The US Fed cut rates by 25 basis points on November 7. This is after an earlier cut by 50 basis points in September. How useful are such changes in interest rates by the Fed? Not much, actually!

This may seem very surprising but it is true. And, it is not about a particular decision or a particular central bank. The difficulty is more basic and much deeper. It applies to the Reserve Bank of India as well.

At present in India, we have significant cost-push inflation due to the high food prices. This is a serious problem but there is an issue even in the absence of such difficulties.

We are familiar with the basic trade-off between low and stable core inflation, and “full employment”, which is faced by any central bank. So, the prevailing interest rate policy is, by its very nature, not very effective in maintaining macroeconomic stability. But this is not all.

The prevailing interest rate policy has adverse side-effects for asset price stability. Think of the 46 per cent fall in prices of “safe” US long-term government bonds as a consequence of a rise in the yields from about 0.5 per cent in 2020 to about 5 per cent in 2023.

Also, the central bank policies have implications for international capital flows and exchange rate stability.

The dollar-yen exchange rate touched a 34-year low level at about 160 in July 2024 when the Federal funds rate in the US had been increased to more than 5 per cent and the Bank of Japan interest rate was barely positive. The story is not just about ineffectiveness and side-effects of the policy.

There is an issue of distribution as well. We are familiar with near zero interest rates for the pensioners and others for many years after 2007.

Paucity of tools

There are some other difficulties as well. What to do? The basic problem is that the central bank has a paucity of policy tools. So, the solution must include new policy tools — outside of the central bank.

This brings us to the possible role of the Ministry of Finance (MoF) or the treasury in setting the interest rates right.

This may seem awkward as we are used to the idea that the central bank alone can correct the market interest rates. This seems intuitive and obvious.

But we need to be flexible in our thought process. The focus here is on just one aspect of the interest rate policy, which is the effectiveness of the policy for macroeconomic stability. Note that though the monetary policy and the interest rate policy by the central bank are related, the two are not identical.

Base money factor

Monetary policy is about changes in reserve money (base money) while interest rate policy is about changes in interest rates. It is true that a change in base money can imply a change in interest rates but this is not the complete story.

At present, interest rates are determined by three factors: financial and non-financial conditions in the debt market, savings and investment in the real economy, and changes in base money by the central bank. The third factor is the concern here.

Consider an alternative scenario wherein the MoF uses a tax-subsidy scheme for correcting the market interest rates.

The idea is that the MoF gives a subsidy on investment when we have a recession or the inflation rate is lower than the targeted rate. Such a subsidy can lower the effective, net of subsidy, interest rate so that aggregate demand gets a push in the real economy.

And, the MoF can impose a tax in an unhealthy boom or when the inflation rate is higher than the targeted rate. Such a tax can increase the effective interest rate and thereby decrease the aggregate demand in the economy. It is true that there can be political pressures on the formulation of the proposed tax-subsidy scheme.

Advisory body

However, it can help to constitute an independent advisory body, which can provide advice that is somewhat mandatory to follow. A precedent or a parallel is the role of a body like the Finance Commission in India.

A similar body can be set up for the purpose of the proposed interest rate policy. The MoF can use the proposed tax-subsidy scheme for two purposes. One is to negate the effect of changes in base money by the central bank on the interest rates and the other is to set the interest rates right.

Consequently, interest rates will be affected by the following three factors now: financial and non-financial conditions in the debt market, savings and investment in the real economy, and the proposed tax-subsidy scheme. Note that the third factor is different from what we have seen earlier under the prevailing policy. In other words, in principle, changes in base money no longer matter for the interest rates under the proposed policy! This is important. Given that changes in base money no longer affect the interest rates, the central bank can use base money as a policy tool in its own right. So, we have two (main) distinctive policy tools now.

One is base money with the central bank and the other is the proposed tax-subsidy scheme with the MoF for correction of the interest rate. So, the public authorities can deal with two objectives viz., low and stable inflation, and “full employment”. There is then, in principle, no trade-off in macroeconomic policy. There is, of course, much more to the story here.

The whole story is told in this author’s forthcoming book, Macroeconomics and Asset Prices — Thinking Afresh on Basic Principles and Policy. To conclude, the prevailing policy intervention is not very effective and it is blunt. It also affects distribution. The innovative policy proposed here has several virtues.

This article has shown only that the proposed policy is more effective in maintaining macroeconomic stability than the prevailing policy. It is hoped that a change in mindset does not become a serious obstacle here.

The writer is an Independent economist