Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday, 13 July 2014

Why macroeconomists, not bankers, should set interest rates

More thoughts on the idea that interest rates ought to rise because of the possibility that the financial sector is taking excessive risks: what I called in this earlier post the BIS case, after the Bank of International Settlements, the international club for central bankers. I know Paul Krugman, Brad DeLong, Mark Thoma, Tony Yates and many others have already weighed in here, but - being macroeconomists - they were perhaps too modest to draw this lesson.

To most macroeconomists, the theory of monetary policy is pretty straightforward. Interest rates should be set at a level which closes the output gap, which can be defined as the level of output and unemployment that will keep underlying inflation constant. We can call this real interest rate the Wicksellian natural rate. The difficulty is not in the concept, but in the practice of putting numbers to this concept when inflation is noisy, the output gap is hard to estimate, there are lags in the system etc etc.

But, respond those putting the BIS case, wasn’t that what monetary policymakers thought they were doing in 2007, and look what happened next. Monetary policy cannot afford to ignore the financial sector, and the risk of excessive lending and bubbles that subsequently blow up the economy. There are signs, they say, that what happened in 2007/8 may be happening again now, so we need to raise rates to prevent another crash, even though there is still a negative output gap and inflation is below target.

Which might seem plausible, until you notice what is going on here. The implication is that a financial crisis only happens because interest rates are set at the wrong level. The Great Recession was all the fault of the Fed, who kept interest rates too low after the 2001 recession. The gradual deregulation of the financial sector in the decades before? - not an issue. The widespread misselling of subprime mortgages? - these things happen. All the other examples of misselling and fraud? - boys will be boys. An industry that profits from a massive implicit public subsidy? - we see no subsidy. Classifying subprime products as AAA? Massive increases in bank leverage in the 00s? - all the result of keeping interest rates too low.

When those putting the BIS case tell you that macroprudential controls (a.k.a. financial regulations) are ‘untested’ and ‘uncertain in their impact’, what they are really saying is that the financial system cannot be regulated to make it safe when interest rates are low. There is no evidence for that proposition, and a lot of history that says otherwise. We do not have to accept a deregulated financial sector which has the power at any moment to derail the real economy. But of course most working in the financial sector hate regulation. They have an interest in perpetuating different stories about the Great Recession. If you spend too much time around bankers, there is a danger that you come to believe these self-serving stories.

But, you might say, what harm would a modest increase in interest rates do? Again, basic macroeconomics, which I have not seen anyone putting the BIS case address. Raising rates implies in current circumstances a larger negative output gap, which will reduce inflation further below its target. As happened in Sweden, and accurately predicted by macroeconomist Lars Svensson. Two things could then happen. First, interest rates come back down again (in Sweden’s case by outvoting the governor for the first time since it gained its independence in 1999), but the cost of lost resources and higher unemployment created in the meantime can never be redeemed. Second, interest rates stay high for long enough that the public will conclude that the inflation target has in reality been revised down, and we risk converging to a deflationary steady state (technical discussion here), or in non-technical terms a Japan-like lost decade or more of low output and deflation.

To see clearly why this makes no sense, consider the symmetric case. Suppose someone argued, when inflation was above target, that we should not raise rates, but instead allow the output gap to be positive. I suspect those currently making the BIS case would scream disaster – it is the 1970s all over again. So why is that wrong but doing the same thing in reverse OK? In fact it is worse than that. If long run expected inflation rises, a central bank can always signal its true inflation target by sharply raising rates. In the opposite case it may not be able to, because of the Zero Lower Bound.

I like to praise the current UK government when I can. In setting up a Financial Policy Committee that is separate from the Monetary Policy Committee they did exactly the right thing. This formalises an assignment: macro prudential policy to control financial sector excess, and interest rates to control demand and inflation. Most macroeconomists know this makes sense. But the financial sector has a pecuniary interest in pretending otherwise. Those that get too close to that sector should be kept well away from setting interest rates. 


22 comments:

  1. You write: "Interest rates should be set at a level which closes the output gap, which can be defined as the level of output and unemployment that will keep underlying inflation constant."

    I wonder if you can recommend a canonical statement of this view in the literature. One also sees it claimed that the interest rate should be at a level that leads to the optimal level of the capital stock or optimal distribution of consumption over time. Is there a standard source for why the output gap criterion should be preferred to this one, or alternatively, why the two criteria will coincide?

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    1. I second J.W.Mason’s question, and I’ll do it by putting the same question in my own words, as follows.

      Simon claims “…macro prudential policy to control financial sector excess, and interest rates to control demand and inflation. Most macroeconomists know this makes sense.”

      So where have “macroeconomists” set out a clear decisive argument in favour of using interest rates to control demand and inflation? As far as I’m concerned that idea is nonsense on stilts, but I’m always happy to be proven wrong by those “macroeconomists”.

