Impotent central banks defeated by deflation

(Bloomberg View) — Central banks are deadly fearful of deflation. That’s why the Federal Reserve, the European Central Bank, the Bank of Canada, the Bank of Japan and Sweden’s Riksbank, among others, have 2 percent inflation targets.

They don’t love rising prices, but they worry about the consequences of a general decline in consumer prices, so they want a firebreak. Unfortunately, they seem powerless to meet their targets in the current economic environment.

The guardians of monetary policy are riveted by Japan, where consumer prices have declined in 48 of the last 83 quarters. This pattern of deflation long ago convinced Japanese buyers to hold off purchases in anticipation of lower prices.

But the result is excess inventories and too much productive capacity, which force prices even lower. That confirms expectations, resulting in yet more buyer restraint. The result of this deflationary spiral has been a miserable economy with an average growth in real gross domestic product of just 0.8 percent at annual rates since the beginning of 1994.

Central banks also fret that in a deflationary environment, debt burdens remain fixed in nominal terms, but the ability to service them drops along with falling nominal incomes and waning corporate cash flows. So bankruptcies leap, while borrowing, consumer spending and capital investment all weaken.

As I argued on Monday, deflation remains a clear and present danger. Worryingly, the remedies central bankers are using aren’t working. First, in reaction to the financial crisis, they knocked their short-term reference rates down to essentially zero, and bailed out their stricken banks and other financial institutions.

That may have forestalled financial collapse but it did little to stimulate borrowing, spending, capital investment and economic activity. Creditworthy borrowers already had ample liquidity and few attractive spending and investment outlets; slashing borrowing costs to record lows stimulated asset prices such as equities, with little economic benefit.

Furthermore, banks were too scared to lend. And as they resisted attempts to break them up and eliminate the too-big-to- fail problem, regulators bereaved them of profitable activities such as proprietary trading and building and selling complex derivatives.

That forced them back toward less lucrative traditional spread lending — borrowing short-term money cheaply and lending it for longer at a profit — just as the shrinking gap between short- and long-term funds made that business even less attractive. With the amount of capital banks are obliged to set aside against their trading activities also leaping, they’re now regulated to such an extent that many of them probably wish they had been broken up.