Interest Rate based Macroeconomic Thinking is a Cancer

Lately I’ve been frustrated with macroeconomic discourse, because of how macroeconomists talk about monetary policy in terms of inputs (interest rates, quantity of money added, size of the Fed’s balance sheet) rather than desired outcomes (inflation, unemployment, NGDP).

An interest rate is a communication device that the central bank uses to let the financial sector know how much money they intend to print in the future. Low interest rates matter by the degree to which they signal more money printing in the future. A zero interest rate makes it hard for the Fed to say that they will print more in the future, primarily because they are reluctant to use different language to describe their intentions.

An interest rate alone isn’t necessary or sufficient for a certain level of inflation. If I told you the interest rate was 5%, you couldn’t tell me what inflation rate that implied. 5% interest is compatible with 5% deflation, 5% inflation, or 50% inflation. Economists describe interest rate targeting like balancing a pole:

Targeting inflation by controlling an interest rate instrument is like balancing a pole upright in the palm of your hand. The position of the top of the pole represents inflation, and the position of the bottom of the pole (the palm of your hand) represents the interest rate.

First it’s an unstable equilibrium. If you keep the palm of your hand fixed, the pole will fall over. You have to keep moving your hand to keep the pole upright.

Second, if you want the top of the pole (inflation) to move north, you have to first move your hand south, so the pole starts to lean north. You then need to move your hand north, to stop the pole falling over.

If it’s a long heavy pole, so only leans slowly (inflation inertia), and if you can move quickly, and anticipate gusts of wind, or observe quickly which way the pole is leaning, you can keep it upright, and keep the top of the pole roughly where you want it to be.

But there’s a wall to your south which you can’t go beyond (the zero interest floor). And your hand is up against that wall, and yet the pole is leaning to the south. You want to move your hand south, to start the top of the pole moving north, but you can’t.
– Nick Rowe

If the Fed sets interest rates above the natural rate, inflation will accelerate downwards and vice versa. But the only way we can determine the natural rate is by watching the market’s response to the Fed’s actions. Interest rate targeting is an inherently unstable, backwards looking, and reactive policy.

Interest rate targeting is Unnecessary
Imagine a world without loans. Everyone just makes stuff and sells it, and uses that money to buy what they need. You can still have corporations, government, welfare, and all the other stuff, just no debt. There’s still money, recessions, and a price level. Instead of government borrowing by issuing debt with an interest rate and then having the monetary authority monetize that debt by buying it with newly printed currency, if the central bank wanted to inflate, they’d just print money to finance government spending directly. The increased money supply would offset taxes.

You can still have monetary policy without government debt and without interest rates. If the financial sector saw the central bank printing tons of money, asset prices would increase and the rate of inflation would increase. Even if you add loans to this world, there’s nothing special about interest rates that implies that the central bank needs to control their price. Supply and demand for credit can determine interest rates, just like they determine every other market.

Interest rates are Confusing
“All propositions about real interest rates are wrong.” – Tyler Cowen’s Third Law

r = i + π
where r = the real interest rate, i = nominal interest rate, and π = inflation

Each of these terms is problematic.

i: There are as many interest rates as there are loans. They vary by term duration, risk (there are various types of risk), and liquidity. The Fed usually limits their purchases to short term government bonds, but that’s not always the case.

π: There are as many inflations as there are people. Inflation is the change in prices of a basket of goods over time, but it is extremely subjective. New goods are added every year, goods leave the market every year, some goods are compliments to others and their prices go in opposite directions. The Bureau of Labor Statistics do their best, but inflation is literally impossible to calculate.

Furthermore, the inflation that matters is the expected inflation at the time the loan is made. Lenders are less willing to lend at a given interest rate if they expect high inflation in the future (preferring to buy durable goods or something indexed) and borrowers are more willing to borrow at a given interest if they expect high inflation, since they know they will be able to pay back the loan for a lower real cost. Not only does expected inflation mismatch actual inflation, but people have differing beliefs on what inflation will be over various time horizons.

r: Being the summation of two incalculable things doesn’t exactly lend itself to being easy to figure out. When someone makes a loan, they are estimating that the subjective value of the stuff they could buy with the money today is less (whatever that means) than the value of the stuff they expect to get with the money they expect to get in the future when the loan is paid off. Time preference is both unstable and immeasurable. You’re basically throwing a bunch of incalculable subjective stuff into one big equation and hoping a simple number is going to pop out. There’s no such thing as “the” real interest rate, and even if there were, it would not be observable by mortals.

