Nominal Illusion: Are People Understanding Real Versus Nominal Interest Rates?

Before the last couple of years, inflation had been low (and reasonably steady) for long enough, it wouldn’t be surprising if even important economic actors now didn’t fully understand that for economic decisions, they should be paying attention to real interest rates, rather than nominal interest rates.

Take the tech sector, for example. There are many possible reasons for the end of the Second Tech Boom that Noah Smith talks about here. But higher interest rates are not a good reason, unless someone, somewhere, despite having a high IQ, fails to understand real versus nominal interest rates. Whatever the business model for monetization that a tech company pursues, the revenues—and ultimately profits—from that monetization should go up an extra amount from any general rise in prices. So for a venture capitalist, what should matter is what the interest is compared to inflation. The interest rate compared to inflation can be calculated as the usual concept of the interest rate—what economists call the “nominal” interest rate—minus the inflation rate. The usual nominal interest rate minus inflation is called the real interest rate. You can see the equation above. “r” stands for the real interest rate, “i” stands for the nominal interest rate and the symbol for pi stands for the inflation rate. (In economics, the symbol pi doesn’t always stand for 3.14159… It is more often the traditional symbol for the inflation rate, and only occasionally stands for 3.14159.)

There is no indication that the real interest rate is going to be all that high in the future. I have been tweeting that the Fed might well have to raise rates to 7% by sometime in 2023, which would be a considerably higher rate than the market seems to expect. But with core inflation running at 6.3%, that would be a real interest rate of only 0.7%. (“Core inflation” is the rate of changes in prices other than food and energy prices. The reason to take out food and energy prices is that they bounce around so much that what they do in any given month can mislead you about what it means for prices in the next few months.) I wouldn’t be surprised if a higher level of national debt (as measured in years’ worth of Gross Domestic Product) raised the long-run real interest rate somewhat compared to its very low rate so far in the 21st century, but that increase should be less than 1%. A long-run real interest rate of, say, 2% is a real possibility, but I’d be surprised to see any higher than that in the US during the next two decades.

The logic above applies to other real assets as well. For example, machine tools are used to produce goods whose price should go up along with other prices. So it is the interest rate compared to inflation—the real interest rate that should matter. That real interest is low, so it is a good time to buy a machine tool unless the price of machine tools is temporarily elevated compared to other prices.

Except for one wrinkle, it is even a good time to buy a house, as long as the house’s price isn’t so high that its price is likely to fall compared to other prices. If a house’s price will go up along with prices in general, the the inflation part of the interest rate you are paying will get recouped as nominal capital gains when you sell.

The wrinkle is an institutional one: the speed at which you are expected to pay back a fixed-rate mortgage is faster when the nominal interest is higher, even if the nominal interest rate is higher only to make up for inflation. “Fixed-rate” could have been—and should have been—defined in terms of real rates, but it isn’t. Traditional adjustable-rate mortgages also ask people to pay back the loan faster if the nominal interest is higher because of inflation. In either case, the same real rate with higher inflation means that someone with a mortgage has higher mortgage payments and builds up home equity faster (as long as the house price goes up along with other prices in the economy). In a high-inflation environment, the typical fixed-rate mortgage has a large component of forced saving to it. Not everyone can swing that high a level of forced saving, so housing demand gets crushed in times of high nominal interest rates, even if the real rate is low. Economists call the cash crunch when a high level of forced saving causes real hard ship a “liquidity constraint.” Liquidity constraints interact with the traditional form of mortgages to make it hard for many people to buy a house. This is unlikely to change any time soon because it scares people to see the nominal value of their mortgage go up, which is typically needed to keep mortgage payments low when inflation is high.

Let me challenge you to notice when you read the news or listen to what people are saying to look for places where people are forgetting the value of looking at real rather than nominal interest rates—or equivalently, where they are forgetting the ways in which a general rise in prices might make an investment in something real more attractive.

Brad DeLong Confirms that Not Having Negative Interest Rate Policy in the Monetary Policy Toolkit Makes People Afraid of Vigorous Rate Hikes to Control Inflation

In my September 5, 2022 post, “How a Toolkit Lacking a Full Strength Negative Interest Rate Option Led to the Current Inflationary Surge,” I write:

  • Thinking falsely that it couldn't fall back on negative rates, the Fed was too slow and timid in raising rates for fear that it didn't have the firepower to quickly reverse a recession if it went too far in raising rates.

