One of the little known facts of the history of monetary policy is that until 1994, the Fed did not actually announce interest rate decisions. Market participants had to infer rate changes from the Fed’s open market operations. This is just one example of how so many things we take to be natural and obvious are, in reality, relatively recent phenomena. In less than twenty years, the Fed has transitioned from near-opacity to an almost obsessive transparency. Another example of a relatively recent monetary policy doctrine that is now unquestioned is the doctrine of inflation targeting. The essential idea of inflation targeting is that people and firms should not have to think about the level and volatility of inflation when they make economic decisions. Inflation must therefore be kept at low and stable levels so that the long-run costs of unpredictable and uncertain inflation are minimised. As Mervyn King notes, inflation targeting has always been about improving the “credibility and predictability of monetary policy”.

However, in a world where money earns interest, minimising the uncertainty of macroeconomic policy does not equate to minimising the volatility of inflation. When all money bears interest, all that matters for those who hold money or bonds is the real interest rate earned on money and bonds. Given the fiscal stance and state of private credit growth, central banks should manage the real rate of interest such that rentiers do not capture a free lunch (i.e. real rates should not be too high) and there is no risk of a hot-potato/credit-bubble cycle (i.e. real rates should not be too low).

Money does not bear interest today because central banks pay interest on reserves. The primary reason why we live in a world of interest-bearing money is the gradual deregulation and innovation in financial markets over the last thirty years that triggered a shift from money to near-money assets. Apart from minimal liquidity reserves, there is simply no need to hold significant amounts of money in one’s zero-interest current account. Individuals can hold money in money market funds or treasury ETFs. Firms and high net-worth individuals can simply hold treasury bills that are as risk-free and liquid as money is. Even treasury bonds consist of a risk-free component that can be separated from the duration-risk component and monetised via the repo market. The equivalence of money and bonds is not just a temporary “liquidity trap” phenomenon. The evolution of financial markets means that the role of interest-free money is obsolete, now and forever.

In such an environment, the uncertainty and the volatility that individuals and firms care about is the volatility of the real interest rate. Let me take a simple example to illustrate this point. Let us assume that you hold a significant proportion of your assets in a short-term T-bill ETF that currently yields 0% in an environment when inflation is 2%. Therefore, the real interest rate is -2% but you swallow this loss as a “safety premium” fearful that investing in risky assets inflated by monetary stimulus may result in much greater losses. Now suppose the Fed decides to adopt an inflation target of 5% instead, which it achieves by buying up private sector assets such as equities1 while still holding the Fed Funds rate at 0%. This move to 5% inflation obviously hurts your investment in T-bills but the real reason is not that inflation has gone up. The real reason is that real rates have turned even more negative from -2% to -5%.

Many economists will complain that there is no other option. But when government bonds effectively function as money, there are a multitude of other options. The 5% inflation target could be hit by instituting a significant increase in fiscal stimulus (preferably via helicopter drops) and simultaneously hiking rates to 3%. From the perspective of most firms and individuals, this option which minimises the volatility of real interest rates is by far the more predictable and less uncertain policy. Those who borrow or invest at fixed rates for longer tenors will obviously suffer more volatility but such activities are explicitly risk-taking by nature. There is no conceivable reason why the central bank or the government should subsidise such risk-taking.

Proponents of inflation-targeting sometimes point to the poor economic performance of many developing countries with high and variable inflation. But what is really at fault in many of these instances is the tendency of the fiscal and monetary authorities to inject unexpected bursts of inflation that are uncompensated for by the interest rate regime enforced by the central bank. It is the persistent erosion of purchasing power due to negative real interest rates2 that is the real source of the poor macroeconomic performance in most high-inflation regimes.

The obvious object to my argument is that there is no reason why real interest rates must be held constant - I agree. My argument is not that real rates should be held constant but simply that excessive volatility in real rates must be avoided even if it is at the expense of a more volatile inflation rate. If the economy is hit by an inflationary supply shock, then it must be met by an increase in the inflation rate and an increase in the nominal interest rate (thus keeping real rates stable) rather than a rate hike to maintain a constant inflation rate (which would simply be an unwarranted transfer of wealth to lenders). There are also limits to how negative real rates can be driven to before an inflationary spiral is triggered. As of now, we are clearly well within these limits but it is foolish to assume that the inflation target can be increased to any level while central bank rates still remain at zero. Sooner or later, increasingly negative real rates will set off a inflationary spiral and a stampede to buy up real assets instead of nominal bonds.

