Interest rates are still a lousy indicator of monetary policy

Paul Krugman recently criticized this view:

One of the odd things about the people arguing that we must raise interest rates to head off bubbles “” Raghuram Rajan, Martin Feldstein, the BIS, and so on “” is the near-universal assertion among this group that just a little rate increase can’t do any real harm. (Just a thin little mint). After all, rates are so low!

He’s right that even a small rise in short term rates can do a lot of harm, but I’d add that another problem with the conservative argument is that they don’t seem to realize that interest rates are a lousy indicator of the stance of monetary policy. When I studied economics that was a point that conservatives emphasized.

Even small increases in interest rates in the US (1937), Japan (2000 and 2006), and Europe (2011) drove each economy right back into deflation and/or depression.

Monetary policy has probably become easier over the past few months. I say ‘probably’ because we lack a NGDP futures market. But consider that stock prices have not changed much in the last few months, and the interest rate at which future cash flows are discounted has risen substantially. We can infer that expected future nominal cash flows are now larger than a few months ago. This doesn’t mean that expected future NGDP has risen, but that seems likely. Note that earlier when I discussed the response of the stock market to recent tapering news I forgot to account for the higher discount factor. I’m indebted to a commenter whose name I forget for pointing that out.

I’m still puzzled by the response of long term rates to the tapering talk. But if long rates always moved the same way in response to monetary news, then interest rates would no longer be a lousy indicator of monetary policy.

PS. Commenter Andrew pointed out that Bernanke recently endorsed targeting the forecast. That’s great news.



37 Responses to “Interest rates are still a lousy indicator of monetary policy”

  1. Gravatar of J J
    11. July 2013 at 05:37

    I certainly agree that the Fed should expand further, which will probably end up raising rates. But, I believe there is something to the argument that low rates are significant, regardless of whether money is actually loose. Just as money illusion exists, there can be a somewhat fixed expected nominal return from financial institutions. If I can’t get the 3% return that top investors expect, then isn’t it plausible that I’m more likely to turn to the “the government will bail me out if I lose a lot of money so I should take on investments with large tails” decision?

    That aside, I completely disagree with the argument made by many that low interest rates are indicative of loose money.

  2. Gravatar of Bob Bob
    11. July 2013 at 06:03

    How hard would it be to create a NGDP futures market? I know that ideally the FED would do it, but what if some rich guy decided he wanted to do it? How hard would it be and what would it cost?

  3. Gravatar of TallDave TallDave
    11. July 2013 at 06:21

    More vindication today?

    I’m starting to wonder if central banks like being in ZLB. Being the primary limiting factor on growth certainly gives them more power to move markets.

  4. Gravatar of 123 123
    11. July 2013 at 06:29

    Then why did the corporate bonds crash?

  5. Gravatar of AldreyM AldreyM
    11. July 2013 at 08:12

    Weekly Initial Jobless Claims rise by 16K in the latest week to 360K, above the 345K expected. But the tendency doesn’t look that bad:

  6. Gravatar of Andy Harless Andy Harless
    11. July 2013 at 08:18

    Am I the commenter whose name you forgot? The cash flow discounting issue came up in discussing my theory of the response to tapering talk (discussed in my blog post, for which I herewith make another shameless plug).

  7. Gravatar of Josh Josh
    11. July 2013 at 08:55

    I’m thinking that a combo of “higher discount rate/higher stock prices” would also signal higher nominal growth expectations, right? So does the fact that we have the former, without the latter, mean the markets expect the NGDP growth to tilt more toward inflation?

  8. Gravatar of o. nate o. nate
    11. July 2013 at 10:20

    Josh – I don’t think you can infer anything about expected inflation by comparing stock prices vs nominal rates. But if you look at the 10yr TIPS/Treasury breakevens, expected inflation has actually declined over the past couple of months.

  9. Gravatar of flow5 flow5
    11. July 2013 at 10:26

    The Fed engages in the mis-allocation & mal-distribution of stimulus. That stocks & gDp have diverged isn’t a surprise.

