Scott Sumner  

Tight money leads to lower interest rates

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Tyler Cowen has a new blog post that has 13 observations on the Fed's upcoming policy decisions. Most are reasonable, especially the first comment. But I strongly disagree with point 6:

6. Now the risks look fairly symmetric. The first reason is that zero short rates for so long might be encouraging excess risk-taking in the financial sector. This can be the "reach for yield" argument, which in spite of its lack of replicable econometric support commands a lot of loyalty from serious observers within the financial sector itself.

One of my great frustrations as a blogger is that I don't seem to be able to get people (even people often sympathetic to my arguments) to see that this assumption is wrong. Tight money leads to lower NGDP growth and lower interest rates over the sort of time period that matters for the issues that people care about. Tight money lowers the Wicksellian equilibrium interest rate. I don't think that's even controversial. And since actual monetary policy tends to adhere pretty closely to that rate, interest rates will be lower over the next 5, 10, 50, and 100 years with tighter money than with easier money. Only in the next year or maybe two would rates be higher.

The ECB thought otherwise, raised their target rate several times in 2011, and now Europe will probably have lower rates than America for many, many years out into the future.

Tyler mentions respectable arguments for raising rates in the near future, such as the tightening labor market. Reasonable people can disagree on whether it's wise. But it seems to me that it's not even debatable that if you are worried that low rates might lead to sloppy financial market decisions, misallocation of resources, etc., then you should be demanding easier money.

If the Fed wants 2% inflation over the next decade they shouldn't raise rates this year. If they want 1.5% inflation, they should raise rates. Which inflation rate is likely to lead to higher interest rates over the next decade or two?

Notice I haven't even addressed the issue of whether the Fed should care about interest rates (I don't think they should.) But again, if they should care about them, then they need to understand that Milton Friedman was right; tight money leads to very low interest rates. It did in the US in the 1930s, in Japan in the 1990s, and in the US after 2008.


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COMMENTS (5 to date)
LK Beland writes:

Lars Svensson has a very good presentation to that effect. He estimates the benefit/cost of a 1 pp rate increase (in Sweden) at 1/350. I wonder what kind of numbers the Fed gets from its own models.

http://larseosvensson.se/files/papers/svensson-cost-benefit-analysis-of-leaning-against-the-wind.pdf

Brian Donohue writes:

Yeah, on that reach for yield thing. Credit spreads have widened a good 0.2% this year on high quality debt, and more on junk. And it's not like these spreads were historically low going into 2015 either.

If anything, 2015 has been a mini-version of the "flight to quality" that was much more dramatic in the "risk on/risk off" days of a few years back.

Philip George writes:

The two graphs on the following page might just make you change your mind somewhat, but I am not sure. It shows real interest rates rising in the recent past at the same time that there has been monetary tightening, and similar movements in previous time periods.

Real interest rates paint a gloomy picture

Scott Sumner writes:

LK, Thanks for the link.

Brian, Good point.

Philip, There's no doubt that tight money can raise real interest rates, and I agree that late 2008 was an example. But this then drove us into recession which caused real interest rates to fall. The same was true in the eurozone after 2008, and again after 2011.

James Oswald writes:

"Notice I haven't even addressed the issue of whether the Fed should care about interest rates (I don't think they should.)"

Do you know why the Fed does target an interest rate? I know it shows up in neo-Keynesian models, but how did that get started? Why would the other side of the argument say that they needed the intermediate interest rate target, instead of targeting inflation or NGDP directly?

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