Monday, March 30, 2015

circuit — Ben Bernanke and the natural rate of interest

Not so fast there. circuit comes to Ben's defense, kinda.

If my understanding is correct, a point that circuit makes is that a natural rate rate of interest, like potential output, is a theoretical term that is model-determined rather than being an observable. Consequently, it may be useful for a central bank to use a model in which a natural rate of interest at full employment figures in theorizing about monetary policy. 

After all, if a central bank is going to set monetary policy through the nominal interest rate, then it has to have some rationale for doing so, and for economists, that means having a model. Since exogenous money has been discredited that leaves the central with with the interest rate as its policy tool. So the question becomes how and when to use that tool.

However, Ben doesn't seem to imply that he thinks there is actually a Wicksellian rate that leads naturally to full employment equilibrium in the long run if market forces are left to operate. What would be the point of monetary policy in that case unless to influence the short term. But that is basically to dismiss the long run as realistically significant. 

Or maybe he does "believe in" an actual Wicksellian rate that naturally leads to full employment in the long run but concludes that doing nothing and waiting for "the long run" is just not practical politically and that monetary policy can fill in.

Fictional Reserve Barking


NeilW said...

The problem is that the model is wrong. It has no bearing to the real world.

They may as well just use a random number generator and conduct a random walk.

Ultimately the problem is that central banks can't really affect anything in a controllable fashion, which means that their interest rate should simply be locked at zero and they should control the banks via qualitative controls on the type and direction of loans.

(Nothing to clear FX transactions for example).

NeilW said...
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A said...


if the Bank of England raised its interest rate to 10% tomorrow, don't you think that would have a severe impact on the economy?

Ralph Musgrave said...

Interest rate adjustments are a daft way of controlling AD, first because they are DISTORTIONARY: that is, if they work at all, they influence just INVESTMENT spending rather than CURRENT spending. That makes as much sense as doing a helicopter drop just on households made up of blondes and redheads, and waiting for a trickle down effect to benefit those with brown and black hair.

Second, as Galbraith put it, “Firms invest when they can make money, not when interest rates rare low”. And that idea of Galbraith’s is backed by the evidence, that is several studies show that interest rate changes do not have much influence on firm’s decision to invest. As for mortgagors, if they’ve got their heads screwed on, they’ll look at LONG TERM rates, not the fact that the Fed has temporarily changed rates recently.

In short, MMTers are right: in a recession, create fiat and spend it (and/or cut taxes).

NeilW said...

"if the Bank of England raised its interest rate to 10% tomorrow, don't you think that would have a severe impact on the economy?"

But they're not going to do that. So why discuss it?

Why is it that people like to use excluded middle arguments all the time. It's such a silly device.

And regardless the answer is 'it depends'.

If I'd just been elected by some quirk of fate, then raising rates to 10% would not affect the economy - because I would offset it.

It would be part of a policy of eliminating private debt borrowing and replacing it with government spending, national saving interest payments and tax cuts.

Likely though I would put it at zero and simply ban the banks from lending money except for very specific purposes. I see no benefit from paying people to do nothing.

Unknown said...

to me, the biggest problem with the natural rate view is that it promotes the false notion that CBs can control the economy through controlling interest rates. Its the rational that has led to the monetarist rise, as if interest rates instead of demand were the most important variable. Thats why we get convoluted bullshit from the mainstream like:

fiscal policy is largely irrelevant, just use monetary policy because deficits are bad

And monetarism has built in excuses, if lower interest rates dont result in full employment = secular stagnation or liquidity trap. And you can always keep raising interest rates until even if for some completely unconnnected reason inflation stops rising, they can always point to the interest rate as the cause. This is exactly what happened in the 70's. Basically, the whole model is closed off to reality and leaves only interest rates as the tool for macro management.

Jose Guilherme said...

several studies show that interest rate changes do not have much influence on firm’s decision to invest

But the interest rate hikes of the Volcker era did trigger a severe U.S. recession in the early 80s - right?

If this is so, then monetary policy does influence the economic cycle and thus the level of output and employment.

Tom Hickey said...

Well, inverting the curve and raising short term rates to 20% could be expected to throw a spanner into the works, but that is so extreme an example as not to qualify.

But more practically, in a developed economy like the US, housing is major component of the economy not only direct through investment in housing and liquidity in the housing market, but associated markets related to housing. So monetary policy using the interest rate setting works chiefly through the housing channel. But his is like steering a deep draft vessel. It takes some time for the ship to respond after turning the wheel less the vessel has multiple props in addition to the rudder. In fact, with multiple props, a rudder isn't really needed.

Monetary policy can be compared with a rudder and fiscal policy with multiple props driven by a powerful engine. Piloting an nuclear-powered aircraft carrier versus a cargo ship is a good example of this. Carriers are remarkably agile for the huge size and weight of the vessel. The response of cargo vessels is very sluggish.

Jose Guilherme said...

There´s also the indirect channel, via lower net exports.

Anyway, the Volcker experiment was a seminal one. It claims to have broken the back of inflationary expectations in the U.S. economy.

This explanation is accepted by virtually all of the mainstream economists including those on the liberal wing of neokeynesianism.

So, it will take lots of theoretical hard pounding to kill the credibility of this supposedly uncontroversial claim for the effectiveness of monetary policy.

Tom Hickey said...

Yeah, funny that Volcker gets paid attention to and not the massive public funding of WWII (and aftermath in Europe) followed by a huge boom with low inflation and distributed prosperity. Go figure.

Matt Franko said...

Well if they went to 20 Tom they would be bankrupt as they would immediately be responsible for ior at that 20% while the portfolio was yielding probably 2 or 3%... re-fi would dry up and they would be stuck with MBS yielding 4% and having to pay 20%...

Instant very serious political crisis .....

Jose Guilherme said...

In the Volcker era the Fed didn't pay IOR so the risk of "bankruptcy" would be minimal :)

Anyway, the two seminal anti Keynesian developments of the last decades were the Friedman/Phelps long run vertical Phillip curve at the NAIRU and the Volcker monetary policy against inflation.

Old myths die hard and these two have been particularly successful in leaving the economy permanently stuck at levels way below potential.