High interest rates are not “ammunition”

This caught my eye:

Unlike these past five major rate hike cycles, today’s Fed will not be moving to fight inflation or cool economic growth. Inflation is running below their target and current U.S. GDP readings are not exactly red hot. What the Fed wants (or needs) to do is raise the target rate in order to have ammunition for the next time our economy stumbles. A well-telegraphed series of small rate increases could allow the Fed to “reload” while having only a minimal to modest impact on overall economic activity. It would be another spectacular tight rope act for the Fed to pull off, but their recent track record suggests it is something possible. One certainty that exists is the fact that the Fed will do no harm to the market or the economy, especially with the next presidential election cycle beginning already.

I guess once people start reasoning from an interest rate change there’s no telling where it will lead.  Of course he has things exactly backwards; if the Fed wants more (conventional) ammunition, it needs to delay raising interest rates to speed up NGDP growth.

The mistake here is that the author assumes the ability to cut rates represents “ammunition.”  In fact, if you insist on thinking in Keynesian terms, then ammunition is represented by a higher Wicksellian equilibrium nominal interest rate, not a higher actual rate.  The farther above zero is the Wicksellian rate, the more ability the Fed has to stimulate using conventional interest rate cuts.  But here’s the problem.  If the Fed raises rates today with a tight money policy then they will be reducing NGDP growth, and hence reducing the Wicksellian equilibrium rate.  They’ll have less ammo.

Now it’s conceivable that the author was suggesting that the Fed could get more ammunition by raising interest rates via a Neo-Fisherian channel (easier money), say by raising the inflation target to 4%.  Sure, that would work, but I sort of doubt that’s what the author had in mind.  Again, a tighter monetary policy gives the Fed less ammo, not more.

PS.  Russ Roberts has a new podcast interviewing me on interest rates.

Update:  The Washington Examiner has a list of 28 “New Voices.”  I was pleased to see my name, and even more pleased to see Matthew Rognlie.  Matt always left extremely thoughtful comments, and I considered him to be one of the rising young stars even before his famous post on the Piketty data issue.  It’s great to see how the internet can give a voice to talented students like Matt (as well as Evan Soltas, Yichuan Wang, etc.)

Update#2:  Ramesh Ponnuru has a very good article on Bernanke’s discussion of NGDP targeting.


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32 Responses to “High interest rates are not “ammunition””

  1. Gravatar of Anthony McNease Anthony McNease
    20. April 2015 at 08:24

    I’ve been hearing commentators, money managers and Fed officials making just this argument for months now: we need to raise rates so that if growth slows we can lower them.

    On a related not…..What would happen if the Fed went to a negative IOR but raised the ON rate?

  2. Gravatar of Edward Edward
    20. April 2015 at 08:37

    This is so stupid.
    Fed official really are brainless.

    What is so unconventional and bad(!?) about QE?

  3. Gravatar of Edward Edward
    20. April 2015 at 08:39

    Jeff Hirsch is mostly the brainless one

  4. Gravatar of CMA CMA
    20. April 2015 at 08:47

    “it needs to delay raising interest rates to speed up NGDP growth”

    Is this reasoning from a price change?

  5. Gravatar of Doug M Doug M
    20. April 2015 at 12:41

    I remember hearing this argument decades ago. The Fed shouldn’t cut today, because things could get worse. If they don’t cut today, it gives them the freedom to cut more next quarter.

  6. Gravatar of Doug M Doug M
    20. April 2015 at 12:42

    It was BS then, it is it BS today.

  7. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    20. April 2015 at 12:47

    Scott’s interview with Russ Roberts is the best Econtalk podcast in some time;

    http://www.econtalk.org/archives/2015/04/scott_sumner_on.html

    In addition to a good lesson on interest rates, Scott makes a very good point about ‘the left’ not understanding the role regulation plays in the inequality debate. I.e., the cost of regulation is often greater income inequality.

  8. Gravatar of ThomasH ThomasH
    20. April 2015 at 15:15

    An excellent example of what Wren-Lewis calls mediamacro. And it shows that it is completely false to claim that central banks have successfully communicated their strategy of targeting inflation to guys like this, not surprising since they have not acted as if they have an inflation target. Given this failure, shifting to an NGDP target or even a higher inflation target (assuming that political constraints allowed them to actually pursue it) would have little opportunity cost.

