Scott Sumner  

What do people believe about interest rates?

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In this post I'll try to describe what various groups seem to believe about interest rates. Undoubtedly I'll get some of the nuances wrong, and I'll try to do updates as people correct this initial post:

Traditional Keynesians:

1. Low real interest rates are easy money and high real interest rates are tight money. Because inflation expectations have been low and stable in recent decades, for all intents and purposes nominal interest rates are now a pretty good indicator of the stance of monetary policy.

New Keynesians (and Austrians?)

2. Easy money occurs when the Fed sets short-term rates (fed funds rate) below the natural rate, and tight money occurs when interest rate targets are set above the natural rate. Because the natural rate is usually fairly slow to change, a major period of declining interest rates usually represents an easing of money policy, and substantially rising interest rates usually represent tighter monetary policy.

Market monetarists

3. Interest rates are not a reliable indicator of the stance of monetary policy. On any given day, an unexpected reduction in the fed funds target is usually an easing of policy. However, an extended period of time when interest rates are declining usually represents a tightening of monetary policy. That's because during periods when interest rates are falling, the natural rate of interest is usually falling even faster (due to slowing NGDP growth), and vice versa.

NeoFisherians

4. A permanent decline in nominal interest rates is usually a tight money policy, and permanently higher interest rates usually constitutes easier money.

In my view, the first two claims are partly false, the third is true, and the fourth is true but does not have the implications that NeoFisherians seem to assume it has, due to reasons explained in point #3 (unexpected rate cuts are usually inflationary.)

Thoughts? How would you characterize the different views on interest rates?


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CATEGORIES: Macroeconomics , Money




COMMENTS (19 to date)
Daniel Kahn writes:

One of the most important contributions of market monetarism is the belief that interest rates are not a very good lens through which to view monetary policy as a whole and are mostly an epiphenomenon rather than THE thing. Almost everyone else, including some very knowledgeable people, seems to think that central bank interest rate policy is synonymous with monetary policy. This contributes to the lack of imagination about other potential policy regimes and the mistaken belief that monetary policy cannot be effective under certain circumstances.

robc writes:

What group is "If the Fed didn't set an interest rate, the only rates would be the natural interest rates and we wouldn't have to worry about easy or tight money, as the natural rate would always be the rate"?

That's the one I am in.

robc writes:

I am also in the "If no one is targeting, we don't have to worry about what metric to target" group.

James Pass writes:

No competent economist would offer such simplistic explanations for interest rates. Mr. Sumner says that he'll get some of the nuances wrong, but that's just the problem: There are not any details, let alone nuances.

Yes, it's true that interest rates are not a reliable indicator of monetary policy, but even a Keynesian economist would agree with that.

I don't mean to sound dismissive. Maybe Mr. Sumner just wants to start a conversation and that's fine.

James Pass writes:

Robc, before the Fed existed and the US had "natural interest rates," there were numerous instances of "tight money" (money or financing that is available only at high rates of interest).

I'm not sure what you mean by saying "we wouldn't have to worry about tight money." I'm not trying to defend the Fed, but tight money can happen even without a Fed and people naturally worry about it when it does happen.

Matthew Waters writes:

Even before the Fed existed, there was monetary policy done by Treasury notes and Greenbacks. National banks could issue Treasury-backed notes if they bought Treasury and state bonds. Greenbacks were pure fiat currency from 1861-1877.

I suppose true and pure monetary policy would mean the government only accepts and issues gold or silver specie. Even then, the Romans debased the silver content of the denarius.

Right Wing House Music writes:

I'm trying to create a mental model of how this all works, but it would help tremendously if someone could give me a solid, tangible definition of the "natural interest rate".

Until then, I'm inclined to agree with the traditional Keynesians. A low cost for borrowing money should lead to more money being lent. I see no reason to believe otherwise.

Jon Murphy writes:

I tend to lean market monetarist, although I am sympathetic to the White-Stigler-Garrison description as well. But, frankly, monetary economics makes my head spin and I usually leave the discussion to people far smarter than I.

Scott Sumner writes:

Daniel, Good point.

robc, The "natural rate of interest" doesn't mean what you seem to think it means. It has nothing to do with "natural" in the sense of unregulated, it means the rate of interest consistent with macroeconomic stability. Just because there's no Fed doesn't mean we are at the natural rate of interest.

Right wing, You said:

"A low cost for borrowing money should lead to more money being lent."

Do you also believe that a low price of oil should lead to more oil being consumed? Because it doesn't. You need to avoid reasoning from a price change.

Robert Schadler writes:

Not sure I understand this: "NeoFisherians
4. A permanent decline in nominal interest rates is usually a tight money policy, and permanently higher interest rates usually constitutes easier money."
How can a PERMANENT decline be a policy? Anything that is a "policy" is something that can be changed.

