Enough with Interest Rates Already

One of the things which alternately frustrates me and fascinates me is the mythology surrounding the idea that the central bank can address inflation by manipulating the price of money, even if it ignores the quantity of money.

I say “mythology” because there is virtually no empirical support for this notion, and the theoretical support for it depends on a model of flows in the economy that seem contrary to how the economy actually works. The idea, coarsely, is that by making money more dear the central bank will make it harder for businesses to borrow and invest, and for consumers to borrow and spend; therefore growth will slow. This seems to be a reasonable description of how the world works. But this then gets tied into inflation by appealing to the idea that lower aggregate demand should lower price pressures, leading to lower inflation. The models are very clear on this point: lower growth causes less inflation and more growth causes more inflation. The fact that this doesn’t appear to be the case in practice seems not to have lessened the fervor of policymakers for this framework. This is the frustrating part – especially since there is a viable alternative framework which seems to actually describe how the world works in practice, and that is monetarism.

The fascinating part are the incredibly short memories that policymakers enjoy when it comes to pursuing new policy using their preferred framework. Here’s the simplest of examples: from December 2008 until December 2019, the Fed Funds target rate spent 65% of the time pinned at 0.25%. The average Fed funds rate over that period was 0.69%. During that period, core inflation ranged from a low of 0.6% in 2010 to a high of 2.4%, hitting either 2.3% or 2.4% in 2012, 2016, 2017, 2018, and 2019. That 0.6% was an aberration – fully 86% of the time over that 11 years, core inflation was between 1.5% and 2.4%. Ergo, it seems reasonable to point out that ultralow interest rates did not seem to cause higher inflation. If that is our most-recent experience, then why would the Fed now be aggressively pursuing a theory that depends on the idea that high interest rates will cause lower inflation? The most-recent evidence we have is that interest rates do not seem to affect inflation.

This isn’t just a recent phenomenon. But the nice thing about the post-GFC period is that for a good part of it, the Fed was ignoring bank reserves and the money supply and effecting policy entirely through interest rates (well, occasionally squirting some QE around, but if anything that should have increased inflation – it certainly didn’t dampen the effect of low interest rates). This became explicit in 2014 when Joseph Gagnon and Brian Sack, shortly after leaving the Fed themselves, published “Monetary Policy with Abundant Liquidity: A New Operating Framework for the Federal Reserve.” In this piece, they argued that the Fed should ignore the quantity of reserves in the system, and simply change interest rates that it pays on reserves generated by its open market operations. The fundamental idea is that interest rates matter, and money does not, and the Fed dutifully has followed that framework ever since. As I just noted, though, the results of that experiment would seem to indicate that low interest rates, anyway, don’t seem to have the effect that would be predicted (and which effect is necessary if the policy is to be meaningful).

And really, this shouldn’t be a surprise because for the prior three decades, the level of the real policy rate (adjusting the nominal rate here by core CPI, not headline) has been completely unrelated to the subsequent change in core inflation.

So, to sum up: for at least 40 years, the level of real policy rates has had no discernable effect on changes in the level of inflation. And yet, current central bank dogma is that rates are the only thing that matters.

I stopped the chart in 2014 because that’s when the Gagnon/Sack experiment began, but it doesn’t really change anything to extend it to the current day. Actually, all you get is a massive acceleration and deceleration in core inflation that all happened before any interest rate changes affected growth (seeing as how we have not yet had a recession). So it’s a result-within-a-result, in fact.

Any observation about how the Fed manages the price of money rather than its quantity would not be complete without pointing out that the St. Louis Federal Reserve’s economist emeritus Daniel L Thorton, one of the last known monetarists at the Fed until his retirement, wrote a paper in 2012 entitled “Monetary Policy: Why Money Matters and Interest Rates Don’t” [emphasis in the original title]. In this well-argued, landmark, iconic, and totally ignored paper Dr. Thornton argued that the central bank should focus almost entirely on the quantity of money, and not its price. Naturally, this is concordant with my own view, plus more than a century of evidence around the world that the price level is closely tied to the quantity of money.

To be fair, the connection of changes in M2 to changes in the price level has also been weak since the mid-1990s, for reasons I’ve discussed at length elsewhere. But at least money has a history of being related to inflation, whereas interest rates do not (except as a result of inflation, rather than as a cause of them); moreover, we can rehabilitate money by separately modeling money velocity.

There does not appear to be any way to rehabilitate interest rate policy as a tool for addressing inflation. It hasn’t worked, it isn’t working, and it won’t work.

