Dollars and Jens
Thursday, October 15, 2015
positive interest rates
Traditionally the reason a central bank raises interest rates is to reduce financing activity that supports "aggregate demand" that might lead to inflation. Inflation and its expectations seem to be low — below the official 2% target for quite a while — which makes me at least cautious about this, and yet I support an interest rate hike at the next FOMC meeting. Here is a smattering of reasons why:
- The most important reason is "to make sure we can". The balance sheets of the fed and its member banks look very different from any time before five years ago, so the Fed expects to use different policy tools to raise interest rates than it has in the past; it has been doing little trial experiments, but a deliberate, sustained increase in interest rates using those tools would be different. I would like to see 50bp worth of increases when they still seem optional as an opportunity to see what actually happens and adapting while raising rates a lot is not yet urgent.
- Interest rates have been near zero for 7 years, and the behavior of market participants has adapted to it. Most specifically, there were concerns when rates were first pushed down that money market funds would break — traditionally they have covered their expenses by taking 10–20 bp from the fund returns, and since money market funds aren't supposed to go down, they would have to shut down if they couldn't get enough nominal returns on invested funds to cover their expenses. They have shrunk and to some extent shifted from commercial paper to repo transactions as corporate issuers have extended the duration of their liabilities and worried more about their liquidity positions; I don't know how things might change again if interest rates were 50–75 bp instead of 0–25 bp, but again I would like for the markets to be given a chance to adapt to low but distinctly positive interest rates well before rates have to go higher.
- There are classic problems with financial market participants "reaching for yield" when interest rates are low, and I worry somewhat that there are pockets of investors who have exposed themselves to too much risk, possibly employing cheap leverage as part of it. This, more than the previous points, is more linear in the amount of rates, such that a 50bp move would have a small effect on it, but it, too, is likely to be a greater problem if rates have to rise quickly than if they can be raised slowly.
- More in the nature of rebuttal than of affirmative argument, I would like to emphasize that a target interest rate of 50 bp would still be very low: What interest rate target would a panel of economists 10 years ago have expected with 5.1% unemployment, >1% inflation, getting stronger?— Dean Jens (@deanjens) September 13, 2015
It's not as though one or two small hikes would constitute a contractionary policy, which is the impression one sometimes gets from the most ardent opponents of a hike.