If economists get tripped up by interest rate targeting, imagine how confused politicians are. All through 2009, if you turned on CSPAN you’d hear speeches about how low interest rates meant that hyperinflation was right around the corner, when the market was expecting deflation. Economists did not do their duty to tell journalists and politicians to calm down and not worry because they didn’t understand how it was working themselves! Economic theory is like eyeglasses that let you see the world more clearly. Not being able to tell whether there will be deflation or hyperinflation suggests that maybe your theory isn’t helping you see the world at all.

No one cares about it
If I told you interest rates changed from 5% to 6%, …so what? If inflation and unemployment are low, no one cares. People care about stuff that affects them. They get upset when they lose their job, or their wages go down, or the price of stuff they buy goes up. If the Fed Funds rate needs to be 20% or -10% to make that happen, no one will care other than maybe a few bankers. Why would you pick a target to base an entire economy around that only a tiny number of people care about? Why not just target something important and let supply and demand determine the interest rate? Which brings us to our next point.

Interest rates are not controllable by the central bank
Interest rates are determined by supply and demand, no matter what delusions of grandeur the central bankers may have to the contrary. Using basic price theory, if a supplier is small relative to the total market, they can’t have a large impact on the price unless price elasticity of supply is extremely low. The total value of the global capital market is around $100 trillion. The Fed’s balance sheet is around $5 trillion, while not insubstantial, is not enough to exert control over interest rates. This was even more true in the past, as the Fed’s balance sheet is at historic highs and normally sits much lower. Normally, the Fed only accounts for about 1% of the world capital market. Furthermore, the argument that the Fed can influence the Fed Funds rate, even if it can’t influence overall interest rates only works if the Fed Funds market were segmented. It’s not, so they can’t.

In the short run, the quantity of investment doesn’t respond much to changes in interest rates, so the Fed can affect interest rates. However, what is important for monetary policy is not the interest rate in a week, or even in a month, but how policy is conducted over the course of a year. The primary way the Fed changes interest rates in the medium to long run is by changing inflation and influencing rates through the Fisher equation.

ZLB is mischievous
Otherwise intelligent people are reduces to incoherent babbling when confronted by 0% interest rates. Under interest rate targeting, if short term bonds are at 0% and the central bank conducts policy by exchanging reserves which yield 0% for bonds, they are just replacing one highly liquid 0% asset with another and thus won’t have an impact on inflation, lending, spending, or anything else.

There’s nothing preventing the central bank from targeting an interest rate below 0, as some central banks are. It’s like we’re in a world where physicists are debating whether heavier than air flying machines are possible when there are airplanes overhead.

Because of interest on reserves, the Fed is replacing a 0% yielding asset (money) with an asset that yields more than 0% (reserves), which is contractionary.

The Fed has had no trouble actually conducting policy. If the zero lower bound were really such a hinderance to conducting monetary policy, why have the policy outcomes been more stable at 0% than they were when interest rates were positive? Wouldn’t one expect policy to become more unstable?

If the liquidity trap were a real thing, we could abolish the national debt and fund government spending by printing money, and still have 0% inflation, so it would be the best thing ever to happen to the government.

Cash is inherently limited/costly to hold in large quantities, and there are legal reasons to hold bonds above and beyond their yield. Despite the fact that they yield the same, they vary in liquidity, so converting bonds to cash can affect spending.

What is called a liquidity trap or zero lower bound basically never is. While interest rates are low, they are not 0 at all maturity dates. There is still wiggle room, however slight. When 30 year Treasuries yield 0, then there will be some justification to talk about liquidity traps, but not before.

The whole idea of a zero lower bound is a steaming pile of nonsense. But it only could have arisen because of interest rate targeting. If the central bank simply targeted something else, no one would have ever thought of it.

Conclusion
Interest rate is not a target (since it can’t be controlled), and it’s not a goal (since no one cares what it is), so what is it? It’s an instrument and a communication device, and it’s bad at both of those jobs. It fails as an instrument because it’s backwards looking, unstable, and doesn’t work at the zero lower bound. It fails as a signal of central banker’s intent because no one understands it.

So why not just target an outcome variable directly? If you’re below the target, print more money. If you’re above the target, print less. Done. I’ve even come up with a Fed announcement template so they can clearly state their intentions:

Notes and Further Reading
SRW on QE
Does QE cause deflation
Monetary policy as a threat strategy
Econtalk with Scott Sumner on interest rates
Negative natural rate might be normal

I’m not sure what exactly central banks did pre-fiat currency. If you can’t control the quantity of money, you can’t really control inflation or exchange rates. Maybe you can fiddle with reserve requirements, but there’s no way you’d have enough resources to change interest rates for anything more than a trivially short duration. If any economic historians reading this could comment on some sources about the 1920s monetary policy, I’d appreciate it.