I noticed that Lars Christensen has a new post about central bankers committing to low interest rates being a strategy for failure. Not to pick it apart because it is a spectacular blog post, but I think that failure is relative. Perhaps it’s the cynic in me that rather doubts the intentions of central bankers, at least these days; meaning there is room to debate whether they are getting the economic conditions they want.
So here’s how Lars starts out his post:
Committed to a failing strategy: low for longer = deflation for longer?
Recently there has been a debate about whether low interest rates counterintuitively actually leads deflation. Narayana Kocherlakota, President of the Minneapolis Fed, made such an argument a couple of years ago (but seems to have changed his mind now) and it seems like BIS’ Claudio Borio has been making an similar argument recently. Maybe surprisingly to some (market) monetarists will make a similar argument. We will just turn the argument upside down a bit. Let me explain.
Most people would of course say that low interest rates equals easy monetary policy and that leads to higher inflation – and not deflation. However, this traditional keynesian (not New Keynesian) view is wrong because it confuses “the” interest rate for the central bank’s policy instrument, while the interest rate actually in the current setting for most inflation targeting central banks is an intermediate target.
It’s interesting that he talks about Market Monetarists making a similar argument toward low rates being deflationary because I did so last year in a post titled: BoE at Jackson Hole: Setting the bar so low failure is impossible.
If you haven’t already, get set for more of the same as the new normal. Central bankers have apparently forgotten all about the basics of supply and demand for [credit] because nearly all of them at the annual Jackson Hole conference have pledged to keep interest rates low for the next two years.
Here are some quotes according to Joshua Zumbrun & Simon Kennedy from Bloomberg.com in their article about the conference:
Bank of England Deputy Governor Charlie Bean said the U.K.’s pledge this month to avoid raising interest rates before unemployment falls to 7 percent should restrain U.K. gilt yields and boost confidence among consumers and companies.
The Bank of England this month embraced so-called forward guidance by projecting it will keep its benchmark interest rate at 0.5 percent until late 2016 as it waits for the jobless rate to fall from 7.8 percent.
“The knowledge that monetary policy will not be tightened until the U.K.’s fledgling recovery is secured should boost confidence,” Bean said. “Moreover, it should reduce the likelihood that the present expansionary monetary stance is withdrawn prematurely through an upward movement in market interest rates.”
The wording in this article, “… as it waits for the jobless rate to fall…”couldn’t be more revealing regarding the intent. I don’t believe that even Pollyanna was as optimistic.
If we take Milton Friedman’s view on interest rates to heart, that low interest rates are a sign that money has been tight, it isn’t all that hard to figure out that a case of the Emperor’s new clothes is afoot. Doing nothing will keep interest rates low in the same way as doing nothing will keep inflation low.
If we got to the ZLB because money was tight, then when central bankers promise to keep interest rates lower for longer, then they are promising that money will continue to be tight for longer. The stellar example of this phenomenon is the experience of the Japanese economy under the BoJ’s IT regime that was more committed to the ZLB than it was to its inflation target until the implementation of the monetary policy component of Abenomics last year.
I have to resist the temptation to grit my teeth when I read news articles that complain about the steady inching up of mortgage rates over the last 12 months or so because it is but one sign that monetary policy has indeed eased with QE 3 (of course easing is relative to the starting point, we are far from where we need to be). But the central bankers have to go and mess with success and taper well before we’re ready to lift off. Why? Because they are married to low interest rates, just like the BoJ of days past, regardless of missing their inflation target by at least 50% on average. It just doesn’t work and I wish they would just keep running the printing presses until they melt down and forget about interest rates because money matters more.
I actually don’t like to talk much about interest rates at all because it’s a level of complexity that really doesn’t need to be there and it’s easy to get bogged down in reasoning from a price change. Hence, the general misunderstanding that low interest rates mean easy money when that is not what it means at all. Interest rates were high during the great inflation in the 1970s, and so low rates can hardly mean easy money.
So when Volker “broke the back of inflation” back in 1981, what did he do? He raised the FF rate to much higher than the natural rate. But really what it meant was that he tightened monetary policy by selling assets (sort of like destroying cash) in order to create a negative disparity between natural rates and the FF rate, because natural rates tend to decline when policy tightens, that would change the trajectory of inflation. And just so happens that when passively tightened monetary policy, like when the demand for money is spiking because of market panic and the demand isn’t accommodated, causes the same kind of disparity between the natural rate and the FF rate, say the natural rate has fallen to -4% and the FF rate remains at 2%, then we get the same effect, a disinflation that causes a recession.
To be fair, I think what these central bankers are trying to say is that they will keep the overnight rate low until well after the natural rate has risen above it, not that they will keep policy tight so that natural rates don’t rise above their overnight rate. But it comes with a considerable credibility problem because most central banks aren’t doing much that would cause the natural rate to rise. They just can’t get us to any pervasive and self-sustaining credit demand growth because they are unwilling to do what it takes to get us there. We were just starting to see the green shoots in the first half of last year from QE3 and they got skittish, some obsessing about non-existent inflationary pressures, the size of the balance sheet and bubbles, proving to markets that they have no stomach for easing and don’t particularly care about the inflation target on the down side.
Let’s face it, nobody wants to take a risk with much of anything out on the edge if they don’t know what the central bank will be doing, participants err on the side of caution. And until we get some clarity, it doesn’t matter much what they say about interest rates. I think a good plan, if they are indeed interested in a self-sustaining recovery, would be to stop talking about interest rates and start talking about hitting the target being more important than anything else. The 2% inflation target isn’t optimal, and I won’t pretend that it is. But taking more about hitting it or maybe even overshooting a little than the current confusing blather about interest rates is probably more credibility enhancing than they imagine and will go much farther than the strategy of the present.
I certainly hope they wish to prove my cynicism about their intentions unfounded and move on to things that would actually help growth, not hinder it.