There has been a long and ongoing debate in the FT and elsewhere about what base interest rate level the world's central bankers should settle upon in the aftermath of the fiasco of their raising rates in a forlorn attempt to tackle inflation when those increases were neither required nor ever had any impact uoon achieving that goal.
The one thing that we do know about existing targets expressed in percentage terms within the macroeconomy is that almost all of them were set either randomly or irrationally, and were then copied on the basis of blind faith by other central bankers who were gasping for precedents rather than an informed basis for decision-making. For example, the 2% inflation target was simply made up without any known justification, and the 3% target for annual deficits within the EU was another simple back-of-the-envelope figure created without any economic or econometric justification. In that case, simple reasoning is all that is required now to suggest alternative targets.
With regard to deficits, the desired target should be obvious. It is that level of deficit that is required to deliver sustainable full employment within the constraints of climate change. Quite literally, nothing else makes any sense. No one should run a macroeconomy in the interest of creating neat government finances. The macroeconomy should be run to deliver the goals of society. My suggestion is designed to do that.
Then there is inflation. There is no known rational justification for the 2% target, meaning that alternatives that might work better might make sense. Most especially, if the 2% target appears to require austerity, then it is clearly wrong. A macroeconomic target should not, by itself, force change onto a macroeconomy when that change has undesirable and unnecessary consequences. It would, therefore, appear to be appropriate to raise this rate to maybe 3%, and let the economy run at this level, instead of forcing the 2% rate that has created considerable discomfort in its delivery.
What, in that case of interest rates? Should they be, in real terms positive or negative?
My answer to that question is an unambiguous suggestion that the bank base rate should always be set to create a small negative real interest rate when compared to inflation. There are many reasons why this is the right thing to do.
First of all, it means that there should, in effect, be no net cost to government borrowing. That would seem to be an absolutely central objective of any government's macroeconomic policy.
Second, this rate also means that the net real cost of funding investment in the economy will be very low, and that is vital, most, especially when almost all investment is funded by loan finance and not by savings or equity, whatever the popular perception might be.
Third, there is the question of what savers require. As became apparent during the period of near net-zero interest rates, these are unpopular with savers, so something a little higher is beneficial, but there is no good reason at all for them to be significantly positive in real terms when cash savings serve no useful economic function within the economy as a whole once the basic target of people having a rainy day fund has been met.
So what is the answer to the question? It seems to me that if the inflation target is 3%, then base rates should be 2%.
I'm quite sure some people will disagree, but that's my opinion, with reasons. If you disagree, please provide your reasons, or don't bother.
Thanks for reading this post.
You can share this post on social media of your choice by clicking these icons:
You can subscribe to this blog's daily email here.
And if you would like to support this blog you can, here:
To calculatr the required base rate, establish an independent body to forecast necessary government spending in the short and medium term that includes:
The social and private housing needed to provide accommodation for everyone (taking into account location, employment needs etc).
Necessary health care provision for forecast population and age profile (with inefficiency built in, needed to provide for shocks like pandemics)
Rates of employment.
And other metrics to provide the government with the data it needs to devise policies to bridge the gap between where we are, and where we need to be.
Set interest rates at a level that allows the economy to meet society’s basic needs and, if this means an overheated economy in the short term, then so be it, its being done for a clear aim.
Short answer, set interest rates at a level appropriate to meeting needs of society not the Square Mile.
Very good blog raising (and answering) some very important questions.
Low interest rates compared to inflation would force savers to look for things to put their savings into – other than a “savings account that offers interest”. The blog has regularly discussed the need for investment in a wide range of societal “goods” – such a interest rate/inflation differential might encourage this much needed investment.
I also agree that the selection of inflation rates & interest rates at the moment is wholly arbitrary, the ECBs can offer no rationale (they never have) and the strnage thing is, ar rarely ever questioned. Strange.
Sections of this blog will be discussed at a mid-March meeting in Bx. Part of the meeting will be discussing money.
Thanks
The “rationale” behind 60% Debt/GDP ratio was (as told to me by the Secretary to the Monetary Committee in the 90s) was that with 5% rates this would give an interest cost of 3% of (nominal) GDP which, assuming 2% inflation and 1% real GDP growth would mean stable Debt/GDP ratios.
Now, I am not a huge fan of this thinking but if we updated this to levels appropriate to the 2020s
4% rates, 3% inflation, real GDP growth 1% this would give a stable Debt/GDP ratio of 100%
So, (assuming we (correctly) exclude CB bond holdings) even “Maastricht headbangers” should be happy with current net debt levels.
