When companies feel things are "normal" they will become less conservative with their investments. With a low interest rates, somewhat counter-intuitively, everyone has been in a fight or flight mode, sitting on troves of cash just because it seems too risky an environment to invest. My personal psychology here has been that if I can't get a good return on my investments I need to build them up rather than spend them. I am also concerned about exposing myself to bubbles. While in theory I should be encouraged to take risks in practice the risks in a low rate environment seem too high, especially if you consider one day the rates must go up.
Historically we've had high inflation with significantly higher rates so I don't think the argument that low rates are a necessary condition for inflation holds. If anything the low rates appear to create deflationary pressure. Wages aren't rising because people and companies are not spending. Japan had low rates for 20 years and that hasn't done them much good. The last 10 year we had unusually low rates and by all accounts other than keeping the ship afloat not too much to show for those. It's time to try something else.
Low rates inflate bubbles. Student loans. Car loans. Real estate. Stock market. Keeping rates too low for too long has many risks and those will grow. The current rates are still historically very low.
> One additional consideration that I think about is the possibility that low rates are scaring people and causing them to save more and invest less, while conventional wisdom is that low rates should lead to more investment and less saving. It is not a crazy argument because negative rates seem to be having unexpected results in some countries that have adopted them. If negative rates can scare people into saving more, perhaps very low rates can too? This would be an argument to raise rates just so people can feel more confident. However, it is hard for me to see how high rates by themselves can lead to more confidence, more spending and more investment. Take Japan: Should the Bank of Japan increase rates dramatically to send a confident signal? Does anyone think that would work in jump-starting Japan’s economy? I doubt it. A signal of confidence from higher rates must be coupled with strong underlying economic fundamentals. When the data indicate that we are approaching our dual mandate targets, I do believe markets will take some confidence from our rate increases because those higher rates will reflect strong economic fundamentals. I don’t find a strategy of raising rates purely as a psychological tool a compelling argument.
EDIT: So far the small increases haven't had any adverse effects. If anything the opposite. So that's one counter-argument. The other thing to consider is that it's not the absolute rate or the derivative of the rate. It's the actions of the Fed vs. the market expectations. The expectation has been set for a long while that the Fed would try to normalize. If anything the Fed has not quite met the expectation. My last point is that the rates businesses borrow at are somewhat disconnected from the Fed rates, at times of higher perceived risk the premium vs. the Fed rate is higher. So the Fed raising rates doesn't necessarily increase costs to businesses.
I have heard this argument before, but only get arguments from authority when I ask for actual data that shows this.
If I owe you $100, and a dollar becomes worth less, I'm better off (since I'm paying you back in dollars that have less real value than what I borrowed).
There is a macroeconomic argument that a predictable and modest inflation rate is good for the economy. Some of the points are:
1) If both parties can accurately predict future inflation, it becomes much easier to negotiate an interest rate for borrowing; if there is much uncertainty about future inflation, then there is extra currency risk added to both the borrower and lender.
2) In the case of deflation, investors will be very cautious, since they become more wealthy just by holding cash.
3) In the case of very high inflation, currency becomes useless as a store of value, so people will rush to convert their currency to something less inflationary.
So if you think that currency should be a useful store of value, that we should encourage those with wealth to invest it in possibly risky endeavors and you want to encourage free-flow of credit by removing some of the risks involved, then those 3 points will be pro modest inflation.
There are of course counterarguments:
A) Free flow of credit has downsides as well as upsides; in particular households with lower net worth have less ability to absorb economic downturns.
B) Forcing wealthy people to invest to preserve their wealth by taking risky investments can create bubbles
C) B+1 means that the bubbles can become highly leveraged.
Like, would we all be better off if maybe student loans were a little tougher to get?
Also, lowering rates speeds up the economy a bit. It's probably better to run a little high, so interest rates can be dropped a little when bad things happen; that'll goose the economy, and power through small rough patches.
Or maybe we need a little more boom and bust to stay healthy, like the occasional isolated brush fire that prevents the whole prairie from going up in flames. It could be that Greenspan kept us too steady for too long. Mini-crashes burn away the rotten companies. Ok, I've changed my mind -- you're right, let it heat up.
Inflation is good for borrowers and bad for lenders. I don't see any reason to prioritize borrowers.
At least, that's the basic argument. In practice, what might happen is that the borrowers mostly borrow to make asset purchases in financial markets rather than in the real economy, which is a kind of spending that doesn't count towards GDP.
To be fair to your question, inflation does not necessarily mean any individual price will rise, but all of them generally more or less. For example, market forces may cause the price of labor to decrease while most other prices are increasing.
I agree that more public officials should publish the reasoning behind their decisions.
BTW I think a single mandate of price stability would be a better choice; perhaps you feel the same way. But that would require an act of congress -- good luck!
What would you propose instead? Anytime they seemingly target something else, they're (rightly, in my opinion) chastised for overstepping their mandate. Are you instead arguing they should have a different mandate? (If not, I don't think we agree on the definition of mandate ;))
I don't agree either. If the economy tanks again, there is almost nothing that can be done, being that one of the usual steps is to lower interest rates to spur growth.
(That's also why deflation is avoided like the plague - in that event, even a zero nominal interest rate is a positive real rate).
