How interest rates matter, and how they don't
By Scott Sumner
There are certain topics that are extremely hard to explain to the average person. Interest rates are one of those topics. I’ve often argued that interest rates don’t really matter that much; they are a sort of epiphenomenon of monetary policy. I’ve also argued that the ECB adopted a tight money policy in 2011, and that this triggered a double-dip recession. And what’s the easiest way for the average person to visualize the ECB’s tight money policy? The fact that in 2011 they raised their interest rate target from 1.0% to 1.25%, and then to 1.50%. But if interest rates don’t matter very much, how could mere 50 basis point increase cause a recession, especially given that they soon started cutting rates again?
One problem is that most people think we are always in the short run. No matter how many times you teach students that tight money raises rates in the short run (liquidity effect) and lowers them in the long run (income and Fisher effects), when the long run actually comes around they will still see the fall in interest rates as ECB policy “easing”. And this is because most people think the term “short run” is roughly synonymous with “right now.” It’s not. Actually “right now” we see the long run effects of policies done much earlier. We are not in an eternal short run. That’s the real problem with Keynes’s famous “in the long run we are all dead.”
I’m going to try to explain why even a 1 basis point increase in the interest rate target could cause a Great Depression, and then afterwards explain why interest rates actually aren’t very important at all. Bear with me.
In most macro models, interest rate pegging is a knife-edge equilibrium. If the rate is pegged slightly below the natural rate, the economy will spiral up into hyperinflation. If slightly above the natural rate we’ll spiral into hyperdeflation. That’s because when you peg the interest rate above or below the natural rate, the resulting movement in the economy starts pushing the natural rate further and further away from where you are pegging interest rates. You gradually get further and further off course.
Perhaps an auto steering analogy will help. Suppose you set off west across the Bonneville Salt Flats. You try to lock the steering at a position where you will go straight west, but the wheel is accidentally set 1 millimeter off center. After 100 yards the car has drifted an inch to the right. That’s not too bad, it seems like you won’t end up too far off course. But here’s the problem, the error will gradually get worse and worse. After 200 yards you’ll be 3 or 4 inches off course, and after that the car will rapidly deviate further and further to the right. The path will be a gradual curve to the right, and before very long you’ll be headed straight north. (Don’t ask for details, I took calculus 40 years ago.)
Why don’t we see real world central banks make even more errors than they do? Because they usually adjust the steering as they see the economy go off course. They adjust their interest rate peg up or down (and do QE at near zero interest rates.) That’s like a driver nudging the wheel a bit to the left or right as he observes the car drift slightly off course. It’s easy for drivers to do, and it’s easy for central banks to do. When they produce bad policy (as the ECB did in 2011) it’s because they were trying to produce the policy we now judge as bad—they were trying to reduce eurozone AD to bring down inflation.
Taylor says the Federal Reserve kept interest rates two percentage points to [sic, ‘too’] low for three years. If you are buying a long-duration asset like housing, such an interest rate break leaves you willing to pay 6% more than you would otherwise have been willing to pay. Are we really supposed to build a 50% nationwide housing bubble on top of the 6% impetus? Only a market already fully infected with the bubble disease could see such a small impetus have such a large impact.
I actually agree with DeLong. Although a tiny change in interest rates might cause the money supply to gradually change in such a way as to create rapid NGDP growth, the actual policy done by the Fed did not do that in the early 2000s, at least no more so than in the 1950s, 60s, 70s, 80s, or 90s. So while in retrospect policy may have been a bit too expansionary, it didn’t miss by all that much. And yet the house price boom was much more dramatic than during more inflationary decades.
Now perhaps interest rates worked on house prices through some channel other than NGDP growth. In that case I’d point to DeLong’s argument, the interest rates were not off base enough to explain such a dramatic price increase. If you are looking at interest rates and home prices from a microeconomic perspective, then you throw out the knife-edge equilibria models, and use common sense. Oddly, while a one basis point interest rate increase can cause a Great Depression in a macro model, it’s very hard to see how even a 200 basis point rate cut lasting three years can boost home prices by 50% in a microeconomic model.
Here’s another way of making the same point. Monetary policy matters because money is the medium of account, the driver of NGDP. If the government were able to reduce interest rates via a non-monetary mechanism (say a smaller budget deficit) then you’d expect a far less dramatic impact on the economy, as compared to Fed policy moving rates around. With Fed policy it’s the change in the monetary base (relative to base demand) that really matters, interest rates are simply the signaling device that people focus on.
The 2011 ECB tightening mattered because:
1. The ECB has a monopoly on the euro base, and hence controls the path of AD.
2. The two rate increases were a signal they wanted to slow the growth in AD.
3. AD growth did in fact slow sharply.
Any two of those would not be enough, but combining all three we can assume that the ECB was the cause of the sharp slowdown in AD growth after 2011. The size of the rate increase is totally irrelevant. The eurozone didn’t have a double dip recession because slightly higher rates discouraged people from borrowing, but rather because the ECB caused eurozone M*V growth to slow sharply.