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    2. Aren't you guys just talking about Friedman and Schwartz? We've learned much since then, but we shouldn't forget or ignore the basics

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  2. It would seem to counter the slack labor and capital equipment markets, over-indebtedness, and the loss of participation in productivity for oh so long, that a central bank thinking of justice could determine that an extended period of excessively tight labor markets and inflation is in order.

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  3. It is far worse for in their zeal to prevent bubbles they are promoting the very action that would produce them in the long term by overreacting to the recent past eventually triggering an overreaction to their preferred policy.

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  4. This is a political problem and needs a political solution. The solution is to hire millions of people to, in the case of the US, modernize it's creaky infrastructures. Just point out to the voter that this work will 'put more money in your pocket,' to spend and to save. Plus the work has 'legs;' this will last five or more years. Arguing interest rates is a no show when it comes to most voters. It means nothing. Inflation means nothing either. Debt and deficits mean nothing. Putting money in their pockets and giving them work. That works.

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  5. This comment has been removed by the author.

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  6. Macroeconomists are not ready yet... until they can get the output gap right. They still see it much bigger than it really is.
    And even low inflation is a consequnce of having and of projecting low nominal rates for long period of time. Fisher effect.
    Could the recent hop up in inflation be due to price hedging as an earlier rise in nominal rates is expected? It does not seem due to wage pressures.

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  7. What a wild concept. Please consider economic reality.

    Jesus Christ, operating in the Economy of God, that is the concept presented by the Apostle Paul in Ephesians 1:10, is acting in stewardship of all things economic and political, to complete, mature, and perfect every age. And as presented in Revelation 6:1-2, has opened the First Seal of the Scroll of End Time Events, to release the First Horseman of The Apocalypse, to effect global coup d etats. The Rider on the White Horse, has the Bow without Any Arrow, and has thus given the Bond Vigilantes, the authority to yield the Bow of Economic Sovereignty, to begin calling the Interest Rate on the US Ten Year Note, ^TNX, from 2.49%, to effect investment coup d etat, destabilizing sovereign authority in the Eurozone and in the US. They will be increasingly successful, in calling the Benchmark Interest Rate progressively higher, producing a new sovereignty and a new seigniorage.

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    1. the prize for best crazy goes to you.

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  8. Simon

    I'm generally informed, provoked and entertained by your posts. They provide me (a non-economist) with an easily digestible technical underpinning to the half-completed musings and hunches that I have concocted for myself.

    This post is no different and I thank you for it.

    But there's a consistent theme that I hear from you and from other economists that I find bemusing. Here, you state the risk for Sweden that "interest rates stay high for long enough that the public will conclude that the inflation target has in reality been revised down, and we risk converging to a deflationary steady state."

    I'm fascinated. Do economists really believe that "the public" (as opposed "the technical cognoscenti") will cogitate at this technical level? Is there any evidence that "the public" has any concept whatsoever of the consequence of relative minor differences future inflation expectations? (I'm thinking here of the difference between say 2% and 4% rather than the difference between 5% and 1000% - in the latter case, any sentient being would clearly need to plan for future inflation just to survive.)

    So, my question is: are the public's fiscal decisions directly affected by the public's future inflation expectations. Or are they affected by more visceral feelings, like their current fiscal position and their feeling of job (in)security?

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    1. The answer to your question is "yes", when you consider that "the public" includes whatever you might call technical cognoscenti. Or, put another way, it includes the professionals in the financial sector, who control money and prices (and the price of money) through their collective market activities, which are in turn driven by expectations

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    2. In other words, there's a huge difference between "the public" in the political sense and "the public" in the financial/economic sense. Gee, I wonder which public's interests are given priority by the rate setters. I know...stupid question.

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  9. "The implication is that a financial crisis only happens because interest rates are set at the wrong level. The Great Recession was all the fault of the Fed, who kept interest rates too low after the 2001 recession. The gradual deregulation of the financial sector in the decades before? - not an issue. The widespread misselling of subprime mortgages? - these things happen."

    Okay, so it seems plausible that low rates *plus* deregulation causes a financial crisis. (There seem to be other ways as well, but those two are a problematic mix.) Then could Simon please weigh in on whether he thinks today the financial sector is regulated sufficiently? Because if it takes two chemicals to create an explosion, and one chemical is already known to be there, it's idiotic to bring the other chemical into the same space, right? (Personally, I think the financial sector is not today sufficiently regulated, and, for example, collateral is being traded far more aggressively than it has ever been. Risk always end up concentrated in the hands of the firm which has priced it too low, and with collateral any problems will get propagated swiftly throughout the financial sector.)

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  10. Prof could you comment on a recent piece in the FT by Chris Giles?

    www.ft.com/cms/s/0/fbbc28de-0a69-11e4-ac2a-00144feabdc0.html

    Giles claims that the reason why the "government has been able to earmark at least £100bn of infrastructure spending in the next parliament [was] because it has maintained strict fiscal discipline."

