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Currently, central banks around the world are setting very low interest rates.

According to Taylor rules, which most central banks can be shown to roughly follow, this implies that they believe that the natural level of output is greater than the current level of output and/or current inflation is below its target. Looking at real GDP per capita charts (e.g., US, Eurozone, World), I could not see that we are far below the medium-run trend in real GDP. Therefore, I am wondering what current factors drive central banks to implement low interest rates?

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  • $\begingroup$ Central banks always favor cheap monetary policies. Printing free money for bankers is why they were created. $\endgroup$ – D J Sims Apr 7 '16 at 3:57
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    $\begingroup$ I agree that printing nonsense is why some stackexchange accounts are created! :-) $\endgroup$ – HRSE Apr 7 '16 at 4:01
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Most central banks' primary goal is maintaining a moderate inflation (around 2 %). In some cases, they also have a secondary and lesser mandate to care for employment numbers.

Since inflation is not taking off but persists at a low level, the central banking system has flooded the markets with money. The thought is that the money will "trickle down" from banks and institutions with easy access to money. However, the effects on the real economy have been somewhat limited.

The central banks' idea is that when capital is cheap to come by, companies will invest and thus hire more people to the workforce, who will in turn consume more. This isn't really happening, which is likely due to demographic and technological factors. After employees were released during the 2008 financial crisis, companies haven't really started to employ people again in the same magnitude. To a higher degree, production processes are now outsourced or automated. Companies who are hiring, typically are looking for people with higher education or specialised skills. Most unemployed people available to the labor market do not meet these requirements. So we have deflationary pressures in the world economy that are keeping inflation down.

If central banks really wanted to get inflation going, it would probably be more effective to just hand out money directly to the consumers' bank accounts, than having money pass through intermediaries. The exception to this is that we have seen pocket bubbles in real estate and some other asset classes. Despite interest rates being record-low, people who already have some wealth aren't really consuming much more, neither are they saving funds in their bank accounts, but have instead tried to find asset investment opportunities to increase wealth. This is creating lending and speculation bubbles in real estate and an upswing in stock and bond prices.

Some economists are also starting to question the objective of pursuing inflation and if it really should be the paramount objective of central banks, when the problems created by massive asset bubbles could become so much worse.

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  • $\begingroup$ "Some economists are also starting to question the objective of pursuing inflation" Could you give a reference to a good example? $\endgroup$ – LondonRob Apr 25 '16 at 11:40
  • $\begingroup$ @LondonRob Perhaps a better way to phrase it is that there has been an increasing skepticism against the methods that central banks have used to achieve inflation targeting in today's economic environment, most notably quantitative easing (QE) and negative interest rates. This is not necessarily a criticism against inflation targeting, but a concern over the effects artificial growth via monetary policy have on the economy. $\endgroup$ – Winterflags Apr 25 '16 at 14:40
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    $\begingroup$ Here is an example of criticism against QE (there are many others): wsj.com/articles/…. Larry Summers on the predominance of monetary policy and need for more active fiscal policies: larrysummers.com/2016/02/17/the-age-of-secular-stagnation. Interview with Mohamed El-Erian, author of "The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse": charlierose.com/videos/20401 $\endgroup$ – Winterflags Apr 25 '16 at 14:42
  • $\begingroup$ And here is some criticism against inflation targeting itself: en.wikipedia.org/wiki/Inflation_targeting#Shortcomings. Most central banks have however adhered to this goal since the 1990s, and there isn't much to suggest that it's going to change. An alternative targeting mechanism could be Nominal Income Targeting. See also Market Monetarism theory. $\endgroup$ – Winterflags Apr 25 '16 at 14:52
  • $\begingroup$ Wonderful! Good and useful references. Consider adding these to the main body of the answer. $\endgroup$ – LondonRob Apr 25 '16 at 16:09
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@winterflags above has some of the main ideas. Also:

A) Although compared with a year or two ago, the GDP per capita doesn't look low, if you compare it with the value if it had continued the trend it had before 2008, then it looks low, particularly in southern Europe. Also, they don't look so much at GDP per capita, but at the 'slack' in the economy which they measure with some measure of unemployment. Unemployment is positively enormous in Spain, Greece, Portugal, etc.

B) Inflation is very low in Japan and Europe, and economic growth is very low in both. Moreover, inflation has stayed low in Japan despite its ever-looser monetary policy, so they want to do something extreme to see if that brings about some inflation!

C) Inflation at or below 2% looked like a reasonable target before the crisis. However, now that we know that big recessions are still possible, it seems necessary to keep inflation at 2% or a bit higher. This seems a good idea because when inflation is higher, then it's easier to create large negative real rates by setting nominal rates to zero.

D) It seems also that they want to make sure that banks don't have a liquidity problem. During the financial crisis, there seemed to be times when liquidity was in high demand. Treasury bonds paid negative interest rates for a period. One way to interpret this is that the market has a high demand for safe assets and so the central banks, by buying bonds with reserves, increase the supply of very safe assets, ie. reserves. Potentially they also create a 'search for yield' phenomenon, which can create bubbles, but that's another matter.

E) The last reason is that probably because of particularly dogmatic, nearsighted politics both in the US and European Union, both economies failed to engage in strong expansionary fiscal policies. They did increase fiscal deficits, but not too much. The crisis was thus not resolved and their debt burdens increased anyway, they increased a lot through the accumulation of many not-so-large deficits! A few years later, we still have sort of a crisis, but we have very little fiscal 'margin': most large countries have a lot of debt relative to historical norms. Therefore the only policy available seems to be monetary policy, so central bankers keep pushing and pushing rates down. People call it "pushing on a string" at this point, but its still seems politically impossible, in Europe at least, to increase spending.

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