  9. Gravatar of benjamin cole benjamin cole
    20. April 2015 at 15:23

    Kudos to Scott Sumner and the other market monetarists in garnering public recognition.

    And when will the Federal Reserve hold a conference on market monetarism? Or even one of the regional banks?

    I also wonder if the interest on excess reserves could be cut by a basis point a month.

    Remember in 1992, when inflation was 3% and real GDP growth was 4%, Milton Friedman said the Fed should do more to promote growth, that it was retarding the economy by being too tight.

    When did timidity become the defining characteristic of monetary policy?

  10. Gravatar of CMA CMA
    20. April 2015 at 16:10

    SSumner: What is the theory that shows higher interest rates lead to less credit?”

    CMA: A higher interest rate will make some entities or projects ineligible for credit or incapable of servicing credit. For example if the fed maintained rates at around 5% through the great recession the contraction in credit should of been worse.

    SSumner: That’s reasoning from a price change.

    CMA: A higher rate at any point in time due to lower demand for bonds and lower loanable funds will stimulate less credit than a lower rate.

  11. Gravatar of dtoh dtoh
    20. April 2015 at 16:27

    @CMA

    Expectations of future NGDP also affect the aggregate amount of credit.

    Think of it this way. Price of credit on the x axis, amount of credit on the y axis, and expected future NGDP on the z axis. Alternatively you can think of just x and y, with the curve shifting left or right depending on future expectations.

    This should help to visualize/understand the relationships.

  12. Gravatar of CMA CMA
    20. April 2015 at 16:49

    “Expectations of future NGDP also affect the aggregate amount of credit.”

    Yes, I know.

  13. Gravatar of TravisV TravisV
    20. April 2015 at 17:03

    I LOVE this 1992 Milton Friedman op-ed Prof. Sumner just linked to:

    http://0055d26.netsolhost.com/friedman/pdfs/wsj/WSJ.10.23.1992.pdf

  14. Gravatar of dtoh dtoh
    20. April 2015 at 18:02

    @CMA
    So rates can up and credit also go up. Or vice versa. Or one can go up and the other down.

  15. Gravatar of ssumner ssumner
    20. April 2015 at 18:12

    CMA, That’s not much of a theory. Lots of things can change interest rates. You’d be better off focusing on those things, and not the interest rates.

  16. Gravatar of CMA CMA
    20. April 2015 at 18:33

    Dtoh

    “So rates can up and credit also go up. Or vice versa. Or one can go up and the other down.”

    Yes. My point is that increasing ngdp will increase credit but, increasing ngdp via hel-e drops will increase credit less than under current rate targeting tools and QE. Hel-e’s will stimulate at higher levels of interest rates for any given level of stimulus created.

    ssumner

    “CMA, That’s not much of a theory. Lots of things can change interest rates. You’d be better off focusing on those things, and not the interest rates.”

    Well I am focused on those things. Those things being higher real gdp and hence nominal gdp, and also greater stability. Im using the interest rate differential among different tools to demonstrate how those things are affected.

  17. Gravatar of dtoh dtoh
    20. April 2015 at 19:00

    @CMA

    “My point is that increasing ngdp will increase credit but, increasing ngdp via hel-e drops will increase credit less than under current rate targeting tools and QE.”

    No.

  18. Gravatar of Major.Freedom Major.Freedom
    20. April 2015 at 20:47

    “If the Fed raises rates today with a tight money policy then they will be reducing NGDP growth, and hence reducing the Wicksellian equilibrium rate.”

    That is incorrect. The Wicksellian equilibrium rate is not determined by the rate of NGDP growth. The Wicksellian equilibrium rate is determined in part by the long term natural interest rate, which is independent of monetary policy. The long term natural interest rate is what is in the minds and manifested through the actions of individuals when deciding how much they value present goods relative to future goods.

    If the Fed System (BIS plus Fed plus member banks) raised rates today by reducing inflation in the form of credit expansion, and we assume very, very, very reasonably that the general population has a higher time preference than what is inferred by today’s extremely low nominal rates (higher time preference means more consumption relative to investment, which raises nominal profitability and interest rates), then what will happen is that nominal rates will almost certainly get closer to the long term natural rates.

