Central Banks can target short term interest rates no matter what

Robert Waldmann

Paul Krugman asks a rhetorical question which I dare to answer. He is still considering Kocherlakota’s argument that low interest rates imposed by the monetary authority must cause deflation.

“First of all, if inflation isn’t sticky, how is it that the Fed can set short-term interest rates at all?”

Second of all, there is a short-term nominal interest rate which the Fed can set no matter what — the discount rate. If the Fed loans at some interest rate, then the Fed loans at that interest rate. Second, I think the Federal funds rate has to be no higher than the discount rate*. Why pay a bank more when you can get a loan for less straight from the Fed.

So what happens if there is high inflation and the the central bankkeeps the discount rate low ? Banks borrow lots and lots of money from the central banks so the money supply increases. This can’t be prevented by open market operations. Even if the central bank’s only asset were loans to banks, the money supply can still be huge and rapidly growing.

This is not a hypothetical. From 1918 through 1923 the Reichbank’s discount rate was low (3.5% IIRC). The result was not deflation.

* update: My thought that the Federal funds rate had to be no higher than the discount rate was incorrect (thanks Ken Houghton). The federal funds rate used to be higher than the discount rate. I don’t understand exactly why except that borrowing from the Fed was a sign that a bank was in trouble. My main argument stands, although the Fed might have to both keep the discount rate low and change some aspects of its discount window policy which I don’t understand to achieve a hyperinflation.

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