One of the little known facts of the history of monetary policy is that until 1994, the Fed did not actually announce interest rate decisions. Market participants had to infer rate changes from the Fed’s open market operations. This is just one example of how so many things we take to be natural and obvious are, in reality, relatively recent phenomena. In less than twenty years, the Fed has transitioned from near-opacity to an almost obsessive transparency. Another example of a relatively recent monetary policy doctrine that is now unquestioned is the doctrine of inflation targeting. The essential idea of inflation targeting is that people and firms should not have to think about the level and volatility of inflation when they make economic decisions. Inflation must therefore be kept at low and stable levels so that the long-run costs of unpredictable and uncertain inflation are minimised. 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. Let me take a simple example to illustrate this point. Let us assume that you hold a significant proportion of your assets in a short-term T-bill ETF that currently yields 0% in an environment when inflation is 2%. Therefore, the real interest rate is -2% but you swallow this loss as a “safety premium” fearful that investing in risky assets inflated by monetary stimulus may result in much greater losses. Now suppose the Fed decides to adopt an inflation target of 5% instead, which it achieves by buying up private sector assets such as equities1 while still holding the Fed Funds rate at 0%. This move to 5% inflation obviously hurts your investment in T-bills but the real reason is not that inflation has gone up. The real reason is that real rates have turned even more negative from -2% to -5%.
Many economists will complain that there is no other option. But when government bonds effectively function as money, there are a multitude of other options. The 5% inflation target could be hit by instituting a significant increase in fiscal stimulus (preferably via helicopter drops) and simultaneously hiking rates to 3%. From the perspective of most firms and individuals, this option which minimises the volatility of real interest rates is by far the more predictable and less uncertain policy. Those who borrow or invest at fixed rates for longer tenors will obviously suffer more volatility but such activities are explicitly risk-taking by nature. There is no conceivable reason why the central bank or the government should subsidise such risk-taking.
Proponents of inflation-targeting sometimes point to the poor economic performance of many developing countries with high and variable inflation. But what is really at fault in many of these instances is the tendency of the fiscal and monetary authorities to inject unexpected bursts of inflation that are uncompensated for by the interest rate regime enforced by the central bank. It is the persistent erosion of purchasing power due to negative real interest rates2 that is the real source of the poor macroeconomic performance in most high-inflation regimes.
The obvious object to my argument is that there is no reason why real interest rates must be held constant – I agree. My argument is not that real rates should be held constant but simply that excessive volatility in real rates must be avoided even if it is at the expense of a more volatile inflation rate. If the economy is hit by an inflationary supply shock, then it must be met by an increase in the inflation rate and an increase in the nominal interest rate (thus keeping real rates stable) rather than a rate hike to maintain a constant inflation rate (which would simply be an unwarranted transfer of wealth to lenders). There are also limits to how negative real rates can be driven to before an inflationary spiral is triggered. As of now, we are clearly well within these limits but it is foolish to assume that the inflation target can be increased to any level while central bank rates still remain at zero. Sooner or later, increasingly negative real rates will set off a inflationary spiral and a stampede to buy up real assets instead of nominal bonds.
I am not opposed to central banks driving down real rates to counter the increased demand for safety during a liquidity crisis. But in an environment like today when junk bond prices are at all-time highs, there is no justification for maintaining artificially low real rates. To restore economic prosperity in today’s crony capitalist and stagnant economy, we need to provide direct transfers to individuals via money-financed stimulus while simultaneously hiking rates to stop the permanent bailout of incumbent banks and firms.
See my earlier post ‘The Case Against Monetary Stimulus Via Asset Purchases’ for why I oppose such a policy. ↩
Negative rates may also be enforced by restrictions on the interest rate payable on deposits and similar financial market regulations. ↩