Can’t resist the temptation to repeat my suspicions that zero interest rate policy is deflationary from the supply and the demand side.


Karim writes:

Great number for low for long camp; gives Fed ample cover to stay on hold.
Y/Y Core now at 34yr low of 0.9%; but likely to bottom around these levels as base comparisons begin to get a bit tougher.

Headline CPI -.07% m/m; Core +.05%
Trend variables stay on trend; volatile components offsetting

  • OER unch; medical 0.2%; education 0.2%
  • Apparel -0.7%; Lodging away from home +1.4%

38 Responses

  1. Yes, deflation can be bad, especially for debtors. Should increasing interest payments be used to create inflation?

    Sounds like interest rate policy is really a distribution issue and should be set politically (at zero). The whole notion of an independent Fed guiding the economy by altering interest rates should give people pause as the Fed is using income distribution as its rudder.

    To avoid current favoritism, altering a uniform lending limit/standard could work better for the Fed and U.S. citizens. This could change current pro-cyclical tightening into countercyclical loosening.

    Currently, the Fed can set interest rates at zero, but how does it help if no one can borrow? From what I hear, few can ‘qualify’ for the low rates being offered. The broker I’ve used for 20 years has given up on doing refinances and now sticks to new sales.

    1. I have a problem with the CB setting rates at all. Price control is the hallmark of a command economy and the antithesis of a market economy. Interest rates represent the price of money. Should a board of “experts” be trusted to set a key price structure? What is the justification for this economically? It also presents a political problem by giving a small group of unelected officials enormous power with no public accountability. On the other hand, fiscal policy is in the hands of Congress and the president, who are accountable to the people for their policy decisions. Seems to me that the emphasis on monetary policy controlled by the Fed is anti-democratic.

      What am I missing here? Why don’t we just eliminate the requirement for debt issuance, stop issuing Treasuries, let the overnight rate fall to zero, allow the market to set rates, and use fiscal policy instead? Why even pay a support rate on reserves?

      1. Tom, you may be interested in the following paper by David Levy.
        Does an Independent Central Bank Violate Democracy?

        He makes an interesting point that the calls for deficit reduction, with government assailed at every turn for spending taxpayers deeper and deeper into debt, the FED is responsible for dumping billions of dollars onto the annual deficit at will, and remains virtually unscathed by criticism for the fiscal effects of its actions.

        And on a brighter note here we have the IMF running around the world setting fires.

        IMF urges Japan to start cutting its massive debt

        Was there some concerted action today by the worlds CBs propping up the Euro?, even the Swiss Franc got a bid.

      2. Was there some concerted action today by the worlds CBs propping up the Euro?, even the Euro got a bid against the Swiss Franc.

      3. BFG, I don’t have any problem with the Fed supplying reserves to the Treasury account for disbursement, since all disbursement required Congressional appropriation. Neither Treasury nor Fed disburses funds into the economy on their own authority, and that authority is political, i.e., accountable to voters.

        The Fed setting interest rates involves undertaking monetary operations that are at the Fed’s discretion, having blanket approval in the law. I think that this aspect of the law, which makes Fed action politically independent in this regard, stretches the bounds of both market economics and democracy. This is equal to the farce of the Supreme Court arbitrating the general election in Bush v. Gore.

      4. Tom, I don’t see a problem with paying a support rate on reserves. Those reserves were created by the government deficit spending and are a cost to the banks which have to pay interest on their deposits to their customers that were created by the government itself through crediting bank accounts. Essentially the government created those deposits, so I think it is right that they pay some interest on them.

      5. BFG: “Essentially the government created those deposits, so I think it is right that they pay some interest on them.”

        Doesn’t paying interest discourage lending by the banks?

        We were told that the reason for pumping the banks full of cash was so that they could lend. Since they are not lending, does it make sense to discourage it further?

      6. BFG, I don’t get the logic here. Banks don’t “have” to pay interest on deposits. Most banks don’t pay interest on deposit accounts and moderate interest on time accounts. Bank manage interest they borrow at against interest at which they lend. The government has no responsibility to banks for currency creation. It is a function of government to do so. The government should just stay out of the interest rate business as far as I see it.

      7. Tom, this is the way I see it, interest is a cost of doing business. If the government stopped issuing bonds and let the excess reserves build up driving the overnight interest rate to zero would the bank not pass on higher fees to their customers to accomodate the increased transactions caused by the treasury? The government can solve that by paying them an interest on reserves for accomodating the transactions.

  2. as the monopoly supplier of reserves, the gov is necessarily price setter.

    think of bus tokens. the overnight deposit rate is 0 unless the issuer decides to pay something higher than that for token deposits.

    and while you might pay an interest rate to borrow tokens from a friend, if you hold them overnight you earn 0. so the rate reflects ‘storage’ charges including credit risk and in this case cost of funds

    1. Interest that government pays is a form of currency issuance (“spending”). Reducing interest payments reduces government disbursement, just like any other form of decrease in government “spending.” This reduces net financial assets and thereby reduces nominal aggregate demand. This adds a deflationary bias in an already deflationary environment.

