Thursday, October 21, 2010

Milton Friedman and the Interest-rate Fallacy

David Beckworth and William Ruger wonder what Friedman would say about Fed policy under Bernanke. Excerpt:

“First, low interest rates do not necessarily mean monetary policy is loose.

Friedman criticized the policies of the Fed in the 1930s and the Bank of Japan in the 1990s on this very point. Both central banks claimed to be highly accommodative at these times, pointing to low interest rates as evidence of easy monetary policy. Friedman countered, however, that low interest rates may reflect a weak economy rather than easy monetary policy.

Back in 1997, in fact, he called the idea of identifying low interest rates with easy monetary policy an interest-rate fallacy. The only time low interest rates do indicate loose monetary policy is when they are below the neutral interest-rate level, which is the interest-rate level where monetary policy is neither too simulative nor too contractionary and is pushing the economy toward its full potential.

The implication for today's Fed is that although its target federal funds rate is low, its stance still may not be very stimulative given that the neutral interest rate is also low. The Fed should not rely on the level of the federal funds rate to measure the stance of monetary policy to determine whether its actions are supporting or hindering the economy.”

Read their article in Investors.com.

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