    In 1931, reserve bank credit (discounts & advances) consisted of (1) re-discounting previously discounted paper by the borrowing banks (endorsing its customer’s paper), & by (2) direct advances through the purchase of the banks’ own promises to pay (secured by the banks’ own collateral). Then in 1932 the Glass-Steagall Act made gov’t securities eligible paper.

    Our Central Bank/FRB-NY (coordinating purchases & sales for the 12 District banks c. 1933) “accepts a broad range of assets as discount window collateral”:

    See: Federal Reserve Collateral Guidelines

    The Fed’s unofficial mandate [supporting the depth & liquidity of the government securities market], is paramount to its regulatory directive [providing liquidity to the individual CBs]. A Central bank directly controls the availability, & indirectly, the cost of credit (& yield curve differentials), but doesn’t have the authority to legislate the allocation & distribution of credit (giving the primary dealer’s a high paying, high profile job).

    Force feeding can only be managed through Congressional approval (e.g., Obama stimulus checks). The economic impact of the Fed’s purchases depends upon where the money is spent & how it is invested. Compared to real investment, the current emphasis on financial investment (wealth effect), is rather inconsequential as a contributor to employment & production. Only debt growing out of real investment or consumption makes an actual direct demand for labor & materials.

    See FRB of Richmond President Jeffrey Lacker: noted that the purchase of MBS represented an inappropriate effort on the part of the Fed to channel “the flow of credit to particular economic sectors.”

    “Deliberately tilting the flow of credit to one particular economic sector is an inappropriate role for the Federal Reserve. As stated in the Joint Statement of the Department of Treasury and the Federal Reserve on March 23, 2009, ‘Government decisions to influence the allocation of credit are the province of the fiscal authorities.'”

    See also Charles I. Plosser, President & Chief Executive Officer, FRB of Philadelphia: Plosser said the same thing:

    “Finally, I also opposed September’s decision to purchase additional mortgage-backed securities. In general, central banks should refrain from preferential support for one sector or industry over another. Those types of credit-allocation decisions rightfully belong to the fiscal authorities, not the central bank. Engaging in such actions endangers our independence and the effectiveness of monetary policy”

  10. Gravatar of flow5 flow5
    11. July 2013 at 10:44

    Monetary policy works with long & predictable lag effects. In fact, contrary to Friedman’s & Schwartz’s position in 1961 (& reposition in 1972), the lags for money flows have been mathematical constants for 100 years (viz – “His new conclusion was that ‘monetary changes take much longer to affect prices than to affect output”).

    The impact of the FRB-NY’s operations on interest rates varies over the short run (as compared to the long run). And interest rates are determined by the demand for, & the supply of, loan-funds (not the demand for & supply of money). The Keynesian exegesis that “tight” money reflects higher interest rates, & “easy” money reflects lower interest rates, – is deceptively wrong.

    An understanding of the temporary & longer term effects of open market operations on rates reveals why initiating a tight money policy can temporarily bring about either a continued decrease in interest rates (or rise in rates), depending upon these distributed lag effects. I.e., real rates of interest can move in the opposite direction of inflation rates.

    In the present situation, the roc in money flows (the proxy for inflation), rebounded in May, thereby sending nominal rates higher, etc. I.e., the rise was preordained given the pre-existing rate-of-change in money flows (i.e., no change in FOMC policy). Going forward the roc in money flows (the proxy for inflation) is decelerating until 2013 year’s end.

  11. Gravatar of o. nate o. nate
    11. July 2013 at 10:49

    Scott, what if in a month or two the stock market crashes? In that case, will it turn out retroactively that the Fed did tighten with its tapering talk? Hopefully this will remain purely an academic question, but recall that monetary tightening started in late 1936 and the stock market didn’t peak until early 1937.

  12. Gravatar of Steve Steve
    11. July 2013 at 12:37


    With all due respect, I think you should post your thoughts on the future Fed chair, rather than interest rate fallacies or Krugman derps.

    Summers, not Yellen, leading candidate for top Fed job: report

  13. Gravatar of Mike Sax Mike Sax
    11. July 2013 at 13:33

    Glad you elaborated on why you think monetary policy has ‘probably’ become easier.

