Monetary Policy Institute Blog #90, by John Smithin

“It is significant that the Bank of Canada is now explicitly using the expression ‘policy rate of interest’.

Back in the day, when I was teaching university courses in ‘Money and Banking’, it was identified simply as the ‘overnight rate’, i.e., the rate determined in the overnight market for ‘federal funds’ (to use the American term).

It required some effort in those days to demonstrate to the students that it really was a policy variable. Now the Canadian central bank openly admits it.”

There used to be a series of ‘self-help’ books with titles like the above. Some years ago, I bought one called Bass Guitar for Dummies. I am not sure how much use it would have been to someone who was really a ‘dummy’, but it was certainly more straightforward and understandable than many of the flashy video tutorials on the internet. I have long thought that monetary policy — which seems an arcane and complicated subject when reading academic journals, websites, and the financial press (with the honourable exception of this blog) — could be similarly demystified.

I think that a ‘near-optimal’ setting of the real policy rate of interest, in a regime with a sovereign currency and a flexible exchange rate, or a ‘fixed-but-adjustable’ exchange rate, is actually zero — a policy that Louis-Philippe Rochon and Mark Settlefield kindly named the ‘Smithin Rule.’

Contrary to what we were taught in the graduate schools of half-a-century ago (the heyday of monetarism), monetary policy now typically means setting or influencing the interest rate that commercial banks pay on loans of central bank base money in the overnight market — the policy rate. What I mean by the ‘real’ policy rate is the nominal policy rate (the actual percentage rate quoted) less the currently observed rate of inflation. Such a zero real policy rate (ZRPR) will achieve as close an approximation as possible to a fair distribution of income, in a particular sense. It also promotes inflation stability, financial stability, higher growth, full employment, and higher real wages. It is a ‘good thing’ from many points of view. The sense in which a ZPRP is ‘fair’ is that rentiers (whose income arises solely from interest payments on existing wealth) do not share in the income generated by current productive activity. Nonetheless, the real value of existing financial capital is preserved. Such a policy also has the virtues of transparency and simplicity.

A ZRPR is different thing than the zero-interest rate policy (ZIRP) favoured by advocates of ‘modern money theory’ (MMT), which is that the nominal policy rate should be zero — or what Rochon and Setterfield called the Kansas City rule. Both are examples of a ‘parking it’ approach to interest rates, but there are two main reasons for preferring a ZRPR to ZIRP.

The first is that a ZRPR promotes the putatively fair income distribution, whereas the ZIRP does not. The second is that a nominal interest rate peg at any level (not just zero) leads to instability in the inflation rate — in either direction — whereas a ZRPR is conducive to stability.

The contrast, by the way, has very unfortunate implications for the monetary policies pursued by real world central banks, who do engage in a nominal interest rate peg — eight times a year between open market committee meetings — and thereby wittingly or unwittingly contribute to instability. We should be clear that inflation stability is not synonymous with low inflation. Nonetheless a stable inflation rate whether high or low is itself a ‘good thing’. At least it will be predictable. Low inflation per se is beyond the scope of the central bank alone, without doing serious damage to the real economy. If low inflation is really desired (why?) then other types of policy must be pursued. There must be policy co-ordination.

Returning to the aforementioned ‘real world’, when I look at the ‘Bank of Canada’ website, the its home page informs us that currently the ‘policy interest rate’ is 5% and that ‘total CPI inflation’ is 3.4%. According to the ZRPR rule, therefore, the Bank of Canada should have lowered interest rates last week, not increased them: they should have cut interest rates by more than a full point, from 4.5% to 3.4%, and not increased them to 5% as they did. Simple as that. And, if everybody knows this rule, there would be no surprises and no uncertainty. People may quibble about whether or not the CPI (consumer price index) is the best measure of inflation for this purpose. There might be a case for choosing an index with a more comprehensive coverage of the various components of GDP (gross domestic product).

However, I do not think this is a particularly important issue. The choice of index has a significant performative role as long as a choice is made and the authorities stick to it. But, it is significant that the Bank of Canada is now explicitly using the expression ‘policy rate of interest’. Back in the day, when I was teaching university courses in ‘Money and Banking’, it was identified simply as the ‘overnight rate’, i.e., the rate determined in the overnight market for ‘federal funds’ (to use the American term). It required some effort in those days to demonstrate to the students that it really was a policy variable. Now the Canadian central bank openly admits it.

Looking at not only just the most recent figures but also over the past couple of months (say), when the real policy rate was typically slightly negative, people may say — why bother? Isn’t the Bank of Canada doing more-or-less what you ask? Well, yes, but this was very recent and happened just by accident, on the analogy of a ‘stopped clock being right twice a day’. For the last few years the real policy rate has often been much more negative. Historically, it has actually been strongly positive on several occasions (episodes I call the ‘revenge of the rentiers’). Unless the central bank makes some kind of definite commitment who knows what will happen in the future?

If one looks at the website of the Federal Reserve Board in the USA they seem much less transparent than in Canada. Under the heading of ‘Policy Tools’ the Fed funds rate is not mentioned. It seems like another flashback to the old ‘Money and Banking’ classes. They go on about open market operations, the discount window, reserve requirements, ‘repos’, and so forth. In fact, the Fed funds rate is currently 5.08% and CPI inflation is 4.98%, so the situation is somewhat similar to that in Canada. Once again, however, there is no reason to think that they are actually following a ZRPR — quite the contrary. It is just where we happen to have landed at the current time.