Back to Friedman and Interest Rates

In a famous paper, written exactly 41 years ago, Milton Friedman argued that “the role of monetary policy” (this is the title of the article published in 1967) should not be analyzed with the interest rate as an instrument – or THE instrument of monetary policy. Well, after four decades of debate, what is happening all over the world – including Brazil and the United States – seems to indicate that Friedman was right.

Central Banks control the nominal interest rate, but do not control the so-called real interest rate (nominal interest rate less some good measurement of inflation) or do not control the local interest rate from the point-of-view of a foreign investor which is based in another currency, or even do not control the interest rate from the point-of-view of a holder of some specific stock or some specific commodity. Even worse: the correct technical thing here would be to write “expected” inflation, “expected” devaluation, “expected” change in the stock price or “expected” change in the commodity price. Central Banks do not control future expectations.

In consequence of this reasoning, either in Brazil or in the United States, raising nominal interest rates could mean lowering real interest rates – and vice-versa – particularly considering the substantial differences between “nominal” and “real” in the realm of the future: the world of formation of expectations, perceptions, and anticipations.

The supposed instrument of monetary policy “nominal interest rate” might affect either inflation or economic growth or the balance-of-payments in totally different directions, depending on expectations about inflation, devaluation, stock prices, commodity prices, real estate prices, etc.

It seems that we are now in 2008 going back in Economic History exactly to that period when Milton Friedman wrote and read his famous piece in front of the American Economic Association: the late sixties and the seventies. Since 1965, higher nominal interest rates in the USA – not to mention Brazil – meant nothing, because inflation was very high – often with two-digit on an annual basis – all over the world. I wrote the Brazilian chapter of a book called exactly “Worldwide Inflation”, published by the Brookings Institution in 1975. At that time, brilliant new economists like Lucas and Sargent were discovering the importance and rationality of expectations and calling attention to the false nature of the dilemmas between inflation and unemployment (the Phillips Curve) together with older economists such as Friedman and Edmund Phelps.

For various reasons, between 1982 and 2007, interest rates regained prestige as monetary policy instruments, closely related to the development of inflation target models under floating exchange rates, as well as papers the significance of Central Bank independence. After some lost years (1982-1988) during the world adjustment to the 1979 oil crisis and the Volcker interest rate shock (1982), there were around 20 years of easy life, with great progress and low inflation all over the world, from the USA to emerging markets, including the emergence of market socialism in China and State capitalism in India and Russia, particularly in the nineties and the beginning of the XXI century.

Perhaps all this “good life” is over. We are back to the sixties and the seventies and need to read Milton Friedman again – as well as forgotten names like Hyman Minsky – to review again the role of monetary policy (and fiscal policy). Do we need a new Paul Volcker in the USA? Do we need a new Plano Real (1994) in Brazil?

The rates of growth of money and credit are exploding in many industrial and developing countries. Consumers and borrowers all over the world do not seem to care about higher nominal interest rates, because their expectations about the prices of the goods and assets they are buying are becoming more and more inflationary. It is a new chase between nominal interest rates and inflationary expectations – just like in the sixties and seventies.

If Bernanke in the USA or Meirelles in Brazil decide to raise further interest rates, they might begin to send the wrong signals for “the chase”. Inflation will not stop. Commodity prices will continue to go up. Higher nominal interest rates will be interpreted as expectations of high inflation by Central Banks. Just like the popular music: You watch me watching you. Financial markets and Central Banks. Fed watchers and financial market watchers.

In our opinion, we are back to a situation where a Brazilian Minister (Mario Simonsen) defined two types of economic policy in the sixties: gradualism versus shock treatment. Gradual changes in interest rates (up or down) will not solve the economic and financial crises anymore. Perhaps we need a shock treatment. A once-and-for-all interest rate change – to zero or to 20%. (And continue to save banks to avoid systemic risk and 1929).

But we are basically talking about Western Hemisphere countries with normal legal contracts in the financial world. What is going to happen in the next few months in Russia, India or China? Not to mention the clear risk of war in the Middle East between Israel and Iran. Great emotions, imperfect thoughts.

We are seriously running again the risk of a worldwide inflation of two-digits on an annual basis, probably equal to the sixties and the seventies, coupled with a level of recession, probably much greater than 1966-1976 – and unfortunately much closer to earlier periods of the last century. Difficult times. I confess I do not know the right solution, but I feel that a shock treatment is needed in the Volckerian style – even if this means bringing interest rates down once-and-for-all, and not up. I have the impression that low interest rates (close to zero) in all important countries will stop the acceleration of inflation and avoid a great recession. But this has to be a coordinated effort, including USA, Europe, Latin America and Asia.

Supply and demand will take care of commodity prices and stock prices. Should Barack Obama call Volcker and Lula call Delfim Netto and Pastore? They can solve the problems of the new century, but I fear that Bernanke and Meirelles cannot. We need to control the supply of money and credit, and not necessarily produce two-digit interest rates. Just remember Brazil between 1980 and 1994, when nominal interest rates had three-digit or even four-digit numbers, but inflation and devaluation were running at more than 100% per year, reaching during the nineties more than 1000% per year (or 1% per day).

6 Responses to "Back to Friedman and Interest Rates"

  1. Robert Fay   June 25, 2008 at 1:47 pm

    Are you suggesting that one should control the money supply rather than interest rates? Don’t you think that it is hard (if not impossible) to accept that money is all exogenous?

  2. Andrew Balley   June 25, 2008 at 1:49 pm

    Why do you think that Bernanke can’t solve the 21st century problems in the Fed?

  3. Vitoria Saddi   June 25, 2008 at 1:52 pm

    Antonio Carlos,Great piece. I love that Friedman that you mention. But I do remember reading Simonsen and the choice b/w gradualism and shock was only the choice b/w heterodox and ‘ortodox’. That’s all he meant. He never said that it was the choice bw hiking interest rates to 20% or decreasing to 0%. What do you mean? Do you really believe that this action will solve anything?

  4. Lemgruber   June 26, 2008 at 4:55 am

    Comment on the First Three Comments:Robert Fay: I was just trying to indicate that Central Banks do not control real interest rates, but I agree that money has endogeneity. Perhaps one should review again the whole discussion (Friedman again) about fixed exchange rates and the gold standard.Andrew Bailey: Yes, Bernanke is highly competent as an academic economist. But perhaps we need something else (more) at the Fed – a new Volcker.Vitoria: I apologize for a paragraph that was either confuse or incomplete. I am in favor of shock treatments, once-and-for all measures either orthodox (Volcker) or heterodox (Plano Real in Brazil). My incomplete paragraph did not clarify my basic point which is: either we go to 0/1% or to 16/20%, but there is no middle-of-the road solution at this point in time. Only shock treatments will solve, but financial institutions deserve special attention to avoid 1929-1933 (there were good ideas in Brazil in the nineties, including PROER, FCVS, etc.)Lemgruber

  5. Guest   June 27, 2008 at 4:01 pm

    It is simply too early to call for radical – unnecessarily panicky – measures…

  6. Guest   November 4, 2008 at 11:23 am

    Not clear, Not up to date with the new monetary theory, just ridiculous what you wrote. If you are insecure about those alternatives, you should remade your Phd…