Real Interest Rates and Central Bank Operating Procedures

In the years following the influential article of Poole (1970), many central banks reoriented their operating procedures to focus more on interest rates and less on monetary aggregates. The rapid restructuring of global financial markets was thought to have led to instability in standard monetary relationships, and Poole's basic insight suggested that a central bank would have better control of the price level if it targeted nominal interest rates instead of monetary aggregates. At the same time, there is a common perception that real interest rates have risen. This paper uses general equilibrium models to suggest that the switch in operating procedures may have caused a bias towards higher real interest rates and (rather perversely) less stable prices. Our model calibrations imply that US real interest rates might be 50 to 100 basis points lower, and prices might be 30-40% more stable, if the Fed switched its focus away from the nominal interest rate and targeted M1 instead. (These estimates assume a coefficient of relative risk aversion between 2.5 and 3.5.) Nominal income targeting would be a good compromise.