- It is nearly nine years since the Federal Reserve last increased interest rates. During that time, the Fed has embarked on an extraordinary program of interest rate manipulation, otherwise known as quantitative easing.
- Partly as a result of these actions, the US economy has continued to grow, albeit at rates below the historical average, and today most commentators believe that the long-term economic prospects of the United States are strong.
- But has the aggressive manipulation of interest rates over the past couple of decades masked a structural growth problem in the United States and other Western nations? Has the Fed created an illusion of prosperity, an illusion that in and of itself has been sufficient to maintain inflation at very low levels, or at least for the time being?
- There is a popular view amongst economists that suppression of interest rates is fine as long as it doesn’t lead to the economy “overheating”. In their view, serious levels of high inflation can only return if the Fed let’s the economy grow too fast. But is this quintessentially Keynesian view accurate in theory and practice? Is the greatest risk to inflation an “overheating economy”?
- The view of The Money Enigma is that this Keynesian view of inflation is flawed. Rather, the primary driver of inflation is a decline in the market value of money, the denominator of every money price in the economy. In turn, the market value of money depends upon confidence in the economic prospects of society: as long-term economic confidence declines, the value of money declines and prices rise.
- Currently, confidence in the long-term economic future of the United States is strong. But is that a fair reflection of reality? Has that perception been skewed by the extraordinary actions of the monetary authorities?
- The view of The Money Enigma is that the suppression of interest rates over the past twenty years has created an illusion of prosperity. Low interest rate policy has pushed out both aggregate demand and supply functions, driving real output growth and keeping the market value of goods in check.
- Moreover, the illusion has propped up the market value of money. In effect, growth has been pulled forward and this perceived “economic success” has reinforced confidence in the value of money, thereby keeping a lid on prices as expressed in money terms.
- But what happens when interest rates rise? What happens as economic growth continues to serially disappoint? What happens if our current economic prosperity turns out to be an illusion?
Why does the Federal Reserve bother to cut interest rates when it perceives the economy as being weak? And why does cutting interest rates seem to have such a powerful effect on economic activity, at least historically?
Lowering interest rates, particularly long-term interest rates through programs such as quantitative easing, impacts the economy in two basic ways:
- Increases Aggregate Demand: Lowering interest rates reduces the cost of borrowing. A lower cost of borrowing allows more consumers to borrow money and “pull forward” consumption. A lower cost of borrowing also encourages firms to borrow and invest. In this way, lowering interest rates stimulates what economists call aggregate demand and this increase in aggregate demand works to increase output and raise prices.
- Increases Aggregate Supply: Less well acknowledged is the impact of lower interest rates on aggregate supply. When interest rates are lowered, particularly long-term interest rates, this reduces the cost of capital for all businesses in the economy. A lower cost of capital encourages more business to invest and, at the margin, encourages new business creation. These actions lead to an increase in aggregate supply and this increase in supply works to increase output and reduce prices.
As you can see, both the increase in aggregate demand and the increase in aggregate supply have the same impact on output: they both lead to an increase in output as demand is pulled forward and as firms are encouraged to invest. In this sense, lowering interest rates has a “double whammy” effect on economic activity, stimulating both demand and supply.
However, these two phenomena have different effects on the price level. An increase in aggregate demand will tend to raise prices, while an increase in aggregate supply will tend to reduce prices. In this way, the inflationary impact of an increase in demand is largely or completely offset by the deflationary impact of an increase in supply.
Surely, this is a recipe for economic nirvana?
Here is a policy that seems to lead to faster growth and no inflation. Indeed, the experience of the last twenty years seems to confirm the benefits of interest rate suppression. Over this period, the United States has generally experienced modest-solid growth while inflation has remained contained.
So, what is the catch?
The problem exists behind the scenes. While there are a couple of different methods the Fed can use to suppress interest rates, the main method the Fed uses to suppress interest rates (particularly, long-term interest rates) is creating money and using this money to buy government debt (in Fed speak this is called “Open Market Operations”).
Over the past seven years, we have seen an extraordinary demonstration of this policy in action: the Fed has created roughly $4 trillion in new money and used this money to buy predominantly longer-term government debt securities. Not surprisingly, this flurry of buying has pushed up the price of government debt, thereby lowering the interest rate on government debt.
So, what is the problem with creating lots of money?
Ultimately, the problem with creating money at pace faster than the growth in economic output is that it leads to a fall in the value of money and a general rise in the money price of all goods.
In the short term, a significant increase in the monetary base may have little to no impact on the value of money and the general price level, particularly if that increase in the monetary base is regarded as “temporary”. However, in the long term, an increase in the monetary base that dramatically exceeds output growth will create inflation.
The view of The Money Enigma is that the market believes that the current expansion in the monetary base is “temporary”. A temporary expansion in the monetary base should have little impact on the value of money because money is a long-duration asset.
However, should the market start to suspect that the current high levels of base money are more “permanent” in nature, then this could easily induce a fall in the value of money and a sharp rise in prices.
In essence, the Fed has backed itself into a corner.
If the Fed begins to unwind the monetary base and raise long-term interest rates, then all of the positive impacts associated with lowering interest rates will be unwound: consumption will fall, investment will fall and economic growth will stall if not go into reverse.
