In the comment section of a recent post, people reacted with shock to my claim that, holding the monetary base constant, higher interest rates are inflationary. I wonder if they thought it was some kind of weird monetarist claim. Actually I learned this from the Keynesians.
During the long (1950s-70s) debate over the relative effectiveness of fiscal and monetary policy, Keynesians used to criticize the Equation of Exchange as follows:
“Sure if you increase M, and if V is constant, then NGDP will rise. But V is not constant. Even worse for the monetarists, more M will tend to reduce V. Here’s why. As M rises, nominal interest rates will fall. At a lower nominal interest rate, there is a lower opportunity cost of holding cash. This makes people hold on to cash longer, and V falls. So it’s not even clear than more M will lead to more NGDP. That’s why we need fiscal policy.”
Don’t blame me, blame the Keynesians. I agree with their reasoning, except the part about needing fiscal policy. The good news is that monetary policy has only a temporary effect on interest rates. When they return to normal, so will velocity, and then the QTM holds in the long run.
So if Keynesian theory predicts that high interest rates are inflationary, why do the Keynesians talk as if the opposite is true? Now we get back to “never reason from a price change.” Here are some reasons why interest rates might rise:
1. Tight money by the Fed (M falls)
2. Fiscal stimulus pushes up interest rates as the government borrows more.
3. Robust animal spirits among businessmen leads to more investment.
It’s no surprise that examples 2 and 3 are associated with higher NGDP and inflation, but what about number one?
In case one the effect of higher interest rates, by itself, is to raise V, which is clearly inflationary. However in most cases V will rise by less than M falls. Thus the overall effect of tight money is not inflationary. It’s deflationary, because the deflationary effect of lower M overwhelms the inflationary effect of higher interest rates and faster velocity.
This example also shows that the quantity of money is what drives the transmission mechanism for monetary policy, which must be an embarrassment for Keynesians, who sometimes talk as if movements in the fed funds rate drive investment spending.
How could this problem be fixed? The Fed could switch from OMOs to IOR as a policy tool. In that case higher interest rates really would be deflationary, just as the Keynesians assume. So you no longer need to put the money stock somewhere in the model. Under our pre-2008 system the monetary base earned no interest. Thus nominal rates became the opportunity cost of holding base money. Higher rates meant less demand for base money, which is inflationary. With IOR it is just the reverse. Higher IOR actually leads people to want to hold more base money, because it’s the reward for holding bank reserves. So if you raise the IOR you increase the demand for reserves and base money, which is deflationary.
I’d guess this is why Michael Woodford is so gung-ho for switching to an IOR approach to monetary policy. He abhors quantity theoretic models in much the same way a vampire abhors sunlight. The IOR policy tool would allow Keynesians to claim that the Fed’s target interest rate isn’t just a policy tool; it actually explains the transmission mechanism for monetary policy. Now they can claim that the quantity of money doesn’t matter (not quite, until we get rid of that pesky currency) and that it’s all about interest rates.
In contrast, I abhor interest rate models in the way a vampire abhors mirrors. I want to eliminate reserve requirements, IOR, member bank deposits at the Fed, discount loans, and indeed anything that connects monetary policy to the financial system. I’d like to return to the pre-1914 system where the base was 100% currency and coin. Except I’d like to have the Fed make base money convertible into NGDP futures contracts, not 1/20.67 oz. of gold.