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Wednesday, November 6, 2013

Theme: Effectiveness Of Interest Rates

One of the defining characteristics of this interest rate cycle (and to a lesser extent, the previous cycle) has been the persistent forecast errors by central banks as well as the market consensus regarding the timing of "renormalisation" of policy rates. The standard explanation is that this can be explained by the reality that there was poorly timed fiscal austerity across the developed economies interacting with the fact that policy rates have hit their lower bound near zero. Alternatively, it may be that interest rates have less impact on the real economy than is commonly assumed.

Chart: US CPI Inflation versus Fed Funds

There was not always a very strong consensus on the subject; for example, there was a debate about the impact of interest rates on inflation during the 1970’s. As shown in the chart above, higher interest rates have been associated with higher inflation. However, the empirical analysis done since then has been broadly interpreted as supporting the view that raising interest rates lowers inflation rates.

More recently, economists associated with Modern Monetary Theory have been arguing that monetary policy is relatively ineffective. This leads to the proposal by Mathew Forstater and Warren Mosler to lock interest rates at zero, as very little policy flexibility is lost in their view.

I will write a series of articles discussing this theme, as this is a critical subject for understanding monetary policy. At present, I am somewhat agnostic on the topic. Monetary policy is clearly effective under certain circumstances; conversely central banks as well as the markets have been incorrect about how stimulative the current regime of low interest rates would be. This does require a fair amount of empirical work, as theory can tell us very little about this topic, since we cannot know in advance the relative power of effects which act in opposite directions.

(NOTE: The list of articles below will be added to over time.)

 

Arguments That Interest Rates Are Effective

References

 

Arguments That Interest Rates Are Not Effective

Articles
 References

(c) Brian Romanchuk 2013

9 comments:

  1. Looking forward to this. Definitely a topic that deserves more attention in the blogosphere.

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  2. Brian,

    I just read this paper on the hyperinflation in Zimababwe, and thought it might interest you, regarding the effect of interest rates:

    ‘Central Bank Quasi-fiscal Losses and High Inflation in Zimbabwe: A Note’ (2007)

    http://www.imf.org/external/pubs/ft/wp/2007/wp0798.pdf

    Some relevant quotes from the paper:

    “Zimbabwe’s failure to address continuing central bank quasi-fiscal losses has interfered with both monetary management and the independence and credibility of the Reserve Bank of Zimbabwe (RBZ). Realized quasi-fiscal losses are estimated to have amounted to about 75 percent of GDP in 2006.”

    “The aim of the paper is to identify and quantify the main sources of the quasi-fiscal activities (QFAs) by the Reserve Bank of Zimbabwe (RBZ) since 2004 as well as their macroeconomic and financial impact… Some sense of the macroeconomic impact of QFAs can be gleaned by reference to the size of central bank losses. While central bank losses in most countries have not exceeded 10 percent of GDP, Zimbabwe’s flow of realized central bank quasi-fiscal losses are estimated to have amounted to 75 percent of GDP in 2006… Quasi-fiscal losses of this sort, rather than conventional monetary or fiscal laxity, have been the mainly responsible for the surge in money supply in Zimbabwe during 2005-7.”

    “Most of the RBZ’s quasi-fiscal losses were incurred in connection with activities that go far beyond conventional central banking functions. There were four main sources of the losses:

    1.Subsidies in terms of free foreign exchange to public enterprises…

    2. Realized exchange losses stemming mainly from the purchase of foreign exchange from exporters and the public at higher prices than sales of foreign exchange to importers…

    3. Interest payments associated with open market operations to mop up liquidity…

    4. Unrealized exchange losses reflecting official devaluations because foreign liabilities exceeded foreign assets…”

    “In Zimbabwe soaring inflation is due more to the RBZ’s substantial quasi-fiscal activity than to conventional government budget deficits. The average central government fiscal deficit for 2003–2005 has been below 3 percent of GDP and since 2001 the primary balance has been in surplus in all years except 2004. However, as shown above, massive QFAs have been carried out outside the budget without adequate provisions for their financing. Therefore, a truer fiscal picture would include both the activity of the government and the QFAs of the RBZ in the fiscal balance.”