      1. Yes, but given an interest rate drop, the vast bulk of what govt dishes out in the form of interest (i.e. interest on existing national debt) remains unaltered in dollar terms. Though the latter is a weak point where national debt rolls over quickly (US rolls over quicker than UK).

        But the whole argument is unimportant, because interest rates are determined by whether the central bank is expanding or contracting the monetary base. That strikes me as the dominant factor. There may be a negative feedback in the form “less interest doled out is deflationary”, but that’s a small effect, I think.

        Put another way, remember Mosler’s law (with which I agree): “There is no financial crisis so deep that a large tax cut or spending increase cannot deal with it”. Quite right: a sufficiently large tax cut or spending increase just steamrollers everything else (including any deflationary effect from low interest rates).

      2. Tom, on another blog I read in interesting idea that may be pertinent. Who gets the interest payments, and what do they do with the money? If it is on the whole people and institutions who save it, then the government probably has other ways of spending the money that will cause more of an increase in aggregate demand. So reducing interest payments, if accompanied by equivalent spending elsewhere, should increase aggregate demand.

        What do you think?

      3. Min, this is central to my argument. My (idealistic) view is that the CB would abandon interest rate setting and leave that to the market. However, modern developed economies are not free market economies in that the government is deeply involved. For example, most economic crises stem from debt-deflation, so government involvement is required to prevent deflation from spiraling or a new equilibrium settling at a much lower level of GDP.

        This means that the government intrudes in finance through both regulation and backstopping, e.g., through explicit and implicit guarantees. The government has also recognized that without assistance the residential housing market would be rather moribund and most people would be renting from a landlord class.

        I would explicitly recognize this by making government the retail banker (or a retail banker and let narrow banks compete), since it already occupies this role. This is where rate setting would take place, with low interest loans for housing especially, and also other low income needs. This would feed aggregate demand, and government could exert some control through its rate setting. This makes a lot more sense to me than paying rich people for their risk-free parking place in Tsy’s.

        When I was entering the job market, banks were known as boring, basically not very different from government bureaucracy. Since then they have become casinos. We need to get back to the narrow banking of yesteryear for consumers, and then let the “big boys” plays with their toys elsewhere and heal their own bruises, or kill themselves if they are not careful. Regulation would still be required to stem systemic risk posed by casinos becoming too big relative to the economy to absorb. You can’t build a prosperous and stable economy based on casinos.

        The purpose of economic activity is the production, distribution, and consumption of real resources in a society, not for individuals to make money, as many erroneously presume. Therefore, economic policy has to be oriented to insuring that society is adequately provisioned at all times, and an important aspect of this provisioning involves employment and price stability. There is no reason that foregone opportunity should be allowed through output gaps or price instability when good policy and appropriate operations can prevent this from occurring or address it quickly and effectively if it should.

        The world needs to recognize that in a complex society, markets are a tool, not an end. Government needs to be involved in insuring the provision of necessities, and we need to take a global stance toward this, especially in light of earth changes. Free markets should only apply to discretionary goods, and even here be limited in such as way that activity does not lead to systemic risk or negative externalities.

  3. Should short term rates be zero or a fair rate of interest?

    It is not clear what advantage monetary policy has [over fiscal policy for achieving full employment and stable inflation], besides the fact that target interest rates can be easily altered every month or even every week. Indeed, by bringing back fiscal policy as the main tool to affect aggregate demand, monetary policy would now have an additional degree of freedom to set the real interest rate, which is a key determinant of distribution policy. The real interest rate could be set at its fair level, which, according to Pasinetti (1981), is equal to the trend rate of growth of labor productivity (see Lavoie and Seccareccia 1996). With such a fair rate of interest, the earnings of one hour of labor, when they are saved, allow its owner to obtain a purchasing power which is equivalent to that obtained with the earnings of one hour of labor in the future.

    Source: Fiscal Policy in a Stock-Flow Consistent (SFC) Model, Godley and Lavoie 2007

    1. The problem that I have with setting rates, in addition to the political issues involving democracy, involves the economics. There are problems with both data and modeling. Greenspan was not being disingenuous when he said that we don’t really know when we are in a bubble, for example. There is no model of bubbles that is empirically sound. That’s is just one instance.

      Beyond this, there is the while question of the contemporary economic enterprise as it is being conducted, e.g., REH, EMH. It just doesn’t square with reality. See, for example, David Ruelle, Chance and Chaos (Princeton, 1991), chapter 13, “Economics.” Makes me think Hayek had a point “The Use of Knowledge in Society”.