  19. Gravatar of Kenneth Duda Kenneth Duda
    20. April 2015 at 22:43

    TravisV, the weird thing about the Friedman Op-Ed (in my opinion) is his urging the Fed to target the quantity of M2. Was Friedman assuming stable velocity? If velocity were stable, then M2 level-path targeting is equivalent to NGDPLT. But then, why not just target NGDP in the first place, so that your monetary regime doesn’t depend on a stable velocity assumption? Or is there something beneficial in Friedman’s mind about an economic collapse if velocity turns out to be unstable?

    It’s strange that someone as brilliant as Friedman can appear so wrong from where we’re sitting today. Maybe the instability of velocity was less clear in the 1980’s?

    (Obviously, I agree completely with Friedman’s comments about low rates != easy money, which seem obvious yet still largely unlearned.)

    -Ken

    Kenneth Duda
    Menlo Park, CA

  20. Gravatar of Blue Eyes Blue Eyes
    21. April 2015 at 00:32

    Slightly off-topic, but Scott you would *love* an idea which is becoming more widespread here in the UK, that the housing shortage here is being caused by “artificially low interest rates”.

    It is being peddled by worryingly-influential right-of-centre finance commentators in newspapers.

  21. Gravatar of bill bill
    21. April 2015 at 02:31

    I recall that one reason the Fed didn’t cut the Fed funds rate in the meeting after Lehman’s collapse was to hold onto its ammunition. I don’t recall if the Fed itself said that or just the press.

  22. Gravatar of vic vic
    21. April 2015 at 02:39

    Scott, I very much like your blog, but I was a little bit disappointed by your podcat with Russ Roberts. In particular I had the feeling that when discussing equity returns, there was a confusion between ex ante returns and realized returns. Realized equity returns have been high exactly because investors have stepped in, and have pushed valuations to a very high level, at which expected equity premium can only be low. Thus, there is no discrepancy between what we see in the bond market and what we see in the equity or housing markets. Everywhere, expected returns and term premiums (including term spread) have decreased to unprecedently low levels and despite what we can infere from demographic and technological trends, this seem puzzling to me. Therefore, I would not rule out that central banks policies have feed an asset valuation bubble there.

  23. Gravatar of Kevin Erdmann Kevin Erdmann
    21. April 2015 at 05:44

    Vic, expected returns on equities are not outside their longstanding range.

  24. Gravatar of ssumner ssumner
    21. April 2015 at 05:50

    CMA, Well then I don’t follow your argument at all.

    Ken, Friedman thought V would be more stable if M2 growth was kept stable. He worried about long and variable lags in trying to fine tune NGDP. Late in his life he moved away from money supply targeting to inflation targeting, and I think today he’d be open to NGDP targeting.

    Blue Eyes, That’s just a silly argument. If interest rates were artificially low then inflation would be soaring. But yes, I see that argument too.

    Bill, It would be interesting if someone could find a statement like that from a Fed official.

    Vic, I agree about ex ante and ex post returns, are you sure I didn’t make that distinction? I certainly should have. I was thinking that even ex ante returns are much higher than returns on T-securities.

    I’m puzzled by your comment on residential markets. Since 2006 house prices have fallen substantially, so are returns on housing all that low right now?

    I think I talked about how the high profits being earned on existing companies like Microsoft and Apple can’t necessarily be replicated by new entrants because of IP rules, or network effects.

    But perhaps I misspoke at some point, that’s easy to do in a long verbal interview.

  25. Gravatar of Edward Edward
    21. April 2015 at 09:02

    “That is incorrect. The Wicksellian equilibrium rate is not determined by the rate of NGDP growth. The Wicksellian equilibrium rate is determined in part by the long term natural interest rate, which is independent of monetary policy. The long term natural interest rate is what is in the minds and manifested through the actions of individuals when deciding how much they value present goods relative to future goods.”

    Vacuous Austrian Garbage. If the Fed raised interest rates to match the consumption/investment ratio, than the economy will shrink dramatically, not to mention hoarding and saving will increase, changing said ratio. I often heard in my sympathetic days to austrianism, (before I recovered from said illness..) “if the consumption investment ratio remains stable..”

    But it isn’t. Its never stable, its always changing, and hence its usefulness as a guide to the empty “natural rate” concept is minimal at best. At best, one’s own PERSONAL time preference as a guide to help calculate how much to save for retirement, is the limit to time preference usefulness.

