Interest rates, we are often told, balance investment and saving. Since jam today is better than jam tomorrow, interest provides the reward for waiting. On the flip-side, high interest rates dampen the spirits that animate investment.
"The inhabitants of this simple world have a single decision: how much corn to eat now and how much to replant for the next harvest?”
Let’s think about corn farmers. Economists like to perform thought experiments on a hypothetical agrarian economy in which there is a single commodity - corn. Although this simple model can be embellished with added complexity, its basic workings remain the same.
Now or later?
The inhabitants of this simple world have a single decision: how much corn to eat now and how much to replant for the next harvest?
Because farmland is of variable quality, the corn-yield diminishes as more corn is planted. The ideal outcome balances the reward for waiting - the extra corn at the next harvest - against the diminishing yield of corn planted.
The equilibrium ‘interest rate’ is then derived from the ratio of corn expected at the next harvest to corn planted now. So, if 10 tonnes of corn planted now yields 11 tonnes of corn at harvest time, the corn interest rate is 10 per cent.
This ‘corn’ rate of interest - known as the ‘natural rate of interest’ (or R-star) - balances saving and investment. And, because it is associated with equilibrium in the goods market, it also has the property that it maintains price stability.
To see this, in the example above, imagine corn could be borrowed at 6 per cent. Compared to the natural rate of 10 per cent, this rate is too low to encourage saving – we would rather eat more corn now. What’s more, planting borrowed corn gives a guaranteed profit of 4 per cent once loans are repaid. Therefore investment would also be too high.
Desired corn consumption and investment would be more than the economy could actually produce. This excess demand would spur corn-price inflation, unless the corn borrowing rate adjusted to match the natural rate.
For some this ‘proves’ why we don’t need central banks - the economy requires no monetary intervention since interest rates, when left to their own devices, will gravitate towards the natural rate.
For the rest of us, this basic corn economy lacks one obvious feature of our own - we use money for our transactions. But, since the central bank is responsible for setting interest rates with the purpose of maintaining price stability, the corn interest rate could serve as a valuable guide. (Any questions about the purpose of money in a world with only a single commodity are left unanswered.)
In reality though, the central bank influences money (or ‘nominal’) interest rates, not corn (or ‘real’) interest rates. In fact, in economic dogma the central bank cannot affect the corn rate at all. Yet, according to corn theory, prices will not be stable unless the money rate somehow mirrors the underlying corn rate.
This problem is solved by leaning heavily on the relationship between money rates, corn rates and inflation postulated by famous American economist Irving Fisher. According to the Fisher Equation, money rates are the corn rate adjusted by inflation expectations.
The relationship works like this: if investors anticipate rising prices (inflation), which will reduce the value of their future money income, they will demand a higher money rate of interest (or yield) as compensation. The corn rate is determined by ‘real’ factors and is beyond the reach of these money matters.
Therefore, inflation expectations provide the link between money rates and corn rates. If inflation expectations are stable, any movements in the corn rate can be matched by a change in the money rate. The Fisher Equation - by prescribing the relationship between nominal rates, real rates and inflation - forms the basis of the celebrated ‘Taylor Rule’ used by central banks to guide their policy decisions.
This explains why central bankers place such great emphasis on (and are very reluctant to change) explicit inflation targets. In the corn world, the Fisher Equation and anchored inflation expectations allow for effective monetary policy.
How so? Suppose we all suddenly started to plant more corn today, say in anticipation of retirement. The immediate effect is an excess of saving which, in theory, should lead to a lower ideal corn rate.
If the central bank leaves its policy rate unchanged, the signal for the new ideal balance between investment and saving may not be received. If they leave the rate too high, there will be too much saving.
With stable inflation expectations, the central bank can lower its money rate to reflect the lower optimal corn rate. Easy!
Unfortunately, both Fisher himself and many subsequent studies have noted that his equation does not hold in practice. If true, nominal interest rates would be much more variable than real rates.
Notable exceptions are the low implied real rates of interest in the inflationary 1970s and the high real interest rates experienced in the 1980s (as central banks used high money rates to bring inflation under control). In both cases, the real rate adjusted to nominal rate - a violation of the Fisher Equation.
The equation is suspect in other ways. If investors expect upcoming inflation, their best course of action is to purchase inflation-protected assets (such as property and equities) and durable commodities right now. This brings forward any anticipated price rise to the present, well before investors have a chance to embed an inflation premium in their demands.
Furthermore, holders of money - which pays no interest and therefore no inflation compensation - would be wise to switch from money into bonds or other interest-paying assets rather than hold an asset with a value undermined by inflation.
The effect of such a portfolio rebalancing is to raise the price of non-money assets. In the case of bonds, this lowers yields - the opposite of the outcome predicted by the Fisher Equation!
Without the Fisher Equation, central banks cannot really be sure their policy moves have the expected effect. But even with it there is uncertainty - for some economists (and the president of Turkey) the Fisher Equation counterintuitively implies that lower interest rates lead to lower inflation.
It gets worse! In the corn world, saving and investment are inseparable. Unless corn is left to rot, saving corn (by not eating it) implies investing it (by planting it). The corn interest rate is entirely unambiguous in its effect.
But in our world, investment and saving decisions are not made in this way. Consumers might want to save more but this fall in sales is not going to make business want to invest more. Saving and investment can get out of line in ways not possible in a corn world.
Even the relevance of interest rates is questionable. Investment is not like planting corn - new capital goods such as buildings, factories, roads, and software are produced, marketed and sold just like any other good.
Therefore, the balance between new capital goods supplied and demanded can be met by shifts in their price, quite independently of interest rates. An investment boom can be choked-off by increases in the price of new capital goods, without any change in interest rates. Low interest rates cannot compensate for a total lack of new profitable investment opportunities.
The central bank’s actions potentially affect economic activity in many ways (or “transmission channels”). Paradoxically, these channels not only reflect the power of monetary policy but also uncertainty about how it actually works. Hence US Federal Reserve chairman and father of Quantitative Easing (QE), Ben Bernanke felt compelled to confess “the problem with QE is it works in practice, but it doesn’t work in theory”.
Unfortunately, the corn world provides only questionable insights into monetary policy and doubts about its efficacy are unsurprising.
James Culham is Director, Institutional Portfolio Management at ANZ