We always knew that interest rate targeting could never work in theory, because it left the price level indeterminate. But it seemed to work well in practice, and kept inflation close to target, so we eventually learned to overcome our theoretical squeamishness and embrace it as part of the reality of how modern central banks operate. But now interest rate targeting has failed in practice, and failed badly. It cannot keep inflation, and expected inflation, on target. We want to loosen monetary policy. And because monetary policy is interest rate targeting, we can't, because interest rates on safe liquid assets are already at zero.

OK, this is probably the weirdest post I have ever written. I am going to argue that interest rate targeting is not what central banks really do; it's a social construction of what they really do. Interest rate targeting is not reality, it's a way of framing reality.

That was weird enough, but I'm now going to get really weird. The failure of monetary policy is not caused by anything central banks are actually doing; it's caused by central banks' way of framing what they are doing, and by the rest of us accepting that same framing. The current recession was caused by those (and that includes especially central bankers themselves) who think that central banks use an interest rate as the control instrument. It's the framing of what central banks do that caused the mess, not anything central banks are actually doing. The social construction of reality is what dunnit!

Let me give an example of what I mean by "framing". It would be quite conventional to say that the Bank of Canada sets an overnight rate target as a function of various indicators, including inter alia the exchange rate. Write that reaction function as i=F(S,I), where i is the overnight rate, S the exchange rate, and I a vector of other indicators. Now, just invert that reaction function and write it as S=G(i,I). Exactly the same thing mathematically, but see how the framing has changed. Now the Bank of Canada is targeting the exchange rate as a function of various indicators, including inter alia the overnight rate. The Bank of Canada is doing exactly the same thing, but the account it gives of what it is doing, the framing, has changed radically. And the Americans would get mad at us if the Bank of Canada targeted too low an exchange rate!

Now here's a real-life example of how the Bank of Canada has changed the way it frames monetary policy, and why framing matters. The Bank of Canada used to construct and publish a "Monetary Conditions Index" which was a weighted average of the overnight rate and exchange rate. And it would talk about what was happening to the MCI whenever it changed the overnight rate target. This did not mean it kept the MCI constant over time. It would adjust the overnight rate target and so adjust the MCI whenever it felt that the indicators warranted it. But the Bank of Canada eventually stopped publishing the MCI, and stopped talking about the MCI, because it found the MCI interfered with the Bank's "communications strategy". People were thinking of the stance of monetary policy in terms of the MCI, and the Bank wanted people to think about the stance of monetary policy in terms of the overnight rate target.

When it stopped publishing and talking about the MCI, the Bank wanted to change the framing of monetary policy. And it succeeded, even though anyone with a calculator can construct the MCI from public data.

As any philosopher or sociologist can tell you, the way reality is socially constructed can have real effects. "I may lawfully nourish myself from this tree; but the fruit of another of the same species, ten paces off, it is criminal for me to touch. Had I worn this apparel an hour ago, I had merited the severist punishment; but a man, by pronouncing a few magical syllables, has now rendered it fit for my use and service..." says David Hume. (One fruit tree is on his land, the other isn't; the guy said he could buy the clothes). When one man body-slams another, is it a fight or a hockey game? A British visitor can't always tell the difference, and not because his eyesight is any worse than the Canadians who know how to frame what they are seeing. One framing causes a cheer; the other causes a call to the police.

How could a stranger, with good eyesight and a time series graph of all macro variables, really tell which one of those variables the Bank of Canada was targeting? OK, there is a way, if he has a very high-frequency data set. The stranger would notice that the overnight rate tended either not to move, or else move in discrete jumps, about 8 times a year. But if Fixed Announcement Dates were held monthly, or weekly, or daily, or hourly, the stranger would see nothing. In the limit, with continuous FADs, the "fact" that the Bank of Canada targets the overnight rate would be only a socially constructed "fact". Since I don't think hourly FAD's would make much difference to policy, especially under current circumstances, when nobody expects the overnight rate to change anytime soon, I think I'm safe in saying that interest rate targeting is at least 95% a social construction of reality.

A socially constructed reality, like who owns what, is a game-theoretic equilibrium held in place by players' shared expectations of how each would react to an out-of-equilibrium move, something they never of course observe in equilibrium. They follow the rules because of what they think would happen if they didn't.

A given time path of overnight rates would be highly inflationary under one set of expectations about inflation and real output growth, and highly deflationary under another set of expectations about inflation and real output growth. A time path of interest rates cannot measure the stance of monetary policy. A time path of interest rates does not define a coherent monetary order. An interest rate reaction function, with feedback from expectations to the time path of interest rates, might define a coherent monetary order. (Equilibrium would be maintained by players' shared expectations of what would happen out of equilibrium.) We thought it did for a decade or two, but events have proved us wrong. We have hit the zero limit where it can react no further, so all we have left is the time-path itself, rather than a reaction function.

If expectations of monetary policy coalesced around the time path of some nominal variable (one with $ in the units), we could escape the liquidity trap. Just let that time path for the nominal magnitude grow over time at a fast enough rate and the equilibrium overnight rate will rise above zero. If monetary policy were framed as the central bank setting some nominal variable, expectations of monetary policy could then coalesce around that variable, monetary policy would be loosened, and the overnight rate, as some endogenous response to monetary policy, would rise above zero. Under an alternative framing, a loosening of monetary policy would mean an increase in the overnight rate.

But we are stuck with framing monetary policy as setting an interest rate. So there is no way the Bank of Canada can try to say that an increase in the overnight rate counts as a loosening of monetary policy. Because given the way expectations are determined by the framing, it would be a tightening of monetary policy. The Bank of Canada is fettered by its own social construction of what it is doing.

Oh hell, it's late. I'm posting this anyway.