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Against Interest Rate Reductionism

Can we reliably infer the stance of monetary policy from interest rates? Many market-watchers think so. They confidently claim that high rates mean money is tight, and low rates mean money is loose. Reality is more complicated. The relationship they describe only holds over short periods of time, and even then only under very specific conditions. Furthermore, there are plenty of instances where the truth is just the opposite! We really need to get over interest rate reductionism.

There are three channels through which monetary policy affects interest rates: the liquidity effect, the income effect, and the inflation effect. 

Financial and economic commentators typically focus on the liquidity effect: Expanding the money supply puts downward pressure on interest rates and contracting the money supply puts upward pressure on interest rates. This works best when money is unexpectedly looser or tighter than previously. Even then, the effect does not last very long. 

The income and inflation effects work in the opposite direction. Monetary conditions also affect total spending, and hence total income. These correlate positively with interest rates. Finally, if monetary policy creates inflation, it should boost interest rates (adjusting for inflation, however, interest rates should remain unchanged).

We need to tweak the above story because we’re in a floor system, rather than a corridor system. The Fed adjusts the fed funds rate by changing the interest it pays banks on reserves. Recall that the Fed funds rate is the rate banks charge each other for overnight loans. Since banks will not lend each other money at a lower rate they can get from parking their funds at the Fed, the Fed funds rate tracks the interest rate paid on reserves. Now that the Fed is changing interest rates through administrative fiat, it has more short-run control than when it relied on open-market transactions. But once we start looking at longer time intervals, the picture gets pretty murky. This has nothing to do with the Fed’s operating system, and everything to do with the limits of monetary policy.

Specifically, the long-run effects (income and inflation) work in opposite directions from the short-run effect discussed above, regardless of how the Fed implements it. Looser money (and lower rates) today turn into faster income growth and inflation (and higher rates) tomorrow. This is why interpreting monetary conditions from interest rates is perilous. Conventional wisdom holds that low rates means easy money. But the reverse could be true: If money is too tight, hampering economic activity, this could make rates lower than otherwise. Lamenting the state of macroeconomics, Milton Friedman once remarked, “I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

In the short run, it’s sometimes appropriate to infer changes in the stance of monetary policy from changes in interest rates. But over longer time horizons, the relationship breaks down. Once we’re looking 10 years ahead, for example, monetary policy is largely irrelevant. Interest rates are determined by real (i.e., non-monetary) factors: the availability of labor, capital, and natural resources; technology and productivity; and institutional-legal factors.

Thus, using interest rates as a proxy for monetary policy is precarious at best and completely unhelpful at worst. What should we use instead? Simple: money supply and money demand. Central banks have significant control over the growth rate of the monetary base. They have less control over the broader monetary aggregates, but even here their powers are non-negligible. Comparing the growth rates of the money supply and money demand is the best way of assessing overall liquidity conditions. If the money supply is growing faster than money demand, all else equal, nominal income will grow too. Economic fundamentals independent of monetary conditions determine the breakdown into real income growth and inflation. The most immediate sign of loose money is a jump in nominal income growth; the most immediate sign of tight money is a decline in nominal income growth.

I’ve said it before and I’ll say it again: Monetary policy is about money, not interest rates. Central bankers should stop trying to implement monetary policy by messing with relative prices. There are better measures and more effective transmission mechanisms.

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