Should-Read: Nick Rowe gets this right. The astonishing thing is that so many people at the Federal Reserve get this wrong, and wrong, and wrong: Nick Rowe: Don’t even try to “Normalise” interest rates: “If you think that the rest of the economy is normalised, so it is time to normalise interest rates too, you are wrong…

…If the rest of the economy is normalised, then interest rates must already be normalised…. We’ve got “normal” both in the sense of an average over time, and in the sense of a desirable norm that central banks should aim for. But when I hear the words “The Bank of Canada (or some other central bank) needs to normalise interest rates soon” I reach for my shovel. If you want to argue against some view, as I am doing here, it is usually a good strategy to try to state what that view is. This is my best guess:

The economy was humming along normally, with the Bank of Canada setting the actual rate of interest roughly equal to the natural rate of interest, so the output gap was roughly zero, and inflation was roughly at the 2% target. Then the financial crisis happened, so the output gap turned negative (a recession), and inflation started to fall below target. So the Bank of Canada needed to cut the actual interest rate below the natural rate temporarily to offset the recession. But now the economy has recovered, with the output gap back to roughly zero, and inflation roughly on target, it is time for the Bank of Canada to normalise interest rates, by raising them back up to the natural rate again…

I don’t want to quibble with … whether the output gap really is zero… inflation really… back to target…. I want to attack the idea of “normalisation” itself…. What is really wrong with the “normalisation” view: “So the Bank of Canada needed to cut the actual interest rate below the natural rate temporarily to offset the recession.”… Now that the economy has recovered from the recession, with the output gap roughly zero, and inflation roughly at target, this means that the actual rate of interest is roughly equal to the natural rate of interest. Normalisation of interest rates has already (roughly) happened. The new normal is not the same as the old normal….If you think that the rest of the economy is normalised, so it is time to normalise interest rates too, you are wrong. If the rest of the economy is normalised, then interest rates must already be normalised.

AUTHORS:

Brad DeLong
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