Plate viii in print

The Policy

the rate as an administered price: a committee sets the anchor of all rates, and the price of time becomes a decision steered toward chosen goals.

There is no rate the market simply finds; there is a rate the authority sets, and a natural rate it can only guess at — and the distance between the two is the whole of monetary policy.

— the thesis of this plate, after Knut Wicksell, 1898

Every theory so far has tried to say what determines the rate — impatience, the productivity of capital, the demand for money. The modern monetary economy has rendered much of the dispute moot in the most direct way imaginable: the rate, or at least the anchor from which every other rate hangs, is no longer discovered at all. A committee meets, deliberates, and votes; a number is announced; and the price of time is, quite literally, set. To ask what an hour of waiting is worth is, in the present economy, to ask what the committee decided.

The mechanism is no secret. A central bank controls the supply of the most basic money — the reserves of the banking system — and through that control it fixes the shortest, safest interest rate, the overnight rate at which banks lend reserves to one another. It does so by creating or absorbing reserves through open-market operations and, in the modern form, simply by decree, paying interest on reserves at whatever rate it chooses and so setting the floor for all the rest. The overnight rate is the foundation; every longer rate is built upon it, since a loan for a year is, in effect, a chain of overnight loans, and its rate reflects the expected path of the overnight rate across that year, plus a margin for term and risk. By fixing the short rate today and signaling where it will set it tomorrow, the central bank shapes the entire structure of interest — the price of time across every horizon.1

1. The mechanism: the central bank controls bank reserves and so fixes the overnight rate, through open-market operations and, in the modern form, by setting the rate it pays on reserves; longer rates rest on the expected path of the short rate plus term and risk premia, so the bank shapes the whole structure. See plate xii, The Curve.

The orthodox defense insists that the bank does not really set the rate freely — that it merely tracks a natural rate, the rate that would prevail if the real forces of productivity and thrift were left to themselves, the rate consistent with full employment and stable prices. On this view the bank is a servant, discovering the natural rate and following it, adding nothing of its own. The trouble is that the natural rate, which Wicksell named and modern economists label r-star, cannot be observed. It is posted nowhere; it is inferred, with wide margins of error and only after the fact, from the behavior of inflation and output — if prices accelerate, the policy rate must have been below the natural rate; if they sag, above it. But this means the bank steers by a star it cannot see and must estimate, revising the estimate as the economy responds to its own past decisions. A discipline that can be known only from the consequences of departing from it cannot constrain the bank the way a posted price would; the bank that claims merely to follow the natural rate is, in practice, choosing where to point, and calling the direction natural.2

2. Wicksell's natural rate (Interest and Prices, 1898), the modern r-star: the rate consistent with stable prices and full employment, set by real forces. It is unobservable — inferred after the fact from inflation and output — so "following the natural rate" cannot discipline the bank as a market price would. See plate vi, The Natural.

It is worth recalling that this state of affairs is recent. For most of history there was no committee setting the price of time; rates were governed by custom, by usury law, by the supply of precious metal, and later by the discipline of the gold standard, under which a central bank's freedom to set rates was hemmed in by the need to defend its reserves. The deliberate, discretionary management of the short rate as the chief instrument of macroeconomic policy is a creation of the twentieth century — of the abandonment of gold, the rise of paper money backed by nothing but the state, and the assignment to central banks of responsibility for inflation and employment. The administered rate is not the natural condition of interest but a particular institutional arrangement, built within living memory, and it could in principle be built otherwise.3

3. The administered rate is recent: for most of history rates were governed by custom, usury law, the metal supply, and the gold standard, which constrained central banks by the need to defend reserves. The discretionary management of the short rate as the principal macroeconomic instrument is a twentieth-century creation, resting on fiat money.
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Here the inversion the whole table exists to make stands at its plainest. Classical theory presented the rate as a fact the market discovers — the price of time, thrown up by the deep real forces of impatience and productivity, which the economy reveals as it reveals any price. The monetary economy presents the reverse: the anchor of every rate is set by a public authority, in pursuit of chosen goals, and revised on a schedule. What looks like the objective price of time — the universe's exchange rate between now and later — is, at its foundation, a decision. The figure and the ground exchange places exactly as they did in the volumes of the wage and the rent: the central bank, conventionally cast as a humble servant responding to the market's natural rate, turns out to be the setter of the price; and the market rates that appear to discover the value of time are in fact reading the bank's decision, and the expectations of its decisions to come. The price of time measures, in large part, the judgment of a committee.4

4. The inversion: the rate is decided, not discovered; the figure/ground swap casts the bank as setter rather than servant, and "market" rates as readings of policy and of expected policy. It is the same reversal as the flagships of The Wage — the wage measures power, not worth — and The Rent — rent measures position, not contribution.

