Central banks can do little to peg interest rates off their course without creating ripple effects across the economy, as the US conservative economist Milton Friedman said © FT montage; Bloomberg

Rocketing house prices, zombie companies, rising inequality, a runaway stock market, struggling savers and even the outright destruction of capitalism — perhaps the only thing that does not get blamed on easy monetary policy from central banks is the weather.

There is little doubt that low interest rates caused some of these effects, some of these forces. But the mistake is to blame low rates on central banks. They have no other choice.

Various champions have set out to right the perceived wrongs caused by central banks. In May, the German constitutional court ruled that the European Central Bank had failed to apply a “proportionality” test to its bond purchase programmes, while Judy Shelton, US president Donald Trump’s nominee to the Federal Reserve board, questions whether a central bank should even be allowed to set interest rates.

“How can a dozen, slightly less than a dozen, people meeting eight times a year, decide what the cost of capital should be versus some kind of organically, market-supply determined rate?” she said in an interview with the Financial Times last year.

The curiosity of such complaints is the idea that central banks have the arbitrary power to set interest rates at whatever level they like.

In the short-run, that may be true. But over any reasonable period of time, central banks cannot fix interest rates and still keep control over prices. Far more than is commonly appreciated, central banks are servants of underlying trends in the economy, not their masters. To blame monetary policy for rising house prices or growth in debt is to assume, mistakenly, that central banks had any alternative.

For more than a century, a central concept in economics has been the “natural rate of interest”, variously defined as the rate that balances savings and investment, the return on an extra dollar of capital investment, or the real interest rate consistent with price stability. The natural rate can, and does, move about. A new invention may provoke an investment boom and move it up; a recession might move it down. But there is nothing a central bank can do to influence it. Something similar would exist even in a barter economy. The rate is, as Ms Shelton likes it, “organically, market-supply determined”.

What happens if the central bank tries to fix interest rates above or below this natural level? In his 1967 presidential address to the American Economic Association, the conservative economist Milton Friedman famously argued that central banks cannot use monetary policy to keep unemployment below its “natural rate”. But in the same speech, he was adamant that they cannot peg interest rates either.

If a central bank tried to hold interest rates down below their natural rate, then surging demand for credit would push prices up. “The monetary authority can make the market rate less than the natural rate only by inflation. It can make the market rate higher than the natural rate only by deflation,” Friedman said.

Speaking in the 1960s, Friedman was mainly concerned about the inflationary effects of postwar attempts to keep interest rates artificially low. In his research on the 1930s in the wake of the Wall Street crash, though, he pointed to the opposite problem: the Fed’s tight monetary policy, at a time when people wanted to save and not invest, was a prime cause of the Depression.

The test of whether central banks have kept market interest rates in line with the natural rate is whether they have kept inflation at its target. In the US, the average inflation rate from 2000-2019 was 1.8 per cent, and fell to 1.6 per cent in the period after 2008 during the long struggle to recover from the recession. In the eurozone, it was 1.7 per cent falling to 1.3 per cent. In other words, inflation was consistently below the figure of 2 per cent by which price stability is widely defined.

That implies central banks have kept interest rates close to but slightly above their natural rate over the past two decades. Monetary policy was too tight, it had a deflationary bias. That is not surprising given the well-known difficulties central banks have had in stimulating economies once short-term interest rates hit zero.

Now imagine if central banks set out to reward German savers, bankrupt zombie companies or hold asset prices down. To do so, they would have to raise interest rates further above the natural rate, and that would cause deflation. When central bankers are legally bound by their mandate of price stability, the option, simply, is not open to them.

There is something of a test case for what happens when you do hold interest rates above their natural rate: Japan. In the late 1990s and 2000s, Japan ran a tight monetary policy. The result was two lost decades, with stagnant growth, underemployment, falling asset prices and average inflation of 0.2 per cent from 2000-2019.

Anybody arguing that the Fed and European Central Bank should adopt higher interest rates to tackle zombie companies, or cool equity markets, should state clearly that a few lost decades is a price they are willing to pay.

The real problem is that the natural rate of interest is in decline, for reasons that are still uncertain but range from demographics to lower productivity growth. Rather than rage against central banks, people should direct their ire — and their efforts to find a solution — in that direction.


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