Fed Independence And The Rates/Inflation Debate

The drumbeat from the White House to replace Powell as the head of the Fed is increasing, and we are seeing potential candidates for the replacement echoing President Trump’s line that the United States needs low interest rates now. (President Trump argued Monday that the policy rate should be 1% or lower - link to news article.) I have just written an article about the difficulties finding writing opportunities about economic theory debates, and I guess I needed to be more careful about what I wish for.

The debate in question is: what is the effect of “low” interest rates on the economy/inflation? The conventional answer is that “low” interest rates will increase inflation/growth. The unorthodox argument (mainly now made by fans of Modern Monetary Theory and the so-called neo-Ricardians, but historically there were others) was that “low” interest rates will not stimulate high inflation, and that raising interest rates will increase inflationary pressures. (If we read between the lines when we look at the mainstream concept of “fiscal dominance,” the latter effect is implicitly held to be true — except nobody wants to discuss that angle, since it crashes into mainstream economic orthodoxy.)

Interest Rates and Inflation: The Short Version

I will quickly outline the arguments why high (low) interest rates might raise (lower) inflation for those readers who have made the tragic mistake of not buying my book Modern Monetary Theory and the Recovery (link to online storefronts). I will focus on the case of why high interest rates might raise inflation on the basis that it is a bit easier to follow.

The argument is that raising interest rates will raise the interest component of government spending. Note that only short-dated debt payments will track the policy rate — existing bonds have their payments fixed until maturity (hence the term “fixed income”). New issues will reflect market rates, but if the weighted average maturity (Macaulay duration) of debt is high (e.g., 8 years), it will take time for the weighted average interest rate on the stock of debt to rise. Nevertheless, interest payments on government debt will rise, and be a component of the fiscal deficit. Since the fiscal deficit is an injection of income to the “non-government” sector, this is stimulative, and thus poses inflation risks due to “excess demand” (the exact linkage between “excess demand” and inflation is disputed, but if one looks past the details, there is not a whole of of disagreement with the principle that large enough fiscal deficits are inflationary under current economic arrangements¹).

The observation that interest payments are part of the fiscal deficit, and fiscal deficits are ultimately inflationary used to fairly common, at least until the Volcker Madness broke everyone’s brain. As noted earlier, “fiscal dominance” worries point in this direction — but the compartmentalised nature of neoclassical thinking means that the exact same people who worry about fiscal dominance will also unquestioningly believe that higher interest rates lower inflation.

Going the other way, the disinflationary effect of lowering interest rates is less obvious — once interest payments shrink and are no longer economically significant, then making them even smaller will have no further effect.

Recessions Lower Inflation

Given that I am comfortable with the arguments in the previous section, it might seem that I am firmly in the “lower interest rates to lower inflation” camp. However, I am somewhat agnostic on the topic in practice.

The first argument is that recessions lower inflation — and rapid interest rate hikes will tend to cause recessions.

The second argument is that the housing sector is of outsized importance in modern economies, and housing is interest rate sensitive. To the extent that animal spirits in the housing market follow interest rates — it is unclear how much this holds for mild interest rate changes — economic growth might track interest rate trends.

There is also the question of the currency (discussed below).

In summary, I think that radical changes in policy rates might work as conventionally expected, but a few incremental changes are unlikely to matter. However, those incremental changes will feed through to interest outlays.

Testing the Theories

Given the number of people with doctorates at central banks that are inflation targeters, an outsider might naively assume that the effect of interest rates on would be empirically determined. In fact, neoclassical economists loudly proclaim that the issue is empirically sorted. However, believing this requires a suspension of disbelief. Neoclassical models assume that interest rates have a direct effect on the economy — the core of the models always revolve around “intertemporal substitution of consumption” (which is close to the definition of a neoclassical model). That is, the predicted effect of interest rates within such a model is determined entirely by the person who created the model.

If we look at data, we run into the problem that central bankers react to inflation in a predictable way. This means that the policy rate tends to always follow inflation with a lag. This generates a strong empirical link between inflation and the policy rate (which is admittedly not friendly towards neoclassical models). You would need policymakers to do something different to get a better idea of what might happen.

(Neoclassical academics have come up with some alternative ways of testing their theories about the linkage, which are convincing if your academic credentials are entirely dependent upon neoclassical economics being valid.)

So we need to find countries willing to break the conventional consensus of how to set interest rates. We have one recent (not very good example, as noted below) of Türkiye, but we now have Donald Trump angling for the United States to try — which would be interesting.

Türkiye — Not a Great Example for Developed Economies

The Turkish (Türkish?) government decided that it would be a good idea to cut interest rates despite inflationary problems in 2023. This policy caused a good deal of jeering in financial markets, and they were forced to reverse course after their currency collapsed.

This was a relatively predictable issue, and is a defect of the previous discussion of the topic, which ignored the effect of the currency. Very simply, if your country is highly vulnerable to the level of the currency, your policy space is constrained.

The problem with the example is that Türkiye is probably not a useful example for most developed economies. It is a small economy, with financial markets that are insignificant in the global scheme of things. Even relatively small countries like Canada have large capital markets that are integrated with other global economies, and have a stock of financial assets that are large comparable to GDP. The ability of a currency to free fall is limited by the feedback from financial and real asset pricing. There is no doubt that people will panic about a 10% currency move (for example), but if we looked at the data, we would realise that 10% currency moves happen all the time and nothing much exciting happens to inflation rates. (As an exercise, look at Canadian and American inflation rates since the mid-1990s and try to guess when the CAD/USD exchange rate moved.)

What About the U.S.?

If interest rate policy were the only thing changing in the United States, it might be an interesting guinea pig for a rate cut experiment. The problem is that this is not the only thing changing. An insane tariff war against literally everybody, direct attacks on the rule of law, as well as the attempt to deport a good portion of the agricultural workforce poses the risk of secular changes to the economic structure. The U.S. dollar could tank and tariffs would add extreme insult to the import price change injury. Of course, price rises on imported goods would give cover for American firms to raise their own prices — even if their input costs did not rise.

Unorthodox rate cuts could easily add to the panic about inflation. Even if the rate cuts theoretically would not matter, the vast majority of the economic commentariat believes that they would. Given that the American public has a very tenuous grasp of what is happening in the economy, social media could amplify problems. (Admittedly, social media might not do this since there is no longer a Democrat in the White House.)

In summary, although my bias would be that cutting rates in a normal environment would be a nothingburger from a fundamental basis, I certainly would be hesitant to position that way right now.

Central Bank Independence

Making central banks “independent” was one of the crowning neoliberal achievements. Neoclassicals have dubious beliefs about what such independence entails (central banks do have to coordinate with the fiscal arm of government), but those problematic beliefs are secondary to the basic problem faced right now.

Having a politician with a background in real estate poses considerable inflation risks (if you believe the conventional story about interest rates, which most market participants do). As such, even in the absence of a policy move, it is entirely reasonable to slap on a inflation risk premium on long-dated bonds if it is clear that the Fed became a puppet of the White House. How much that premium should be is left as an exercise to the reader, but I do not think it would be large enough to justify the amount of attention it will draw in financial commentary.

Concluding Remarks

Ha ha, interesting times.

1. In particular, that we are not monkeying around with price controls and rationing, which is exactly what governments did in World War II to avoid inflation due to wartime deficit finance.