  26. Gravatar of What does it mean to suggest that interest rates are “artificially low”?, Scott Sumner | EconLog | Library of Economics and Liberty What does it mean to suggest that interest rates are "artificially low"?, Scott Sumner | EconLog | Library of Economics and Liberty
    21. April 2015 at 09:03

    […] I recently received this request in a comment section: […]

  27. Gravatar of Major.Freedom Major.Freedom
    21. April 2015 at 16:08

    Edward:

    “If the Fed raised interest rates to match the consumption/investment ratio, than the economy will shrink dramatically, not to mention hoarding and saving will increase, changing said ratio.”

    Vapid monetarist childish pleasure and pain epistemological anti-intellectual gobbledygook.

    If real savings cannot sustain the lengthening and deepening of investment projects brought about because of nominal interest being put lower by way of inflation in the form of credit expansion, then that “shrinkage” you are referring to is inevitable. Persistent hostility against the healthy and corrective market forces, which drives you mad, can only make such corrections even more painful.

    If the economy is on a physically unsustainable trajectory, which is not only possible, but veritably inevitable in an economy that lacks market prices, market interest rates, and market credit, then that “shrinking” is what we should strive to overcome as soon as possible so that we can be assured that growth going forward is sustainable.

    Silly naive aggregated thinking that masks the underlying relative factors and events, is what is preventing you from postively contributing to the marketplace of ideas. Your ideas are expressedly designed to destroy markets. You actually believe in the myth of there being such a thing as a free lunch.

    “I often heard in my sympathetic days to austrianism, (before I recovered from said illness..) “if the consumption investment ratio remains stable..””

    I don’t believe you. If you actually understood economics by way of what the field is actually about, deviating from it is what would constitute a malady to be healed by way of “recovery”.

    “But it isn’t. Its never stable, its always changing, and hence its usefulness as a guide to the empty “natural rate” concept is minimal at best.”

    Don’t look now but you just alluded unintentionally to precisely why ANY stable socialist rule can only be destructive to what is fundamentally “never stable, always changing”.

    The allowance for these changes to be made, where errors are made and constantly corrected, only to have more errors and corrected once again, an a dynamic, unplanned spontaneous coordination, THAT is what Austrians refer to with the not very good phrase “stability”. By stability Austrians don’t mean constancy. They mean that whatever errors have been made, people have as maximum as possible the economic freedom to correct those errors so that any pain caused by errors is as minimized as possible.

    “At best, one’s own PERSONAL time preference as a guide to help calculate how much to save for retirement, is the limit to time preference usefulness.”

    Then why do you want YOUR “personal” preferences to be imposed on me through a coercive, non-voluntary set of institutions?

    It is always amusing reading and listening to socialists debunk their own beliefs by way of what they believe is a valid attack on free markets. Without fail, all the problems and issues and challenges you people see in the market, is not only not solved by attacking markets, but are engrained and entrenched in the very “solution” you agitprop for.

    There is one absolute truth to social coordination. Whatever the problems, whatever ails people’s lives, the minimum they need to be able to fix those problems, is for gun toting maniacs and coercive shysters to get the hell out of the way.

    You are not helping me in any way if you deny and seek to oppress my own choices for myself. You are so unbelievably arrogant. You presume to know what’s best for not only me, but millions of other people. You want me to follow and obey what you want for me, whereas I do not want you to do anything with your person or property that you don’t want to do.

    You antagonize me on this blog, and yet in our actions, it is my worldview that is considered normal and sane. What you preach, contradicts your actions. If I lose my job, or if one of family members loses their jobs, you and I would both consider it wrong for either you or me to do what you want politicians and central bankers to do as a means to stop what would otherwise be unfettered market forces from free people deeming my job obsolete or producing something too much too soon.

    There is no justification for believing that the combined sum of your income and my income must grow no matter what we produce no matter what means we use, no matter if what we are doing is not able to be coordinated as long as other people’s personal preferences are able to judge our activity and output with no coercion that would initiate violent harm and reduce their standards of living for the sake of yours or mine.

    I would rather me lose my job and my house in a free society than keeping a job for another year in a violent society. Yes, that is my “personal preference.”. But guess what? What I want does not need your involvement. You just need to refrain from initiating force against me. If you don’t want freedom, then go ahead and enslave yourself and find the oh so difficult moral courage to at least respect what other people want for themselves.

