Ashwin — On The Folly of Inflation Targeting In A World Of Interest Bearing Money

As Mervyn King notes, inflation targeting has always been about improving the “credibility and predictability of monetary policy”.

However, in a world where money earns interest, minimising the uncertainty of macroeconomic policy does not equate to minimising the volatility of inflation. When all money bears interest, all that matters for those who hold money or bonds is the real interest rate earned on money and bonds. Given the fiscal stance and state of private credit growth, central banks should manage the real rate of interest such that rentiers do not capture a free lunch (i.e. real rates should not be too high) and there is no risk of a hot-potato/credit-bubble cycle (i.e. real rates should not be too low).

Money does not bear interest today because central banks pay interest on reserves. The primary reason why we live in a world of interest-bearing money is the gradual deregulation and innovation in financial markets over the last thirty years that triggered a shift from money to near-money assets. Apart from minimal liquidity reserves, there is simply no need to hold significant amounts of money in one’s zero-interest current account. Individuals can hold money in money market funds or treasury ETFs. Firms and high net-worth individuals can simply hold treasury bills that are as risk-free and liquid as money is. Even treasury bonds consist of a risk-free component that can be separated from the duration-risk component and monetised via the repo market. The equivalence of money and bonds is not just a temporary “liquidity trap” phenomenon. The evolution of financial markets means that the role of interest-free money is obsolete, now and forever.

In such an environment, the uncertainty and the volatility that individuals and firms care about is the volatility of the real interest rate.

Macroeconomic Resilience
On The Folly of Inflation Targeting In A World Of Interest Bearing Money
Ashwin

UPDATE:

Frances Coppola comments:

The liquidity trap as herald of fundamental change

UPDATE: Andy Blatchford notes:

Kalecki 1943

The rate of interest or income tax [might be] reduced in a slump but not increased in the subsequent boom. In this case the boom will last longer, but it must end in a new slump: one reduction in the rate of interest or income tax does not, of course, eliminate the forces which cause cyclical fluctuations in a capitalist economy. In the new slump it will be necessary to reduce the rate of interest or income tax again and so on. Thus in the not too remote future, the rate of interest would have to be negative and income tax would have to be replaced by an income subsidy. The same would arise if it were attempted to maintain full employment by stimulating private investment: the rate of interest and income tax would have to be reduced continuously."