US monetary policy functionally changed after the 2008 economic crisis. Traditional fractional reserve banking was replaced with the Fed collecting huge amounts of deposits from financial institutions due to multiple rounds of QE programs.
Fighting deflation became the overarching objective of the central banks in the name of financial system stability – for a more “pedestrian” example, take a look at Canada’s financial institutions if asset collateral were to drop (deflate – I understand this is not the usage of the word in the ‘traditional’ sense of the term, and I am more concerned with asset prices rather than consumer prices in this post by using the phrase “deflation”) by a 20% magnitude. The cascade of defaults that would occur would trigger waves of selling and it would be the proverbial landslide that conquers everything underneath.
You can take a look at a chart of Goeasy (TSX: GSY) for the scenario that central banks have been trying to avoid with the whole financial system. If you want a more extreme example, what happened with Bear Stearns and Lehman Brothers gave enough of a heart attack for central bankers that they never wanted it to ever get to that point again.
Now we live in the altered reality world where central bankers need to promote that asset price stability but their traditional tool, the short-term interest rate, loses its effectiveness the closer it gets to zero.
Keep in mind that the real rate of interest is the nominal rate minus inflation.
Your goal is to lower interest rates. Keeping bullets in your monetary policy firearm is keeping the market on notice – if you fire your bullets and drive rates to 100bps, the market knows that you’re waving around an unloaded gun. You need to keep the reserve, especially if a “true” crisis happens.
So your other policy tool is to give everybody the impression that there is inflation. By increasing the perception of inflation, you are decreasing the effective rate of interest in everybody’s heads.
Was this one reason that the middle east is erupting in conflict all of a sudden?