The Federal Reserve must start to lower the nominal interest rate since inflation is now at 3% and the real market rate of interest is sufficiently positive after two decades of negative real interest rates through “persistent liquidity” injections by the Fed that have led to over $4 trillion in reserves sitting at the Fed, as the Fed pays banks not to lend out money. This is the definition of moral hazard in monetary policy.
Wicksell (1898) in Interest and Prices wrote about a natural rate of interest as being the market value that exists in the absence of central bank interference with the rate. That interference would traditionally be done, Wicksell wrote, by increasing or decreasing the supply of money faster or slower than the economy’s demand for money in order to lower or raise interest rates temporarily as a “liquidity effect.” Wicksell wrote that this could even be a “persistent liquidity effect” if the central bank for example kept increasing the money supply (by buying Treasury debt) at an increased rate for a sustained period of time, which the Fed has done over the last two decades.
Then came Woodford (2003) writing a book called Interest and Prices, again, even though he ingeniously miscontrues the money message of Wicksell. Woodford allows money to be used only for reserves in this early chapter and then eliminates money from the rest of the book. Wicksell in contrast was focused on the natural movements of capital markets over the business cycle and how the real rate of interest naturally fluctuates with the expansion and contraction of credit. Wicksell made clear what was monetary interference by the central bank, while Woodford champions the idea that the central bank can set the interest rate at any level it wants without regard for the central bank money supply.
There is no government budget constraint with money in any standard New Keynesian model. Gali’s (2008) cookbook distillation of the NK Woodford world uses money in the utility function in his lead-in chapter about why we do not want money in the model. His model’s equilibrium conditions are flawed by the fact that there is money in the economy, but no way in which the money enters the economy since there is no government budget constraint in which government expenditure is financed in part by printing money (buying Treasury debt). Gali justifies leaving money out by using an incomplete model in which the log utility specification gives money no role in the economy except to affect utility. There is no inflation tax in Gali or ANY NK model.
Laubach and Williams (2003) and their international follow-up with Holston is supposed to measure some constant that they call the natural rate of interest using the Gali 3-equation model. They estimate the Phillips curve there by very carefully picking a data period in which the inflation – output-growth relation is positive. They do this by including the 1960-1969 Phillips curve era of the Vietnam wartime build-up in which government spending and money printing were so high as to break down the Bretton Woods gold standard. Naturally in war inflation and output growth move together positively. In fact, and despite the sharply documented monetary phenomenon of that War, a Review of Economic Dynamics article explains the Vietnam War inflation as a long monopoly mark-up shock and like Woodford, Gali and Laubach and Williams omits money from the model.
We know that money supply printing through the Fed buying Treasury debt during war, pandemics, or as in every crisis in every country historically typically causes inflation. For example, see the nice article in the 2023 STL Fed Review by Kevin L. Kliesen and David C. Wheelock “The COVID-19 Pandemic and Inflation: Lessons from Major US Wars.” All NK models from Woodford to Gali to Laubach and Williams leave out money and the inflation tax used to finance government expenditure. That is a fact and that is why NK people do not like to use the cash-in-advance (CIA) economy in which inflation is always a tax. In a CIA economy, by adding exchange credit to avoid the tax, you get a downward sloping money demand per unit of consumption and a realistic view in the model about how inflation effects the economy negatively. Add in endogenous growth and the inflation tax lowers the output growth rate, which was emphasized by the originator of the NK 3-equation model, in Kenneth N. Kuttner’s Estimating potential output as a latent variable (JBES 12:361-368, 1994). The same year Kuttner also produced in Sbordone & Kuttner, 1994, “Does inflation reduce productivity?, Chicago Fed Economic Perspective, about how inflation and productivity move opposite of each other in both trend and cycle. And we know well that productivity is very procyclic and the very definition of the business cycle through Ed Prescott and Fynn Kydland’s ever-lasting work on real business cycles that has yet to be overturned in any way. Here is the 1994 graph:
Inflation therefore moves opposite of output growth in the work of the founder of the NK 3-equation model, all the way back in 1994, although there may have been earlier such contributions of which I am unaware.
The Laubach and Williams natural rate is a fantasy of an econometric estimation of a Phillips curve that existed because inflation results from money printing during wars. Phillips curves also exist after financial deregulation, which I call a bounce-back Phillips, and during every recession almost without fail. These Recession Phillips curves are of course Irving Fisher’s debt-deflation curves that show how when private bank money contracts during recessions as investments and loans drop, the inflation rate is pressured downwards. While the wartime or Covid build-up Phillips curves are caused by government money printing, the recession Phillips are caused by private bank money relative contraction.
During these business cycles the “natural” real rate of interest rises and falls. If the central bank did not intervene in markets at all, in Wicksellian terms, you would see the real rate of interest almost always being above zero and fluctuating up with expansions and down with contractions. Mind you the real rate was positive 10% during the Great Depression, which those advocating zero market interest rates seem to ignore, from Keynes onwards.
Now we live in a world where the Fed as in Woodford actually sets the market interest rate by diktat regardless of the money supply growth rate. They have made the surreal world of Taylor’s rule of the NK fiction in which monetary policy is setting the interest rate come true: Stranger than fiction but the Fiction becomes the absurd fantasia reality.
What matters is the real rate of interest that occurs naturally in capital markets over the business cycle. It is not a constant. It rises with productivity, which is why the interest rate is the marginal product of capital in our models (though NK models typically omit capital as in Laubach and Williams). This real world is the world of Ed and Fynn in which we actually labor.
The Fed now must decide how to set interest rates and that is what we call monetary policy. Wicksell called monetary policy how you set the government money supply growth rate. So do the Cash-In-Advance monetary models. So does anyone without a vested interest in the fictional world of the NK industry in which there exists zero money and inflation ALWAYS is from a monopoly mark-up shock. Right.
Actually monetary policy is supplying money. That is the only thing a central bank has the legal right to do. The Fed sets the Interest on Reserve Balances by violating the intent of the 2006 Financial Services Regulatory Relief Act (FSRRA) designed to pay interest only on (Woodford’s) required reserves. See Mark Guzman’s (Reading U, UK) work on the Fed paying interest on required reserves. The US moved the 2006 FSRRA’s starting date from 2011 up to 2008 during the Fed’s run on reserves in 2008, and then the Fed starting paying interest on ALL reserves instead of the intended required reserves only that was designed so as to not tax small banks by more than big banks. Well, now the big banks have hugely gained over the small banks because they get paid the interest rate of 5.2% on the $4 trillion in reserves at the Fed. The Fed turned the Congressional writers of the 2006 FSRRA on their heads and must have laughed at their own wit in increasing their power along with the transfer of seigniorage to the private banks instead of the US Treasury. This is why the Fed is running into budget problems: the interest paid on reserves.
We should lobby: STOP INTEREST ON RESERVES for a bumper sticker. Or RETURN THE INFLATION TAX TO THE TREASURY, which probably would not fit on a bumper sticker. Or: FED: SET MONEY NOT INTEREST RATES. Any of these would return the natural rate of interest to the normal one that fluctuates over the business cycle at a positive rate.
Especially, this would work if the Fed would respect the statutory law of the 1978 Full Employment and Balanced Growth Act that sets the inflation rate target legally at zero percent in 2023.
Max Gillman 