    This is particularly odd statement for two reasons, first spending and net debt are higher than the Osborne ever planned. Second, during this parliament Gilts have consistently had a negative real yield. Despite this, Osborne has chosen to cut government investment by more than any other item of spending. Surely Giles should mention this? Would any qualified (i.e. non-city) economist agree with Giles's statement? Would it pass an Oxford exam? Or the laugh test in an economics seminar?

    Even more bizarrely Giles cites "£7bn of science investment" for 2015-20 without bothering to inform his readers of the significant real terms cuts to the science budget over this parliament. Presumably this means Osborne accepts it was a mistake to cut the science budget in the first place?

    This article would be a par for the Telegraph, but I thought the FTs business model was based on accuracy and quality? Is Giles a credible source of economics journalism?

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  11. "The implication is that a financial crisis only happens because interest rates are set at the wrong level. The Great Recession was all the fault of the Fed, who kept interest rates too low after the 2001 recession.
    ...
    what they are really saying is that the financial system cannot be regulated to make it safe when interest rates are low. There is no evidence for that proposition, and a lot of history that says otherwise. "

    It might help to point to actual instances of this. Was the S&L crisis caused by too-low rates? The period up to 1989 when bank failures peaked had rates well above 5% for most of it.

    For any banker making a statement saying that rates should be increased, they should produce an estimate of what the impact would be to their firm's bottom-line.

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  12. If instability is the real concern (not, per Krugman, the latest rationale) then address the rise in inequality that meant that demand could only be sustained by a commensurate rise in ever riskier credit.

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  13. One lesson that we seem to be missing from the 2008 is that interest rates by themselves will never be enough to manage an economy. Instead, macro prudential tools provide the best means of dealing with trouble spots in the economy whether it be too much lending in certain sectors or too much risk taking at banks. Interest rates have such a central role in economic theory that economists don't seem to want to put away their favourite toy. Excess global liquidity has also sapped the ability of central banks to influence interest rates which further makes the use of other tools more crucial. I would like to see more use of macro prudential tools on route to a new type of monetary policy with less emphasis on interest rates. For more on this, see http://yourneighbourhoodeconomist.blogspot.co.uk/2014/06/monetary-policy-surgery-needed.html

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  14. At some point the negatives of ultra low interest rates seem to be larger than the benefits.
    Take housing as an example: when you first lower rates to zero, increasing house prices, as households can afford larger mortgages, it's not surprising that if you at some point need to increase interest rates again, the whole thing will go in reverse putting a break on consumption: higher mortgage costs causing lower consumption, and house prices going down, causing a negative wealth effect for households who are underwater, lowering consumption even more (maybe this did happen in Sweden?).
    How about not letting interest rates go under a minimum level, let's say 2-3%?

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  15. Hang on, I am having trouble seeing the general equilibrium here ...

    The gradual deregulation of the financial sector in the decades before? - not an issue. The widespread misselling of subprime mortgages? - these things happen. All the other examples of misselling and fraud? - boys will be boys. An industry that profits from a massive implicit public subsidy? - we see no subsidy. Classifying subprime products as AAA? Massive increases in bank leverage in the 00s? - all the result of keeping interest rates too low.

    But if we had not had all of these things, output would have been lower too, wouldn't it? You can't help yourself to the statement that "the interest rate was set so as to close the output gap" while washing your hands of the means by which the output gap was closed. If that lending wasn't there, then interest rates would have to have been set even lower, or (more likely) we would never have recovered from the post dot-com slump and would have settled into the stagnation equilibrium ten years earlier than we actually did.

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  16. The Swedish CPI is dysfunctional because of its owner-occupied housing component and does not provide a reliable measure of inflation. I am not sure how wise it was to send the bank rate down again as Sweden appears to be having a housing bubble. See my comment (attached) on one of Shaun Rchard's excellent columns:

    http://www.mindfulmoney.co.uk/wp/shaun-richards/what-does-yesterdays-interest-rate-cut-in-sweden-teach-us/

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  17. Shocking to see that an Oxford fellow is struggling with basic logics.

    Prof Wren-Lewis writes: “Monetary policy cannot afford to ignore the financial sector, and the risk of excessive lending and bubbles that subsequently blow up the economy. There are signs, they say, that what happened in 2007/8 may be happening again now, so we need to raise rates to prevent another crash, even though there is still a negative output gap and inflation is below target.

    The implication is that a financial crisis only happens because interest rates are set at the wrong level”

    I feel strange having to clarify that to anyone above the age of 10.
    But acknowledging that changes in the base rate DO HAVE AN EFFECT on price bubbles is something entirely different from stating that changes in the base rate are the EXLUSIVE CAUSE of asset bubbles.

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