The International Monetary Fund has urged the European Central Bank to consider cutting interest rates to below zero as it warned that deflation in the eurozone was a key new risk facing the world economy.
Since central banks cannot cut nominal interest rates below zero, deflation raises real interest rates, slowing the economy further and raising the real value of debts.
Furthermore, because central banks cannot force interest rates below zero, deflation means that real interest rates must always be positive.With its ageing population and sluggish growth, the euro zone bears a worrying resemblance to Japan.
It cannot cut interest rates below zero.
That move would free the Fed to cut interest rates below zero.
In a surprise move, Japan on Friday cut interest rates below zero, aiming to weaken its currency and stimulate growth.
First, real (inflation-adjusted) interest rates rise, and the central bank becomes powerless to prevent this, because it cannot reduce the level of nominal interest rates below zero.
And, since it is impossible to cut interest rates below zero, there is a limit to what policymakers can do to ease the pain.
The bank has tried a number of tactics to lift prices, including a reduction of interest rates below zero and buying large quantities of government bonds.
After Tuesday, the Fed will have to resort to mostly untested tools for promoting growth, because it cannot reduce its benchmark interest rate below zero.
In a deflationary situation, he said, a central bank has somewhat more difficulty in responding because it is impossible to reduce interest rates below zero.
