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Ben Bernanke’s Blog: Interest Rate Confusion
TND Guest Contributor: Paul-Martin Foss |
Former Federal Reserve Chairman Ben Bernanke has a lot more free time on his hands now that he’s no longer in charge of messing around with the US economy. Since leaving the Fed, Bernanke has been a Distinguished Fellow in Residence at the Brookings Institution in Washington, DC. Yesterday, Bernanke began posting at his new blog on Brookings’ website. In his first post he engaged in a bit of wishful thinking, stating that “Now that I’m a civilian again, I can once more comment on economic and financial issues without my words being put under the microscope by Fed watchers.” His words may not be parsed anymore, but they certainly will be examined. It is Bernanke’s second post, on interest rates, that requires some attention. It’s a fascinating insight into Bernanke’s thinking and makes you realize just why the Fed’s monetary policy is so screwed up.
If you asked the person in the street, “Why are interest rates so low?”, he or she would likely answer that the Fed is keeping them low. That’s true only in a very narrow sense. The Fed does, of course, set the benchmark nominal short-term interest rate. The Fed’s policies are also the primary determinant of inflation and inflation expectations over the longer term, and inflation trends affect interest rates, as the figure above shows. But what matters most for the economy is the real, or inflation-adjusted, interest rate (the market, or nominal, interest rate minus the inflation rate). The real interest rate is most relevant for capital investment decisions, for example. The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed.
I’d give the edge to the man on the street in this instance. The Fed has kept interest rates low for years. How does the Fed keep interest rates low? By purchasing assets. That pumps more money into the banking system, more money is available to be loaned, so interest rates drop. But that money creation, all other things being equal, will also lead to a rise in prices. The rise in prices, the effect of money creation, is what the Fed refers to as inflation, and Austrian economists refer to as price inflation. The real interest rate that the Fed refers to here is the nominal interest rate minus the inflation rate.
Let’s assume that the nominal interest rate is 3% and the inflation rate is 2%. The real interest rate is 3% – 2% = 1%. But suppose the Fed starts pumping money into the system, buying up assets in order to push the nominal interest rate to 2%. But inflation then rises to 3% because of that new money in the system. Now the real interest rate is 2% – 3% = -1%. So the Fed’s actions, by affecting both the nominal interest rate and the inflation rate, affect the real interest rate. The reason Bernanke tries to claim that the Fed can’t affect the real interest rate is because the Fed tries to pretend that its monetary policy does not result in inflation. Inflation to the Fed is something that is just out there, endemic to the system, and which the Fed can try to influence one way or another but over which they claim to be ultimately powerless. The reason for this is because if enough people realized that it was the Fed’s actions that are the primary cause of rising prices they would clamor to shut the Fed down.
Also, the “prospects for economic growth” Bernanke refers to are nowadays strongly influenced by the Fed. Every time the Federal Open Market Committee (the Fed’s monetary policymaking committee) meets, markets wait with bated breath. Will the Fed raise interest rates? Will it buy more assets? Will it give us more easy money? Or will it start to tighten? Businesses and individuals are affected by the Fed’s actions, and the uncertainty surrounding the future of the Fed’s monetary policy has a lot of people in a holding pattern. If you take on too much debt and the Fed begins to raise rates, you’re going to end up in a world of hurt because that debt will get a lot more expensive to pay off in the future. The Fed has inserted itself into so many areas of the economy through its monetary policy programs that there is almost no sector anymore that isn’t affected in one way or another by the Fed’s actions. The first thing anyone says when asked what the prospects for future growth are is “It depends on what the Fed ends up doing.”
If the Fed wants to see full employment of capital and labor resources (which, of course, it does), then its task amounts to using its influence over market interest rates to push those rates toward levels consistent with the equilibrium rate, or—more realistically—its best estimate of the equilibrium rate, which is not directly observable.
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The Fed influences market rates but not in an unconstrained way; if it seeks a healthy economy, then it must try to push market rates toward levels consistent with the underlying equilibrium rate.
This equilibrium rate Bernanke refers to is not something that is measurable or observable. Yet the Fed tries to influence it anyway. Bernanke is essentially confessing here that the Fed just guesses when it engages in monetary policy. But more importantly, why does Bernanke believe that market rates are not consistent with the equilibrium rate? He apparently believes that market rates are not the same as the equilibrium rate, but why? Is it just a belief that he holds without any apparent rationale? Does he appreciate that if market interest rates are out of whack that much of that has to do with the Fed’s monetary policy and its lending actions causing distortions to market interest rates and causing them to deviate from equilibrium?