    Taper talk: Scott Sumner vs. Marcus Nunes on the Fed

  14. Gravatar of ssumner ssumner
    11. July 2013 at 14:13

    Bob, I know of one wealthy person who considered it, but it’s obviously something the Fed needs to do.

    123, Because long term rates have risen.

    Andy, Yes, I think it was you. I tried adding an update, but all I’ve got with me is an iPad, and I couldn’t get it to take.

    Josh, I don’t think you can infer that.

    O. Nate, More likely it would reflect money tightening at the time of the crash.

    Steve, Summers would be a horrible choice, which is why I expect him to be picked. The blind leading the blind.

    BTW, this post praised Krugman and attacked conservatives.

  15. Gravatar of ChargerCarl ChargerCarl
    11. July 2013 at 15:41

    If we were really smart we’d nominate Lars Svensson…

  16. Gravatar of JimP JimP
    11. July 2013 at 17:20

    FT – Samuel Brtittan

    The real target that Carney should be aiming for.

    This is fine as far as it goes. But central bank lending rates are intermediate creatures. They are only a means to an end: the commonly agreed goal of non-inflationary growth. Why not then state that goal more directly? This would not eliminate forward guidance – for what that is worth – but place it in a broader context.

    The statistical representation of that goal is an objective for nominal gross domestic product. That is the familiar GDP, but as it comes in the raw without a correction for price changes. For most western economies a reasonable objective would be about 5 per cent or 6 per cent growth a year. The beauty of this measure is that it puts a lid on inflation – implementation errors aside. It provides that price stability will be accompanied by real growth and not go to waste in stagnation. Obviously errors of implementation will occur but at least we will know for what we are aiming.

  17. Gravatar of Geoff Geoff
    11. July 2013 at 18:17

    Every conceivable monetary statistic in a central bank hampered economy is “a lousy indicator of monetary policy.”

  18. Gravatar of Mike Sax Mike Sax
    11. July 2013 at 19:10

    I will always remember where I was standing at this momennt! I make Delong’s webpage!

  19. Gravatar of Benjamin Cole Benjamin Cole
    11. July 2013 at 19:46

    I’m starting to wonder if central banks like being in ZLB.–Tall Dave.

    I think they do. Remember, central bankers do not stand for election, and hold secret meetings. Yet, the Fed is a quasi-public agency, and does not fear the “creative destructionism” of free markets and competition.

    Inevitably, the Fed has created an exalted mission statement and a cloistered self-reinforcing culture.

    With the marble pillars, the pompous pettifogging about inflation and the genuflections to the sanctity of the money supply—it’s deification of monetary policy. Toss in some monetary asceticism too.


    Ask any central banker this question: “Would you like 1 percent real growth and 1 percent inflation for the next five years, or 5 percent real growth and 5 percent inflation?”

    Central bankers would answer, “Well…that’s a hard one….”

    In their heart of hearts, central bankers have already answered. As we have seen since 2008.

  20. Gravatar of Edward Edward
    12. July 2013 at 07:29

    Usual nonsense.

    Ben Cole, good analogy. Except its worse than that. The p/y split is tilted in favor of y, so it’ll be more like 4 percent inflation+ 10% real growth. (14% ngdp) the theomonetarists/ Austrian lunatics in central banking (fisher, plosser) are sadists, pure and simple

  21. Gravatar of 123 123
    12. July 2013 at 08:05

    Scott, credit spreads have widened.

  22. Gravatar of ssumner ssumner
    12. July 2013 at 08:06

    ChargerCarl, Yup.

    JimP, Good column.

    Mike, Brad must have a lot of free time.

    Ben, Or maybe they just don’t know how to escape, because they don’t read this blog.

  23. Gravatar of ssumner ssumner
    12. July 2013 at 08:07

    123, Define credit spreads.

  24. Gravatar of 123 123
    12. July 2013 at 08:10

  25. Gravatar of 123 123
    12. July 2013 at 08:11

    VIX was up too

  26. Gravatar of 123 123
    12. July 2013 at 08:12

    During monetary easing, we should expect higher treasury yields together with lower BBB spreads.

