Perhaps I am misunderstanding the Q&A posted by Scott Sumner today where he posts a question from his comments section and then proceeds to answer it in a context that seems more mystifying than enlightening.
The question is this:
An elementary question on the topic of interest rates that I’ve been unable to resolve via google: Regarding Fed actions, I understand that reduced interest rates are thought to be expansionary because the resulting decrease in cost of capital induces greater investment. But I also understand that reduced interest rates are thought to be contractionary because the resulting decrease in opportunity cost of holding money increases demand for money.
One? Neither? Both? Little of each? Depends?
Here is the answer:
It’s not at all clear that lower interest rates boost investment (never reason from a price change.) And even if they did boost investment it is not at all clear that they would boost GDP.
But two things are very clear:
1. Open market purchases reduce short term nominal rates.
2. Open market purchases boost NGDP.
Here’s what people forget. The Fed doesn’t wave a magic wand and reduce interest rates. They do so via a boost in the monetary base. Now let’s think about the effect of a sudden and instantaneous 1% boost in the monetary base. Contrary to most macro models, there is an immediate impact on NGDP, although almost certainly less than 1%. The instantaneous impact on NGDP comes from the fact that the OMP immediately boosts commodity prices, and hence the gold and oil flowing out of the ground in America has a higher nominal value. But that’s nowhere near enough to instantly boost NGDP by 1%. Instead interest rates must fall by enough so that Americans are willing to hold extra non-interest bearing base money. The lower interest rates reduce velocity in the short run. So NGDP might rise by 0.2%, and V might fall by 0.8%, within seconds.
In the very long run money is neutral, V is unchanged, and NGDP rises by 1%.
The medium term is the most complicated. There may well be a period when velocity goes up, especially if inflation rises and real growth is strong.
So the correct answer is that the lower interest rates tend to reduce NGDP, but the thing that causes lower interest rates may increase NGDP by more than the reduction caused by lower V. At least if that “thing” is OMPs. Yes, easy money often makes rates fall in the short run, but it’s the larger money supply that does the “heavy lifting” of boosting NGDP.
It seems that perhaps this needs some context because the causality appears to be flipped as in “normal” times the Fed pegs interest rates via OMOs, assuming it isn’t just talking about “changing” them. But it is still problematic when discussing the context of the Friedman’s observation that low interest rates are a sign that money has been tight and the Fed has one half of the keys to the kingdom for short term nominal rates.
The entire piece is worth reading if you’re interested. The trouble I’m having with it is that lack of context makes it appear contradictory and perhaps misleading on the point that interest rates have anything to do with the stance of monetary policy. In generalities, if the Fed has a neutral policy, then it would work much as described. But the important point is that it isn’t always true. In the case of a non-neutral policy the markets will outweigh the Fed and the ability to control where nominal interest rates go is lost. And that is where we are now due to money having been persistently too tight.
Maybe this graph needs to be photo-shopped because the parts of interest are a bit small. But neither lowering of the benchmark nominal rate from late 2007 through early 2008 show up here as adjustments in Fed holdings; and I think should at least be a blip – the difference between the 6-something percent as of the end of 3Q 2007 and the 2% for much of 2008 – if it actually happened.
What I am saying is that the Fed can say whatever it wants, but sometimes the saying and the doing are not quite the same. And so for someone to be an intellectual slave to the Fed Funds rate is a bit of an oddity that needs to be addressed and wasn’t.
On a personal note: I started reading Sumner’s blog regularly back in February of 2009 because he made sense in a world that had gone mad. He made the kind of sense that one can step through from top to bottom; and after five years I am not positive that is still true. I have trouble keeping up with his posts more often than not lately, wondering if perhaps he recently attended a course in “Fed speak.” Perhaps I just reached the limits of my cognitive ability or elitist have gotten a hold of him – maybe it’s a little bit of both. In any event, I am planning on taking a break from it for a while and see where I end up. It probably doesn’t matter much, however. I am much better at this than I was when I started out, but it’s been a better part of the “job” to say what needs saying and leave the debates to the pros.