There is a state of imbalance in the current climate, and it cannot continue. At some point, keeping the economy afloat by allowing debts to soar (even) higher, meaning that negative interest rates are required to ensure borrowing continues, will not be possible. Here, we take a close look at the sheer complexity and, at times, idiocy of the present situation and why inflation is the preferred solution.

The Federal Reserve (Fed) assumes that the neutral level of real interest rates is approximately 0%. This refers to real interest rates (so the difference between nominal interest rates and inflation) with an economy running at full capacity, which neither decelerate growth nor stimulate it. Assuming this is actually 0%, this means that if the US economy needs to be stimulated, real interest rates will have to go back to negative levels again.

The reality

This is an important point because historically, the US economy has long been due another recession. Following the credit crunch, there has been an abnormally long period without a recession. Normally speaking, real interest rates are lowered by approximately four percentage points to come out of the recession.

With the current inflation, and assuming it declines in a recession, this would therefore mean that nominal interest rates will have to be lowered to approximately minus 4%. At a practical level, this is probably not possible. Fortunately, it is the case that the Fed has other instruments at its disposal as well – for example quantitative easing and forward guidance – but they have proven to be not too effective in recent years.

This problem will therefore only disappear if there is a degree of inflation again, at least 2%, but preferably more. Nominal interest rates may be lowered to 0% or slightly below this level in that case. This is feasible in practical terms at least. So what Yellen meant to say is that the US cannot afford to take any risk with regard to inflation. It is not allowed to decline, but should actually increase. This is also why the Fed must not initiate a rate hike too soon.

A global view

We would immediately like to view this in a broader perspective. The global economy is being plagued by excessive indebtedness, which is increasingly pushing down economic growth, as a result of which supply is offset by too little demand. In turn, this means the economy has a tendency towards deflation. However, the combination of deflation and excessive indebtedness is disastrous for an economy.

Indeed, in the event of deflation nominal income declines, while interest and repayment obligations usually remain more or less the same. This means that less will remain for expenditure, causing deflationary forces to increase and so on. Deflation will therefore need to be avoided at all costs.

However, this will only be possible by boosting demand, but this will require even more debts. However, if indebtedness is already very extensive, more will only be borrowed if interest rates for this are very attractive. In other words: in the event of excessively negative real interest rates.

This brings us to the idiocy of the present time. In practice this means that in many countries, negative interest rates will need to be used. Under the current circumstances, this is the only way to push down real interest rates to a level that is low enough to keep credit provision at constant levels. However, it is actually sheer nonsense that if someone wants to borrow money, additional money is received for this. There is no logic that can justify this.

However, this is actually indicative of the extent to which our system is in imbalance. It may therefore be predicted with 100% certainty that this cannot be sustained.

Indeed, what is actually at issue in practice is that the economy can only be kept afloat by allowing debts to soar even higher. This, in turn, means that increasingly negative interest rates will be required to ensure that borrowing continues. At some point, this will no longer be possible.

A way out of imbalance?

There is only one way out of this situation, namely higher inflation. Not only can old debts be repaid in this case with money that has decreased in value, but it will also be practically possible to significantly lower real interest rates (should this be required). In addition, the greater the indebtedness, the more real interest rates will need to be reduced in order to prevent a collapse in the event of a recession.

This means that, even if quantitative easing and forward guidance are used, an inflation level of approximately 3% at least will be required to accumulate a sufficient buffer. This may even have to be higher because inflation will actually come down again significantly in the event of a recession.

Taking the above into account, it subsequently raises the question of how the various central banks will act in the coming period. We believe they will proceed as follows. If we look at the Fed first, then it has little to fear as far as the US economy is concerned. Against this background, we anticipate the Fed will prefer to postpone a further rate hike until there is a distinct onset of wage increases. However, this also entails a significant risk if this causes inflation expectations to rise too rapidly.

What also plays a part is that we anticipate many of the factors that are currently slowing down the economy and pushing down inflation will gradually diminish in force. Real interest rates will then need to be raised significantly to keep inflation expectations in check again. Share prices will then decline in no time and credit spreads and the dollar exchange rate will then increase so much that this actually provokes a recession. The challenge for the Fed is therefore to let inflation (expectations) rise slowly by increasing interest rates at a very measured pace.

European perspective

In contrast to the US, shortages on the labour market in Europe have not yet reached levels at which there can be an onset of wage increases. As long as this does not happen, it will be almost impossible to boost inflation. The major drawback in Europe is also that its credit provision is impeded too much by the fact the banks usually have too little capital at their disposal. This means they cannot supply many additional loans, even though the central bank creates all manner of conditions that make this attractive for them with a view to profit.

The fact remains that European growth prospects are slowly improving. This year, a growth of approximately 1.5% is forecast and next year a growth of approximately 1.7%. Given the very low productivity increase, this will be just about enough to allow unemployment to slowly decrease further. However, it may easily take two years before this will actually lead to additional wage increases and more upward pressure on inflation.

Looking ahead

The conclusion is that the European Central Bank (ECB) is likely to continue to stimulate the economy monetarily as far as possible for a long period of time, in order to push down unemployment and drive up inflation. However, all this may well yield results at too slow a pace, as a result of which fiscal stimulus will ultimately be resorted to after all.

What also plays a part is that we anticipate many of the factors that are currently slowing down the economy and pushing down inflation will gradually diminish in force.

Germany will be strongly opposed to this, so that we also foresee a very difficult period for the Economic and Monetary Union (EMU) by 2017, certainly if the refugee crisis persists. This means that Europe will then remain very vulnerable to economic setbacks and/or will have to create inflation in a forced manner, by having rising public deficits directly funded by the central bank.

In other words, we think the two biggest central banks will continue to do everything to push up inflation. Although this causes downward pressure on long-term interest rates in the short term, at the end central banks will likely succeed and that means much higher long-term interest rates in the coming years than many analysts now think is possible.