    You were never sympathetic to Austrianism. You don’t even get it.

  28. Gravatar of Major.Freedom Major.Freedom
    21. April 2015 at 16:54

    Edward:

    Also, you completely dodged the intellectual point, the theoretical argument concerning Wicksellian interest rates.

    If people hoard cash, this alone is not sufficient to conclude that the Wicksellian rate has changed. For people could reduce both their consumption and investment by the same relative degree, leaving the ratio unchanged.

    Far too often cash holding is conflated with a change in time preference.

  29. Gravatar of Edward Edward
    21. April 2015 at 17:25

    “If real savings cannot sustain the lengthening and deepening of investment projects brought about because of nominal interest being put lower by way of inflation in the form of credit expansion, then that “shrinkage” you are referring to is inevitable. Persistent hostility against the healthy and corrective market forces, which drives you mad, can only make such corrections even more painful.

    If the economy is on a physically unsustainable trajectory, which is not only possible, but veritably inevitable in an economy that lacks market prices, market interest rates, and market credit, then that “shrinking” is what we should strive to overcome as soon as possible so that we can be assured that growth going forward is sustainable.”

    Thats simply assuming the silly Rothbardian conclusion.

    “The allowance for these changes to be made, where errors are made and constantly corrected, only to have more errors and corrected once again, an a dynamic, unplanned spontaneous coordination, THAT is what Austrians refer to with the not very good phrase “stability”. By stability Austrians don’t mean constancy. They mean that whatever errors have been made, people have as maximum as possible the economic freedom to correct those errors so that any pain caused by errors is as minimized as possible.”

    Now you’re just making up definitions. Somehow “stability” means “lack of coercion” despite’ it being used in the context of “if the consumption investment ration remains stable, there is no reason why the real economy should shrink”

    “Then why do you want YOUR “personal” preferences to be imposed on me through a coercive, non-voluntary set of institutions?

    I don’t want anything of the sort. I would rather you and me not suffer under a dictatorship wrought by overly tight money that brings down the capitalist system… Some coercion is worse than others you fool… you’d know this if you had any subtlety.

    “Also, you completely dodged the intellectual point, the theoretical argument concerning Wicksellian interest rates.

    If people hoard cash, this alone is not sufficient to conclude that the Wicksellian rate has changed. For people could reduce both their consumption and investment by the same relative degree, leaving the ratio unchanged”

    Thats precisely the point. it a shortcoming of the inane and rather simplistic time preference theory.

  30. Gravatar of CMA CMA
    22. April 2015 at 00:03

    Ssumner

    “CMA, Well then I don’t follow your argument at all.”

    I think its pretty basic. All I’m saying is that emoney heli’s (hel-e’s) stimulate ngdp while stimulating credit and financialization less because they stimulate at a higher level of interest rates than current rate targeting tools or QE.

    A higher rate occurs under hel-e’s because expansions of money aren’t accompanied by bonds purchases and therefore the demand for bonds is lower and because expansions of money don’t increase loanable funds.

  31. Gravatar of Jeff Jeff
    22. April 2015 at 11:03

    Ken and Scott,

    In their discussion of the 1980 redefinition of the monetary aggregates, Anderson and Kavajecz of the St. Louis Fed say this:

    Published analyses at the time of the 1980 redefinition cited with approval the lack of trend in the velocity of the new M2 relative to the old measure, although they stopped short of proposing a less variable long-run velocity as a choice criterion.

    Choice criterion or not, it does appear that velocity of the redefined M2 was stationary up until about a decade after the redefinition. Some colleagues and I published the AER “P-star” paper exploiting that property of V2 in 1991, after which the relationship between M2 and GDP immediately fell apart. This is my favorite illustration of the First Law of Econometrics: The data are out to get you.

    At any rate, if M2 were known to be cointegrated with nominal income (as it seemed to be until the 1990’s), then targeting one is pretty much like targeting the other. So perhaps Milton Friedman wasn’t so different from today’s Market Monetarists after all.

  32. Gravatar of ssumner ssumner
    23. April 2015 at 17:31

    CMA, The difference in terms of interest rates would be small, and the effect of slightly different rates on “financialization” would be very small, it’s not clear what the optimal level of financialization is.

    Meanwhile heli-drops are highly wasteful, leading to higher burdensome taxes in the future.

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