This is the response to an fellow economist who wondered given Milton Friedman's comments on Japanese monetary policy in the 1990s if our current low interest rates were a result of Fed policy having been too tight. It was written on July 9th.

I can see that your focus is on the sentence that "Low interest rates are generally a sign that money has been tight; high interest rates that money has been easy." Starting from an overheated situation (or any other for that matter), a tightening of monetary policy in terms of slower or negative monetary growth will slow nominal economic growth, including real economic growth, or even turn such into negative growth. Typically with more of a lag, inflation will also come down.

While the initial tightening of monetary growth will raise interest rates, the decline in inflation premiums and in real interest rates because of the slow real economic environment will cause nominal interest rates to decline. This is the basis of the statement above. In Japan the Bank of Japan kept monetary growth too low. That contributed to keeping the economy depressed and interest rates down.

The current situation is somewhat different in that our monetary growth has not been that slow and our economy has had mediocre growth, but interest rates are still low. In the past two years M2 has grown at a 6.2% rate and at a 6.9% rate in the past year.

There is false impression that the Fed controls interest rates. It only influences them. The impression that the Fed controls rates is one of the ways that the Fed influences rates by its interest rate targets, but it is through the creation or contraction of reserves that the Fed has its direct impact.

As noted above, the initial efforts as reflected in monetary growth rates has a lagged impact of economic activity and prices, which in turn moves interest rates. So the question is, if we have had respectable monetary growth, why has nominal economic growth not been higher and why are interest rates still so low.

Slow growth and low inflation abroad is one factor, but one would expect differing interest rates due to different local rates of inflation and economic activity to impact forward exchange rates and spot exchange rates rather than mainly a convergence of interest rates. A difference in the supply of money and the demand for money should impact economic activity. But aside from that the Fed's impact on real economic activity is limited.

Erratic and inflationary monetary policy will create more uncertainty, which in turn will hinder real growth potential. A situation of accelerated monetary growth can shift some demand forward (and a contraction the reverse), as participants engage in capital and durable goods spending (investment) sooner to lock in the lower interest rate costs. It could even result in overall investment being higher because the lower cost of capital might allow more investments to be profitable to a greater extent than periods of higher interest rates might permanently reduce investments. However the poor economic conditions of the time also tend to reduce expected returns, limiting the impact of temporary lower capital costs. But overall these impacts are either limited or temporary.

Real growth will depend on technological developments, capital investment, culture (including attitudes toward risk and innovation), legal and regulatory conditions, political conditions, etc. Savings depends on the desire of people to save for emergencies, retirement, education, etc.; rates of return; inflation; income distributions; diversification opportunities; acceptable risk levels on investments, etc. Investment depends on expected rates of return, the ability to get money to those willing to make capital investments, capital market trends, alternative uses of borrowed money, etc. The relation of savings to interest rates is complicated.

On one hand, people tend to prefer current consumption to deferred consumption, so require returns on savings to postpone consumption. But the marginal utility on basic necessities in retirement or future medical costs, etc. might be higher than on additional current consumption.

In essence people may have fixed level of savings objectives based on the expected costs of that future consumption. When returns are low, more savings flows might be required to meet those objectives. The net effect of these two reactions is an empirical question that can vary from place to place and from time to time.

Income distribution is a factor in this savings/investment situation. When you have countries such as China running up dollar reserve balances for domestic political and social reasons and others such as the oil producers some years ago having such strong revenue growth that they also accumulated dollars, you had a larger amount of savings provided to the U.S. As income growth has mainly gone to the upper 1%, etc. who have a lower marginal propensity to consume for obvious reasons, overall savings is high. (Note that since some of these saved funds will be borrowed by consumers, you would have to have a focus of savings by income groups, not just overall households to really analyze this question.)

But if income growth of the main part of the population is minimal to negative and population growth is limited, who will buy the increased output that results from investment? That lowers the prospect of future returns.

Increased regulatory burdens and delays, also discourages investment, as does all the uncertainties about the EU, future growth potential in China, the U.S. election outcome, etc. There is also a reluctance to undertake some types of risk, which makes it more difficult for new businesses outside of a few high tech glamour areas to get the necessary investment. With returns so low, those with savings will tend to bid up prices of existing assets. That reduces term spreads on interest rates, overpricing longer term securities and may also result in bubbles in other areas.

The ability to borrow cheaply encourages short term speculation. Excessive monetary creation may not result in faster nominal economic growth under such circumstance with attendant higher consumer price inflation but result in asset price inflation instead.

That is what happened with the housing bubble in the first decade of this century. The government has to create more favorable conditions for economic growth and reduce the advantages of crony capitalism to deal with some of the income misdistribution.

In essence I disagree with the conclusion that low interest rates here are a result of monetary policy that has been too tight. There are two approaches to monetary policy. One is to focus on interest rates, with moves by the Fed to nudge interest rates either above (tight policy) or below (easy policy) the fundamental non-inflationary real rate.

The other is to aim to have the money supply equal the amount of money demanded in a non-inflationary environment. Friedman favored a constant non-inflationary rate of monetary growth. Both approaches depend on an assumption for the latter items, that is, the fundamental real interest rate and the non-inflationary demand for money. We cannot measure either.

Given the experience of recent decades, I no longer assume a stable demand for money and hence do not necessarily believe a steady rate of monetary growth is the ideal policy for all situations. We do not really have an ideal measure of money. It seems that a measure that is broader than pure transactions money (M1) is desirable, that is the inclusion of some deposits or instruments that can easily be converted to transactions money with minimal or no cost. Friedman and I have both tended to favor M2.

But there are many other short term assets that have a degree of moneyness that varies over time. I prefer to look at both approaches to determine how easy or tight monetary policy is. Monetary growth at present at a time when other assets like short-term Treasury bills have a high degree of moneyness seems modestly easy to me. I say modestly as international uncertainties might increase the demand for money.

I should note that monetary growth has not been steady and there have been some periods when the growth rate was a bit too low. That may or may not have had some temporary impact on economic growth over short periods. Recent higher growth suggests that this is not a current problem.

There are some who believe that the real fundamental interest rate has declined so much that monetary policy is currently tight. I believe that most have lowered their perception of this rate from the past norm but not by so much as to characterize the current policy as tight.

I might also note that some like Meltzer have preferred to focus on the monetary base. My focus is on public money, that is what the public uses for its transactions, which is M1, or can easily convert to M1, such as M2-M1. Aside from the currency component which is present in both, reserves are bankers money. That is transactions between banks require use of the monetary base.

In theory rapid monetary base growth should result in banks making loans and buying securities. But if they hold such as excess reserves, it is like hoarding cash. It has no direct economic impact. The only impact is whatever impact results from a shift in bank holdings from the securities they have sold to the Fed to excess reserves. That is the impact on the interest rates on those securities relative to the Fed funds rate may be impacted.

The public does not have reserves in its balance sheet. As such those inactive reserves would not be expected to have any impact on the public's economic activity. The longer term risk is that those excess reserves will be utilized, rapidly increasing M2 growth at some future time if the Fed is not successful in counteracting such trends. That would likely result in more inflation.


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