A normal interest rate is a rate that actually charges interest.
It’s not called “free money rate” for a reason. Borrowing is supposed to have consequences. Allowing large financial institutions to borrow without the requisite return of interest provides a perverse incentive to borrow as much as possible and see what shit sticks to the wall.
It is, historically, untreaded territory for interest rates to be so low for so long. Given the strong growth in the economy, particularly in employment, inflation tendencies are growing and a measured return to a normal interest rate is in the best interest of the economy as a whole.
The Chinese meltdown is, of course, throwing a wrench into that equation. The Fed will likely be forced to keep it where it is for the time being.
Any yokel knows to take his foot off the gas when 50 feet away from a stalled car. But by that time it’s too late.
BTW, the real interest rate (rate minus inflation) is NOT “supposed” to be near zero; indeed its size correlates with economic health. (In a healthy economy competition for investment capital bids up rates.)
But, despite these comments, I have no opinion on what the Fed should do. The economy is sailing through uncharted waters.
When you say a normal interest rate is one “that actually charges interest,” are you saying interest rates are currently zero? Because I got a good interest rate when I bought my last car, but it wasn’t 0.
What’s not called “free money rate”?
I’m not sure what you mean by this. Are you saying large financial institutions are borrowing interest-free? From whom?
Are you saying they’re being reckless? If so, what makes you say that?
I chose 3 month Treasury bonds, because the recorded data went back the furthest: from 1934 (0.24%) to 1947 (0.38%) the highest rate was 0.38%. The lowest rate was 0.02% (1940). That’s 13 years.
From 2009 until now, interest rates have been lower than that: 0.13% in Jan of 2009 and 0.03% as of July 2015. The highest rate was 0.21%, in March of 09. So interest rates have mostly been lower, by about 0.1% - 0.3%, but for a shorter time - about 6 years.
Having said that, during the 6 years of low interest rates, the unemployment rate has fallen from about 10% to about 5.3%, with little or no inflation. If it’s a previously untried experiment, it seems to have been a success.
That’s a statement, but you haven’t provided any argument or support for it. The most recent inflation rate was 0.2%.
A couple of other factors. One thing a central bank does when the economy starts to lose steam is to lower interest rates. If they are already near zero (and banks borrowing from each other get better rates than you or I do) there is nowhere to go.
Inflation encourages spending. If you know the price of something you want is going to go up next year, you buy it now. If the price is going to stay static you have an incentive to put off the purchase.
You are cruising along a highway at night; no cars are around you. How much pressure should you put on the gas peddle? What is the natural rate of pressure on the gas peddle?
The natural rate involves sufficient pressure to stay at the desired highway speed. It varies with terrain and road conditions. Similarly interest rates should be adjusted so as to attain full employment/ the natural rate of unemployment / NAIRU: the non-accelerating inflation rate of unemployment. I don’t think we’re there yet.
That said, core CPI has ticked up to 1.8 percent over the past year. We’re within striking distance of 2.0%, which the Fed says is its target but really appears to be a soft ceiling. This is misguided. For reasons discussed in other threads, the Fed needs to shift to nominal GDP level targeting or a higher target rate of inflation- I’d prefer the 3-4% range, though even that is arguably too low. That way they can secure lower real interest rates if there’s an adverse shock to the economy.
But they want 2% core inflation over the medium run. But what’s the rush? Why not wait until rates hit 2.25%, then ease them down to 2%? We’ve had inflation under 2% for the last 7 years or so after all. Former FOMC member Narayana Kocherlakota advocated a 2.25% trigger. Why doesn’t the Fed hit its 2% target from the top: that would insure that positive and negative risks are more balanced?
There are 2 categories of explanation on the table.
Krugman, this week. He walks through a number of possibilities here and in a freebe manner here (excerpts). But I also suspect that a lot has to do with the urge to resume a conventional central-banker role. The whole culture of central banks involves saying no to stuff people want, taking away the punch bowl as the party gets going, having the courage to do unpopular things; everyone wants to be Paul Volcker. The Fed is really, really eager to return to that position — and is, I fear, engaging in wishful thinking, believing much too readily that a return to normalcy is appropriate.
It’s not. I’m with Larry here: this attitude has the makings of a big mistake. Think Japan 2000; think ECB 2011; think Sweden. Don’t do it. Or think about the US in 1936 for that matter.
The 2nd has to do with “Financial stability”. The Fed cares about the level of short term rates, but they are also concerned with raising rates too quickly. Long term rates are low now and the markets are used to very low rates. Maybe they will have a seizure if you raise rates by a quarter point 8 times in a single year. So the Fed would rather take things slow. But if they take things slow, they need to start earlier.
Ookay, say I. But now we have financial instability. IF we get drops in the stock market of 25% or more, we should respond like Greenspan did to the 1987 crash: drop real rates by 2 percentage points. Except we can’t do that, because rates are currently under 0.25%. The higher inflation is, the more stimulus the Fed is capable of applying to the economy with conventional policy. So I guess the Fed should launch QE4 under such circumstances. I don’t know if it works, but it’s the only tool they have left (nominal GDP level targetting excepted). At any rate explicitly postponing a rate hike until after December 2015 would be prudent and is possibly too little. Say the words: “The Fed is ready to serve as a source of liquidity to support the economic and financial system.”
Incidentally, the go-to guy for watching the Fed is Tim Duy’s blog.