In the weak (but recovering) economy of the past few years, all indications are that the equilibrium real interest rate has been exceptionally low, probably negative.
First of all, it’s important to differentiate between the natural rate of interest and monetary interest rates. The natural rate of interest is the ratio in the valuation of present goods versus future goods. People prefer to consume in the present rather than in the future, e.g. “A bird in the hand is worth two in the bush.” Offer someone $10 today versus $13 tomorrow and some will take the $10. Others will wait for the $13. But offer someone $10 today versus $9 tomorrow and everyone will take the $10. The natural rate of interest can never be negative. A negative natural rate of interest means that someone would rather have less in the future than more today, which is a completely nonsensical concept. The natural rate of interest must always be positive. Monetary interest rates can be negative because, especially with bank deposits, they essentially act as a fee charged for deposits. Being charged a -0.1% interest rate, which is paying money to the bank to hold your money, may be cheaper than withdrawing the money and sticking it in a safe and hiring armed guards to watch it. But that’s why monetary interest rates are different from the concept of the natural rate of interest. Once again, the natural rate of interest is always positive.
When Bernanke uses the term “equilibrium real interest rate” he uses it in the same sense that Austrian economists would use the term “natural rate of interest”, i.e. not referring just to monetary interest rates. So either Bernanke has confused the concept of the equilibrium real interest rate with real monetary interest rates in this passage, or he has a strange notion that the natural rate of interest can somehow be negative.
A similarly confused criticism often heard is that the Fed is somehow distorting financial markets and investment decisions by keeping interest rates “artificially low.” Contrary to what sometimes seems to be alleged, the Fed cannot somehow withdraw and leave interest rates to be determined by “the markets.” The Fed’s actions determine the money supply and thus short-term interest rates; it has no choice but to set the short-term interest rate somewhere.
Talk about a confused argument. Let’s break it down. Bernanke argues that the Fed exists and engages in monetary policy, which requires setting short-term interest rates. Therefore the Fed cannot stop engaging in monetary policy and setting short-term interest rates. And why exactly can it not do that? Those of us who argue that the Fed’s actions distort markets advocate for the Fed’s abolition. Ending the Fed would end its involvement in monetary policy and leave interest rates to be determined by the markets. It has been done before and it should be done again. Bernanke’s argument boils down to an assertion that the Fed is, therefore it must be.
You have to give Bernanke credit, he really started his blogging off with a bang. It will be interesting to see in his subsequent posts if he fleshes out some of his views even more. On the one hand, blog posts aren’t always the place for a complete exposition of one’s views, so I’m willing to cut Bernanke a little bit of slack for making some of the unsubstantiated assertions he did. But on the other hand his views on interest and interest rates, particularly the possibility of a negative natural rate of interest, his complete acceptance of the desirability of price fixing, which is what the Fed engages in when it sets interest rates, and his seeming inability to see where his opponents are coming from make it clear just why the Fed’s monetary policy was so bad. If Janet Yellen is cut from the same cloth, then the US economy will be in for quite a few more rough years.
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About Paul-Martin Foss:
Paul-Martin Foss is the founder, President, and Executive Director of the Carl Menger Center for the Study of Money and Banking, an Arlington, VA-based think tank dedicated to educating the American people on the importance of sound money and sound banking.
Prior to founding the Menger Center, Mr. Foss worked in the U.S. House of Representatives for seven years, including six years as Congressman Ron Paul’s legislative assistant for monetary policy and financial services, and one year as Deputy Legislative Director for Congressman Thomas Massie.
As Congressman Paul’s legislative assistant, he assisted the Congressman in his duties as Chairman of the Subcommittee on Domestic Monetary Policy by helping to develop hearing topics, agendas, and briefing Congressmen and their staffs on monetary policy topics. Mr. Foss also was responsible for the management of Dr. Paul’s monetary policy and financial services legislation, including the “Audit the Fed” and “End the Fed” bills, and was co-editor of Ron Paul’s Monetary Policy Anthology, a multi-thousand page compilation of hearing transcripts, lecture transcripts, and other documents related to Dr. Paul’s chairmanship.
Mr. Foss received his Bachelor’s degree from The University of the South (Sewanee), and Master’s degrees from the London School of Economics and Georgetown University’s Edmund A. Walsh School of Foreign Service.
This article appeared on the Carl Menger Center for the Study of Money and Banking and is reprinted with permission, “Creative Commons 4.0.”
Source: http://thenewsdoctors.com/ben-bernankes-blog-interest-rate-confusion/
