Raising Interest Rates

Many people are calling for the Fed to raise rates. Part 1 of this post will address the arguments for raising interest rates. Part 2 will address whether the Fed even has the ability to raise rates in the way that supporters imagine. Importantly, the second question has normative consequences for the first. The purpose of this post is not to provide a complete analysis of these issues but rather highlight some of the underlying theoretical positions in the debate.

Part 1:

The argument to raise rates come from a couple of sources. First, the John Taylor (Taylor Rule) camp has come out for higher interest rates under a Taylor rule model, which is a formula that provides an ideal interest rate based on macroeconomic inputs. The formula looks like this: i= r* + pi + 0.5 (pi-pi*) + 0.5 ( y-y*); where r*= real fed funds rate, pi= inflation, pi*= target inflation rate, y= real output, and y*= potential output. The starred variables are estimates within the model. Importantly, the real fed fund rate is generally assumed to be 2%. Under an assumption of a 2% real interest rate, nominal interest rates have been artificially low for some time and, the argument goes, the Fed should raise rates to normalize the economy. However, it is entirely possible that the real interest rate in the economy is lower than in other periods due to a combination of demand and supply side factors (this is consistent with the secular stagnation story). If that is true, the Taylor Rule would call for lower interest rates under its own model. So what world are we living in?

One litmus test to determine whether interest rates are artificially low is to observe whether inflation has taken off or if the economy is growing at a faster-than-usual pace. Inflation for 2014 and 2015 was slightly below the Fed’s 2% target rate and NGDP growth has been sluggish at best. Put differently, Taylor’s reasoning for raising rates relies in part on the idea that unnaturally low interest rates will lead to inflation and high growth rates, which we haven’t yet observed. Further, it is difficult to hold that view, as Taylor does, that the economic recovery has been weak and the Obama administration has implemented serious supply-side restraints on the economy; and at the same time call for rates to rise due to a fear of explosive nominal growth.

The second reason for raising rates comes from the Neo-Fischerian camp. Their argument proceeds as follows: low interest rates over a long time period creates an expectation for low inflation, and therefore, raising rates would increase inflation expectations and grow Aggregate Demand. The logic for this position flows from the basic idea that nominal interest rates incorporate inflation expectations and from the observation that many periods of high inflation are accompanied by high interest rates. The Neo-Fischerian story is that the economy adjusts to an expected interest rate target in the long run and they assert that the US has currently adjusted to a low interest rate world. In other words, low interest rates cause low inflation/low aggregate demand in the long run. This is an alternative theory to secular stagnation where low growth is a byproduct of the long term low interest rates rather than real factors in the economy.

There is a basic logical appeal to the Neo-Fischerian camp but it is necessary to recognize the causal assumption in their story. Interest rates lead to inflation expectations. There are two potential problems with this theory. First, the causation story could be reversed. Inflation expectations could actually cause interest rate movements. Where we have observed hyperinflation, this is the story people generally assume. High interest rates in the economy are not causing hyperinflation but rather interest rates are trying to keep pace with high inflation expectations. Second, the Neo-Fischerian story is arguably a long term adjustment story and it is unclear whether the long-term expectations of higher interest rates is baked into the inflation rate calculus immediately. In other words, if inflation expectations across the economy significantly lag the rate increase, then you could face deflationary pressures in the short run with a high nominal rate of interest set by the Fed and a low real rate of interest. Interestingly, the first critique relies on an argument that the economy sets interest rates and can override Fed Reserve attempts. The second critique, instead, assumes the Fed sets interest rates for a non-trivial time period and the economy is slow to adjust.

Overall, it is important to recognize how these two arguments are conceptually distinct. The first set of proponents (the Taylor camp) argue that rates are artificially low given the current state of the economy and continuing low rates risks overheating the economy. The second set (Neo-Fischer) see a need to raise Aggregate Demand and rely on interest rates as an inflation expectation peg in the long term. The two stories not only diverge on the current view of the economy but also diverge on the long term effect of low interest rates. The first imagines an economy with a real interest rate of 2% (with nominal interest rates held low by the Fed) and the economy will overheat if we continue on the current path. The second imagines an economy that has adjusted to a low real interest rate and will remain there for the forseeable future until interest rates are moved upward.

