No interest cut, please!

The IMF's deflation "ogre" has given way to a "lowflation" lithany in a recent IMF blog, which culminates in a call for lower ECB rates. Among other arguments, the well written post points out two key problems from low inflation:

The first problem is the presence of nominal rigidities, i.e. the difficulty of cutting wages and prices. The internal devaluation that countries in the euro periphery need to accomplish requires an inflation differential to Germany and the rest of the core.  Nominal rigidity in wages make this adjustment harder to achieve if inflation in the core is low. And where prices must fall but can’t, the adjustment falls on volumes: lower output, lower employment.

But here are some important qualifiers:

1) The nominal rigidities are the underlying problem.

The nominal rigidities are a reflection of labor market inflexibilities that remain to be addressed. Rather than a monetary quick-fix, it is finally time to correct these problems through labor and product market reforms. These would also prevent the reoccurrence of diverging price trends in the future.

2) The HICP differential does not capture the full relative price adjustment.

As pointed out here, asset prices in Germany and elsewhere are rising strongly, and—although not directly captured in the HICP—will indirectly influence relative prices. Thus, the adjustment in relative prices may be greater than the HICP differential suggests.

3) Too much fuss for too little.

The core countries have a much greater weight in the euro area HICP than the periphery, and once their inflation nears 2 percent, the ECB would have to raise interest rates consistent with its euro area-wide inflation target. Thus, the maximum inflation differential without deflation in the periphery is about 2 percentage points, and hardly ever more. 

The second problem pointed out by the IMF blog is the balance sheet effect. For a company or household with high debt, low inflation means that the same amount of nominal debt has to be serviced and repaid from lower incomes. Yet, the relevant parameter here is the real interest rate, which is record low across advanced economies. As result, indicators to gauge the debt service burden, such as the debt service to income ratio of households, have often fallen despite low inflation. The reason why this fails to be the case in periphery countries is the broken monetary channel, i.e. the failure of ultra low policy rates to feed into low interest rates in those countries. To fix this, unconventional measures are better suited than another reduction of ECB policy rates.

Dear ogre, please no interest rate cut!