...interest rates are not determined by some invisible natural force; they are set by people. Central banks pin down the short end of the yield curve, while financial-market participants price longer-dated yields based on how they expect monetary policy to respond to future inflation and growth, taking into account associated risks. Observed real interest rates are measured by deducting expected inflation from these nominal rates.
Thus, at any given point in time, interest rates reflect the interplay between the central bank’s reaction function and private-sector beliefs. By identifying the evolution of real interest rates with saving and investment fundamentals, the implicit assumption is that the central bank and financial markets can roughly track the evolution of the equilibrium real rate over time.
But this is by no means straightforward. For central banks, measuring the equilibrium interest rate – an abstract concept that cannot be observed – is a formidable challenge....
Moreover, central banks’ policy frameworks may be incomplete. By focusing largely on short-term inflation and output stabilization, monetary policy may not pay sufficient attention to financial developments. Given that the financial cycle is much more drawn out than the business cycle, typical policy horizons may not allow the authorities to account adequately for the impact of their decisions on future economic outcomes....
With financial-market participants as much in the dark as central banks, things can go badly wrong. And so they have....
Monetary policy cannot overcome structural impediments to growth. But the actions that central banks take today can affect real macroeconomic developments in the long term, primarily through their impact on the financial cycle.Minsky.
Project Syndicate
The Interest-Rate Enigma
Claudio Borio, Head of the Monetary and Economic Department at the Bank for International Settlements, and Piti Disyatat, Director of Research at the Bank of Thailand
1 comment:
Central banks could "pin down" the long end, too, if they wanted. Trying to manipulate peoples' "reaction function" is ridiculous. Why go through such an exercise in the first place? To give credence to the false notion of the sacred, "free market?" Absurd.
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