Interest rates are important, but not as much as most people think. To see why, it may help to start with an analogy. Why is inflation important?
If you ask the average consumer, they will tell you that inflation is obviously bad because society has to pay more for the things they buy. But if you find any economics book, nowhere do they mention this factor as “cost inflation”. That’s because when people spend more money on goods, other people earn more money by selling those goods. By themselves, higher rates are a zero-sum game.
That’s not to say that high inflation isn’t a problem—I believe it’s a much bigger problem. But it is not a problem for the reason that many people think it is a problem.
The same is true of interest rates. Many people (mistakenly) think that low interest rates are good for the economy. Stock traders know better, and indeed stocks fell sharply on Friday, even as long-term interest rates fell. Like inflation, interest rates can matter—but not for the reasons you might think.
I suspect that many people make the same mistake that consumers make with inflation, thinking about personal experience. So they might think how low prices would make it easier to buy a house or a car. But interest rates are a zero-sum game. When one person pays more interest, the other gets more interest.
I suppose you could argue that a change in interest rates would cause some sort of “redistribution”, although it’s hard to say how. When rates are low, the media complain that big banks benefit and retirees with savings accounts suffer. When rates are high, the media complains that credit card holders suffer and the big banks benefit. But even if interest rates were to fall, money would be redistributed to low-income people, that does not mean that it will help the economy. Low prices also tend to slow down the pace, as people have more incentives to hoard money. As always, it depends on why interest rates change.
Consider the following two claims:
1. It is nonsense to talk about how interest rates affect the economy. It would be like talking about how changes in oil prices affect the oil market.
2. It makes a lot of sense to talk about how monetary policy affects the economy.
If both are true, then clearly interest rates cannot be monetary policy. So what is monetary policy?
3. Monetary policy is a set of actions taken by central banks that affect the supply and demand for basic money, usually with the aim of influencing macro aggregates such as prices, employment and/or NGDP.
So what do interest rates have to do with monetary policy?
1. Before 2008, the Fed controlled the money supply rate by instructing its open market desk to buy and sell Treasury securities. This policy directly affected the base money supply, and indirectly affected interest rates.
2. After 2008, the Fed continued to change the base money supply (through QE), but also used the instrument of interest on bank reserves to influence the demand for base money.
3. The Fed also affects the demand for base money by affecting the expected growth rate of NGDP. Faster NGDP growth means less real capital demand.
Note: These three effects do not all work in the same direction!
This is an important point that many people miss, even many economists ignore the problem. (If you are familiar with the recent debate, the first two approaches are emphasized by Keynesians, and the third has implications related to NeoFisherianism.)
Because monetary policy affects interest rates in a complex and often conflicting way, it is not possible to look at changes in interest rates and make any inferences about the stance of monetary policy. I suspect that the reason America has never had a mild recession (defined as unemployment rising 1% to 2%, then falling) is because our central bank has always been confused about the relationship between interest rates and monetary policy. When the economy reaches a mild recession, the Fed initially makes things worse by tightening monetary policy—causing a major recession. They mistakenly think that they are not tightening policy because they are lowering their interest rates. But low prices aren’t easy money—especially when the environment is falling so fast.
Let’s say that the big banks started to realize this mistake little by little. And then, if my hypothesis is correct, the US should start getting smaller cuts. This will happen instead of a general recession because the Fed will no longer be fooled by the obsession with interest rates. The Fed will begin to focus more on a variety of financial market indicators, and is also more willing to use a “whatever it takes” approach to strengthen market expectations of future aggregate demand (NGDP.)
It would take many decades of advanced practice to be sure it wasn’t just luck, so I won’t be around to see if my predictions come true. I certainly don’t know if the Fed has begun to see past the fallacy that interest rates are monetary policy, a necessary condition for any improved performance. It is also possible that they can reduce the severity of the business cycle through different policy changes, implying the adoption of standard deviation.
I would guess that there is more than a 50% chance that we will enter our first minirecession. If so, I think it’s possible that this period is not labeled a “recession” by the NBER. If so, it will be our first soft landing. And closely related to these points, would be our first violation of “Sahm’s Law”.
Otherwise, we could have a full blown recession. Either way, the next 12 months will likely be more interesting than the last 12 months. Here are my (non-scientific) guesses:
1. Boom: Unemployment reaches 4.3% – 5% chance.
2. Recession: Unemployment rises between 4.4% and 5.3% — 65% chance
3. Recession: Unemployment rises above 5.4% — a 30% chance.
I’d be interested in what readers expect—feel free to add in the comments section. As an aside, these are my explanations; the NBER uses a different approach to defining recessions. I define a soft landing as at least three years of sustained growth without causing high inflation, even after unemployment has fallen near cyclical decline. We never did that. That would be a more impressive national goal than repeating the 1969 moon landing in the 2030s.
PS. This is kind of a cool graph:
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