Part 2 Preview:

WSJ: The Fed’s Interest Rate Machine; Fed not responsible for low rates

Interestingly, both of the arguments outlined in Part 1 presume that the Fed can raise or lower rates. This is not an unusual assumption and one that generally aligns with popular belief. However, it is important to describe the Fed’s interest rate setting mechanism and the causal influence of the overnight rate in order to assess the theories in question.



WSJ: Uber and School Choice

WSJ: James Courtovich on Uber and School Choice

The regulatory battles underway for uber are not unique but rather indicative of a much larger struggle between entrenched interests and innovation. Government induced monopolies are wide reaching across our economy and the creative destruction process is stilted when regulators block market entry.

Tyler Cowen on the Gender Gap


Cowen argues that as female participation levels grow, positive reinforcement mechanisms help alter the norms of business interaction and participation. As such, Cowen is not convinced that experimental evidence showing disparate negotiating tactics and results between men and women will hold over time.

Robert Litan- Ted Talk Event


Supply Side Restrictions in Healthcare

John Cochrane highlights how “certificate of need” regulations place supply-side constraints on the healthcare market. 

Externalities vs. Transaction Costs

After listening to Terry Anderson on Russ Roberts’ Econtalk this week, I am reminded of an important distinction between externalities and transaction costs. Too often it seems that the term ‘externality’ is used on its own to describe a situation in which an efficient outcome cannot be reached because multiple parties are impacted by a particular action. What ‘externality’ really means in this context is that transaction costs are too high to reach private solutions that internalize the cost of the externality. Importantly, the presence of an externality is not the problem itself. The problem is that impacted stakeholders cannot reach a coordinated solution on their own (often due to an inability to negotiate) and, as a result, an efficient allocation of resources occurs. This difference between ‘externality’ and ‘transaction costs’ underlies the Coase theorem and should be remembered when diagnosing problems that require regulatory solutions. It is not enough to say that an externality exists and, therefore, some type of intervention is required.

Smart House Devices and the Insurance Industry

Forbes profiles SmartThings

“SmartThings, the firm he founded a year after the Colorado trip, is now doing a brisk business selling a $100 hardware hub with a smartphone app and cloud service that connects thousands of gadgets. It also sells more expensive kits crammed with third-party sensors and devices for home security, temperature control and water detection.”

Just as cars have sensors that activate upon certain malfunctions, SmartThings provides the opportunity for your home to give warning signals in order to mitigate damage. The cost of insurance is integrally connected to the expected cost of damage. In a world where catastrophic damages can be limited through either warning signals or automated responses, the cost of insurance should fall accordingly. It may not be long before home insurance companies begin to offer cheaper coverage bundled with smart home system installations. 

Cash for Clunkers Auto Industry Impact

NBER: Mark Hoekstra, Steven Puller, Jeremy West argue that Cash for Clunkers was a net negative on the auto industry due to countervailing policy goals of the program. 

“Cash for Clunkers was a 2009 economic stimulus program aimed at increasing new vehicle spending by subsidizing the replacement of older vehicles. Using a regression discontinuity design, we show the increase in sales during the two month program was completely offset during the following seven to nine months, consistent with previous research. However, we also find the program’s fuel efficiency restrictions induced households to purchase more fuel efficient but less expensive vehicles, thereby reducing industry revenues by three billion dollars over the entire nine to eleven month period. This highlights the conflict between the stimulus and environmental objectives of the policy.”


Corporations as Board Members

Stephen Bainbridge and Todd Henderson in the Stanford Law Review

Edmund Phelps on Inequality

FT: Corporatism versus Capitalism


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