Summary: the balance of risks don’t support the case for a rate increase: “I doubt that, if rates were now 4 per cent, there would be much pressure to raise them.”
I’ve always thought that the inflation measurement as used by the FRB to set interest rate should give a very low weight to imported commodities (like petroleum) whose prices are set by the world market (and perhaps a positive weight to asset price inflation).
The reason is simple. The idea of tightening money is to prevent shortages, or excess demand for domestic production. But petroleum price does NOT reflect domestic demand(*), it reflects world conditions not subject to FRB policy.
Comments?
(* - Yes, the U.S. is such a big player that its domestic demand can effect world commodity prices. For the sake of this discussion assume we’re discussing central bank policy of a somewhat smaller country.)
You’e comparing Fed policy to driving a car. It’s true that you should take your foot off the gas when you see a stalled car in front of you. But where is the stalled car?
US GDP growth was -2.8% in 09. Since then it’s averaged about 2%. Real GDP growth has averaged about 3.3%, since 1929.
To put it differently, we’re going slower than average - and that average includes recessions, the Great Recession, and the Great Depression. During periods of high employment we’ve grown in the 4%-6% range. To use your car analogy, we’re not going very fast, and there’s nothing we’re about to crash into.
When you say the real interest rate is not supposed to be near zero, why do you say that? Why shouldn’t the real interest rate be near zero?
Does the health of the economy drive interest rates? Or are interest rates controlled by the Fed?
Because I would submit that the Fed controls interest rates, not the economy; and that low interest rates tend to improve the economy, while high interest rates lead to recessions and unemployment.
My understanding is that banks aren’t lending to each other right now. They have so much in excess reserves, they have no need to borrow. The Fed is, however, paying them 0.25% on excess reserves.
Inflation does encourage buying. Inflation itself, however, is the result of supply and demand: (a) the demand for money, (b) the supply of money, (c) the demand for goods and services, (d) the supply of goods and services.
So long as the economy is able to produce more goods and services to supply a growing demand, the result is GDP growth and increased employment, without inflation. Inflation occurs when, for whatever reason, the economy is not able to produce enough goods and services to meet demand. I’d argue we’re not there yet: our economy is capable of producing substantially more than it’s producing now. To put it differently, GDP could grow faster, without creating inflation.
I don’t think that’s a good analogy: we have lots of information about the economy. If you want to use the economy as a car example, I’d argue we have a pretty good sense of what’s around us, and we can see a reasonable distance ahead.
What is the non-accelerating inflation rate of unemployment? Is it 2%? 5%? Some other number?
I’m curious where you got the 1.8% number. The Fed is showing 0.2%, as of July 2015. That’s up from -0.2% in January, but still down from 2.1% in May of last year. The US Inflation Calculator is also reporting 0.2% inflation, as its most recent number.
Thanks for the links.
I’m not seeing any signs of inflation, and I think the unemployment rate is still too high. It looks like monetary base has fallen slightly in the last few months, from $4.1 trillion to $3.9 trillion. (That is of course still far higher than the $0.8 trillion in 08.) I’d argue the Fed should be increasing MB right now, and the Treasury should be spending more. The deficit has fallen from $1,413 billion in 09 to $485 billion in 2014. Deficit spending has fallen too much, too quickly. The combination of Fed purchases and Treasury sales is the best way to improve the economy.
I’m sure Krugman’s theory is at least partly right.
Assuming I’m interpreting this correctly (always a tenuous thing), I’d say this pretty much hits the mark. Basically, the Fed uses a drop in interest rates to stimulate the economy during a recession. If the rate stays the same as it is right now, the Fed will have no tools available to it to try and stimulate the economy in the next recession, which WILL happen at some point…it’s the nature of a modern economy that you’ll have recessions. We are 6 years into the current recovery, so a recession is in our future in the next year or so. By that time the Fed needs to have raised interest rates so that, when that new recession comes they have the ability to lower those rates to stimulate the economy.
The first article was written three years ago. How have those predictions panned out?
For point 3, I’m pretty sure housing prices and home buying have increased since then. Point 4 is pretty laughable – oil has hit pretty serious lows. Point 5 – unemployment has come down. Point 6 – what’s the natural rate?
I’m not really qualified to opine on 1, 2, or 7, but this looks like the author wants rates to be raised and is thrashing around for reasons to do so. And, with the passage of time, has been shown to be pretty wrong.
And when the next recession comes anyway? The Fed is just supposed to raise it’s hands and say ‘well, the interest rates are already at zero, so there isn’t anything we can do…good luck!’? The Fed would lose credibility if it can do nothing to help the economy in the next recession. Unless you want to posit that there won’t be a next recession and the good times, such as they are, will just keep rolling along?
I suppose we COULD go to negative interest rates such as they are doing in Europe. How’s that working out for them? How would that work out for things like pension plans and underfunded entitlements with negative interest rates wrt rate of return?
Of course there will be more recessions. Raising rates now, though, will only hasten it. It happened in Sweden and in the UK.
If the recession comes and rates are still low, the Fed can try quantitative easing again. Or, maybe congress can earn its keep and try some fiscal stimulus. We have crumbling infrastructure, and the bond markets are begging us to borrow from them. For quite a long time, real rates out to 10 years were negative – borrowers were going to pay us to borrow from them (in real terms) and instead we laid off federal workers and cut investments in infrastructure.
