to keep foreign investors from driving up the value of its currency. Switzerland tried something similar in the 1970s.

In fact, in the aftermath of the financial crisis, academics publicly debated whether the Fed should deploy a similar strategy to promote growth here at home.

During the depths of the crisis in 2009, Greg Mankiw, a key economic adviser to President George W. Bush, argued in this New York Times piece that then Fed chairman Ben Bernanke should try out negative rates to get the U.S. economy out of recession then.

A year later, Alan Blinder, former vice chairman of the Fed and a key economic adviser to President Bill Clinton, backed negative rates specifically on Fed-held excess reserves in the Wall Street Journal.

Ultimately, the Fed turned to another out-of-the-box idea — direct bond purchases in the open market, as part of so-called quantitative easing — to promote growth.

Still, negative rates proved to be one of the few ideas that economists on both side of the political aisle embraced in the crisis.

How radical is that?

TIME Economics

Japan’s Big Economics Experiment Needs More Experimenting

Japan's PM Abe makes policy speech during start of ordinary session at lower house of parliament in Tokyo
Japan's Prime Minister Shinzo Abe makes a policy speech during the start of an ordinary session at the lower house of parliament in Tokyo on Jan. 24, 2014 Yuya Shino—Reuters

Abenomics hasn’t gone far enough to fix what ails the world’s third largest economy

Japan is often in the crosshairs of economists for all the wrong reasons. Its two decades of malaise since a property-and-stock bubble collapsed in the early 1990s has been studied again and again by experts looking to understand the causes and effects of financial crises. Now, however, economists are watching Japan extra closely for another reason: Can a batch of unorthodox economic policies revive the moribund economy once and for all?

The strategy, dubbed Abenomics after Prime Minister Shinzo Abe, who inspired it, is aimed at restarting Japanese growth with a massive infusion of cash from the central bank and spending by the central government. The idea is to reverse Japan’s perennial and crippling deflation, which acts as a disincentive to spend and invest, causing companies and consumers to loosen their purse strings and boost growth.

(MORE: The Limits of Abenomics)

Supporters have argued that Abenomics will finally give the economy the jolt it has long needed to break free of its never-ending crisis. Critics fear that the program could only worsen the already feeble state of the nation’s finances — government debt is the highest in the developed world relative to GDP, at more than 240% — without lasting economic benefits. Either way, the results of Abenomics will influence the way policymakers around the world use monetary and fiscal policies to tackle downturns and pursue growth.

Abenomics has had a few successes. Prices are rising, as its drafters had hoped, and employment has improved. But recent data gives ammunition to the skeptics. On Monday, the Japanese government announced that GDP accelerated a measly 1% (on an annualized basis) in the fourth quarter of 2013, well below consensus forecasts. Though consumers did spend more and companies boosted investment, the increases were lackluster. Most of all, exports, the bread and butter of Japan’s economy, disappointed as well, despite a weak yen and recovering global growth. The outlook doesn’t look much brighter. In April, a hike in the consumption tax — instituted to help close the government’s yawning budget deficit — will kick in, likely further dampening consumer spending.

(MORE: ‘You Mean Women Deserve Careers?’ Patriarchal Japan Has Breakthrough Moment)

These latest figures bolster the argument (made by myself and many others) that Abenomics has so far failed to go far enough in changing Japan. What Japan needs is more than just a deluge of cash; it needs a fundamental overhaul of the very structure and workings of the economy to increase its potential for growth. Though Abe fully realizes this and has announced plans for further reforms, they have come slowly. The flagship project — special economic zones in which companies would have greater freedom from Japan’s often entangling regulation — is still being devised, and skeptics fear the measures won’t be bold enough to eliminate the bureaucratic meddling and red tape that hamper competition and investment. An overly controlled labor market is pushing workers into marginal, part-time jobs, while Japan desperately needs to boost immigration and encourage more women to join the workforce to compensate for its aging population. Corporate Japan, meanwhile, requires its own reforms, to free up innovation, encourage more risk taking on new businesses and open up clubby management suites to outside influences.

Whether or not Abe can achieve any of this is an open question. Though he is in firm control of Japanese politics right now, opposition to many such reforms remains entrenched in Japan, even within Abe’s own ruling party. Yet the lesson from Abenomics to this point is that monetary stimulus alone can only take a struggling economy so far. If Abe can’t manage to press ahead with bigger and more drastic reforms, his experiment in economics, and all of the hopes that came with it, will likely be dashed.

MORE: A Hawkish Japan Rediscovers Its Samurai Spirit

MONEY

Why Isn’t Anyone Afraid of Deflation?

All right, not exactly no one. Fed chairman Ben Bernanke is worried about it — hence the latest round of quantitative easing.

But listen to talk radio, read a financial blog or two, or just talk to some of your friends, and you won’t find much populist anxiety about falling prices. To the contrary, a lot of people are terrified about inflation, even though it’s currently running at an annual rate of 1.1%.

Part of the reason is that Bernanke does seem to be trying to signal the market that he wants to generate some inflation — and if you’re an investor, it’s only rational to try to hedge your portfolio for the possibility that this effort will work. (I have my doubts.)

But I think something else is going on. The evil of high inflation is especially vivid, in a way that deflation’s cost just isn’t. In our high school history textbooks, we all saw an image like this one:


Those are German kids during the 1920s hyperinflation crisis stacking up nearly worthless marks.

Do you have an instant mental snapshot of what a similarly severe deflation might look like? Me neither. But if we did, it would look like this Dorothea Lange photo from the Depression:


This iconic image, like other Depression-era photos, conjures up “hard times.” It doesn’t signify “falling prices.” But it should: prices declined at an annualized rate of 10.3% from 1930 through 1932. So now we’re in this weird moment when Americans’ historical imagination is focused on an episode of the Weimar Republic when we could just as easily be thinking about our own Tom Joad.

Now a reality check. There’s little cause to worry about either hyperinflation or a deflationary, ’30s-style depression. But some deflation, and a long, slow recovery from today’s high unemployment, does seem like a real danger right now. In a general deflation, people hang on to money tightly, and that can be devastating for businesses and the people who want to work for them. It’s also awful for anyone trying to service a debt. (Paul Krugman has a good, clear explanation of why deflation — or even too-low inflation — can be a bad thing.)

So question on the table is: Is it worth risking a spike in inflation to fight off deflation?

How you feel about that should depend on who you are. Inflation has serious costs for a lot people. It eats away at savings, which is a burden on those who are living off the assets they’ve accumulated over their lifetime. That’s well known; inflation is often called a “hidden tax.”

But less well-understood is that deflation has costs for a lot of other people, too. People like, well, me. I’m 39 and have two kids. Even though I’m a good saver, my household’s wealth still depends far more on our current and future ability to get work than it does on any assets we’ve accumulated so far. That’s not because we’re imprudent; it’s just that we’re relatively young. So deflation scares me.

But it doesn’t seem to scare anyone around me.

And that’s scary.

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