Today’s Must-Must-Read: Matt O’Brien: What People Talk About When They Talk About Zero Interest Rates
Today’s Must-Must-Read: This is an important point that is worth saying as often as necessary–perhaps as often as possible:
…At least that’s what Wall Street thinks. Gillian Tett… tell[s] us… they think in between their flights from Davos to Aspen… that:
ultra-low interest rates have a nasty habit of distorting markets in all manner of unexpected ways, all over the world… [in the money in] U.S. activist funds, angel investments, laying down wine or jumping into the art market.
In other words, we should worry that billionaires are paying so much for Picassos and pinot noirs as part of the hyperinflation in the Hamptons. Now it’s true that lower interest rates make asset prices go up, but ‘distorts’ is a funny way of putting that. After all, we don’t say that higher interest rates ‘distort’ asset prices down…. [If] rates are inappropriately low… where’s the inflation? It’s not like central banks can keep rates lower than they should without prices going higher….
It’s the economy, not interest rates, that are distorted. People want to save more than they want to invest, and that is why rates are so low…. The mistake that Wall Street, and even some famous economists, make is… they think that lower rates are what’s messing up the economy, rather than reflecting the fact that it’s already messed up….
Just look at the countries that have tried, and failed, to keep rates up after they’ve hit zero: Japan, Europe, and Sweden. Each of them told themselves a story about why they needed to hike rates—they thought they’d recovered, or inflation was coming to get them, or maybe a bubble–and they each did so…. Well, it turns out that raising rates when your economy is still kind of weak isn’t a good idea. All of them ended up having to cut rates back down to zero, and then start buying bonds with newly-printed money…. It’s not the Fed’s job to worry about the Billionaire Price Index. It’d be… unnatural if it did.
The neutral or natural rate of interest is the rate of interest that balances desired savings with planned investment when the economy is at full employment, and when people’s expectations of the prices and inflation rates which they will be able to charge or have to pay are by-and-large correct. That is how things have been ever since Knut Wicksell started this particular sub literature of economics back in 1898. As John Maynard Keynes wrote back in 1923, having the market interest rate below or above the natural interest rate corresponds to monetary policy that produces a money stock that is either inappropriately high or inappropriately low, and generates:
inflation [which] is unjust and deflation [which] is inexpedient. Of the two perhaps deflation is, if we rule out exaggerated inflations such as that of Germany, the worse; because it is worse, in an impoverished world, to provoke unemployment than to disappoint the rentier. But it is necessary that we should weigh one evil against the other. It is easier to agree that both are evils to be shunned…
The right way to think about it is: Yes, interest rates are scarily low right now. But they are so because the Federal Reserve and other central banks are trying to mitigate the damage caused by the fact that the entire global macroeconomy is so distorted–inappropriate fiscal austerity, a global savings glut coming from emerging markets and elsewhere, secular stagnation, and a clogged housing-finance channel.