WOULD a rise in interest rates by the Bank of England’s Monetary Policy Committee (MPC) constitute a tight monetary policy? Not necessarily.
Economists tend to refer to the “neutral interest rate” as that which coincides with output growing at its trend rate and low inflationary pressure. Austrian school economists would also stress that interest rates are neutral when the economy is on an intertemporally sustainable path – or as Roger Garrison puts it, real savings are being invested in ways consistent with people’s time preferences.
A 2005 report by the Federal Reserve Bank of San Francisco (FRBSF, see graph, right) used the trend real interest rate as an estimate of the neutral real rate, suggesting that it steadily fell during the so-called “Great Moderation”.
How does this relate to the MPC? Put simply, it shows that interest rate rises do not necessarily equate to a tight (as opposed to a tighter) monetary stance. In a world of static equilibrium analysis, it is tempting to take the current policy rate as the status quo and judge MPC decisions in relation to this. However, the benchmark should be the neutral rate.
The nominal neutral rate is conventionally estimated to be about 5 per cent, and a 2010 Morgan Stanley report suggested that in future it would fall to 2.5-3 per cent.
But this is still higher than the Bank rate. In this case, keeping the Bank rate unchanged – when this is below the neutral rate – is an active monetary stimulus. The longer the interest rate is below the neutral rate, the greater the degree of intertemporal misallocations of capital. In monetary policy there is no such thing as standing still.
It would be wrong to ignore the role of expectations or other signals of the monetary stance, however the neutral rate does provide an important lesson – that raising interest rates to levels that are still below the neutral rate is different to raising them to levels above it. This may appear to be semantics, but a tightening of interest rates can still imply loose ones. The policy debate is not about loose or tight monetary policy, but between looser or less loose interest rates.
Anthony J. Evans is associate professor of economics at London’s ESCP Europe Business School, and Fulbright scholar-in-residence at San Jose State University.