Superfreakymacroeconomics
The following post is a sort of response to Raghuram Rajan’s recent post at Freakonomics:
If you are a college econ teacher, you’ve had this experience. You explain how an expansionary monetary policy can boost AD. A student raises his hand:
“But isn’t low interest rates just like the government providing a subsidy to borrowers? And aren’t government subsidies bad?”
The student is so far off base you wonder how you are going to fix things with a short answer. But let’s try anyway.
1. Yes government subsidies are bad for two reasons. They require higher future taxes, which impose deadweight costs. And they distort relative prices.
2. Now let’s think about monetary policy. The first misconception is that the Fed “controls” interest rates. In fact, the Fed controls the monetary base, and targets interest rates. Rates are always allowed to find their free market values, given the setting of the monetary base. So if the Fed wants to reduce rates, it might increase the monetary base until the equilibrium free market rate falls to the desired level.
3. But doesn’t the Fed distort the bond market when they swap cash for T-bills? Maybe a tiny bit, but that’s not really why rates fall when the Fed increases the monetary base. The same liquidity effect used to occur in the old days when the Fed bought gold. The effect occurs because there is more non-interest bearing money in the public’s hands. Until consumer prices have had a chance to rise, the only way to get people to hold this extra money is for free market rates on alternatives assets to fall. These rates are the opportunity cost of holding cash. So monetary policy is fundamentally about the supply and demand for money. Interest rates are just one of many variables that change as a result of changes in the money supply. Exchange rates and consumer prices also change. Imagine someone criticizing a reduction in the inflation target from 3% to 2% on the grounds that it would be a subsidy to consumers!
4. Interest rates are (as a first order approximation) a zero sum game for the public. Lower rates mean one group pays less, and the other group receives less. But isn’t there some sort of “natural rate” and isn’t the Fed messing things up by setting rates below that natural rate? All serious attempts to find a natural rate of interest look at the macroeconomy, especially inflation and NGDP. Obviously credit markets (financial asset prices) can adjust to any inflation rate, but the real economy has trouble when inflation (or NGDP) rises or falls unexpectedly. So if there is a “natural rate of interest” it would be the rate where inflation or better yet NGDP is optimal, where the macro economy is in some sort of equilibrium. Where you don’t have mass unemployment, or overemployment, because nominal wages are temporarily stuck at the wrong level. Even if you don’t believe in sticky wages or prices, and simply support steady 2% inflation, there is still a natural rate; it is the rate that generates that target inflation rate. But one shouldn’t even focus on the natural interest rate, as we don’t have any way of directly estimating it (Taylor Rules notwithstanding.) Instead, the focus should be on NGDP and inflation expectations. Get those variables right, and then interest rates will also be at the proper level.
5. Thus the question is never whether low rates unfairly subsidize borrowers, or whether high rates unfairly tax borrowers, because the Fed is not directly fixing interest rates, or driving any sort of tax or subsidy wedge between lenders and borrowers. Rates are set in the market. The question is whether the money supply is set at a level that produces the sort of interest rates, exchange rates, prices, NGDP, etc, that are consistent with optimal macroeconomic performance.
6. Of course right now expected inflation and NGDP growth are much too low for macro equilibrium, so we need easier money. Does that mean we need lower rates? Here is where things get complicated. If both long and short term rates are very low, it is generally a sign that money has been too tight, and the level of nominal spending is too low to provide optimal macroeconomic conditions. So can you solve this problem by raising rates? It depends what you mean by raising rates. If you mean setting a higher fed funds rate, and implementing it through a reduction in the base, then the answer is no. If you mean trying to raise rates by printing lots of money and promising to do more in the future, or promising higher future inflation, or promising to steadily devalue the dollar, then the answer is yes.
The problem with recent essays by people like Rajan and Kocherlakota is that they don’t seem to understand this distinction. Or if they do, they express their ideas in a rather garbled fashion. They both think that higher rates might be desirable for various reasons. So far so good. But both also strongly imply that the way to get higher rates is through the Fed raising its short term fed funds target. But that requires tighter money–which would be a disaster right now. I’d also like to see higher rates on long term bonds (I’d love to get back to the 4% rates we saw on the 10 year bond a few months back) but want to get there through easier money. Since the fed funds target can’t be lowered much further, I support unconventional methods of boosting inflation and NGDP growth expectations.
Steve Williamson left this comment over at Nick Rowe’s blog, in support of Kocherlakota:
In a flexible price world Williamson would be correct. If the Fed suddenly increases the fed funds rate by 200 basis points as Rajan suggests, then the money supply growth rate must also increase by 200 basis points. Since the real rate is unaffected (money is neutral) the expected inflation rate also increases by 200 basis points. And that means right away, inflation rises literally overnight.
In the real world prices are sticky. How do we know? Because all the various markets respond to fed funds rate surprises as if prices are sticky. If there is a sudden and unexpected rise in the fed funds target at 2:15 pm, then here is what typically happens at 2:16 PM:
1. Nominal stock prices fall sharply.
2. Nominal commodity prices fall sharply.
3. Foreign currency prices fall sharply.
4. Inflation expectations (TIPS spreads) fall sharply.
So Williamson’s model is not applicable to the fed funds tool that most people refer to when discussing interest rates. Increases in the fed funds target cause short term real rates to rise by at least as much as nominal rates. It is only true as a long run proposition.
It’s funny how right-wingers who supposedly believe in markets go out of their way to lecture markets about how they don’t understand the true model of the economy, which it seems has only been revealed to freshwater economists. Here is Rajan:
I’ve spent most of my life studying the 1930s. And I have to agree with Rajan. Just as in the 1930s, the markets are very “frightened” of monetary tightening during a recession.
Here is Kocherlakota:
Just the opposite is true. The market isn’t falling because they think the Fed knows more than they do, in fact the problem is just the opposite. The market understands that there is a serious shortfall in NGDP growth–nowhere near enough to generate economic recovery. It is the Fed that seems clueless, and that is what has markets very frightened. If the Fed really did do something aggressive, more than expected, markets would not fall because they saw the Fed was worried, they’d soar in relief that the Fed was finally doing something. Ironically it is people like Krugman and I that are doing ratex modeling. We have models where the various markets’ expectations are consistent with the predictions of the model. The difference between Krugman and I is that I always make this assumption.
Apologies to commenters–I will be way behind for a while. This is an important moment.
HT: Daniel Carpenter, Marcus