What is a low interest rate policy?

Some commenters struggled with my previous post, which looked at two types of low interest rate policies, one expansionary and one contractionary. In that post, I focused on the expected path of exchange rates.

Today, I’ll tell the same story in New Keynesian language, focusing on the role of the natural rate of interest. Consider the following two policies:

1. The Fed reduces market interest rates at a time when there is relatively little change in the natural rate of interest.

2. The Fed reduces the natural rate of interest. It also reduces market interest rates, but by less than the decline in the natural rate of interest.

These are both “low interest rate polices”, but the first is expansionary while the second is contractionary. When Keynesians speak of a low interest rate policy, they have in mind the first type. When NeoFisherians speak of a low interest rate policy, they visualize the second type.

In my previous post, I gave an example of a central bank that simultaneously appreciated their currency and generated expectations of further currency appreciation (as with Switzerland in January 2015.) The currency appreciation sharply reduced the natural rate of interest. The promise of further currency appreciation led to lower nominal interest rates. Because the natural interest rate fell by more than the market interest rate, the policy ended up being contractionary.

Keynesians often forget that central banks can move the natural interest rate by more than they move the policy rate. NeoFisherians often forget that central banks can move the market interest rate relative to the natural rate.

I try to remember both truths.

PS. The National Review just announced that the US is in recession because of two quarters of negative RGDP growth. Who’s going to tell them?

PPS. NGDP grew at a 7.85% annual rate in Q2. That’s way too fast.


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20 Responses to “What is a low interest rate policy?”

  1. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    28. July 2022 at 12:08

    Interest rate policies assume that the Gurley-Shaw thesis is correct.
    https://www.economicsdiscussion.net/money/liquidity-theory-of-money/liquidity-theory-of-money-by-radcliffe-statement-radcliffe-report-and-evaluation-economics/31342

    “substitutability between money and wide range of financial assets, also called near- moneys”

    “an appropriate definition of money must include the liabilities of non-bank financial institutions.”

    R * revolves around the activation of monetary savings. The impoundment of monetary savings lowers R * and vice versa.

  2. Gravatar of Justin in Texas Justin in Texas
    28. July 2022 at 14:36

    Saw the GDP report and was dismayed. How is this real? We should have 2% or 3% annualized GDP, not 8%. The FOMC are digging us all into an ever deeper hole, setting us up for a Volker reset recession.If the Dems had a clue they’d be pushing to have a mild corrective slump now, and get it done by mid/late 2023.

  3. Gravatar of Tacticus Tacticus
    28. July 2022 at 15:34

    NGDP growth also accelerated from Q1. Fun times ahead.

  4. Gravatar of Fernando Fernando
    29. July 2022 at 00:55

    When you say “The currency appreciation sharply reduced the natural rate of interest” you mean “the expectations of further currency appreciation sharply reduced the natural rate of interest”, right?

  5. Gravatar of Fernando Fernando
    29. July 2022 at 01:41

    Oh, sorry. Forget my previous comment. I think I understand it now. The sudden currency appreciation can affect negatively the natural rate of interest by breaking debtor expectations.

  6. Gravatar of Michael Rulle Michael Rulle
    29. July 2022 at 04:48

    The last SF FED estimate (in June) I saw for the neutral/natural interest rate was 2.5%. This is the approximate current FF rate. We have full employment (at least by measuring those seeking work) and we have high NGDP growth—-but negative real growth. We have inflation (is it automatically better to measure inflation per 12 months ago——or per last month?). I assume this means the Fed will continue to hike—-until inflation drops to 2%(who cares about FAIT—not the Fed anymore.) and presumably when NGDP drops close to 4% from almost 8%——while hopefully keeping employment full—-

    Is this really what they are trying to do?

  7. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    29. July 2022 at 05:06

    “Measured in “current” dollars, “nominal” GDP jumped by an annual rate of 7.8% to $24.8 trillion”

    People don’t have an historical clue. Lending by the DFIs is inflationary (where S “≠” I). Whereas lending by the nonbanks is non-inflationary (where S = I), ceteris paribus.

    The ABA got jealous of the S&Ls, etc.
    Reg. Q ceilings were gradually eliminated.
    The nonbanks were turned into banks.
    Interbank demand deposits were remunerated.
    Legal reserves were gradually eliminated.

    The recipe was the fallacious Gurley-Shaw thesis.

  8. Gravatar of Todd Ramsey Todd Ramsey
    29. July 2022 at 06:09

    Is there any explanatory power from the anomaly that measured RGDP is negative while measured RGDI is positive (through Q1 at least)?

  9. Gravatar of Daniel Daniel
    29. July 2022 at 06:24

    “The Fed reduces the natural rate of interest.”

    Could you explain this more?
    If the Fed can control the natural rate, then they’d never mis-set nominal rates, they’d just converge the two.

    I suppose the current natural rate could be a function of long-run real factors, which are a function of short-run nominal factors, which are a function of monetary policy, which is a function of the estimated natural rate…it’s extremely circular, can you add more clarity?

  10. Gravatar of Marco Marco
    29. July 2022 at 07:08

    I was really surprised by yesterday’s FED actions and especially words. It seem that they are afraid of the recession risk even with a 8% NGDP growth, or that’s was the market take.

