Monthly Archives: May 2016

Monetary Policy Thoughts

Monetary policy is supposed to be a balance between unemployment and inflation rates. The higher interest rates are, the lower inflation and the higher unemployment. The lower interest rates are, the higher inflation and the lower unemployment. Central bankers then are supposed to find a nice middle ground. Farther left ones like the idea of targeting full employment and accepting whatever inflation it takes to produce that. Farther right ones like the idea of targeting some inflation rate (sometimes 0 for the dumber ones) and accepting whatever unemployment it takes to hit that inflation rate.

However, this isn’t what modern monetary policy debates look like. Currently we have moderate unemployment and low inflation. The response by the Fed has been to raise rates – theoretically increasing unemployment in order to drive inflation even lower. It seems crazy. But it’s less so when you remember one crucial additional factor: Central banks are run by bankers, and the higher interest rates are, the better it is for bank profitability. So there is always a major interest group within a central bank pushing for higher interest rates no matter what the macroeconomic situation, just because that’s good for their former/current/future employers, and all their friends and colleagues who work in the financial industry.

(There’s also a point to be made about how the tradeoff is really more between economic growth and inflation rather than between unemployment and inflation, with reduced unemployment just being a factor of improved growth, but that’s less relevant to this discussion.)

So all over the world we have central banks that are desperate to raise interest rates whenever it is remotely economically justifiable to do so. This gives us a significant bias in favor of tight money (high interest rate producing) policies. Anyone who thinks economic growth is a good idea should get angry about monetary policy and demand changes in the Fed’s governing structure. Rather than having the Fed’s leadership be composed of bankers, people who have ever worked at a bank should be banned from working at the Fed. A non-partisan council of academics and bureaucrats tasked with setting interest rates to maximize overall economic growth could do MUCH better than the current setup.