On The Folly of Inflation Targeting In A World Of Interest Bearing Money


Ashwin Parameswaran over at Macroeconomic Resilience (image from Wikimedia Commons):

One of the little known facts of the history of monetary policy is that until 1994, the Fed did not actually announce interest rate decisions. Market participants had to infer rate changes from the Fed’s open market operations. This is just one example of how so many things we take to be natural and obvious are, in reality, relatively recent phenomena. In less than twenty years, the Fed has transitioned from near-opacity to an almost obsessive transparency. Another example of a relatively recent monetary policy doctrine that is now unquestioned is the doctrine of inflation targeting. The essential idea of inflation targeting is that people and firms should not have to think about the level and volatility of inflation when they make economic decisions. Inflation must therefore be kept at low and stable levels so that the long-run costs of unpredictable and uncertain inflation are minimised. As Mervyn King notes, inflation targeting has always been about improving the “credibility and predictability of monetary policy”.

However, in a world where money earns interest, minimising the uncertainty of macroeconomic policy does not equate to minimising the volatility of inflation. When all money bears interest, all that matters for those who hold money or bonds is the real interest rate earned on money and bonds. Given the fiscal stance and state of private credit growth, central banks should manage the real rate of interest such that rentiers do not capture a free lunch (i.e. real rates should not be too high) and there is no risk of a hot-potato/credit-bubble cycle (i.e. real rates should not be too low).

Money does not bear interest today because central banks pay interest on reserves. The primary reason why we live in a world of interest-bearing money is the gradual deregulation and innovation in financial markets over the last thirty years that triggered a shift from money to near-money assets.