Raising rates tightens money, but isn't (necessarily) tight money
By Scott Sumner
Bob Murphy has a post criticizing me for being inconsistent on the subject of interest rates and the stance of monetary policy. Sometimes I say that changes in interest rates don’t tell us anything about the stance of monetary policy. Indeed more often that not, higher rates indicate easier money (as in the 1970s.) Other times I suggest that raising rates is a tightening of monetary policy, as when I said there is no justification for the Fed raising its target rate right now, as we are already likely to fall short of its policy objectives.
Perhaps it’s easiest to explain this seeming contradiction by using a real world example: Fed policy during the 1970s. Since most people like to think about monetary policy in Keynesian/Austrian (interest rate) terms, let’s use the best interest rate model—Wicksell’s natural rate concept.
Wicksell said that an easy money policy occurs when the central bank sets the policy rate below the natural rate of interest, resulting in inflation. In contrast, if the central bank sets the policy rate above the natural rate of interest you have a contractionary policy and end up with deflation. (Substitute rising and falling NGDP, if you prefer.)
In the late 1960s and 1970s, the Fed consistently set the policy rate (fed funds target/discount rate) below the natural rate of interest. This led to ever-higher inflation rates from 1965 to 1981. And here’s what’s important. The higher inflation caused the Wicksellian natural rate of interest to rise steadily—via the “Fisher effect.” Thus the Fed found itself in a position where it needed to set rates at higher and higher levels in order to get inflation under control.
This invisible rise in the natural interest rate is what causes confusion. It looked like the Fed was steadily tightening monetary policy during the 1970s, and yet inflation kept rising. (That’s because the natural rate was rising even faster.) Hence the Fed (and many private sector economists who should have known better) concluded that monetary policy was not responsible for the high inflation. In fact, while rates were being raised, due to inflation they were falling further and further below the natural rate of interest.
OK, this shows rates are misleading, but it still doesn’t address Bob’s complaint. How can I say higher rates tomorrow would be monetary tightening, when I’ve just said the opposite? Here we need the ceteris paribus condition. During any of those meetings during the 1970s, a decision to not raise the target rate would have meant easier money than a decision to raise the target rate. Not raising the target rate would leave rates even further below the Wicksellian equilibrium, leading to even more inflation. Raising them was not enough to lead to tight money in an absolute sense, but on that particular day a rise in interest rates meant tighter money than not raising them.
Similarly, the decision by the Fed to raise rates or not raise rates in September may not influence whether money is expansionary or contractionary in an absolute sense, but a decision to raise rates in September will make money more contractionary than not raising rates in September. What would be required for a Fed move to change the absolute stance of policy? Simple, if the Fed action pushed rates from below the Wicksellian equilibrium to above the Wicksellian equilibrium, then the stance of monetary policy would flip from expansionary to contractionary. Those sorts of flips don’t occur very often, and when they do they often have dramatic macro effects.
Similarly, you can’t tell whether a car is going fast or slow by looking to see whether the accelerator pedal is depressed. I could be depressing the pedal and going 15 mph. Or I could have my foot off the pedal and be coasting 60mph down a steep mountain road. But I can say that depressing the pedal will make the car go faster, ceteris paribus, than not depressing the pedal.
In macro, look at the speedometer (NGDP futures prices) not the position of the accelerator pedal (interest rates.) If the Fed switched from interest rate targeting to NGDP futures targeting, the market rate of interest would always be exactly equal to the Wicksellian natural rate of interest. By analogy, if you use cruise control to drive 70 mph across Nevada, then the accelerator pedal adjusts up and down automatically, always staying at the Wicksellian equilibrium natural rate of accelerator depression.
OK, I’ve stretched that analogy about as far as it will go. . . .