In his Project Syndicate op-ed “When the Fed Stops Trying,” Brad DeLong confirms that this concern is on his mind, and indicates he thinks it has been on the mind of policy-makers in the Fed. Here are some key quotations from that piece, separated by added bullets:

  • Biden’s team knew that if the reopening inflation shock was too large, it could easily trigger an overreaction from the US Federal Reserve. That, eventually, would put America back in a semi-depressed or depressed state of secular stagnation, with little policy traction to respond to the next crisis or to promote a recovery.

  • The situation was thus analogous to Odysseus sailing between Scylla (a multi-headed monster) and Charybdis (a massive whirlpool). The Biden administration could either not try to navigate the strait at all (the first mistake), or it could try its luck with Scylla (secular stagnation) and Charybdis (stagflation).

  • Not without reason, financial markets seem to be betting that the Fed is about to make mistake number two: pursuing policies that will likely drag the US back toward secular stagnation. If past is prologue, we eventually will return to a scenario in which monetary policy is stuck at the zero lower bound. The economy may suffer another lost half-decade of growth, and socially and politically destabilizing inequalities will become even more pronounced.

In the last passage, Brad makes it clear the “secular stagnation” means being stuck at the zero lower bound. But of course, there is no zero lower bound. The idea that interest rates cannot be cut below zero, or cannot be cut very far below zero, is inside-the-box thinking—and the box is made of only flimsy material. The more I have worked on the details of how to best implement deep negative rates, the clearer it becomes that it is an available policy option. You can see the details in the resources laid out in my bibliographic post, “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.” (You can always get there by clicking on the “NEG.RATES” button at the top of this blog.)

Also, despite West Virginia v. EPA, the authority of the Fed (a) to buy and sell Treasuries and (b) over its own reserve accounts needed to implement negative interest rate policy are so clearly authorized by statute, I believe the Fed, under current law, has the authority to implement deep negative rates along the lines of “How the Fed Could Use Capped Reserves and a Negative Reverse Repo Rate Instead of Negative Interest on Reserves.” (I am currently writing an article with a law professor, intended for a law review, making this case.)

Note that, as things stand, the likely timeline for needing negative rates allows plenty of time to lay out a monetary policy strategy including negative interest rates as part of the toolkit before we will need to actually implement negative rates.

Right now, one of the main objections people might make to negative interest rate policy is “You have to be kidding! How could you be talking about negative interest rates when inflation is so high. We need big interest rate hikes, not negative rates.” That is true as far as it goes, but I am arguing that the Fed’s slowness to raise rates is partly due to its fear that it doesn’t have the tools to deal with a serious recession. That raises the cost of raising rates too much—by a lot. The Fed will be scared to with inflation vigorously and promptly unless it also has the tools to deal with deflation. Imagine driving on a mountain road with a sheer drop to your right. Wouldn’t that increase the danger that you would hew to close to the middle of the road and collide with oncoming traffic? Or to take Brad’s analogy, if we know we can disarm and defang Scylla with negative interest rate policy, then we can steer far away from Charybdis.

A Portrait of Larry Summers

This article gives a good sense of the Larry Summers that I know—particularly how much he loves a good intellectual discussion from almost any starting point. Having Larry as one of my professors in graduate school and watching him during breaks at conferences gave me the view (which I still hold), that the most important economics is what happens in the hallways on those breaks (and often beyond, as those in a good discussion play hooky from the next formal talk). I draw from that premise the conclusion that the purpose of economic models is to train our intuition so that we are well prepared for such free-wheeling discussions.

Chimamanda Ngozi Adichie's Advice on the Benefits of Failure

I ran across this article (“Protect and Value the Truth”) about a wonderful talk by author Chimamanda Ngozi Adichie. Here are my favorite quotations from her that are given in the article. I separated them by added bullets:

  • It is hard to tell ourselves the truth about our failures, our fragilities, our uncertainties. It is hard to tell ourselves that maybe we haven’t done the best that we can. It is hard to tell ourselves the truth of our emotions, that maybe what we feel is hurt rather than anger, that maybe it is time to close the chapter of a relationship and walk away. And yet, when we do, we are the better off for it.