Now, should we change the inflation target? Well, the econometric view runs that raising the inflation target allows larger (in magnitude, not sign) negative real rates before hitting the zero lower bound. Personally, I think this is nonsense as it attaches too much importance to interest rate policy in responding to shocks to an economy – besides, several countries have had negative policy rate so zero is no longer a “lower bound” (and in all cases it has been fiscal policy that has “saved the day”).
So, I am content to keep a 2% inflation target IF (and this is key) other variables are also targeted like employment, investment and other measures of well being for society AND that the inflation is sacrificed in a situation that we currently experience where high rates do not really help.
I like the analysis, but I do not quite follow the conclusion; “So, I am content to keep a 2% inflation target”, in this sense: it does not appear to be a rational deduction from the sound premiss of your argument. I have no objection if it is an intuition, it may well be a viable one.
My reason for being fussy about this is that all of the assumptions being made by the monetary policy committee, central bankers, economists and politicians on this matter are presented to the public as if they were representations imprinted on reality; commandments built in to the foundations of the physical world. This is a ridiculous, unsustainable proposition. The assumptions of the standard model are founded on unreliable evidence or unproven or unprovable theory; just as Richard more summarily and critically argues in the Blog.
The obsession with a target Debt-to-GDP ratio, for example is better considered a dysfunctional, disciplinary neurosis into which economists are prone to fall; an obsessive-compulsive disorder (OCD), in which a person experiences uncontrollable or recurring obsessions; or succumbs to repetitive behaviour disorder. It requires treatment. History provides the facts.
The facts are Britain has had a Debt-to-GDP% of 100% or far above for more of its history than at 60% (the peak was around 1945 @ 250%). The low periods tend to be shorter, are not sustained or sustainable; for example assisted by North Sea Oil (it made Margaret Thatcher look good, and the City thrived on it). Japan is stable and currently its Debt-to-GDP% is around 250%. The US, Q3 2023 was !20% (St.Louis Fed).
Ehat is the “right” Debt-to-GDP%? The length of a piece of string. It is a derivative statistic, it doesn’t represent the movement in quantum (which is even more rare than the ratio falling), and is therefore highly misleading. A good perspective on trading, major importing economies in the modern world (and not the world’s reserve currency), would as usefully track the balance of payments as Debt/GDP.
“So, I am content to keep a 2% inflation target” was not meant to convey that it is the right choice; if I were starting from scratch I might well choose differently. It was meant to convey that I do not think it SO terribly wrong that I want to use all my effort getting it changed. Rather, keep it and downgrade its importance in policy making.
In fact, whatever target is chosen becomes a hostage to fortune or out of date in a changing world… so I would rather have an all round more flexible mandate…. and a bit of humility about what monetary policy can actually deliver.
Negative real interest rates is hardly the incentive for long-term investment that you claim is needed!
Yes it is.
Saving is not investmenbt.
Invetsment can more easily make positive returns the lower the cost of capital.
Might I suggest you learn some economics before trolling?
Negative real interest rates certainly force people to take more risk than they would do otherwise, i’m not sure this is a good thing. Nor is the asset bubbles created during the suppression of medium and long term interest rates during QE. There is a strong argument that negative real interest rates leads to a miss allocation of capital.
Cash savings are not capital. They are just money taken out of circulation.
Why don’t you understand that?
Please explain – and do not say banks lend those funds on, because quite emphatically, they do not.
“Cash savings are not capital. They are just money taken out of circulation.”
They are not taken out of circulation forever they are deferred expenditure. Folk want to save whilst they have earning power to fund a time in their lives when they don’t. What is wrong with that?
Nothing, per se
But they are not a source of capital and whilst withdrawn from circulation they reduce national income
Why do we want to encourage that?
Au contraire – Negative real rates force “lazy” savers to actually go out an do something productive with their savings rather than just live of interest income that keeps growing (if real rates are positive).
Quite so
I am not sure that we are entitled to rebuke elderly people from being “lazy” investors. Perhaps they do something more worthwhile; like read philosophy. I do not think active investment is a duty, or even a virtue. Capitalism is so embedded in Britain (though not especially successfully, on the whole) it has become an expectation that a worthwhile life commands its centrality; I find it difficult to challenge those who see it, at best as a tedious necessity; like the water closet. It reminds me of the crude Conservative demand that everyone become the drudges of capital and work; the absurdity of that proposition reminds me of Fritz Lang’s ‘Metropolis’, 1927. Pointless, robotic production for its own sake; but bereft of meaning.
