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Interest rate mania

from Peter Radford

People keep asking me about interest rates. I wish they would stop. The question always make me feel like mimicking Eugene Fama: rates are rates. They are what they are. Perfect reflections of whatever they meant to be reflections of. And so on.

Such amazing analytical insight is worthy of one of those pseudo Nobel prizes.

Seriously though: people do seem a little more concerned than usual. Why?

Because rates have been low for so long and don’t seem to have accomplished much for all that. I think it’s hard for some people – including quite a few prominent economists – to grasp why interest rates are mired in this near historically low trough. I would have thought the answer is obvious: the economy sucks.

It still sucks after all these years.

Let’s look at it through the eyes of the textbook – this doesn’t imply we all agree with the textbook, so please relax. What are we looking for? Something called the “natural rate”. Let’s set aside that there’s absolutely nothing “natural” about the economy simply because it is an entirely humankind construction reflecting the complex interplay of a zillion intentions and expectations. Economists love to pretend that there are such “natural” things in the economy and this so-called natural interest rate is one of them.

What is it?

Well, that’s simple: it’s the rate of interest at which the economy settles into its Goldilocks comfort zone. Not too hot. Not too cold. Just right. This zone is what economists strive to maneuver the economy towards. It’s where they all imagine the economy with a gigantic happy face. People are employed. Wages are rising, but not so fast they induce inflation. Profits are good. Demand is strong enough to get businesses to invest, but not not over-invest. It is, as I said, a happy place. It’s just right.

So: how do we know what this natural rate is? Aah. That’s a tad more difficult. It depends. And therein lies the rub.

The natural rate of interest appears to be much lower now than in the past. This, so we are told, is because the potential of the economy is more limited and thus the in- and out-flows of investment are reduced. If you believe that the in- and out-flows are what gives rise to the natural rate – a big if – then a reduction implies a lower rate.

This simply begs the question: why is potential so much lower?

There are a few reasons proffered for this. A common one is that our current wave of technological innovation is simply not very good at translating into economic growth. At least when compared to waves of innovation in the past. This ineffectiveness of technological advance tends to bend the trajectory of growth downwards, which limits sales potential and thus reduces investment opportunity. This is the standard “stagnation” argument and is often touted alongside stern warnings about how this decline in potential also limits our ability to pay for all those entitlement programs we want for ourselves – the economy will be growing too slowly to generate the tax revenue to pay for them. Naturally this notion is attractive to anyone on the right who is inclined to dislike entitlements anyway. So we tend to get this from mainstream economists and their libertarian friends.

Another cause of a slowdown in potential would be demographics. It is often overlooked in our discussions of economics, but a growing population is associated with a growing economy. At least as we currently measure economic growth. The reason ought to be obvious: the more there are of us to buy stuff the greater the opportunity for profit, sales, and employment etc. So a faster growing population is closely associated with a faster growing economy. That and an equable climate, but that’s another question.

So a decline in the rate of population growth, and/or a shift into retirement and out of prime consumption mode of a large proportion of the population will slow the economy. Which is what we’ve witnessed in the past few years. So, no surprises if lower potential drags down the so-called natural rate of interest: the economy is simply settling into a lower state of activity.

Then there’s the stagnation of wages over the past few decades and the enormous rise in inequality. Not many economists want to talk about this: the distribution of income is something they are remarkably indifferent to. Their obsession with efficiency and inventing complicated models to show how we might achieve maximal efficiency precludes them worrying much about inequality. This is because their models, in order to squeeze that maximal efficiency out of the economy just assume inconvenient stuff like the distribution of incomes to be of no importance. And if you don’t go looking for something like that you won’t often find it.

In any case it seems fairly clear that the enormous redistribution of incomes upwards to the higher echelons of income earners has had a deleterious effect on economic potential. That is not potential as measured in terms of possible output, but as measured in terms of possible demand. You would have thought that in a world in which supply and demand are tossed about as inseparable twins, economists would look  at potential demand a little more carefully. But many don’t, so they also often forget to mention the downward influence of sluggish demand. I am afraid that the old, and foolish, Say’s Law still lurks in the backs of too many economic minds. If you redistribute incomes way from people who might spend that income and put it in the hands of people who are more likely to save it – they have already managed to buy most of the stuff they want so the extra cash is simply saved and not spent – what do you generate? A whole lot of “excess” savings. That is cash looking for a place to go. At the same time you have reduced the potential sales for business and so have reduced the demand for investment. That is to say you have reduced the productive places for all that cash to go.

The net result?

Lower interest rates.

Now the supply and demand for all that cash does not produce the interest rate. The supply and demand for investment does. And the supply and demand for investment is supposed to be a response to economics potential. So we are back where we started.

What does monetary policy have to do with all this?

Simple: monetary policy is designed to get interest rates to settle at the “natural rate”. This, of course, implies that the central banks have an idea of what economic potential is. Which is why we read so much at the moment about what the Federal reserve Board is thinking and about how the economy is doing and what it is likely to be doing.

