As they struggle with the Taylor Rule
ROCKVILLE, MARYLAND — Is there a ‘correct’ level for the interest rate?
In Biblical times, interest on loans was considered unjust or immoral. Charging of interest of any kind was called usury, and, for example, Proverbs 28:8 states “He that by usury and unjust gain increaseth his substance, he shall gather it for him that will pity the poor.”
The proper interest rate was then literally zero.
Today, we take non-zero interest rates for granted; they are usually ‘at market’ – a price contractually paid by a borrower to a lender.
We also know from monetary history that central banks have evolved into institutions that conduct ‘monetary policy’ and this particular role given to them has meant that they intervene in the credit market.
The market interprets such interventions as ‘official guidance’ on the direction and level of interest rates, even as the market may have a mind of its own.
The average person has difficulty discerning the official stance of central banks. Typically, their pronouncements are cryptic, rooted in their goals of containing inflation, promoting stable exchange rates, supervising the banks, and providing liquidity in times of ‘financial’ crises. Unfortunately, these goals can be simultaneously unattainable.
The reality is such that central banks at present face a conundrum, akin to a game of ‘Either way you lose.’
Confronted with today’s inflation, which they caused in part, and a stagnating world economy, central banks will be blamed if they take no action against an inflation that makes people’s lives miserable.
But fighting inflation with ‘tight money’ means that interest rates will rise and could cause or exacerbate an unwanted recession.
What is a responsible central bank to do? Is inflation a lesser evil compared with the unemployment that attends a recession?
Ordinarily, central banks wouldn’t have to face their present predicament. The forces that propel an economy toward recession, such as an inadequacy of ‘aggregate demand’ also tend to lower inflationary pressures.
This is the lesson from the so-called Phillips Curve, which suggested that in the short run, inflation is negatively related to unemployment.
The pandemic and the Ukraine war changed all that. The world felt the twin ‘supply shocks’ – of producers unable to produce or transport their output because of the pandemic; and of the sharp rise in food and energy prices (reminiscent of the early 1970s when the major oil producers in the Middle East cartelized the global crude oil market, and when inflation was thought to be of the ‘cost-push’ variety).
Inflation has once again reared its ugly dinosaur-like head. As aggregate demand eased, economic policymakers have turned to fiscal policy (government spending) to limit the recessionary impact.
It is possible, however, as suggested by some (Larry Summers, for example), that fiscal policy had gone ‘too far’ and contributed to the inflation already underway.
What is not readily admitted is that the major central banks have been engaged in a monetary policy that results in negative real interest rates.
To understand what follows, it is necessary to be clear on how central banks conduct monetary policy. They do so by intervening in the credit or bond market by buying or selling bonds; such transactions – also known as ‘open market operations’ – will cause nominal market interest rates to fall or rise (for example, when a central bank buys bonds, bond prices rise, which means that interest rates fall).
What exactly are negative real interest rates? Why are they a bad thing? And given that they are bad, why are the major central banks staying with such a policy?
Negative real interest rates are defined as nominal (market) interest rates below the expected inflation rate.
For example, if risk-free bond yields are at zero percent, and inflation is at four percent, the real interest rate is minus-4 percent.
Historically, negative real interest rates occurred when inflation spiked, even as nominal interest rates were comfortably above zero. Such was the case soon after WW II, and when OPEC quadrupled the crude oil price in the 1970s.
Today, central banks have affirmed their religion of ‘Inflation Targeting’ (Thou shalt limit inflation to 2-4 percent per annum).
They also embraced something else, called ‘Quantitative Easing,’ which is a two-word name for printing money.
Quantitative Easing allowed the central banks to think that very low nominal interest rates (in a few cases, even negative ones) were not necessarily a bad thing if they shored up a weak economy, and if inflation somehow stayed low.
For a while, inflation did stay low after 2008 and until 2021, but inflationary pressures were, as noted above, awakened by the pandemic and the Ukraine war.
The lesson, it seems, is that inflation can remain low and ‘dormant’ until expectations of it arise and become self-fulfilling. Today, we are witnessing negative real interest rates.
How did central banks come to believe that it’s okay to push for low or negative real interest rates? Why did they go down this ‘tiptoe through the tulips’ path of monetary policy?
The best answer I can come up with is that they inherited an anemic world economy after the Great Financial Crisis of 2008, and they embraced easy money as an additional policy response to the usual Keynesian one of shoring up the economy through government spending.
The central banks had previously gotten lucky in the period after Paul Volcker ‘killed’ inflation in the early 1980s. The world was treated with something called The Great Moderation of the mid-1980s until 2007, when inflation and unemployment were both low and relatively stable.
It was too good to be true, and when the 2008 financial crisis hit, most economists, including those working for central banks, were caught off guard.
Just about the only ones who thought that negative real interest rates would generate a crisis of their own were the Austrian School economists who believe that negative real interest rates do not last, and eventually spell disaster with a capital D.
Again, why are negative real interest rates bad medicine? The answer begins with the concept (attributed to Knut Wicksell) of a ‘natural’ (non-negative) interest rate as one that is compatible with stable commodity prices.