  1. Jon
    June 21, 2023 at 5:25 pm

    Interesting. How do they affect the quantity of money? QT? Does that mean only QT will/can lower inflation and that they are not doing enough of it?

    • June 22, 2023 at 8:08 am

      Right – the best thing the Fed is doing right now is shrinking the balance sheet. A pause in rates and continued balance sheet shrinkage is the best medicine. We still have a lot of make-up to do as velocity recovers, but the first mission is to get the Desk operating at the margin again.

    • R L
      June 29, 2023 at 1:35 pm

      The quantity of money is directly correlated to the amount of debt the US sells. So unless there is a 180 degree change in DC and they all start to become fiscally responsible, the recent contraction in the money supply will be short lived especially since the raising of debt limit ceiling. Volker was only successful in conquering inflation because the Reagan administration as well as congress was cutting spending and privatizing parts of the government, there by reducing the need for the government to sell more debt. The velocity of M2 was at its greatest level during Clinton’s 2nd term as they balanced the budget and actually ran a budget surplus.

  2. Phil
    June 21, 2023 at 7:22 pm

    “It hasn’t worked, it isn’t working, and it won’t work”. Indeed. Would tax be an effective tool (if available)? And if so, is the idea of having a base level of tax in the hands of central banks silly/crazy?

    • June 22, 2023 at 8:09 am

      Personally, I prefer to leave taxation in the hands of directly-elected representatives!

    • Dan
      June 26, 2023 at 2:52 pm

      Tax policy cannot pivot fast enough to be effective. Instability in tax policy reduces long range investment via the same mechanism as appropriation risk when investing internationally. Appropriating assets for the sake of directing the economy = stealing and leads to poverty for all ie. Russia, Venezuela, pick your third world country…..

  3. June 21, 2023 at 10:22 pm

    ”For reasons I’ve discussed at length elsewhere”. Can you provide links?

    • June 22, 2023 at 8:09 am

      You’re in the right place. Search this blog and you’ll find lots and lots…

  4. Kevin Lee
    June 23, 2023 at 12:10 pm

    Excellent article, Michael. Do you think the Fed’s monthly QT of roughly 75 billion (they never hit the target of 95 billion due to slow MBS rolloff) is too slow? What do you think is a good number for QT? Is the slow QT designed to protect the market? I was arguing for 200 billion a month. Thank you for your article.

    • June 24, 2023 at 12:31 pm

      I would do it faster, but then my view of where they need to end up is a lot lower than their view has been. But frankly, I didn’t think M2 would respond at all until they were operating on the margin of required reserves. HQLA adds a wrinkle that’s difficult for me to unravel – so a slower pace might be more prudent. That being said, I was pleased when they paused in hiking rates BUT continued QT.

  5. Mark
    June 23, 2023 at 9:15 pm

    To control the quantity of money authorities must first know what money is. The Fed gave up on quantifying M3 decades ago and that decision was related to pursuing interest rate targeting as the the Policy tool. M3 itself did not capture all money anyway. I think Alan Greenspan said something like “to apply monetary policy we must first locate money”. You state M2 has a weak connection to changes in the price level which I think is probably due to its narrowness as a measure of money. You may have already given your views of what money is in other articles (I am a new reader) and if so could you point me to them please? Thanks

    • June 24, 2023 at 12:33 pm

      No, M2 has a very strong connection to changes in the price level over time – in recent decades it has by itself not had a good short-term record. But that’s just because velocity has become more volatile; if we model velocity, M2 is still pretty tightly linked. As for my other articles – just search the blog. There are more than 1,000 articles there so you’ll find plenty. 🙂

  6. Greg
    June 24, 2023 at 11:11 am

    This is verbatim the debate that happened as Paul Volcker became chair of the Fed in the late 1970s. Almost the same words. The Fed was obsessed with controlling rates while pretty much ignoring money supply (both fiscal and monetary sources), inflation was getting out of control. Volcker said the Fed needed to emphasize total money supply with rates as a secondary factor.

    The Fed forgot the lesson. Same obsession with rates, same increase in inflation. Same garbage in, same garbage out

  7. Sanjiv Sharma
    July 1, 2023 at 9:33 pm

    With debt to GDP > 100% raising rates is fiscally (but regressively) stimulative.
    Also for capital intensive industries the higher rates are passed on to consumers with “sellers inflation”. Also for non perishable commodities, forward prices increase. QE and QT change the duration of Federal debt. As Volker observed, monetary policy works to curtail inflation, one bankruptcy at a time.

  1. July 2, 2023 at 10:15 am
  2. August 10, 2023 at 9:43 am

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