Friday, February 13, 2015

What do Central Bankers Want?

Scott Sumner asks if central bankers are more concerned with the bond market than the labor market.

My theory of central banker behavior is to minimize the increase in short term interest rates subject to the constraint that neither unemployment or inflation rise to high.

So, that is different from being worried that long term interest rates will rise,  creating capital losses in bond markets.   A series of small increases in short term rates should immediately depress long term bond prices if anticipated.  

In the old days, a liquidity crunch would cause a spike in short run interest rates.   This would be really bad for money center commercial banks (who borrow "hot" money,) as well as investment banks borrowing short to fund their inventories of securities that they have underwritten and not yet sold.

Central banks have not forgotten.   Avoiding spikes in short term rates is their key mission.

Now, they have learned that never increasing short term rates can be a disaster in some circumstances.   Inflation might rise too high.   While this is bad because of voters and politicians don't like high and especially higher inflation, it is also true that when they are finally forced to respond to the inflation, they must hike short term rates.   A series of small and modest interest rate increases now is better than much larger increases later.

And, of course, they have learned that when they finally act to choke of the inflation, unemployment will rise and voters and politicians hate that as well.

So, raise interest rates a smaller amount now each month and keep it up.   While that is "bad" compared to leaving interest rates the same, which is ideal, waiting until inflation picks up and interest rates must rise alot and unemployment will rise--so much the worse.

While this theory provides no explanation of why central bankers don't like lower short term rates, I think there the problem is almost entirely a worry that they will be forced to raise them latter.

They don't mind lower interest rates, but they don't really see it as a  good thing, but if they must raise them latter, that is really bad.

Of course, presumably they understand that failure to lower interest rates when needed can lead to rising unemployment, which voters and politicians hate.   And so, they do need to lower interest rates sometime.

Basically, the ideal is for short term interest rates to stay constant.   And when that troublesome economy forces them to adjust them to avoid unemployment or inflation, they will do so.   And a series of modest changes is better than sudden changes.


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