The elderly, it seems to me, are entitled to save modest capital, and invest in a genuine safe asset, with a fair expectation of a return; so they may spend their latter days on something more life affirming. If they are ‘hoarding’ capital then taxation should manage the problem.
I recall being at an event at which Bernard Litaer, one of the (technical) founders of the Euro, proposed a currency that continually declined in value (in effect building in inflation, precisely in order to motivate people not to hoard it in cash savings, but to invest (truly) in productive activities. (What he later thought about the neoliberal ECB, I don’t know!)
Richard’s proposal for ISAs and SIPPs to be obligated to invest in green infrastructure etc, or lose their tax advantages, is surely relevant.
It’s called demurrage. I think of it as rusty money, money which automatically declines in value as it ages so as to encourage spending it which increases the velocity of money. The idea was put into practice a good while back in the small Austrian city of Worgl and proved so successful, bought such prosperity, it was promptly banned by the authorities who I’m guessing were in the pockets of the local banksters. Much more in Google 🙂
I have never studied economics but intuitively what you are saying about negative real interest rates not being an incentive for long-term investment seems plain wrong. If anything, the opposite is the case.
Those determined to save will do so anyway as it still beats putting your money in a box under the bed and incurs no extra risks.
Those who are determined to invest in a pet project will do so anyway, and would probably find it easier to raise any necessary capital.
For others, it is a matter of weighing up the risks of investment with the possible return as compared with saving.
At a purely intuitive level, the higher the real interest rate, the more risky investment becomes as a result of the higher cost of capital. But it is also true that higher the interest rate the lower the difference between the return from investment and saving is likely to be. Both these considerations seem to me to skew the decision away from investment as interest rates become higher.
I would therefore expect negative real interest rates to encourage investment, not the reverse.
As I said, I have never studied economics so I may have missed something. I’m sure someone will tell me if I have.
Yiu haven’t
As you mentioned the FT, I thought it might amuse you to see that it has apparently missed the MMT view, at least judging by its 404 error message at https://www.ft.com/…/6fb1602d-a08b-4a8c-bac0.
I did not get that…
It seems you have to copy and paste the whole link, including the three dots.
Oh….
Is that their normal error message page?
I’m not sure, Bernard. First time I’ve seen it. Perhaps it escaped into the wild, because I don’t believe the FT has a sense of humour, laughable though its stance on the Magnificent Seven is. But we are getting way off the subject, so apologies to Richard and the audience here for the distraction.
Now I get it
Sort of amusing…
Heh… 🙂 and yes, they didn’t go there, even in jest. What are they afraid of, one wonders?
A paradigm shift that turns their world upside down, perhaps? Being accused of heresy, likely?
Slightly off-topic, but I just read this in the New Statesman: https://www.newstatesman.com/comment/2024/02/labour-bond-market-bank-of-england
This appears to me pretty incoherent, of have I missed the point?
QT should be stopped
The argument is made incoherently in that piece: it is really badly presented
Rises in interest rates affect the Public Works Loan Board (PWLB) rates too in the public sector and we’ve seen our affordable schemes start not to break even at 50 year payback.
So now, we considering 60 year loan paybacks.
The Treasury seems to be very negative about interest rates – and when you consider they are deliberately trying to create recession, that to me adds insult to injury when considering higher interest rates. It just creates more unease where I work, when we should be solving problems with investment because you need enough bravado and courage to do that in the public sector these days.
Ridiculous
Your example would be a fair rate, Richard. 2% interest rate for 3% inflation. As the inflation rate is given every month, interest rate similar to a tracker mortgage could be 1% less than inflation, the next month.
The BoE never need input again.
Mortgage rates are not base rate
I was meaning that it’s easy enough for the BoE interest rate to track inflation, the following month being 1% less than the CPI/RPI , whichever is used.
That is never the aim though…..
In trying to make sense of economics (from a non-economics background) the question of the “right” inflation rate and interest rate has intrigued me. In fact I think I have raised it here and failed to get a definitive answer.
The best answer I have seen seems to be that since deflation is more damaging than inflation (see Richard’s recent blog on that point) and inflation can only be imperfectly controlled, the best target is to aim for an inflation level which is above zero but not so much as to cause problems. And someone came up with 2%; no doubt an arbitrary figure but possibly informed by experience of different inflation levels in the past.
The next question of course is where should interest rates be set, and Richard’s approach is reasonable that they should be slightly below inflation. The “slightly below” meaning that actual commercial rates (e.g. mortgage rates, bank loans, overdraft rates) which are above base rate will be somewhat higher than inflation to avoid incentivising borrowing. In the perfect world never met outside the classroom, relatively small changes in base rate could then change consumer behaviour to incentivise saving or spending on average and act to moderate changes in inflation.