  27. Gravatar of 123 123
    12. July 2013 at 09:14

    Garret Jones tweeted: “I see the rise in rates partly reflecting the market’s view that the expected stock of QE is lower–especially in bad states of the world.” 8 Jul 13,

  28. Gravatar of TallDave TallDave
    12. July 2013 at 10:06

    Ben, Or maybe they just don’t know how to escape, because they don’t read this blog.

    Sure, that too. I used to think it was ~90% not knowing how to, 10% not wanting to. But maybe it’s more like 70% not wanting to. They’ve always had the option of raising the inflation target.

    (If it were just the Fed, okay. But BOJ and ECB, too? I am starting to think even CBs respond to power incentives…)

  29. Gravatar of Mike sax Mike sax
    12. July 2013 at 12:56

    Gee Scott I’ll remember where I was standing for that moment too. But I never could of got here without all your encouraging comments.

    At this point if you have better things to do than dread Diary of a Republican your also in the minority. Cheers

  30. Gravatar of ssumner ssumner
    13. July 2013 at 05:44

    123, I agree regarding what we should expect, but then what explains sharply higher equity prices?

    TallDave, I agree it’s a mixture of factors.

  31. Gravatar of Zarathustra Zarathustra
    13. July 2013 at 09:35

    a bit off topic, but im wondering if there’s a commentator who could help me out here:

    i’ve read the FAQ and the intro and such, and that all makes sense. i also generally am able to follow the posts / discussions.
    and maybe this comes from a lack of comprehensive knowledge about futures markets but how would an NGDP futures market work? what would it look like? I assume someone like CME would run it, i guess i just dont totally get how you could settle these things in real time when gdp (and possibly ngdp?) figures get revised and such whereas a stock or index you can look at the most recent price.

  32. Gravatar of 123 123
    13. July 2013 at 12:04

    Scott, that’s a conundrum. On the other hand, stock were sharply down during three days following the July FOMC meeting.

  33. Gravatar of ssumner ssumner
    14. July 2013 at 04:06

    Zarathustra, I have a paper coming out in the next few weeks that explains that.

    123, I agree with the claim that the yield rises during those three days reflected expectations of tighter money. But would you agree that the strong stock market response to the recent Bernanke “clarification” reflected easier money? And that the stock price rise (and bond yield rise) after the employment report reflected stronger growth expectations?

    So there are a lot of things happening, not just one thing.

  34. Gravatar of 123 123
    14. July 2013 at 12:33

    Scott, yes, there was a partial backpedalling by Bernanke, and there were some positive data surprises. Regarding growth expectations, I thing second moments are more important here. The current policy is a gamble. Maybe strong data will validate the tapering decision, and everything will turn out OK. Maybe not. I’m not sure. There were many such gambles, for example, when Trichet signaled higher rates in early February 2011, EURO STOXX 50 index fell initially, but at the end of April it reached the Feburary levels again. But we know that later events have not validated Trichet’s gamble.

    14. July 2013 at 23:57

    The crucial question is in my opinion: wouldn’t there be no fatal herd instinct and no asset bubbles, when the interest rates were a little higher?
    Would hedge funds or other speculators make no more hunting for double-digit returns and take excessive leverage for that reason, when interest rates would be higher one or two percentage points? I guess not. Meaning that the claims don’t apply that low interest rates cause asset bubbles.

  36. Gravatar of ssumner ssumner
    15. July 2013 at 04:13

    123, The gamble may succeed from Bernanke’s perspective, but will almost surely fail from my perspective.

    Acemax, Yes, asset bubbles generally occur at relatively high rates.

  37. Gravatar of Taper Talk and the Fed's Monetary Stance: Scott Sumner vs. Marcus Nunes | Last Men and OverMen Taper Talk and the Fed's Monetary Stance: Scott Sumner vs. Marcus Nunes | Last Men and OverMen
    16. April 2017 at 03:57

    […] rates would no longer be a lousy indicator of monetary policy.”       Sumner goes on to note the commentator is Andrew. So this is what he […]

Leave a Reply