Allow Interest Rates To Rise While Keeping Monetary Policy Accommodative

The minutes of the December 11-12 FOMC meeting, released today, have emboldened me to come out of the closet with a monetary policy suggestion and the reasoning behind it that I’ve been reluctant to express before lest I be ridiculed as hopelessly naïve. My suggestion is that the FOMC allow interest rates to rise a bit without tightening monetary policy.

I was raised a Milton Friedman monetarist who viewed changes in the money supply as the essence of monetary policy even though such changes were normally associated with pressures on interest rates. Speeding up money growth along with the accompanying downward pressure on interest rates would tend to stimulate a depressed economy. For practical purposes, it wasn’t necessary to determine precisely how much of the stimulus came from money supply growth and how much came from lower interest rates.

The FOMC’s easing throughout 2008 finally brought its policy interest rate, the Federal Funds rate, and related short-term rates, close to zero. At that point—the zero bound point—strict Keynesians focusing only on interest rates declared the Fed out of ammunition to stimulate economic activity further. Monetarists and other non-Keynesians believed that further expansion of money and related credit aggregates would stimulate the economy further even if interest rates were stuck in a liquidity trap. The attempt to stimulate the economy further through open market purchases was called quantitative easing to distinguish it from interest-rate easing. Of course, as the FOMC modified its open market operations into longer maturities and different asset classes, the term “quantitative easing” lost its purity as various other interest rates were targeted along with the size of the balance sheet or the quantity of money and credit aggregates.

Now, getting to my point, I’ve never believed that a given interest rate target required a precise quantity of open market purchases or sales. As long as the open market operations are broadly consistent within a wide range, it is the Fed’s announced intention regarding the Federal Funds rate that signaled the market to make it a reality. In other words, if the FOMC announces that it wants the Federal Funds rate to be 4 percent rather than the existing 5 percent, the amount of open market purchases needed to achieve this target is likely a range rather than a point estimate. And, given Fed credibility, that range might not be so narrow. This leads me to believe that it may be possible to separate, to some extent, the Fed’s interest rate target and its quantity targets.

The recovery in the economy since mid-2009 has been slow and fragile and, in my opinion, in need of the support the Fed has given it. Hence, for a while longer—hopefully not too long—the Fed should keep its balance sheet growing slowly so as to support growth in the money supply. I think that may be possible, while at the same time announcing that it will support interest rates slightly higher than current rates, for the Fed to avoid “tightening” monetary policy in a significant sense. In other words, keep overall policy accommodative through open market operations while signaling a willingness to see somewhat higher interest rates.

Short-term interest rates have been near zero since the end of 2008, and longer-term rates have been depressed as well. We’ve had four years of financial repression as savers struggle to find a meaningful return on their savings. An easy money policy always hurts savers while trying to help investors. For a short-while one might ignore the down side for the greater good, but four years, going on five, is too long. The damage to savers needs to be considered along with the potential further benefits to spenders.

As I indicated earlier, I was prompted to propose such heresy—allow interest rates to rise while keeping monetary policy accommodative—by the minutes of the latest FOMC meeting. According to those minutes, several FOMC members thought the new round of asset purchases and balance sheet expansion might be ended by the end or even before the end of 2013 while interest rates would presumably remain on the floor much longer. Therefore, the Committee has implicitly separated interest rate policy from open market operations, as I am proposing. Unfortunately, they foresee doing the opposite of what I’m suggesting—stopping open market purchases before letting up on interest rates. Maybe further reflection might lead them to consider doing it the other way—easing up on interest rates while continuing open market support.



Comments (4)

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  1. Derek says:

    Bob, I think you really misrepresent the Keynesian position here. The idea is that conventional monetary policy at zero bound doesn’t work, but there is no Keynesian I know of that doesn’t think QE has an effect. The problem is it doesn’t have enough of an effect because the money is not getting out into the economy with enough velocity. It’s a little like me saying you can’t just strap wings to your arms and jump of a cliff and fly. Then you accusing me of saying that wings cannot make things fly, and since airplanes fly, I am obviously wrong. It’s not the same thing.

    The idea that artificially higher interest rates might improve the current situation is also very dubious. A big part of the current problem is that savers are in fact very willing to accept the low interest rates on offer because they see very little else to invest in with the economy struggling. Artificially adjusting interest rates up would increase the incentive to pour more money into government bonds further taking money out of the productive economy.

    Now, since the savers are getting hit by low interest rates, there is another way to increase interest rates and get the economy moving at the same time, but I know you’ll hate it on principal. If the US gov’t were, let’s say, become irresponsible and start spending more money it doesn’t have in the private sector, that might create both 1) economic opportunity for private sector firms to expand (albeit temporary) and 2) higher rates.

  2. Bob McTeer says:

    Admittedly, it’s been a long time, but as I recall the Keynesian model, increases in the money supply interacting with a downward sloping demand for money (liquidity preference) reduces interest rates. Once the demand for money becomes horizontal at low interest rates, further increases in the money supply don’t stimulate because rates won’t fall further–the liquidity trap. This means that further increases in money supply are matched by declines in velocity.

    As for higher interest rates not helping, it is a trade-off–helps some hurts others. All I’m saying is that it has been one-sided (hurting savers) too long and some balance needs to be restored.

  3. George Fuget says:

    Mr McT

    Mr McTeer, In the ancient times of the 50s I took a college course in money and banking that defined money as 1.a medium of exchange,2 a store of value, and 3.a unit of measure. over the course of the last 55 or so years I have had a tangential interest in the subject.I have come to believe that in a modern information economy using fiat money you can pretty much throw away the store of value and medium of exchange( most transactions are done electronically).This means you are left with a unit of measure. I invite you to consider what would happen in areas of endeavor outside of the economy if you tried to influence the outcome by increasing or decreasing the amount of the unit of measure. Consider an NBA basketball game.
    You are watching the worst game in history. The score is 12 to 10 in the fourth quarter and not because of good defense. Neither team can get out of their own way. Fans are booing and leaving in droves. The commissioner of the league realizes that this will ruin the reputation of the NBA so he decrees that each team get 100 more points making the score 112 to 110. Will this make the game better? The obvious answer is no. The only thing that will make the game better is better players. If I am right about money being nothing but a unit of measure of real wealth(what is produced), Then most of what the Fed does is at best useless. This is not a screed for a gold standard. Connecting the unit of measure to something that has nothing to to with the production of wealth would in my opinion create many more problems than it might solve.

  4. Gabriel Odom says:

    “The idea that artificially higher interest rates might improve the current situation is also very dubious.”

    Indeed, but isn’t the Federal Reserve just a tool to create artificial interest rates anyway? What’s the difference? The problem with the economy isn’t necessarily the artificial interest rates, but rather the artificially inflated prices of goods and services based on the artificial value of money.