More on real yields and inflation. The world economy and global policy making is at a fascinating juncture at the moment. Policy making over the last 30 years has been characterised by inflation targeting, a policy that has been largely successful with inflation below 2% in virtually all industrialised countries. Up to 2008, that was associated with the ‘Great Moderation’, the low volatility of global growth, a source of great satisfaction to policy makers. The Great Recession of 2008/2009 shattered that satisfaction and revealed it to be more like complacency. Since then, the world economy has recovered somewhat but it has been a weak recovery and with interest rates at or close to zero around the world, monetary policy is increasingly seen as impotent. Keynesian economists has been largely correct in saying we are caught in the liquidity trap and that an increased emphasis on fiscal policy is the way out. I am not disputing the fiscal policy argument for a moment. But there is another policy response that is required and that is higher inflation, or a higher inflation target. Real yields are -2% and with an inflation target of 2%, nominal yields will be on average 0% and so we will be stuck in the liquidity trap for some time. Given that policy makers cannot influence real yields, if they wish to get out of the liquidity trap they need to raise the inflation target, say to 4% or 5%. This is what makes policy making so fascinating; policy makers are trapped by the 2% target. Because high inflation was a ‘bad thing’ in the 1980s (and it was), policy makers cannot envisage an environment in which more inflation is actually a ‘good thing’ even though the world is crying out for more inflation. Policy making needs to be flexible. What is right in one era may not be right in another. Keynes was right in the 1930s, but Keynesianism was not the right policy in the 1960s and 1970s. Milton Friedman was largely right in the 1980s and monetarism worked as a means of defeating the high inflation of those times. But again circumstances have changed and new thinking and strategies are required. So far, sadly, there is not much sign of that happening.

Real Yields The world economy is characterised by slow growth and the weakest recovery on record, There are four reasons given for this:- a) Global savings surplus b) Debt super-cycle c) Restrictive fiscal policies d) Secular stagnation All have their supporters and all are probably contributing to the problem. a) Many countries are running huge current account surpluses, a sign of excess savings, most notably China and Russia. These to some degree reflect capital outflows, certainly in the case of Russia. b) Debt levels are high and rising. Debt in itself is no bad thing as long as returns on the leveraged assets earn sufficient to pay off that debt. But following the financial crisis, corporations particularly banks and individuals found themselves with excess debt and so are saving to pay down that debt. c) There is no doubt that governments have been running tight fiscal policies because they are fearful of excessive debt to GDP ratios, at its worst in Southern Europe as a consequence of German inspired austerity rules following the Eurozone crisis in 2010. d) Finally there is secular stagnation, which basically says that the post WW2 economic boom has come to an end. The internet age may be delivering many new products and services but they are not resulting in a surge of spending. Demography too is not helping as falling birth rates post 1970 lead to an ageing population. In discussing the relative merits of each hypothesis, it would be useful to focus on one key metric, the decline in real yields. Using UK index linked government bonds as a proxy, real yields have fallen from roughly a positive 3% in the 1980s to a negative 1.5% today. With inflation at again roughly 1.5%, it is clear why we have hit the zero bound for short term interest rates and have entered the Keynesian liquidity trap. It is also clear that this has been a long run trend, and whilst the Great Recession of 2008/2009 may have exacerbated the trend, it did not cause it. This rather suggests that it is the fourth reason above, secular stagnation, that is the principal cause of our current problems. The other three reasons are probably the consequence of the secular stagnation hypothesis. For example, the rise in debt has been partly caused by the need to improve returns through increased gearing, which in the long run results in disaster as we found out in 2008. Similarly it is hard to believe that fiscal austerity has caused the fall in real yields over a 30 year period, albeit austerity since 2008 has not helped the weak recovery. As regards the savings glut, the fall in interest rates could reflect either a fall in investment demand (i.e. the demand curve shifts to the left) or a rise in savings supply (i.e. the supply curve shifts to the right). The first would reflect itself in a fall in investment and the latter in a rise in investment. The weakness in investment has only become apparent since the turn of the century so it is possible that the fall in real interest rates since the 1980s reflects in part a rise in savings certainly in the 80s and 90s and in part the secular stagnation kicking in since then. This fall in real yields has profound implication for monetary policy. Negative real yields and low inflation implies that the zero bound is permanently with us, so rendering monetary policy impotent, something that is now slowly dawning on governments. Given that governments do not have control over real yields, the only way out of the trap is to increase the inflation target, but if that sounds like a step too far, introduce a nominal GDP target of at least 5%, It is ironic that the introduction of inflation targets has been so successful that it is now an impediment to implementing the correct economics policies in today’s economic climate.