Wicksell said that if the actual or market interest rate deviated from the natural rate, inflation or deflation would result. Thus, if the market interest rate were below the natural rate, prices would rise.
The Austrian economists then viewed the disequilibrium in the credit or bond markets as a causal factor behind booms and busts.
Furthermore, the Austrian School concluded that central banks risk economic instability when they ‘fight’ the natural rate of interest.
The harm from negative real interest rates should also be seen in the light of where we are today in the international monetary system, which is a fiat-money floating exchange rate regime practiced by almost all countries.
This regime has its benefits (we get rid of gold as a ‘barbarous relic’ as emphasized by Keynes), but we bear the cost of ensuring that central banks will behave, and not print money like crazy.
That cost is akin to a bargaining cost, given that central banks tend to operate as a herd – if a major central bank tightens its monetary policy, other central banks have to follow suit, if only to keep exchange rates stable.
Economists who study history will notice that inflation was low or absent, and negative real interest rates were relatively rare, when the world was on gold or the gold standard.
The likelihood of negative real interest rates subsequently rose when the present system of fiat currencies and floating exchange rates came to be sometime in the 1970s.
It was then a trade-off accepted by the international community – with fiat money, inflation was ‘just around the corner’ – major central bank or a bunch of them could easily trigger inflation by printing money. In effect, the risk of having inflation was thought acceptable. After all, within limits, price and wage inflation could match up (neither consumers nor laborers can complain), and nominal interest rates could be higher than inflation (in which case, bond holders cannot complain). All should be well, but is that how things have turned out?
Obviously not. Central bankers are today scratching their heads to explain how they messed up, and how they intend to get out of the mess. In the words of a responsible former central banker, “.. zero or negative interest rates are not a natural phenomenon but are, in large part, the result of heavy central bank purchases [of bonds] which can be reversed over time” (Jacques de Larosiere, in early 2021). John Taylor, the proponent of a monetary policy rule (called unsurprisingly the Taylor Rule), cannot disagree more.
The Rule is a practical but rough guide: Central banks should raise interest rates when faced with unwanted inflation, and lower them when the economy is in a recession. The Taylor Rule also suggests that as inflation and GDP growth targets are met, the policy interest rate would approach a ‘baseline’ level equal to the natural rate plus the inflation target.
Another way of restating the above is to deduce that central banks would be violating the Taylor Rule if they were to keep policy interest rates too low or high. For example, ‘too low’ in this context means an interest rate that is below the baseline level adjusted for the tightening or ease required to achieve the set inflation and output targets.
An illustrative calculation that is admittedly very rough is as follows. We start with a natural interest rate of 2%, as in Taylor’s original 1993 formula and add to that an inflation target of 2%. We then take a ‘gap’ of – for example – 5 percentage points of unwanted inflation (such as when projected inflation is 7% vs an inflation target of 2%). These figures correspond roughly with the latest data on the US economy. The appropriate policy interest rate would then be equal to 4% plus half the gap, or 6.5%. We can then compare 6.5% with the current Fed funds rate of 1.75% (which is widely expected to be raised shortly to 2.5% or even higher at 2.75%). On this basis, the US interest rate is set too low, and the Federal Reserve has been doing too little too late.
A defense of the current levels of the Fed funds rate is to imagine that projected inflation in the near future would fall very quickly to the 2% target, or that the US economy is in recession, which would justify a bias toward the currently low policy interest rate. However, such an alternative interpretation does not seem credible, if only because the unemployment rate is currently at historic lows.
A similar calculation can be made for the Philippine policy interest rate (the overnight lending rate), which was last raised this month to 3.25%. We can start with a natural rate of, say, 3% for the country, it being a developing country with a good record of economic growth in the past decade or so. We would then add a midpoint inflation target of 3%, to give a baseline policy rate of 6%. The latest data suggest an inflation rate (about 6% as of June) that is well above the central bank’s inflation target of 2-4%. The Rule-based appropriate policy rate would then be in the neighborhood of about 7.5%, which is double the current overnight lending rate. On the basis of the Taylor Rule, the monetary policy of the BSP is ‘too easy.’ It is cold comfort to say that at least it is not alone; the US Federal Reserve also has a similar stance in its monetary policy.
When the BSP announced its latest interest rate increase, it remarked that it did so to counter inflation, but it was left to others to interpret the move as also one of “rescuing a faltering peso” (which at P56/$ is near its record lows last seen in 2004). The 3.25% current policy rate may not seem so low if the BSP is implicitly assuming a large negative ‘output gap’ in the overall economy. However, the latest IMF report on the Philippines shows only a small negative output gap projected for 2022.
Following the Taylor Rule is perhaps easier said than done. The usual caveat is that monetary policy cannot be set by simple algorithms, and that judgment with respect to other factors is required. Such factors should be discussed and explained. We, ordinary folk, will listen.
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Author’s email: oroncesval4@gmail.com; Twitter: @ORoncesvalles