    Any explanations? Any thoughts?

  11. Gravatar of Kester Pembroke Kester Pembroke
    29. July 2022 at 07:15

    “Fiscal discipline” means interest rates above zero.

    That’s free government money to rich people. “Basic income for those who already have money”.

    There is no such thing as a “neutral rate of interest”. It’s complete woo. Up there with homeopathy, crystal healing and alchemy.

    Under their “expectations theory”, where everybody has the capacity to discount their future income flows to the present, if there was such a thing they would automatically know what it was.

    It’s all self referential BS. Modern Ether Theory.

    Dear Scott Sumner, have you read Bill Mitchell’s criticism of the natural rate of interest:

    http://bilbo.economicoutlook.net/blog/?p=4656

    Warren Mosler’s take:

    http://moslereconomics.com/wp-content/uploads/2018/04/The-Natural-Rate-of-Interest-is-Zero.pdf

    Please read these in full before replying

  12. Gravatar of ssumner ssumner
    29. July 2022 at 07:59

    Todd, It is claimed that the average of the two is more accurate.

    Daniel. One way to make the two converge is to stop targeting interest rates and start targeting NGDP futures contracts at something like a 4% growth rate.

    Marco, Obviously the Fed believes NGDP growth is about to slow sharply, which seems a reasonable guess. (Markets expect the same.)

    Kester, Yes, I’ve read that nonsense and even wrote a long paper on what’s wrong with MMT. Feel free to read it.

  13. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    29. July 2022 at 09:21

    Bank Credit, All Commercial Banks (TOTBKCR) is on a tear.
    https://fred.stlouisfed.org/series/TOTBKCR

    As Sheila Bair said: “It should replace the shock and awe of major interest rate hikes with new targets based on money supply, and aggressively shrink its portfolio, selling securities at a loss to do so, if necessary.”

    Never are the commercial banks intermediaries in the savings->investment process.

  14. Gravatar of Gene Frenkle Gene Frenkle
    29. July 2022 at 09:53

    Here’s what I will be keeping track of to determine if we are in a recession. These numbers are updated monthly and so as of right now we are not in a recession.

    https://fred.stlouisfed.org/series/PAYEMS

  15. Gravatar of Ricardo Ricardo
    31. July 2022 at 07:34

    I don’t understand why you guys present the argument this way.

    Nominal GDP is just gross domestic product evaluated at current market prices. If a nation sells more products and services than it did last year, then NGDP will increase.

    You are simply referring to inflation, which is reflected in the rise in Nominal GDP, but that has nothing to do with selling a product or a service in the marketplace. There is no such thing as the market “growing too fast”. More consumption is good as long as it doesn’t revolve around a printing press, or maxing out your credit card. In other words, if the fast growth is the result of natural market conditions, instead of government intervention, then one should not be concerned.

    You also continue to move the goal posts when it suits your interests. Changing the definition of a recession, on a whim, because you don’t like the political implications during election season, is not science. It’s pseudoscience.

    And lastly, the Fed cannot raise the interest rates too high, because the U.S. is already paying around 400B to service their unsustainable fiscal debt. If you raise those rates, your payment will double. On the other hand, if you don’t let the market correct, like the Japanese, because you artificially keep rates low, decade after decade, then you’ll pay for it with devaluation of currency. The Yen will continue to implode over the next few years, and the dollar, euro and pound are probably next.

  16. Gravatar of ssumner ssumner
    31. July 2022 at 07:43

    Ricardo, You said:

    “You also continue to move the goal posts when it suits your interests. Changing the definition of a recession, on a whim, because you don’t like the political implications during election season, is not science. It’s pseudoscience.”

    That’s an awful lot of stupidity packed into one paragraph. Are you even aware as to how ignorant you are?

    “Nominal GDP is just gross domestic product evaluated at current market prices. If a nation sells more products and services than it did last year, then NGDP will increase.”

    LOL, you have no idea what you are talking about.

  17. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    31. July 2022 at 11:02

    @Gene Frenkle

    U * is fictional. The unemployment rate is always going to be “too low”. See: “The Great Demographic Reversal” by Charles Goodhart and Manoj Pradhan.

    The Total Nonfarm Payroll shouldn’t collapse as it normally would going into a recession. There were 4 girls on a busy streetcorner each holding up signs for bus drivers today. There are hiring signs everywhere.

    Inflation is going to be augmented.

  18. Gravatar of AJ AJ
    31. July 2022 at 19:23

    Pretty sure Ricardo managed to hit on every right wing talking point while also demonstrating he may not have even read a single word off this blog…..guessing the quantity theory of money means absolutely nothing to him as well….

  19. Gravatar of ssumner ssumner
    1. August 2022 at 13:59

    AJ, Most of my trolls have no idea what I believe. I’d say 90% of the time when they say I believe X, I actually believe not X.

  20. Gravatar of chrisjbillington chrisjbillington
    3. August 2022 at 15:25

    What kind of actions by a central bank would change the natural rate of interest in a direction of their choosing? This is the first I’m hearing of central banks having that ability.

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