Geldcast: what’s the outlook for inflation rates?

Let’s talk about rates: Columbia University’s Stephanie Schmitt-Grohé and Fabio Canetg. Live Fabrik GmbH

Stephanie Schmitt-Grohé, one of the best-known inflation researchers in the world, talks about rates in the US, Europe and Switzerland, and the limits to central bank stimulus measures.

The German economist, who teaches at New York’s Columbia University, moved to the US early in her career and has been researching inflation for over three decades. SWI swissinfo.ch met her at the Swiss National Bank’s Study Centre to talk about her influential work. 

2008 – the start of a vicious circle

On paper, the task of the central banks is simple: if they expect inflation to be too high, they raise interest rates. This makes credit more expensive and dries up company order books. These companies – for example in the construction sector – can then no longer raise prices and inflation falls. 

When inflation is too low, central banks do the opposite – they lower interest rates. This makes saving less attractive and people spend more money. When companies notice this taking place, they raise prices more sharply again.

However, a paper by Schmitt-Grohé shows that there is a limit to such stimulus measures. Once interest rates are close to zero, central banks run out of options. Interest rates cannot go too low – would you accept negative interest on your bank account? Hardly. People could withdraw their money and put it under the mattress to avoid being charged negative interest. 

If the so-called lower bound on interest rates prevents the central bank from continuing with stimulus measures, inflation often falls below the target value. And that in turn forces a downward adjustment of inflation expectations. A vicious circle ensues that ends in an equilibrium of very low interest rates and inflation that is too low – just as Switzerland and the eurozone experienced between 2008 and 2021. 

Low-rate land Japan

Switzerland and the eurozone have returned to higher interest rates. In Japan, on the other hand, interest rates have never been higher than 0.5% since 1996. Japanese inflation has averaged just 0.2%, missing the 2% target. Economists have long been preoccupied with the question of how Japan can increase inflation. 

Schmitt-Grohé has a simple answer, at least in theory: the Japanese central bank needs to lift interest rates over a longer period, prompting inflation to move closer in line with the targets. This is because interest compensates for inflation – and this compensation cannot be higher than inflation for too many years. However, it is a highly controversial approach and it is unknown whether it would work in practice. 

Is high inflation here to stay?

Outside Japan, prices have recently been rising far too much. The US saw inflation rates of up to 9.1%, in the eurozone by 10.6%, while in Switzerland price rises peaked at 3.5% last year. More recently, inflation has fallen and the problem has receded into the background. So what happens next? 

In her latest paper, Schmitt-Grohé attempts to answer this question. In contrast to most other researchers, she uses data from before the end of the Second World War. After 1945, there was only one major sustained rise in inflation – in the 1970s. Schmitt-Grohé looks back further to the year 1900. The advantage of this approach is that the additional data captures short-lived surges in prices between 1900 and 1945.

And thanks to this additional data, Schmitt-Grohé can better assess whether the current inflation will persist or be more short-lived.  

The full interview (in German) with Stephanie Schmitt-Grohé is available on Spotify:

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