  • Be courageous enough to say ‘I don’t know … Ignorance acknowledged is an opportunity; ignorance denied is a closed door. And it takes courage to admit to the truth of what you do not know.

  • You cannot create anything of value without both self-doubt and self-belief. Without self-doubt, you become complacent; without self-belief, you cannot succeed.

  • Your story does not have to have a traditional arc.

Donald Yacovone: How Ubiquitous History Textbooks Taught White Supremacy →

The details in the book excerpt linked to above are telling.

One very troubling idea, but one that might have too much truth to it, is that an outgroup is necessary to generate unity in an ingroup. Donald Yacovone asserts:

… if no slaves ever existed in the South, Northern white theorists, religious leaders, intellectuals, writers, educators, politicians, and lawyers would have invented a lesser race (which is what happened) to build white democratic solidarity, and in that way make democratic culture and political institutions possible. As one of our greatest authors, Toni Morrison, once explained, in the United States the rights of man were “inevitably yoked to Africanism.” In other words, American democracy depended on Black inequality to sustain white equality.

Jonathan Haidt talks about “groupishness” as one mode of being human. Groupishness makes us act very well towards the ingroup and badly toward the outgroup:

As Rob Henderson says, "A psychopath is a person who treats their ingroup the same way that normal people treat their outgroup."

I hope that having an outgroup is only a shortcut to getting ingroup solidarity and not an absolute necessity. It may require an advance in social cohesion technology to have any better way.

Current Information Provision is Inadequate: Let's Put Salient Warnings on Alcoholic Beverages

Alcohol causes health harms of the same order of magnitude as tobacco, but health warnings on alcohol are much less salient than those on tobacco. It is past time to rectify that. The New England Journal of Medicine “Perspective” piece shown above has useful points to make. Here are some passages, separated by added bullets:

  • … alcohol consumption now accounts for more than 140,000 deaths per year in the United States, or more than 380 deaths per day. The Covid-19 pandemic has exacerbated alcohol-associated harm in the United States, with alcohol-related deaths increasing by 25% during the first year of the pandemic as compared with the previous year.

  • In addition to the data on fatal and nonfatal injuries resulting from acute intoxication (including injuries caused by motor vehicle crashes), mounting research links longer-term alcohol consumption to chronic diseases including hypertensive heart disease, cirrhosis, and several types of cancer.2 Even light or moderate drinking increases the risk of these conditions, particularly cancer.2

  • Warning labels are most effective when they are displayed prominently on the front of product packaging, include pictorial elements such as photographs or icons, and rotate the content of their messages to avoid any one message becoming “stale.” A randomized trial involving 2149 smokers, for example, found that large, front-of-pack, pictorial warning labels for cigarettes increased smoking quit rates by 50% (from 3.8 to 5.7%) over 4 weeks as compared with smaller, side-of-pack, text-only warning labels.4 Similar benefits have been documented in longitudinal studies examining smoking behaviors after countries implemented well-designed cigarette-package warning labels and in quasi-experiments evaluating grocery purchases after implementation of prominent front-of-package warning labels for unhealthy foods and beverages.

  • The current alcohol warning in the United States lacks all the key elements of evidence-based warning design: it uses small text, typically appears on the back or side of product packaging, and doesn’t include any pictorial elements (see figure). The warning message is also static, having remained unchanged since the label was first implemented more than three decades ago.

  • … when large, pictorial warnings about cancer risk were temporarily added to the front of alcohol containers in some stores in Yukon, Canada, alcohol sales dropped by 6 to 10%.5

The pleasing idea that a little alcohol is good for health has done a lot to maintain a positive image for alcohol. Unfortunately, that idea is false. I lay out one of the most telling pieces of evidence damning alcohol in “Data on Asian Genes that Discourage Alcohol Consumption Explode the Myth that a Little Alcohol is Good for your Health.”

Warnings are likely to substantially reduce alcohol consumption. And we should not stop there. It would help protect people if every instance of alcohol consumption was considered an indulgence and social disapproval of more than minimal alcohol consumption gradually increased.