Paul Krugman and Larry Summers have recently argued that the Fed should not raise rates later this year. I agree, mostly because I believe it will prevent them from hitting their announced inflation target, but also because it slightly increases the risk of another recession. If anything Summers and Krugman seem even more concerned about recession risk than I am. Here’s Krugman:

Larry Summers argues that a Fed rate hike would be a big mistake; I completely agree. Yet he also suggests that the Fed “seems set” to do this foolish thing.
. . .
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.

Rather than focus on the risk of recession, I’d like to use this example to illustrate a point that causes endless confusion. (Partly because it really is confusing.)

Tyler Cowen mentioned to me that Krugman’s worry that a 1/4% rate increase might push us into recession seems at odds with his frequent claim that the 1/4% interest on reserves can’t explain very much. In those earlier posts, Krugman seems to suggest that just a quarter point isn’t all that important. And yet the 2000 increase in Japanese interest rates was just a quarter point, and the 2011 ECB rate increase was just 1/2%. Krugman cites both examples, and I think he’s right to do so. In both cases a small interest rate increase seemed to tip weak economies back into recession.

To make things even more confusing, I often argue that interest rates tell us nothing about the stance of monetary policy. So how can I argue that a quarter point increase risks tipping us back into recession?

I’ll try to explain this with an example. Suppose what really matters is the difference between the Fed target rate (fed funds rate) and the Wicksellian equilibrium rate, which is the interest rate setting that would produce macroeconomic stability (perhaps defined as 4% NGDP growth.) Now here’s the tricky part. When the Fed tightens, it slows the economy and reduces inflation. And this reduces the Wicksellian equilibrium interest rate. If the Fed doesn’t later cut its target rate, the gap begins to widen, and monetary policy becomes tighter and tighter.

Now in practice the Fed generally does realize its mistake, and begins cutting rates. But not fast enough to close the gap, at least initially. And this leads to a strange paradox, in most cases monetary policy is tight when the Fed is cutting rates, and it’s usually expansionary when the Fed is raising rates. That’s why I always say that interest rates are not a reliable indicator of the stance of monetary policy. And yet on any given day, money is tighter if the Fed raises rates than if they don’t. In the very short run the conventional view is right, but we are mostly living in the long run, when peoples’ intuition is backwards.

Because the Wicksellian equilibrium rate is unobservable (at least without an NGDP future market), it’s difficult to be certain how much impact any quarter point change in rates has on the economy. All we know is that is could be highly consequential, or it might not. For instance:

1. The increase in reserve requirements in 1937 effectively pushed up short-term rates by a quarter point. We now know that policy was far too contractionary, but don’t know the extent to which that would have been true without the reserve requirement increases.

2. The institution of IOR in late 2008 initially raised rates by more than 1/4%, but soon after settled into a 1/4% higher IOR (relative to pre-October 2008.) We also know that in retrospect policy was far too contractionary, but don’t know the extent to which policy would have been far too contractionary without the higher IOR.

3. We know that, in retrospect, the 2000 decision of the BOJ to tighten policy was a mistake, as was the 2011 decision of the ECB to tighten policy. But we don’t know the extent to which the small interest rate increases caused that tightening, and to what extent it was errors of omission.

If the Fed raises rates later this year, and we then go into recession, critics will rightly point out that policy was too tight. But we won’t know the extent to which the interest rate increase itself caused that tightness, we’ll just know that it was a mistake–the Fed shouldn’t have been tightening.

My only real complaint with Summers and Krugman is that they need to be consistent. If a 1/4% increase in rates could set in motion cumulative forces with vast consequences, and it’s certainly possible that it could, then one should not discount the possibility that the October 8, 2008 institution of IOR (which the Fed did for reasons that even it admits had a contractionary intent) might have been a very consequential error that dramatically worsened the recession. Perhaps it even created the liquidity trap. We simply don’t know.

Interest rate changes may or may not have big effects; it depends on what’s happening to the Wicksellian equilibrium rate. But one thing is clear; one should never discount the importance of an interest rate change by a central bank merely because it looks small.

Some pretty big avalanches have started from a small pebble being dislodged.

PS. In fairness to Krugman, in some of those earlier posts he was also making a separate point, that a liquidity trap could form even without IOR. That’s true. But what is not true is the implicit suggestion that a mere 1/4% IOR couldn’t plausibly have big effects. For instance, here’s a typical quote by Krugman:

Incidentally, small nerdy note. Some people argue that the concept of the monetary base has lost its relevance now that the Fed pays (trivial) interest on reserves. I disagree. Reserves and currency are fungible: banks can turn one into the other at will. But the total of reserves and currency is fixed by the Fed — nobody else can create either. That, as I see it, makes them a relevant aggregate — and anyone who believes that all those reserves are sitting idle because of that 25 basis point reward is (a) silly (b) ignorant of Japan’s experience, where the BOJ sharply increased the monetary base without paying interest on reserves, and what happened looked exactly like our own later experience.

This post certainly leaves the impression that if the number were larger, than the argument would no longer be “silly.” And that’s also Steve Waldman’s reading, commenting on this quote:

Perhaps there are people in the world who think that paying 25 basis points of interest on reserves means that base money doesn’t matter, but I have not met any of them. I certainly agree with Krugman that those 25 basis points have a pretty negligible macroeconomic effect now.

Again, the 1/4% might be irrelevant, as we saw Japan fall into a zero rate trap without IOR, or it might be really, really important. But the fact that it’s only a measly 1/4% is not the deciding factor.