      1. Tom, setting the interbank rate to zero is no different than setting this rate to any other number. It is all price-fixing. And it will not result in the long term rates moving to zero.

        *Unless* you arguing from the Mayan-zero-is-not-a-number perspective, in which case I would accuse you of dadaist-obfuscation rather than just not thinking clearly.

        But more importantly, how does one get an avatar on this blog? I’ve seen some avatars, but don’t see a link to upload one.

      2. RSJ, I would not have the CB set the rate at all. Using fiscal policy without requiring debt issuance instead, there would virtually always be excess reserves and no need to set rates. The overnight rate would fall to zero.

        Remember, i would also have the government as the narrow bank, setting consumer rates very low. Other narrow bank could compete with the government if they wished, but the bulk of finance would not be involved at the retail level, and it would be without government guarantees. If I had my ideal, there would be no corporate finance. Principals would assume the risk themselves without any veil.

  4. I can understand the logic of zero rates being deflationary — it’s the conceptual equivalent of arguing that falling prices are deflationary, or that falling returns are deflationary. That these things have inertia is believable.

    But what is more important is how to get an avatar on this blog?

      1. An “avatar” is a little image or icon that appears next to your post. For example, you probably want to be Spiderman, so you could download an image of spiderman and it would appear next to your comments. Then you could add a tagline “with great fiat powers comes great responsibility”

        Alternately, you can appear as a wad of money, a palm tree, or even a pencil. Avatars can be quite enjoyable when reading through comments.

    1. What was it really then that “broke the back” of inflation?

      How would you have handled that situation in total?

      1. I’ve heard Warren state that it was the switch from oil based electrical power plants to natural gas.

  5. By what logic does the government have the authority to spend money and to create money, but not to price money?

    1. The government does have the authority to set prices. IT is called “price controls” and “rationing” It is just a bad idea in a market economy, and that goes for the price of money, too. If the government is going to have the authority to set the price of money and use it then it should also have the authority to set the price of labor and use it, too, by establishing a JG. If the government (CB) is going to be the LLR, then the government should also be the ELR. Using rates to target “inflationary expectations,” taken as tantamount to actual inflation, using unemployment as a tool is biased toward rentiers and against workers.

    2. Fair enough.

      That’s an argument in favour of balancing the use of price controls for both money and labour.

      But does balance really require decimating the rentier share with zero rates? That seems more like vindictive JG bias, than balance.

      I.e. does the right balance = systemically 0 rates?

      1. I am not advocating zero rates but a market set rate. If a suitably low rate were set for reserves, that probably is OK as long as the CB doesn’t use the support rate to set policy. The principle here is to let the market determine risk and therefore rates.

        These are policy questions that would need to debated. I’m just saying that we need to have a debate. I’m not an economist, and I could be convinced otherwise by cogent argument.

        I think there are two issues here. The first is principle and the second is application. I have enunciated some broad principles as a simplistic idealized notion. I am open to how the application of such principles would work out in practice.

        One thing we do know for sure is that the system in place is not working very well with the CB using rate-setting and employment as tools, when employment is supposed to be a target.

  6. “…zero interest rate policy is deflationary…”

    Since the natural rate of interest is zero, is deflation then the natural state of the economy?

    1. “Deflationary” simply means not providing net financial assets as opposed to providing them. Interest increases net financial assets and is therefore “inflationary.”

      Interest rates are usually low in deflationary times, when the economy needs more net financial assets, and they are high in inflationary times, when the economy needs less financial assets. So interest rates exacerbate price instability.

      1. Tom,

        I understand deflationary as causing deflation, which is different from just not providing NFA.

        Of course, I’m not Warren, so I don’t know what he meant by the statement I highlighted. Perhaps he can explain.

      2. In a deflationary environment, cutting interest payments contributes to deflation by reducing NFA.

        In the broader sense, when inflation threatens then government should adopt a “deflationary” policy (not cause a deflation to occur), and when deflation threatens, then government should promote an “inflationary” policy (but not so much as to cause inflation). The objective is achieving balance by alternating between these two stances.

    1. Keynes never said euthanasia was painless. :o)

      However the money quote in that article is when the financial planner said, “The Fed is determined to keep rates very low, and while it’s painted as fiscal stimulus I think it’s really a stealth bailout of the banks”.

      Jon Stewart mentioned the other day that the Government is the “worst loan shark in history”, poining out that the Fed loans banks money at near zero interest, who then turn around use the loans to buy long-term Treasuries at 3% to “fund the deficit”.

      Now that’s an arbitrage play! Why not cut out the middle man by no longer issuing long-term Treasuries and just have Tsy borrow from the Fed at zero interest? Oh yeah, because then the Fed and Tsy would be acting in the public’s interest and not the banks.

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