There are many economic distortions when the US Federal Reserve System sets interest rates below the inflation rate at an “unnatural” level. It is not an equilibrium level since the market interest rates normally, naturally in line with the business cycle supply and demand for capital, fall below the inflation rate only rarely during pre-2008 US monetary history. In our stochastic, dynamic, general equilibrium models based on Keynes’ student Frank Ramsey, the real interest rate cannot be negative along the stationary equilibrium. Clearly twenty years of negative real interest rates, which started in 2002, are not “natural” real rates of interest that Knut Wickcell famously wrote about. Ignored in those NK theorists quoting Wicksell about the natural rate is that he clearly states that temporarily the government can drive down the market interest rate through money supply increases. Further he states this can be a “persistent liquidity” effect if the government does it for a prolonged period. This the Fed did from 2002-2004 and then decided as inflation began to rise from 1% in 2002 to 4% in 2004 that they need to start raising the Federal Funds interest rate (FFR) quickly. That they did. So quickly that the investment banks seeking the next best “safe asset” other than negatively yielding Treasury debt bought massive amounts of safe mortgage backed securities (MBS). These had been safe and probably would have continued to be safe. But then the Fed quickly raised interest rates starting in 2004-2006 in order to get a “normal” market rate above the inflation rate. With inflation rising, the Fed had to keep raising the FFR even higher.
Repeat this again in 2021. With the payment of interest on reserve balances held at the Fed (IORB) through the Fed setting the market interest rate by diktat at levels below the inflation rate since 2019, combined with massive Treasury deficits financed by increasing Fed purchase of Treasury debt during 2020-2022, the inflation rate finally took off far above the near zero IORB. Then again came the catch-up by the Fed to try to get the IORB above the inflation rate. The result was a steep sudden rise in interest rates that markets did not anticipate.
Inflation is finally coming down. The IORB has just barely crested above the inflation rate, being about equal to it now but probably soon to exceed it for a positive real interest rate for the first time since the eleven months from 2018-2019.
Many distortions have resulted from the Fed intervening in capital markets and setting interest rates separately from what the money supply growth would dictate. Normally the money would enter circulation and inflation would have begun rising well above 2% back in 2011 or so. But about $3 trillion in excess reserves stayed at the Fed as it “sterilized” their increase in the money supply by paying banks not to lend it out and instead leave it at the Fed. They are still doing this, with over $4 trillion in reserves in 2023. This disconnect between the money being created through Fed financing of Treasury deficits and the market interest rates that would exist in equilibrium if the money entered circulation as in all pre-2008 history when there were zero excess reserves at the Fed (or 1000 times less at about $1 billion on average – banks tried to keep these as close to zero as possible) has caused untold economic distortions throughout capital markets and internationally as other countries mimic US policy of negative real rates so as to not experience currency appreciation vs the US dollar.
Now it is common internationally for central banks to intervene in capital markets and set interest rates below the inflation rate. This is true in the inflation rate is 80% as it was in Turkiye, 50% in Hungary, or many variations of this. These countries set interest rates far below the inflation rate to create vastly negative real rates of return on “risk-free” government Treasury debt.
Of course this causes portfolio managers that invest in US Treasury debt or international portfolios investing in other sovereign nation debt to balance out the “safe” negative return on Treasuries with riskier higher yielding alternative investments. This makes the entire financial system more instable.
Silicon Valley Bank went from short run Treasuries to higher yielding longer term Treasuries. This was sensible, safe, investing, just moving to the next best asset that had a slightly positive yield. Just as it was after 2002-2004 to move into MBS.
Yet again, SVB and Credit Suisse were bankrupted in essence because the Fed had to quickly, suddenly chase the rapidly rising inflation by rapidly increasing the IORB interest rate that they set by diktat. This would never have happened if the Fed allowed the “natural” rate of interest to prevail in which the Fed is not intervening in capital markets. The risk the investment banks in 2008 and SVB and Credit Suisse in 2023 did not anticipate was the risk created by the ad hoc intervention policy of the Federal Reserve System.
This could be ended by ending Fed payment of interest on reserves. Then no money would be sterilized. It would enter circulation as it was printed. Interest rates would reflect this and rise with inflation and with business cycle changes in the real interest rate (fluctuations almost always above a zero rate).
The unintended consequences are that markets have no idea when the money that has been sterilized as reserves will actually enter circulation and cause inflation. Then markets have no idea what the Fed will do once inflation starts up again. All of this Federal Reserve created risk could be eliminated: Stop the payment of interest on reserves.
The Fed likes IORB policy because first, inflation can be suppressed through reserves held at the Fed. Second, the Fed gets to pay the interest to the largest most powerful private banks holding most of the reserves rather than to the US Treasury as required under Federal Reserve mandates. This earns the Fed a lot of gratitude from the finance industry. Third, the Federal Reserve officials become ultimately powerful by dictating interest rates rather than letting markets do that job.
Since the banking industry lobbies the Fed, and the Treasury and Fed officials go through the revolving door often to the finance industry, the Federal Reserve officials benefit from this unprecedented upsurge in discretionary policy. They are not bad people, but they are doing bad policy and gaining fame in the process (even Nobel prizes). George Stigler also won the Nobel prize; his was partly for the Economics of Regulation in which those in government doing the regulation over private industry create benefits for the private industry that they are regulating, since it also yields benefits to them personally.
Try reading my book The Spectre of Price Inflation, Columbia U. Press in the US, for more policy analysis.
Max Gillman 