This must be said with care, for the strong version is false and the careful version is the powerful one. It does not mean the bank can set the rate anywhere it likes with impunity. It is hard-constrained by consequences: hold the rate too far below what the economy can bear, and inflation follows; hold it too high, and output and employment collapse. And over long spans the average level around which policy operates is shaped by real forces the bank does not control — the productivity of the economy, the age structure of its people, the world's appetite for safe assets — forces whose drift has pulled the whole structure of rates downward across recent decades, toward and even through zero. The claim is not that the rate is arbitrary, but that it is chosen within those constraints: that there is no single natural rate sitting in the world to be read off, only a policy decision, made under deep uncertainty, toward goals that are themselves chosen — and that no observation of the market rate can separate the real component from the policy one, because the market rate already contains the policy.5

5. The honest edge: the bank is constrained by inflation and by recession, and the long-run average level is shaped by real forces — productivity, demography, the demand for safe assets — that have pulled r-star down for decades. The claim is "chosen within constraints," not "arbitrary." See plate ix, The Zero.

The goals are worth naming, because they reveal what the price of time is now made to serve. The dominant modern framework directs the bank to set the rate so as to hit a target for inflation — most often two percent a year — leaning against the economy with a higher rate when inflation threatens and a lower one when it flags, in a pattern regular enough that economists describe it with simple rules. Under such a regime the rate is no longer even pretending to be the price that balances the impatience of savers against the opportunities of investors; it is an instrument, adjusted to govern the pace of prices. The price of time has been subordinated to the stability of the price of everything else — a reasonable arrangement, perhaps, but one that makes unmistakable that the rate is a tool held for a purpose, not a fact left to emerge.6

6. The inflation-targeting regime: the bank sets the rate to hit a target, commonly two percent, in a pattern approximated by policy rules such as the Taylor rule. The rate becomes an instrument governing the price level — no longer the equilibrator of saving and investment.
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And if the price of time is set by a committee toward chosen ends, the unavoidable question is whose interests the setting serves, for the level of the rate is not neutral among them. A higher rate rewards creditors and savers and guards the value of money — which is to say, it protects the wealth of those who hold money and are owed it; a lower rate relieves debtors and borrowers and quickens the hiring of the unemployed. To set the rate is therefore to adjudicate, every few weeks, a contest between groups: lender against borrower, the rentier against the mortgaged, the holder of bonds against the seeker of work. It is no accident that the institution entrusted with the decision is deliberately insulated from democratic pressure — made independent — precisely so that it may, when the two conflict, favor the stability of money's value over the relief that inflation would bring to debtors. That independence is among the most consequential institutional choices a modern society makes, and it is, beneath the technical language, a standing decision about whose side the price of time shall take.7

7. The distributive dimension: a higher rate favors creditors and savers and the value of money; a lower rate favors debtors and the unemployed. Central-bank independence insulates the decision from democratic pressure so that, in conflict, it may protect money's value. Setting the rate is thus a recurring verdict between creditor and debtor — compare The Wage and The Rent.

So the rate completes the lesson the family of prices was assembled to teach, and completes the trinity with which the table opens. The wage, the volume of labor found, is part worth and part power. The rent, the volume of position found, is the toll of a scarcity owned. The rate, this volume finds, is part real fact and part deliberate decision — and of the three it is the one in which the decision has become most explicit, most institutional, most openly a matter of authority: a number with a date and a vote attached, announced from a podium, taking a side. In none of the three is the price the fact of nature it appears; each is the residue of a contest the number is arranged to conceal — between worker and employer, between owner and the rest, between creditor and debtor. The price of time is simply the one where the concealment has worn thinnest, where it is no longer even denied that someone decides. The future is not discounted at a rate the universe supplies. It is discounted at a rate we choose — and the choosing, like every price in this family, is a verdict, and falls on a side.8

8. The trinity drawn together: wage (worth and power), rent (position), rate (fact and decision) — each a contested verdict rather than a natural fact, the rate being the one where the deciding is openly institutionalized. The remaining plates pursue the consequences — The Zero, The Discount, and The Curve.