But I also think that this is difficult to get right.
the argument "we need to raise rates so we can lower them if the economy tanks" doesn't fit well with me. its sort of like saying lets take poison so that if we get sick we can stop taking poison and feel better.
it might hold some water if there was inflation, but there's not. deflation is still a bigger risk.
I think the fed should use interest rates to fight inflation, and QE to fight unemployment.
I've always wondered if the worry about deflation is overblown. We still have a lot of things that people and businesses buy that have inelastic demand which will not change regardless of whether or not we are experiencing deflation.
Also, when looking at expenses related to computer hardware, it has been going down relative to its capability. That hasn't led to a delay in purchases from either consumers or businesses from what I understand.
Mass production and technological advancement reduce prices, sure, but whole economic deflation makes debt's real value increase, basically exponentially punishing people holding debt while favoring lenders, where as inflation obviously does the opposite. So, the majority of people with a mortgage, car or student debt get screwed during a deflationary event.
Of course the evidence is hard to interpret. The 19th century was poorer than the 20th. Well Duh. The had 19th lots of recessions and depressions. But nothing so bad as the Great Depression. But also nothing so good as the Great Moderation.
My guess is that moderate anything is fine. But that policy wonks get the heebie-jeebies about not having the monetary lever in "their" hands.
Is that only a bad thing? If we have overcapacities and therefore prices fall then producing less would be the rational thing to do. I do understand that this has negative consequences as well though.
Raising interest rates isn't poison.
Also, at the moment deflation isn't a bigger risk. It says right in the article inflation is slowly rising, not falling.
Higher interest rates are intended to slow down the economy by making borrowing harder.
"Also, at the moment deflation isn't a bigger risk. It says right in the article inflation is slowly rising, not falling."
1.74% is very low, and on the wrong side of target inflation. ~3% inflation is considered historic, and we are no where close to getting there. not even a little bit. if that anemic .03 growth went even a smidgen on the wrong side of 0, that would be bad. so yeah, deflation is still a bigger risk.
Which is precisely what you need to do to get inflation under control. You may be correct that inflation is too low right now to tighten the screws, but calling interest rates poison is ignoring the reason the fed sets them.
And then you have the impact of oil, whose volatility is derived from difficult-to-predict geopolitics and abundance, making it useless as a short-term inflation indicator and even more useless as a very long term indicator, and yet we heavily rely on it regardless. Might as well include Bitcoin while we're at it. Not to mention the absence of real estate / college tuition / credit card debt in these measurements. Here's an interesting look at some cost comparisons, showing just how difficult it is to capture inflation using a CPI or even PCE approach.
While the author is concerned with meeting his distorted inflation metric on paper before raising rates, there's another reason to keep rates low: the cost of debt is about to rise for the world's largest debtor, and the payment is going to further add to its deficit. If the Fed is only concerned with the short-term problems of the US economy, like it usually is, then it should probably never raise rates.
>One additional consideration that I think about is the possibility that low rates are scaring people and causing them to save more and invest less, while conventional wisdom is that low rates should lead to more investment and less saving.
I will say that even when times are good, but can no longer be assured, people will save more. Moreover, when the costs of economic vulnerability have never been higher, the spending habits of the past no longer work.
Many of us are one pink slip away from permanent unemployment, underemployment, and financial ruin.
Many of us are one chronic - not necessarily life-threatening - illness away from peonage.
It seems unrealistic to expect people to behave as if it's 1957 or even 1987. Jobs for everyone or the threat of nuclear war probably spurred a bit more "live for today" mentality than what we might experience today.
Also, historically a leader of the various Feds does not necessarily have to be an economist - similar how supreme court judges don't necessarily have to have a legal/judge background. Given there is a whole committee of opinions, having some "fresh" outsider views may actually help the discussion. (Though I am not saying that having a former Goverment Sachs fellow necessarily is a poster child of fresh ideas here :)
A decent intro (<25 pages) to US monetary policy (I read it during intro macro), if you're interested: http://www.frbsf.org/education/files/MonetaryPolicy.pdf
They meet and discuss and then form US monetary policy. You can google and read their decisions.
It's not easy to get up to date with this stuff. You're going to have to put in over 100 hours of study to get a basic handle on the vocabulary.
People have rose-colored glasses with gold and silver backed currencies, but they were a factor in the Great Depression and directly responsible for several severe recessions and panics.
The gold standard of Bretton Woods also never had enough gold to back it up. It was a fiction the world kindly played along with the US on.
That's where you started being wrong in your post.
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I suppose letting the architects of the housing bubble (who also didn't predict it) set the discount rate is preferable?
Not having the ability to adjust the central interest rate has resulted in recessions in the past. It means every recession could be a depression. Interest rates would increase dramatically right as we desperately need them to lower to prevent the economy from going into a tail spin.
Economics is so much more than simply worshiping the invisible hand - if it was nobody would need to get a degree in it. We also need to understand when and how market failures occur.
I guess I'm just blessed with not running with herd.
The affiliated link, that was my bad. But money is fiat...
Markets do set interest rates on assets. The interest rate is just the rate of loans the Fed offers to banks. The markets have decided to use this rate as the basis for the loans they offer without coercion from the Fed or the government.