But the more interesting question comes in the effect of the target inflation rate on the decision-making of the Bank of England. The Bank is clearly not “independent” as advertised but has a delegation of the government responsibility to set interest rates; personally I see some merit in depoliticising those decisions which weren’t previously managed particularly well by politicians either. But setting a crude target has to be wrong, circumstances change. When inflation rates rose to over 10% due to external forces, it would have been appropriate for the government to change the 2% target to something more realistic: to aim for, for example to timed targets of 5%, 4%, 3% at points during 2023-24.
I may be naive, but I would hope that would have lessened the desire of the BoE to hold rates high in the vain hope of driving inflation all the way down to 2% – and then inevitably overshooting. However it would also depend on having sensible decision making by the Bank, and that is deterred by the current groupthink, it needs to be set up to involve a proper diversity of economist thinkers.
Thanks
Richard
Excellent reasoning on base rate and cost to government.
“…With regard to deficits, the desired target should be obvious. It is that level of deficit that is required to deliver sustainable full employment within the constraints of climate change. Quite literally, nothing else makes any sense…”
Well, this nonsense certainly won’t help:
https://www.theguardian.com/environment/2024/feb/12/litigation-terrorism-how-corporations-are-winning-billions-from-governments
I’ve no wish to ruin anyone’s day, but I’d expect anyone rational will be as outraged as I was on reading that. I don’t see how these settlements can do anything other than create deficits; the impediments to tackling climate change are all too clear.
This needs to be shared as widely as possible; I hope you, your regular commenters and passive readers agree.
Agreed
One of the concerns regarding SEZs/Charter Cities/whatever you want to call them is that should a government get in which doesn’t like the idea and move to dissolve them then thanks to our recently joining the CPTPP the businesses involved can now appeal to the ISDS courts to compensate them for all the lost potential revenue. The idea there would to further hobble Labour I’d think.
Richard, a fella by the name of Keynes supported you observation
“Second, this rate also means that the net real cost of funding investment in the economy will be very low, and that is vital, most, especially when almost all investment is funded by loan finance and not by savings or equity, whatever the popular perception might be.”
Keynes said – “Increased investment will always be accompanied by increased saving, but it can never be preceded by it. Dishoarding and credit expansion provides not an alternative to increased saving, but a necessary preparation for it. It is the parent, not the twin, of increased saving.” (Keynes 1939)
and “…in general, the banks hold the key position in the transition from a lower to a higher scale of activity. If they refuse to relax, the growing congestion of the short-term loan market or of the new issue market, as the case may be, will inhibit the improvement, no matter how thrifty the public purpose to be out of their future incomes. […] The investment market can become congested through shortage of cash. It can never become congested through shortage of saving. This is the most fundamental of my conclusions within this field.” (Keynes 1937)
Agreed
I take a lot from Keynes.
Richard
Do you have a way of matching Keynes’ https://en.wikipedia.org/wiki/How_to_Pay_for_the_War in which he not only had the very low rates to finance the war, he found ways of reducing the competition for scarce resources. He reallocated resources to fight the war, and he reduced consumption.
Milton Friedman advocated interest free money in this paper, but advocated borrowing during the war so people were locking up their savings.
” government expenditures would be financed entirely by either tax revenues or the creation of money, that is, the issue of non-interest-bearing securities. Government would not issue interest-bearing securities to the public; the Federal Reserve System would not operate in the open market. This restriction of the sources of government funds seems reasonable for peacetime.
The chief valid ground for paying interest to the public on government debt is to offset the inflationary pressure of abnormally high government expenditures when, for one reason or another, it is not feasible or desirable to levy sufficient taxes to do so. This was the justification for wartime issuance of interest-bearing securities, though, perversely, the rate of interest on these securities was pegged at a low level. It seems inapplicable in peacetime, especially if, as suggested, the volume of government expenditures on goods and services is kept relatively stable. Another reason sometimes given for issuing interest-bearing securities is that in a period of unemployment it is less deflationary to issue securities than to levy taxes. This is true. But it is still less deflationary to issue money.10″
https://miltonfriedman.hoover.org/internal/media/dispatcher/214916/full
It woulod be great to write a modern version of that incredibky important and practical (as well as short) work
“With regard to deficits, the desired target should be obvious. It is that level of deficit that is required to deliver sustainable full employment within the constraints of climate change.”
That is such a beautiful concise sentence! Excellent!