Robert Schadler writes:

Not sure I understand this: "NeoFisherians
4. A permanent decline in nominal interest rates is usually a tight money policy, and permanently higher interest rates usually constitutes easier money."
How can a PERMANENT decline be a policy? Anything that is a "policy" is something that can be changed.

James Pass writes:

Mr. Sumner, in your response to Right Wing you wrote "Do you also believe that a low price of oil should lead to more oil being consumed? Because it doesn't."

Let's say the price of oil fell by half and this price reduction was stable. This would lead to significantly lower prices for gasoline and heating oil, among other things, which would lead to more consumption of oil.

I'm also perplexed about what you meant by "You need to avoid reasoning from a price change." Of course, price changes aren't the only factor that can affect consumption, but certainly it can be a significant factor.

As for the point Right Wing made, that lower costs for borrowing money should lead to more money being lent, I don't see the problem with that reasoning. Can you explain why this isn't generally the case?

James Pass writes:

Jon Murphy wrote: "But, frankly, monetary economics makes my head spin and I usually leave the discussion to people far smarter than I."

More knowledgeable, but not smarter. I suppose it's time I look for a decent book that explains monetary economics so I can get a clue about whether US monetary policy is doing more harm than good.

Regarding interest rates, start with yourself: Under what circumstances would you be willing to lend money? Here's something to consider: When you put money into bank accounts, 401K's and financial investments, you're a lender.

Mark Bahner writes:
Let's say the price of oil fell by half and this price reduction was stable. This would lead to significantly lower prices for gasoline and heating oil, among other things, which would lead to more consumption of oil.

There haven't been any "stable" doublings or halvings of oil price, but based on this figure, there doesn't seem to be much relationship between world demand for oil and price:

World oil demand versus price from 2000 to 2015

Jonathan writes:

When you say that #4 is -

true but does not have the implications that NeoFisherians seem to assume it has

Are the implications the expansion of the market, like you might expect in real estate for instance: when home prices rise you should get greater inventory in the sales market. Likewise, do you presume that higher interest rates would free up more money, or make money more accessible and that this is the easing in the form of greater access to capital?

Emerich writes:

James Pass, If the price of crude oil falls 50%, it could be because the world, or at least a major economy, has fallen into recession, and the price decline is the result of a fall in demand. In such a case, the price decline would consistent with a fall in demand for crude oil and crude oil products. You can't "reason from a price change" because the price change by itself is insufficient to draw conclusions about demand.

Matthew Waters writes:

In my own view, there is a big difference between explaining:

1. "Interest rates" in general, as in nominal interest rates.

2. Real interest rates.

In regards to nominal interest rates, then the #3 option gives the best explanation. Most nominal interest rate volatility has been explained by monetary policy and inflation (Fisher effect).

I honestly don't understand #4. How could a permanently higher or lower interest rate level be in the central bank's control? If such a permanent movement happens under inflation/NGDP targeting, it's the market that made it happen.

Real interest rates are the only interesting question to me. Historically, real rates have varied maybe +/- 3% since WWII while nominal rates have varied +/- 10+%. So the underlying inflation is the big deal with nominal rates.

But you invest money to spend that money in the future, right? So real rates are interesting to me. This is the best summary I've found of the long-term decline in real rates from a Bank of England study.

To add some more detail, the study suggests that of the 300-bp contribution of the global savings glut to lower real rates, a bit more than half (160 bps) is due to higher desired saving: demography accounts for 90 bps, inequality for 45 bps and EM current account surpluses for 25 bps. A little less than half (140 bps) is due to a decline in investment demand, with a lower relative price for capital goods contributing 50 bps, lower public investment contributing 20 bps, and a wider spread between the risk-free rate and the rate of return on capital contributing 70 bps. As the authors note, these estimates are highly uncertain. Yet they manage to explain the bulk of the decline in real long-term interest rates using evidence independent of the decline itself. And, taken at face value, the results support the thesis that a global savings glut has been the dominating factor behind the decline in the real equilibrium long-term interest rate.

https://www.pimco.com/en-us/insights/economic-and-market-commentary/macro-perspectives/no-end-to-the-savings-glut

The estimates are really rough. Interestingly, central banks may have indirectly caused 70 bps in decline of risk-free real rates. The pre-2008 market didn't price in a 1929-esque worldwide drop in NGDP. After 2008, the market has a higher spread between risk-free and risky investments. This is not a drop in interest rates overall. It did depress the risk-free rates which most people consider "the" interest rates, such as Treasury rates.

Scott Sumner writes:

James, You said:

"Let's say the price of oil fell by half and this price reduction was stable. This would lead to significantly lower prices for gasoline and heating oil, among other things, which would lead to more consumption of oil."

That's not true. It entirely depends on whether the reduction in oil prices was caused by more supply or less demand.

robc writes:

Scott,

This may be another case of terms not meaning what they should, but macroeconomic stability seems like one of those things that only exists in dystopian science fiction.

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