Raising interest rates with zero inflation is a hard sell

Wed Aug 5, 2015 12:53am EDT
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By Mike Dolan

LONDON (Reuters) - Americans and Britons bracing for their first interest rate rises in almost a decade are puzzled: why are rates about to go up when there's no inflation?

Both the Federal Reserve and Bank of England are proclaiming that they are on the cusp of raising interest rates for the first time in almost a decade. It may take a few months, but the message they are sending still heavily-indebted households either side of the Atlantic is clear: 'be warned'.

It's not hard to see why near-zero interest rates should be 'normalized' when you do a quick economic health check.

After years in the post-credit crisis doldrums, both economies are now growing at brisk annual clips of between 2 and 3 percent. Jobless rates are near long-term averages of less than 6 percent. Real estate and financial asset prices have raced higher over the past couple of years.

The problem is that annual consumer price inflation rates are zero in Britain and just 0.1 percent stateside, far below the 2 percent consumer price growth targets both have committed to in one form or another as a policy guide.

Even the Fed's favored inflation measure - the index of personal consumption expenditures (PCE) - is running as low as an annual 0.3 percent.

The policy mantra for much of the year has been that headline inflation was artificially depressed by the collapse of energy and raw materials prices in late 2014. Once these stabilized - as they did through the spring - then the assumption was these base effects would wash out of CPI indexes and reveal far livelier 'core', largely domestically driven, price rises pushing headline inflation back toward its target.

In other words, central banks would face down what they saw as a temporary drop in headline inflation, focus on core price developments and pull the interest rate trigger anyhow.   Continued...

U.S. one hundred dollar notes are seen in this picture illustration taken in Seoul February 7, 2011.   REUTERS/Lee Jae-Won