    “Sterilization of monetary expansion resulting from QFA financing has increased central bank quasi-fiscal losses as nominal interest payments have increased rapidly with rising inflation. Rising interest payments have also increased the financing requirement of the central government, creating further monetary expansion (ultimately weakening the effectiveness of sterilization).”

    “In January 2004 the RBZ started to issue its own bills at effective interest rates of over 900 percent per annum. These RBZ Financial treasury bills were naturally attractive to the market but too costly to the RBZ, so they were soon abandoned and replaced by Open Market Operation (OMO) bills, introduced in May 2004, and Special RBZ bills, introduced in June 2004. The OMO bills had the same interest rates as the existing government treasury bills but the accounting for them was clearly separated from holdings of government treasury bills since the interest cost was charged to the RBZ.”

    “The RBZ has accumulated substantial domestic interest-bearing liabilities through open market operations to absorb liquidity. The vicious circle of rising losses and rising remunerated liabilities has resulted in inflation and increases in the interest rates of the bills, further accelerating the interest cost for the central bank. By 2005 the net interest cost of sterilization equaled 40 percent of GDP.”

    ReplyDelete
    Replies
    1. I'll take a look. But my feeling is that I would classify these as fiscal policies, as the name they use suggest. What I consider to be monetary policy is interest rates and open market operations; I would view some central bank activity like purchasing gold in a non-Gold Standard country as fiscal. The fact that the central bank does these activities is more of a historical accident, which makes analysis messier.

      Delete
    2. they are fiscal as you point out, just carried out by the central bank.

      The basic point is the government was running an overall budget deficit equal to 75%-78% of GDP (40% of GDP due to interest payments), and the central bank was paying 900% interest on bank reserves.

      End result: hyperinflation.

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    3. Yes, high interest rates did not reduce inflation. But I guess the response would be that real rates were negative.

      Delete
    4. How could they have made the real interest rate they paid on reserves positive? i.e what would they have had to do?

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  3. The real interest rate is the nominal interest rate less than inflation. According to the standard view, real rates are what matters. So they needed to hike rates above the very high inflation rate; even 900% annual rates were below the rate of inflation. I have mainly looked at developed markets, and the highest inflation rates were only around 10% or so, so I do not have a lot of experience with hyperinflations. I have some ideas on the subject, but I want to read up a bit more onn the topic myself.

    ReplyDelete
    Replies
    1. "So they needed to hike rates above the very high inflation rate"

      But that would have actually increased inflation in the case of Zimbabwe:

      “Sterilization of monetary expansion resulting from QFA financing has increased central bank quasi-fiscal losses as nominal interest payments have increased rapidly with rising inflation. Rising interest payments have also increased the financing requirement of the central government, creating further monetary expansion (ultimately weakening the effectiveness of sterilization).”

      “The RBZ has accumulated substantial domestic interest-bearing liabilities through open market operations to absorb liquidity. The vicious circle of rising losses and rising remunerated liabilities has resulted in inflation and increases in the interest rates of the bills, further accelerating the interest cost for the central bank. By 2005 the net interest cost of sterilization equaled 40 percent of GDP.”

      See what I mean?

      Delete
  4. Yes. That effect is the "interest rate channel" that I talked about. The view that high real rates combat inflation is the mainstream view, which I have doubts about. In the case of a hyperinflation, I think high rates are definitely a source of inflation. In developed economies with inflation under 10% or so, it is possible that the mainstream view is correct. The mainstream will point to a lot pf empirical work which shows that high real rates reduce inflation. But if you see my post from last week about DSGE model identification, it may be the empirical studies are picking up something else, and attribute it to real rates.

    ReplyDelete

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