I had no idea that Sweden has gone all-in on raising interest rates to fight “financial instability.” (Alas poor Lars Svensson!) Simon Wren-Lewis has details, Krugman has more, and Peter Orszag had a great column about how New Zealand is instead using regulations to fight worries about the financial system.
I’ve been long fascinated by this topic. The stakes are very high: should we endure a mini-recession, with lower employment and output, to fight a thing called “financial instability”? I offered a list of reasons why the answer should be a resounding “no”, but I recently found two more. These two are much clearer, and I think should provide a major hurdle to clear for those who think we should raise rates.
First: Every Target Needs an Instrument
I hate to spoil what happens when you try to kill two birds with one stone, but you usually end up missing both of them.
In policy we have targets and we have instruments. Targets are states of the world we want to bring about but don’t control, and instruments are means of bringing them about that policymakers do control. Targets for the Federal Reserve are things like full employment, price stability, and now financial stability, and its main instrument is the interest rate.
There’s an old principle in policy called Tinbergen’s Rule (h/t JW Mason). Tinbergen’s Rule says that you need at least as many instruments as there are targets. One instrument can’t hit two targets consistently or with any regularity.
In modern macroeconomics there’s an interest rate consistent with both full employment and price stability, so that’s functionally one target. Now what people are saying is that we will take one instrument, the interest rate, and try to hit both financial stability and full employment. That can’t be done, or at least not regularly or with any consistency. (And there’s no reason to think that a set of regulatory tools could, with any real effect or consistency, create full employment, so there’s no way to cross them.)
Doing something that common sense tells us we can’t is a really bad way to establish how we want macroeconomic policy to look after the crisis. If we need financial stability, and I really believe we do, we need to develop a separate set of tools through law and regulations.
Second: What Would the Net Effect Even Be?
The short answer here is that we have no idea what the actual effects of raising interest rates would be on financial stability. This was on clear display in the IMF’s “The Interaction of Monetary and Macroprudential Policies” from earlier this year. Here’s a great chart from that report:
That’s a lot to take in, so let’s walk through it. Imagine we raise interest rates right now, in the name of financial stability. That in turn reduces employment and decreases incomes, making it harder for people to make payments and worsening their balance-sheet situations. The higher rates themselves will lead to higher payments for those with loans linked to variable payments. Raising rates to fight financial instability will lead to weaker balance sheets and more defaults, thus increasing the problem it was meant to solve.
(That’s why in the balance-sheet channel of the chart above, there’s a red arrow, representing a decline in financial stability, under an increase of policy rates.)
But there are other channels as well. Under the risk-taking channel, lowering rates can cause “intermediaries to expand their balance sheets, increase leverage, and reduce efforts in screening borrowers.” However, for the risk-shifting channel, increasing rates “tends to reduce the margins of intermediaries that are funded short-term at variable rates, but lend long-term at fixed rates.” Thus, to maintain a return on equity, there may need to be a shift into riskier assets. These two effects go in opposite directions, and it’s not clear which would be greater.
There’s also an asset price channel. It’s not clear how much low interest rates cause asset price booms in practice. But to the extent that they do, they can increase financial stability by increasing asset value and borrowers’ net worth. However, in the exchange rate channel, raising interest rates will lead to more capital inflows (the IMF says “excessive capital inflow,” heh) and capital growth, which will decrease financial stability. (JW Mason flagged this as a major problem with the “raise rates” crew in a guest blog post here a while ago.)