What does normal monetary policy actually look like?

What are interest rates? This isn’t a trick question. Anyone following the news today would probably (and quite correctly) answer that they are a policy tool, used to control inflation. But historically speaking, using interest rates in this way is a relatively recent development. Tying them to an inflation target, even more so.

We know that ancient societies had their own interest rates, which were often fixed by law. In ancient Mesopotamia, interest rates were 20 per cent; they were 10 per cent in ancient Greece, and 8.33 per cent in ancient Rome. Michael Hudson, a professor of economics at the University of Missouri, said that “with our modern ways of thinking”, it is easy to imagine that interest rates fell over the centuries as financial risk diminished with the progress of civilization. After all, in more stable economies, creditors no longer had to protect themselves with exorbitant interest rates. But he thinks that a far more pragmatic explanation probably explains the change. 

Hudson points out that the Mesopotamians divided their currency into 60 – and charging 1/60 of the principal amount per month equates to an annual interest rate of about 20 per cent per year. In Ancient Greece, the normal rate of 10 per cent was probably tied to the common fractional unit of 1/10. The Romans used 1/12, which works out at a rather clunky 8.33 per cent. Looking back at these civilizations reveals that ‘ease of calculation’ was probably the main rationale behind interest rate policy. And it might feel iconoclastic, but some economists question whether ‘meeting an inflation target’ is a much better one. 

In his book, The Price of Time, financial historian Edward Chancellor argued that keeping interest rates low in an effort to meet an inflation target can have serious unintended consequences: whenever money is too easy, financial markets become unstable. And he is not alone in these concerns. Last month, former chair of the US Federal Deposit Insurance Corporation, Sheila Blair, said that “ultimately, higher rates will lead to a fairer, more productive and resilient economy”. 

In an article published in the Financial Times, she said that low rates can make economies less efficient by encouraging flows into “unproductive uses”, such as crypto, meme stocks and zombie firms. She recommended that we abandon zero interest rates for good, and rely less on central bankers to run the economy in the future. “Once we get through this transition [to higher rates], the Fed should fundamentally reassess its belief that a single-minded pursuit of 2 per cent inflation is good for the economy”.

Even more radical are calls for inflation targeting to be put in the hands of the government, rather than the central bank. One key argument for this is that higher interest rates distribute the costs of curbing inflation unevenly: studies show that the burden falls more heavily on those with debts – who tend to be younger and poorer in the first place. In an article last month, philosophy professor Alexander Douglas set out the argument for holding interest rates permanently to zero, and letting tax and spending policy do the work.

Douglas said that targeted consumption taxes on luxury goods could be used to slow demand and curb inflationary pressure, which would have the advantage of ensuring that “the most socially undesirable forms of spending are the first to be reduced”. This might sound neat (or dystopian depending on who you ask), but raises the prospect of governments manipulating tax and spending around election years. This contributed to the push for central bank independence in the first place. 

With central banks wedded to their inflation targets (and governments committed to supporting them), there is currently no prospect of such radical change. Yet in this tightening cycle, our attention has zoomed in: first, to meeting-by-meeting changes in the interest rate, and now to when rate cuts might arrive. Only by zooming out are we reminded that our idea of ‘normal’ interest rate policy is a relatively recent invention, and just how different ‘normal’ interest rates have looked over the years (see table). As the dust settles after almost two years of interest rate hikes, a broader perspective is no bad thing.