I am not opposed to central banks driving down real rates to counter the increased demand for safety during a liquidity crisis. But in an environment like today when junk bond prices are at all-time highs, there is no justification for maintaining artificially low real rates. To restore economic prosperity in today’s crony capitalist and stagnant economy, we need to provide direct transfers to individuals via money-financed stimulus while simultaneously hiking rates to stop the permanent bailout of incumbent banks and firms.

  1. See my earlier post ‘The Case Against Monetary Stimulus Via Asset Purchases’ for why I oppose such a policy.  ↩

  2. Negative rates may also be enforced by restrictions on the interest rate payable on deposits and similar financial market regulations.  ↩


Ralph Musgrave

The last sentence of the above article claims that interest rates should be raised so as “to stop the permanent bailout of incumbent banks..”. Existing rates only constitute a “bailout” if those rates are ARTIFICIALLY low. And the fact that rates are currently low does not prove “artificiality”. I’m all for interest rates being determined by market forces alone: i.e. I favour dispensing with “artificiality”. The way to do that is to implement something along the lines of the idea mentioned in last sentence of the above article, that is regulate demand via “direct transfers to individuals”, while leaving interest rates to market forces. And there are plenty of detailed arguments behind the latter “market force” policy. E.g. see here (especially p.22): and some more relevant points on my own blog:


Ralph - Thanks for the comment. In today's essentially artificial market, it is obviously very hard to figure out the natural real rate. Till even six months ago I would not have advocated raising rates. But now the disconnect between asset prices and the macro situation is so stark that we need to get away from this asset-price obsessed monetary stabilisation to a broader toolset.


Hi Ashwin, I can't reccomend this paper highly enough, it talks directly to your reslience vs efficiency paradigm using variable costs vs fixed costs (from the biological analysis of r-type and K-tye species strategies). This is an ecological economics approach which aligns closely with yours although I think reaches somewhat different conclusions. All ecologically inspired approachs to economics must ultimately be grounded in non-equilibrium thermo, and this paper serves as somewhat of an intro to that. The paper basically says that in a mature ecosystem or economy you basically do expect very low interest rates. I'm not sure you can create a high nominal rate by fiat, which is what you appear to be suggesting here. Anyway, I'd be interested in your thoughts on the link.


scepticus - Thanks. I will take a look. I'm not debating that the end-point of the fiat money system will probably involve close to zero rates (if there is no out-of-control fiscal-monetary print money + spending program). But at least in the West, we aren't there yet. And we won't ever get there if we have say a periodic helicopter drop that provides a basic income (which I don't support btw). If helicopter drops provide 5% inflation every year then rates will not be zero. Sooner or later, the hot potato effect will drive inflation even higher in a spiral. My point is that right now, we're funnelling free money to the richest sections of society by supporting asset markets and spreading this impact over the rest of society via the small inflation created. My point is also that if we do print money at a steady pace and give it to the citizens, then the interest rate decision is simply dependent on the pace of this money printing. There are literally an infinite combination of rates + heli-drops that are feasible.


Sounds like you are assuming linear dynamics here. Actually, the interest rate that transpires will correspond to the velocity of the created money (plus existing). Since WWII, collected data shows an exponential relationship between velocity and interest rates with velocity being higheest with high rates. The causality here is difficult to unpick (because what we are talking about is an autocatalytic process) but its far from clear that merely printing money will feed through to velocity - it has not done so far. The other problem with giving money to citizenry is that when it is spent on products and land rent it wil end up with the producers of said products and landloards of said land. Unless they spend it back as consumption then the money will hit a velocity choke as soon as it gets into the hands of capital owners won't it? In past episodes of financial crisis following the extreme concentration of fixed capital in few hands, what generally transpires is an attempted redistribution of the fixed assets which constitute the actual wealth. The attempt is ar, communism or both, both of which tend to destroy the assets in question rather than transfer them.


meant 'is war, communism, or both'


scepticus - so far we have done nothing that can be remotely termed as printing money. Obviously this isn't a solution to all our problems. If the inherent structure of the economy remains as cronyist as it currently is, you're right that the money simply flows back to capital.


I'm of the same mind as MMT-ers in that I hold that government bonds are money as well as currency so running a deficit basically is money printing. Given the entrenched cronyism, I would have thought a better way to energise the excluded parts of the economy would be to provide investment capital and make sure that the recipients of that capital get to keep (e.g. own) the majority of the fruits of their labour. The question is, what forms of capital could excluded sectors of society be helped to create that would retain value and compete with existing large fixed cost installations (both in services and manufacture and finance)? Its a tricky one for sure.

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