If there is one zombie myth that needs to die in 2013, it is that low interest rates and bond yields in Canada and the United States constitute loose monetary policy. On the surface, the idea makes sense – if the Bank of Canada loosens monetary policy by lowering the target for the overnight rate (a type of interest rate), then low interest rates must mean loose policy.
This idea suffers from problems beyond erroneously treating the overnight rate and interest rates as synonymous. In his 1968 essay The Role of Monetary Policy, Milton Friedman warned us against this kind of thinking when he stated “[a]s an empirical matter, low interest rates are a sign that monetary policy has been tight-in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy-in the sense that the quantity of money has grown rapidly.”
A quick examination of either the history of the overnight rate or the history of bond yields quickly puts an end to the idea that low rates mean loose policy. The overnight rate during the high inflation period of the late 1970s and early 1980s was often well in the double digits, yet inflation would not fall below four percent until the end of 1984. The five year mortgage rate was also in the double digits during this period and would not fall under eight percent until 1993. Nobody would describe the late 1970s as a period of tight money, so the high interest rates=tight money theory fails this test.
Imagine for a moment that you live in Zimbabwe, where monetary policy was so loose it caused a hyperinflation. What level of interest would you need to be willing to lend money? Despite the fact that money is being printed by the boatload, you would want to earn at least enough interest to cover the expected inflation. Otherwise you would not bother lending – you would be better off converting the dollars into a physical asset such as gold. This is exactly what happened, as inflation rates went well over 800 per cent before the entire lending system broke down. Under the mistaken myth that low interest rates equals loose monetary policy, interest rates should have fallen to zero.
There are a number of economic indicators that will assist in judging the current stance of monetary policy, including the expected inflation rate, forecasted nominal GDP growth rate and the growth rate of the M2 money supply. Interest rates, including the overnight rate and bond yields, tell us lots about past policy, but little about current policy.