So, when you ask about what interest rates are likely to do, you are engaging in a sort of mind reading exercise. You are really asking what the Fed is thinking.

Which, right now, seems to be a little confused.

There are few at the Fed talking about how weak the economy still is, about how employment is not strong, and how, therefore, the Fed ought to keep rates low. That is they think that by keeping rates low they can nudge potential back upwards and create room for more growth. After that, these folk argue, will come a time to raise rates.

But there is another camp, which sounds a lot more strident, which argues for higher rates sooner rather than later. These people – the so-called hawks – are those who believe we are on the precipice of rapid inflation, that the economy is about to heat up, and that employment is just dandy. They are arguing, in other words, that we are about to exit our Goldilocks state and enter into one that is overheated. So, they suggest, we need to act and foreclose such a possibility and raise rates. Perhaps as soon as this coming year end.

Which is right?

Well it depends on whether you think we are indeed in a Goldilocks state. You have probably guessed by now that I would err on the side of caution. Demand is weak. Too weak. Goldilocks be damned, things are still too cool. Raising rates might help those who make a living by owning assets, but it would harm those who live by working for a wage, and those people have been hammered enough by stagnant wages long enough.

So when you next ask me what I think interest rates should be, think twice. You really don’t want me to have to run through all this again simply to end up saying something really simple like: they need to stay low.

You knew that already.

  1. Larry Motuz
    November 3, 2015 at 5:14 pm

    “In any case it seems fairly clear that the enormous redistribution of incomes upwards to the higher echelons of income earners has had a deleterious effect on economic potential.”

    Very good. One of the central tenets of most mainstream economists is the ‘neutrality of money’. Such ‘neutrality’ in-builds an assumption that the distribution of income has no affect upon demand or output, and it largely does so by implicitly assuming that affordability problems do not arise within any segment of the population. Thus, if nominal prices double, it is simply and implicitly assumed that consumers’ budgets can double also, leaving nothing changed in terms of demand in ‘real’ terms.

    But, in fact, many consumers may simply be priced out of some markets, largely because, in trying to keep body and soul together, they must redirect expenditures away from, for lack of a term, less essential ‘maintenance’ goods, to what keeps at least the body together.

    This, in turn, leads to inventory accumulation among those goods many consumers can no longer afford to purchase out of their incomes. And this, in its turn, leads to lowered employment and output in these less essentials, further dampening incomes growth.

    Credit expansion in terms of ‘consumer loans’ can temporarily offset this process, but hardly in any permanent way.

  2. November 3, 2015 at 5:18 pm

    That was quite a dose Peter.
    I think that if we follow the maxim: “Money will go where the profits are to be had”, we will end up in the speculative casino economy that has evolved as financial regulation and effective enforcement has been demolished over the last number of years.
    That has drained the productive economy of available funds, leading to an atrophy in activity which can be readily seen in the level of two leading economic indicators: The Harper Peterson shipping index http://www.harperpetersen.com and the Baltic Dry Index: http://www.bloomberg.com/quote/BDIY:IND.
    The reason why interest rates have to stay low in the present economic environment is that raising them would simply choke off whatever life is left in the productive economy.
    The only viable fix is effective re-regulation and enforcement of the operating rules of the financial system, accompanied by economic stimulus from central banks.

    I.e. The stick and the carrot applied judiciously across the board.

    • BC
      November 3, 2015 at 8:05 pm

      Helge: “[W]e will end up in the speculative casino economy that has evolved as financial regulation and effective enforcement has been demolished over the last number of years. . . . That has drained the productive economy of available funds, leading to an atrophy in activity . . . The reason why interest rates have to stay low in the present economic environment is that raising them would simply choke off whatever life is left in the productive economy.”

      Correct, but now the US energy, energy-related transport, and industrial sectors are in recession, with credit spreads widening, GDP growth decelerating, and evidence that a bear market for the broader equity indices has begun.

  3. BC
    November 3, 2015 at 8:01 pm

    https://research.stlouisfed.org/fred2/graph/fredgraph.png?g=2oPM

    https://research.stlouisfed.org/fred2/graph/fredgraph.png?g=2oZB

    Because the economy generally sucks (subprime auto loan-induced bubbly auto sales, notwithstanding), risk spreads have widened again as occurred when the Fed went “all in”, spring 2008, summer 2001, and winter-spring 1982.

    https://research.stlouisfed.org/fred2/graph/fredgraph.png?g=2mPb

    https://research.stlouisfed.org/fred2/graph/fredgraph.png?g=2n96

    And the increasing indication of credit risk is occurring coincident with the collapse in the acceleration of money velocity to private GDP and an incipient bear market for the broad equity market, which similarly occurred in 2008, 2001, and the early 1980s.

    The probability that the Fed will raise rates under these conditions is zero. Rather, the Fed will more likely be required to resume QEternity to credit primary dealers’ balance sheets in order to fund larger fiscal deficits to prevent nominal GDP from contracting now that the post-2007 trend rate of nominal GDP per capita is below 2% (and post-2007 trend real GDP per capita is below 1%).

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