[Lee Jong-woo's Economic Reading] US Fed Declares 'Zero Interest Rate'... Emphasizes Need for Aggressive Fiscal Policy by Government

Price Decline More Dangerous Than Inflation Rise
Central Bank Struggles to Revive Economy by Giving Leadership to Government
Government Dreams of Economic Growth Through Gradual Inflation but Fears Bubble Collapse if Low Interest Rates Persist

The U.S. Federal Reserve (Fed) has changed its policy direction. Instead of raising interest rates to curb inflation whenever the annual inflation rate exceeds 2%, the Fed has revised its approach to avoid raising rates or reducing the money supply if inflation temporarily exceeds 2% but there is no sustained inflationary pressure.

There are two reasons behind the Fed's policy shift. First, it judges that in the current economic situation, falling prices pose a greater risk than rising prices. When inflation falls below an appropriate level, inflation expectations weaken, leading to a vicious cycle of further price declines. If this situation persists, it eventually develops into deflation. Price declines cause bigger problems than inflation. While inflation mainly affects households, deflation can weaken the entire economy. Japan is an example of this. For over a decade, prices either fell or rose only slightly, significantly reducing economic vitality. Companies had to sell goods at lower prices than ten years ago, worsening profits, and households postponed consumption anticipating further price drops. These changes negatively impacted the economy, and the Fed concluded there is no need to ignore such concerns and deliberately lower prices.

Second, the Fed believes that even if employment improves in the future, inflation will not rise. Since inflation has not increased even as the unemployment rate fell from double digits to the mid-single digits, the Fed sees no need to raise interest rates in response to inflation.

The Fed's focus on inflation as a policy target also signals that the central bank has done all it can, and that economic policy should now be pursued under government responsibility.

When inflation is high, central banks generally gain more power. This is because they have the means to control inflation through interest rate hikes. Governments cannot pursue aggressive fiscal policies because rising interest rates increase the interest burden on government bonds issued.

Conversely, when inflation is low, the government takes the lead in policy. In a low-inflation, low-interest-rate environment, even if the central bank lowers rates further, it is difficult to achieve results. Economic agents, including companies, are already accustomed to low rates, so fiscal policy must fill the gap. In this situation, the central bank chooses not to take the lead in policy implementation but to lower interest rates to reduce the government's debt burden. Reducing the debt burden enables the government to implement stronger policies, so the central bank plays a supporting role.

Currently, governments hold the reins both domestically and internationally. Previously, central banks led policy through interest rate cuts and liquidity expansion, but the situation changed after the COVID-19 pandemic. With fewer tools available, central banks have stepped back and called for greater government involvement. This shift was already evident in statements by senior central bank officials in advanced countries. Fed Chair Jerome Powell repeatedly urged active fiscal policy without worrying about rising debt. Other advanced country central banks also emphasized the necessity of fiscal policy.

Governments hope that gradual inflation will mark the end of low growth, low inflation, and low interest rates. Gradual inflation not only signals the economy returning to normal but also amplifies policy effects. The impact of interest rates on the economy is determined by the real interest rate, which excludes the inflation component from the market-formed nominal rate. Even if nominal rates remain unchanged, higher inflation lowers real rates, enhancing easing effects. Even if governments compensate for reduced household income due to illness through fiscal measures and actively promote employment growth, it is difficult to see effects unless real interest rates fall.

Contrary to expectations, downward pressure on prices is currently stronger than upward pressure. This is due to weakened demand from the economic downturn. When prices fall, the real value of debt held by governments and companies rises. To prevent this and reduce interest burdens, central banks resort to negative interest rate policies. They do not rule out extreme measures to avoid immediate risks.

Lowering interest rates below zero delays economic normalization. Negative rates reduce interest income and cause consumption to slow as people anticipate falling prices, among other side effects. Europe is currently experiencing this. Negative rates, which began in Switzerland, have spread to countries like Germany and France. Despite nearly a decade of low rates and liquidity provision creating a favorable environment, growth rates have been lower than when negative rates were not implemented.

Negative interest rates undermine financial stability and cause asset bubbles. Savers receive interest rates below inflation under negative rates. This has a particularly adverse effect in countries like Korea and Japan, where many elderly people live on savings. Since the elderly account for a significant portion of consumption, reduced income among them can sap economic vitality.

Negative rates reduce savings but increase investment in riskier assets. Since savers receive returns below inflation, they are motivated to invest in other assets for higher profits. This is the current situation. With low interest rates persisting for over ten years, expectations for interest income have declined, and investments in real estate and stocks have increased.

The problem arises after this capital movement ends. If the economy cannot support rising asset prices, a bubble burst may occur. A bubble is when prices rise solely due to money flow without economic fundamentals backing them, and historically, such price levels have never been sustained.

Central banks in advanced countries, including the Fed, are aware that low interest rates can harm financial stability and cause asset price bubbles, but they cannot abandon low-rate policies. Raising rates to ensure financial stability risks worsening the economy further. Therefore, both governments and central banks only use passive measures like regulations or taxes to control asset prices instead of reducing liquidity or raising rates. The longer low-rate policies continue, the more financial stability deteriorates and the greater the risk of impairing efficient private investment. Advanced country governments have employed all possible growth policies to exit this phase as quickly as possible but have yet to see results.

This content was produced with the assistance of AI translation services.