What does it mean to suggest that interest rates are "artificially low"?
By Scott Sumner
I recently received this request in a comment section:
Slightly off-topic, but Scott you would *love* an idea which is becoming more widespread here in the UK, that the housing shortage here is being caused by “artificially low interest rates”.
It is being peddled by worryingly-influential right-of-centre finance commentators in newspapers.
Let’s start with the term ‘artificially’—what does that actually mean? It might mean a shortage or surplus exists, as when New York rent controls artificially hold rents below equilibrium. It might mean monopoly power, as when OPEC artificially raises equilibrium oil prices though output restrictions. This latter use of ‘artificially’ means something more like monopoly power than price controls. Clearly the role of monetary policy in the credit markets is more like OPEC than NYC rent controls. The fed funds rate does find an equilibrium, it’s just that central banks are such big players that they can affect that equilibrium rate.
OK, but how would we establish whether the equilibrium interest rate is “artificially” low or high? There’s really only one set of criteria, which (AFAIK) were first modeled by the economist Knut Wicksell. He referred to the natural interest rate as the rate that would lead to macroeconomic equilibrium. He used price stability as the benchmark for equilibrium, although in modern central banking the analogous criterion would be something like 2% inflation. Because Britain and other major developed countries are currently experiencing less than 2% inflation, there is no evidence that rates are artificially low. If they were, inflation would be much higher.
Some people argue that supply-side factors such as competition from China are holding down inflation, and that the inflation shows up in asset markets like housing and stocks, instead of consumer prices. That’s a good argument in principle, but is it true? George Selgin and others have persuasively argued that something like NGDP growth is a better criterion for monetary stability. Selgin suggests that rapid productivity growth should lead to lower inflation, and that if central banks artificially maintain something like 2% inflation in an environment of fast productivity growth, then the economy might become overheated and distortions would occur. I agree.
Unfortunately most proponents of the “artificially low interest rates” hypothesis don’t seem to have a coherent macro model underlying their arguments. If China competition were actually holding down inflation, we should see unusually fast productivity growth. But in the UK there has been almost no productivity growth in the past decade, and hence pointing to supply-side factors actually deepens the puzzle. If rates were artificially low in the UK, then we ought to see either high inflation or high productivity growth. But both of these variables are growing very slowly.
There is absolutely no mechanism by which monetary stimulus could boost asset prices without boosting NGDP. None.
If rates were artificially low, then attempts to raise them should be successful. But recent attempts by central banks to raise rates have all gone poorly. Japan tried in 2000 and 2006, Sweden in 2010, the ECB in 2011. In each case the economy soon went back into recession and/or deflation, and the central bank had to cut rates back to zero to prevent an outright depression.
When I studied macroeconomics at the University of Chicago in the late 1970s, I felt we were ahead of the rest of the profession. One advantage was that we never reasoned from an interest rate change. Friedman emphasized that low rates did not mean easy money, and that you needed to look at other indicators (he preferred M2, and then later in his life inflation.) It’s very discouraging to see things flop-flop in 2015, where you now tend to see people on the right drawing all sorts of unjustifiable conclusions from the low level of interest rates. In contrast, many economists on the left recognize that low rates reflect a weak economy and low inflation, as well as possible long-term “stagnation” factors. I guess we’ll have to keep fighting this battle over and over again.
PS. I have some comments on interest rates at a new EconTalk interview with Russ Roberts. A commenter pointed out that I didn’t clearly enough distinguish between ex ante and ex post returns on capital. I should have emphasized that it is ex ante returns that matter.