Karl Smith recently commented on my post about Hume and Woodford. I had argued that during “normal times” (when rates are positive) the future path of the base is a much better indicator of the future path of NGDP than is the future path of interest rates. (I should have added that exactly the reverse is true at the zero bound.) Karl responded:
Are you simply saying that we can’t solve for the interest rate path and therefore it is difficult to set up an effective communications strategy?
I think that’s true though we have to be aware the problem works both ways. The actual economy consists of millions of different economic agents all of whom face an interest rate that is based off of the Funds rate or the Interest on Reserves rate. However, each of their relationships to NGDP is less clear.
To know what this policy means they – or more realistically their banker – has to solve backwards.
For example, suppose I am expanding a hot new burrito chain in East Texas. Does a 30% higher NGDP for the US in 2017 mean I – and my banker – want to expand faster or slower?
Its not clear. The overall growth path of NGDP for the US is only loosely connected the actual revenue that I am going to receive. A booming national NGDP might mean I grow at 14% nominal rate rather than a 11% nominal rate. Though it could go the other way if my customers get lured away to work in West Texas.
However, the interest rate over this period is going to determine whether dumping a bunch of money into new restaurants is a good idea or not. Is that going to be higher or lower because of your target. Again, its not clear.
So, its not clear what I should do.
On the other hand if you said – interest rates will be zero through at least 2014, then it is at least certain that no one is getting any surprises over the construction loan period and that more than likely some decent loan is going to be available when my stores are done.
I have two problems with this. Any macro signaling will seem to have a trivial effect if discussed at the micro level. Let’s suppose the Fed did something now that caused the representative firm to boost output by 2% more than on the old Fed policy. That’s a really big deal for the macroeconomy, but small potatoes for the representative firm within the economy (as 2% more business on average is swamped by local real shocks.)
But my bigger problem is Karl’s claim that interest rates are of more interest to the average business owner than the monetary base. Suppose Karl and I both looked into a crystal ball and saw that the fed funds rate would be 12% in 2014. From Karl’s post, I infer that he’d advise that small businessman to hold off on the investment project, as the cost of that floating rate business loan would soar in 2014. I’d have the opposite reaction. I’d beg, borrow, and steal every penny I could get my hands on, and pour all the money into REITs. That’s because the 12% rate in the crystal ball would tell me I am wrong and Bob Murphy is right—that the inflated monetary base is going to drive inflation and NGDP dramatically higher in 2014, forcing the Fed to raise rates sharply in order to hold inflation down. I see that as incredibly bullish for real estate.
To summarize, not only is the interest rate path not a good indicator of whether you want to invest more or not, it’s not even clear whether low rates are a good sign or a bad sign. It’s hard to think of any other indicator that’s worse. Most asset values at least have a monotonic relationship with NGDP growth, but not short term nominal interest rates.
BTW, there is an interesting discussion of exactly what the Fed’s low rates until 2014 promise (or prediction?) really means. Romer and Romer have a good PP slide that correctly explains the flaw in the Fed’s policy. But the art of signaling in a messy real world with a divided FOMC is about as subtle and complex issue as exists in all of macroeconomics. So after reading Romer and Romer I’d recommend Ryan Avent, who I think strikes exactly the right balance. The Romer’s are right that the policy is not what it might seem to be, or even close to what it should be, but as Ryan points out it’s probably something.
PS. Ryan is also the only one who seems to understand what that “silly” OECD graph really means. BTW, people who take medication tend to be sicker than those who don’t.