Why I am subscribe to Neo-Fisherism on Interest Rates (It's the National Debt)

Managing Financial Instability

Interest rates have many complex effects on finance and the economy, most of which are contingent on market conditions and responses, everything from domestic markets, fixed assets like real estate, consumer goods, and foreign trade.

Given the complexity of interest rates, the recommendation most MMT people would make, is to use collateral to manage the price level.  As I discussed in a previous article, this does have political concerns, in that, in addition to ensuring liquidity and backstopping markets against financial insecurity, governments must engage in independent assessment of asset prices.

Most western countries would prefer to have markets exclusively set asset prices, but the problem is, as soon as you dispatch government to backstop volatile markets, they have stepped into the game of pricing assets.  If you prevent large drawdowns, you are inherently creating an upward bias on asset prices.  How might we compromise on this? Is there a way that governments can prevent financial instability, without biasing asset prices?

The most aggressive recommendation, which we will not cover here, beyond this paragraph, is avoiding backstopping finance altogether, and merely backstop the labor market instead.  This proposal has many interesting properties, especially in terms of supply and demand curves, but look for that in another post.  The logic is, if you guarantee jobs, and thereby support incomes, then financial markets can sort themselves out.  It is a very aggressively pro-market solution to the problem of financial instability, and keeps governments out of the game of pricing assets.

Absent a Job Guarantee, I think the next best proposal would be to focus on price discipline on the way up, using financial regulations.  On the way down you then are selective about which assets you provide support levels for, and where you start providing supports.  Personally, I think the relative costs of housing are very high by long term historical standards, so while housing is a very basic essential commodity, you would do well to let markets correct the values of existing housing stock downward.

As for the complexity of interest rates, Cullen Roche suggests several possible "monetary transmission" channels, including financial crises, exchange rates, expectations, credit, exchange rates, and "portfolio rebalancing".  It is this last channel that I want to focus on now.

Are rate hikes a good tool for inflation control?

Rate hikes can definitely "pop" financial asset bubbles, and therefore, if you have asset driven inflation, or another form of inflation accompanied by high asset prices, then wiping out such inflated markets can have a considerable impact on inflation.

Given that financial leverage is a considerable part of how such asset markets are propped up, from real estate bubbles to crypto markets, interest rate increases can often force a reckoning for asset holders.  

On the flip side, one must consider that interest rate payments, on the national debt and other assets, could be channeled into buying and propping up other asset markets.  This effect would be much less dramatic, and in all likelihood, simply smaller overall.  But it is something to consider.

It's about the National Debt

So if rate hikes can help correct overpriced asset markets, why not use them for controlling inflation?

Well, I am not opposed to all uses of interest rate "management", to help manage the price level, but such portfolio effects are likely a one time event, whereas the interest rate may remain elevated to avoid an inducement in the opposite direction.

Sustained, elevated interest rates have particular costs, and one of these is "servicing" the national debt.  In fact, this may be the most important cost of all.

I am definitely of the opinion that an excessive national debt can be one of the primary instigators of inflation, especially coupled with fiscal spending programs that are relatively low value impact, like transfers and benefit programs.  If the national debt is larger than the amount people want to save in a currency, then this will either drive up the interest rate as people devalue their bond holdings against other assets, or it will devalue the currency itself. (the bond market is an artificial one, between government ious, much like a time-locked smart contract.)

Importantly, it is not necessary for a large scale "selloff" for the relative prices of two assets to move significantly in a market place.  The nature of "mark to market" accounting, means that relative prices can change with very little overall trading volume.  So calling this "bond selloff" or a "firesale" would be a mistake. When the overall "demand" for savings, or desire to save contracts, I do not think this would have a big impact on who wants to save, but only how much overall, so for the most part, this would have a very slow and gradual effect on bond and currency markets, as the "bid" part of the depth chart dries up, without the "ask" side dropping too quickly.  This includes both the market for bonds, and FX currency markets, and to a lesser extent consumer markets.

One of the problems with an interest rate hikes, especially hikes that target the "real" rate of interest, is that you effectively prevent any downward market correction to the national debt.  So even though outstanding bonds are immediately devalued based on duration, they still payout the same at maturity, and subsequently.  Real interest rate targeting policies amount to the federal reserve trying to keep U.S. dollars in the form of bonds, rather than letting investors express their preference to hold those dollars as cash.

As the "cost" to service the debt rise, or rather, the amount of nominal interest income, the inflation adjusted debt levels cannot effectively correct.

Politicians ARE Responsible for Inflation

Politicians are responsible for inflation.  Inflation, more than anything else, may be one of the political catalysts that reach across partisan divides.  Nobody likes inflation, and importantly, if we are to tolerate inflation, a very strong justification must be offered, such as national defense against an aggressive adversary, or saving lives in a pandemic.

Outside of such scenarios, when there is not a role for government to play in coordinating massive economic shifts, the voting populace in democracies will rightfully have little political tolerance for inflation.

Both the debt level and the "value impact" of fiscal programs has a huge effect on inflation.  So instead of trying to stop any inflation, if inflation is fiscal driven, technocrats may be well advised to let the fiscal programs 

The purpose of markets is to use assets to bid on scarce resources, so letting markets work themselves out, even if this involves inflation, can be important.  Importantly, if you try to use interest based inflation control, you can actually accelerate the growth of the national debt, which may have exactly opposite of the intended effect.

Notably, this contradicts what would normally be considered "accomodative" federal reserve behavior. So really, the fed is not accomodating an exuberant and misguided treasury, but rather the investor preference to hold their currency as cash and not bonds.  Actually accomodative fed behavior would involve aggressive actions to stave off inflation, so that the treasury can pursue its fiscal goals without interruption.  If the fed monetizes the debt, rather than supporting a real fiscal program, this hastens the market discipline of the political process, and the market correction to the valuation of outstanding debt.

Interest Management: Quick Impulses With Planned reductions

So if you do manage interest rates, first of all, instead of targeting a "real rate", which is effectively impossible and even suboptimal, because future inflation is unknown, you focus on nominal rates.

I will go over this in the following article about ZIRP and a couple alternatives, as well as a "Secret bonus third thing".