However, if the Fed does not reduce the monetary base, then the value of money will fall and inflation will return.
A return to high-single digit levels of inflation would create a series of poor outcomes for markets and the economy more generally. Moreover, a return to this type of inflation would force the Fed’s hand, potentially leading to a significant fall in real GDP.
A Theoretical View: Ratio Theory and the Goods-Money Framework
So far we have touched on several important theoretical concepts that I would like to discuss in more detail.
Over the past few months, we have talked a lot about a new microeconomic theory of price determination “Every Price is a Function of Two Sets of Supply and Demand” and its application to certain markets “Is the Price of Apples Determined by Supply and Demand for Bananas?”
This week, I want to extend this microeconomic theory of price determination to a macroeconomic level. More specifically, we will introduce a macroeconomic model of price level determination called “The Goods-Money Framework”.
The Goods-Money Framework, illustrated in the slide immediately below, can be used to examine the impact of interest rate suppression on real output and the price level. Moreover, it can be used to demonstrate concepts that standard Keynesian or Monetarist models struggle to accommodate.
In simple terms, the Goods-Money Framework implies that the price level (“p“) depends upon both aggregate supply and demand for goods/services and supply and demand for money.
Aggregate supply and demand for goods determines, in the first instance, the market value of goods (“VG“), the numerator of the price level. Conversely, supply and demand for money determines the market value of money (“VM“), the denominator of the price level.
The price level, the price of a basket of goods in money terms, is a relative measure that measures the market value of goods in terms of the market value of money.
The key concept behind Ratio Theory is that every price is a relative expression of the market value of the two goods being exchanged. Therefore, the price level is a relative measurement of the market value of goods VG in terms of the market value of money VM.
At a microeconomic level, the price of a primary good, in terms of a measurement good, is merely an expression of the market value of the primary good relative to the market value of the measurement good.
For example, if one apple (the primary good) is three times more valuable than one dollar (the measurement good), then the price of an apple, in dollar terms, is three dollars.
In order to state this concept mathematically, we need to recognize that market value can be measured in both absolute and relative terms. This is an issue that was discussed at length in “The Measurement of Market Value: Absolute, Relative and Real” (published 04/21/15).
In simple terms, in order to measure something in absolute terms, all we require is a “standard unit” for the measurement of that property. If we adopt a standard unit for the measurement of market value, then we can measure the market value of two goods (A and B) in terms of this standard unit. If the market value of good A as measured in terms of the standard unit is denoted as VA and the market value of good B as measured in terms of the standard unit is denoted as VB , then the price of good A, in good B terms, is the ratio of VA divided by VB.
If we extend this microeconomic principle to a macroeconomic level, then we can say that the price of the basket of goods (the general price level) is a ratio of (a) the market value of the basket of goods, as measured in terms of the standard unit, divided by (b) the market value of money, as measured in terms of the standard unit.
This principle is reflected in the slide below and is called the “Ratio Theory of the Price Level”. In simple terms, if the market value of the basket of goods VG falls, then the price level p will fall. Conversely, if the market value of money VM falls, then the price level p will rise.
If the price level is determined by the ratio of (a) the market value of goods, and (b) then market value of money, then the next obvious question to ask is what determines each of these two factors.
The view of The Money Enigma is that the market value of goods is determined by the intersection of aggregate demand and aggregate supply, as demonstrated on the left hand side of the slide immediately below. Furthermore, the market value of money is determined by the intersection of supply and demand for the monetary base as illustrated on the right hand side of the slide below.
We can now use this framework to think about what might happen when the Federal Reserve suppresses interest rates by increasing the monetary base.
As discussed in the first section of this post, the view of The Money Enigma is that lowering interest rates pushes both the aggregate demand and aggregate supply functions to the right. The net effect is a dramatic increase in real output, but very little change in the market value of goods as measured in terms of the standard unit.
The more complicated issue is what impact does the increase in base money have the market value of money?
If we take the diagram above at face value, then an increase in the monetary base should lead to a fall in the market value of money and a commensurate rise in the price level (remember: the market value of money is the denominator of the price level).
But in the short term, this may not be the case.
The reason for this is that money is a long-duration claim on the future output of society. The value of money depends not just on the current levels of real output and the monetary base, but also on expectations regarding the long-term future path of both real output and the monetary base. An increase in money supply may be accompanied by an increase in money demand if the increase in money supply is viewed as being “temporary”.
The view of The Money Enigma is that the suppression of interest rates can create a growth illusion that bolsters confidence in the long-term economic prospects of society, thereby supporting the value of money, even in the face of a dramatic expansion in the monetary base.
However, if confidence in the long-term economic prospects of a society begins to falter, or if market participants start to believe that a temporary expansion in the monetary base is actually more permanent in nature, then the market value of money can quickly erode leading to a rapid rise in prices.
In summary, the manipulation of interest rates can create an illusion of prosperity. In the short term, there is no doubt that lower interest rates bolster growth. This higher level of growth fuels confidence in the long-term economic prospects of society that, in turn, supports the value of money and keeps a lid on prices. However, should this confidence begin to fade, then the market value of money can quickly erode, shattering the dream that we have created.