Scott Sumner  

Don't try to normalize interest rates

So Far... Tibor Machan RIP...

Marcus Nunes has a new post that discusses a recent Wall Street Journal article. Here's the WSJ:

The Fed needs to keep raising short-term interest rates to diminish risks to the economy and markets of "excessive accommodation," Mr. Kaplan told the Journal on Monday. However, fragile and interconnected financial markets, slow global growth, and the perils of driving the economy back into recession all mean the Fed can't move aggressively, he said.

"We want to try to normalize [interest rates] as fast as we can," Mr. Kaplan said in a Dallas office stuffed with memorabilia from his home state of Kansas and with management "how to" books he wrote at Harvard. "But we have to be patient and gradual.

I was most struck by the term "normalize". I was not aware that there was any normal level of interest rates. I've observed rates ranging from 0% to roughly 20%, and in some countries rates have recently gone negative.

Is this a harmless concept? I don't think so. If the Fed is trying to normalize interest rates as fast as they can, then interest rates have become a goal of Fed policy, in addition to employment and inflation. And that means they are willing to trade off worse outcomes of employment and inflation in order to get better outcomes for interest rates.

I also see an even great danger. In the past, the Fed's biggest errors occurred in the 1930s, in 1966-81, and in 2008. (And yes, Bernanke has now admitted the Fed should have cut rates faster in 2008.) In all three cases, interest rates were already "abnormal" and the appropriate policy was to make them even more abnormal. Now think about Kaplan's view that the Fed should want to normalize rates as fast as possible. People holding that view in the 1930s, the 1970s, or 2008 would have been likely to make the exact policy errors that led to our greatest monetary disasters.

Maybe the Fed should try to control the variables that actually lead to economic instability, and let the market determine what level of interest rates is "normal."

Another Marcus Nunes post discusses a recent post by Narayana Kocherlakota. Here's Kocherlakota:

Notice that I have not said that the Fed should provide a collective forecast for its short-term interest rate target. Policymakers' forecasts are inevitably seen as something akin to commitments. The Fed should be committed to delivering particular inflation and employment outcomes, not to a specific path for interest rates.


Comments and Sharing

COMMENTS (7 to date)
Brian Donohue writes:

If by "normalize" he means flattening the yield curve and pushing real rates farther into negative territory, I guess I understand it.

MikeDC writes:

I mean, I understand the point, but I'd think a "normal" rate of interest is one that reflected a somewhat sustainable balance between current and future consumption.

Just at a gut level, 0 and negative interest rates make me want to go watch Children of Men and be depressed.

bill writes:

Kocherlakota is great.

There is one interest rate I wish they would "normalize". Interes on reserves. 95 years at zero. 8 years in positive territory and now the Fed is raising it? That's abnormal.

smiley face.

Rajat writes:

OT, but any views on Bernanke's latest suggestion for the Fed to peg long-term interest rates

Would this strategy be an effective way to lower the two-year interest rate, and, by extension, to reduce still longer-term interest rates (which are influenced by the two-year rate) as well? A lot would depend on the credibility of the Fed’s announcement. If investors do not believe that the Fed will be successful at pushing down the two-year rate, or expect that it might abandon the program before the stated end date (due to inflation concerns, for example), they will immediately sell their securities of two years’ maturity or less to the Fed. In this case the Fed could end up owning most or all of the eligible securities, with uncertain consequences for interest rates overall. On the other hand, if the Fed’s announcement is fully credible, the prices of eligible securities might move immediately to the targeted levels, and the Fed might achieve its objective without acquiring many securities at all.

To achieve credibility, the Fed needs to ensure that any peg it sets is consistent with the likely path of its short-term policy rate. A reasonable strategy would be to combine the announcement of a peg with (consistent) forward guidance about the path of short-term rates. The two announcements would reinforce each other, with the interest-rate target helping to guide market rates toward levels consistent with the forward guidance, and the forward guidance increasing the credibility of the target.

I'm confused as to what effect this might have. If the policy is 'credible', could it be contractionary - because rates are kept low without increasing the path of the money base or the target level of nominal variables? And if it's not credible, it might lead to the Fed owning all short-term securities but have little impact on nominal variables as it would be a temporary injection.
Dustin writes:

Pegging a long-term rate sounds a lot like NGDP targeting.

Dustin writes:

Pegging a long-term rate sounds a lot like NGDP targeting.

SG writes:


I used to wonder about the Fed's interest rate obsession, but then I read the text of the Federal Reserve Act, and this is what I found:

12 U.S. Code § 225a - Maintenance of long run growth of monetary and credit aggregates

"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

For better or worse, the Fed actually has a triple mandate, and the "interest rate" prong of that mandate really doesn't make any sense, for the reasons you state in your post.

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