The financial instability argument for raising rates

There is a nice juxtaposition of recent articles in the Economist. This one, by P.W. (it is weird this convention they have for signing with just their initials), puts the “case against maxing out monetary policy” (a.k.a. raise rates now). The Fed, Bank of England and ECB “argue that the priority is to restore growth and to do battle against low inflation. But [they] grievously misread the risks before the financial crisis, which weakens their claim to be reading them correctly now.” Let’s call the proposition that we should raise rates now to avoid financial instability the BIS case, after the Bank of International Settlements who have been making this argument ever since the recession began. In contrast Ryan Avent writes that there are two big problems with this argument. I want to expand on his discussion, and be a little less polite.

I want to begin by conceding a point. Suppose, as a monetary policymaker, you believe a financial crisis is possible, and that by raising rates you may be able to prevent it. Assume, crucially, that there is nothing else you can do to help prevent the financial crisis. In that case, you will consider raising rates, even if inflation is below target. If you have just one instrument (interest rates) and two targets (inflation and preventing a crisis) you will be influenced by both targets. If you want this point expressed more formally, see this post and the paper by Mike Woodford it discusses. 

 

However that is not the end of the story. If you raise rates to prevent financial instability when inflation is below target, inflation will remain below target or may fall even further. You cannot ignore that. So if interest rates are raised today to head off a financial crisis, they will have to be lower in the future to deal with the lower inflation or even deflation you have caused.

This is not just what macroeconomic theory says. In mid-2010 the Swedish central bank started raising interest rates (from 0.25% to 2%), despite forecasts that inflation would stay below target and with unemployment well above its natural rate. They did this explicitly because they were worried about the build up of household debt and a possible housing bubble. Inflation began to fall, and since 2013 it has been at or below zero. As Lars Svensson has pointed out, even on its own terms this is not a very clever policy, because with lower inflation the real value of debt is higher than it would otherwise have been. But the key point for the current discussion is that now interest rates are coming down again (currently 0.75%), because you cannot ignore inflation being over 2% below target.

Some of those making the BIS case understand this. What they hope is that if interest rates are raised to, say, 2% and stay there, that will still give us enough monetary stimulus to eventually get inflation back up to target. It clearly was not correct in the Swedish case, and with Euro inflation still at 0.5% it looks pretty improbable there too. But maybe it could be correct for the US and UK. So by raising rates by a modest amount today we might prevent financial instability, but at the cost of delaying the recovery.

I want to make two observations that follow from the BIS argument. The first is that they are in effect saying that the Zero Lower Bound (ZLB) constraint on monetary policy is even more severe than we thought, because if we leave interest rates at the ZLB for too long this generates an unacceptable risk of financial instability. That in turn must strengthen arguments (pdf) for raising inflation targets above 2%. Strangely, I do not hear advocates of the BIS case also arguing for higher inflation targets. The second is that, the more severe the ZLB constraint is in practice, the more compelling the case for using fiscal stimulus when we hit the ZLB. (Fiscal policy has become more expansionary in Sweden.) Again, this is something you do not hear BIS advocates argue for – in fact they often push austerity.

As Ryan Avent says, we can avoid all these difficulties by adding an extra instrument, which is macroprudential regulation. If parts of the financial system appear prone to instability because people are taking insufficient account of risks, bring in controls (or maybe taxes) of various kinds to stop this happening. Now, as R.A. notes, those taking the BIS position counter that such measures are untested and may not be effective. Here is a typical example in the FT, where it is stated that “macroprudential policies will fail to stop investors taking irrational risks”.

So we must raise interest rates, and delay the recovery, because nothing else can stop some in the financial system taking excessive risks. To which I can only say, summoning all my academic gravitas, what audacity, what impudence! Not only have we had to suffer the consequences of the Great Recession because of excessive risk taking within a largely unregulated financial system, we now have to cut short our main means of getting out of that recession because they might do it again. I do not know what planet these people are on, but if its mine, can they please get off and play their games elsewhere.