The central banks’ manipulation of interest rates is a prominent tool, reported daily in the press.  Now the world’s attention is on the actions of the US Fed, an anticipated announcement to raise rates a smidgeon on December 16th.

Bradford DeLong writes about the economic doctrines propounded since the beginning of the global financial crisis  put forward by John Taylor, an economist at Stanford.  Taylor claims the post-crisis economic policies being carried out in the United States, Europe, and Japan are putting a ceiling on long-term interest rates that is “much like the effect of a price ceiling in a rental market where landlords reduce the supply of rental housing.” The result of low interest rates, quantitative easing, and forward guidance, Taylor argues, is a “decline in credit availability [that] reduces aggregate demand, which tends to increase unemployment, a classic unintended consequence.”

Taylor’s analogy fails to make sense at the most fundamental level. The reason that rent control is disliked is that it forbids transactions that would benefit both the renter and the landlord. When a government agency imposes a rent ceiling, it prohibits landlords from charging more than a set amount. This distorts the market, leaving empty apartments that landlords would be willing to rent at higher prices and preventing renters from offering what they are truly willing to pay.

However, when a central bank reduces long-term interest rates via current and expected future open-market operations, it does not prevent potential lenders from offering to lend at higher interest rates; nor does it stop borrowers from taking up such an offer. These transactions don’t take place for a simple reason: borrowers choose freely not to enter into them.

So how does Taylor arrive at his analogy? My intuition is that his reasoning has become entangled with his beliefs about the free market. Taylor and others who share his view probably begin with a sense that current interest rates are too low. Given their belief that the free market cannot fail (it can only be failed), they naturally assume that some government action must be behind the unnaturally low rates. The goal then becomes to figure out what the government has done to make interest rates so wrong. And, because any argument that treats government action as appropriate can only be a red herring, the analogy to rent control emerges as one of the possible solutions.

Given real economic conditions, European and American monetary policy is not too loose; if anything, it is too restrictive. The “natural” interest – what would be ground out by the Walrasian system of general equilibrium equations – is actually lower than what current monetary policy is producing. Yes, the inertial expectations of the economy have combined with monetary policy to distort interest and inflation rates, but not in the direction that Taylor is proposing. On the contrary, compared to what is needed (given the current state of the economy) or to what a free-market, flexible-price economy in proper equilibrium would deliver, interest rates are too high and inflation is too low.

There is indeed something wrong with today’s interest rates. Why such low rates are appropriate for the economy and for how long they will continue to be appropriate are deep and unsettled questions; they call attention to the “dark corners” of economics, where research has so far shed too little light. What Taylor and his ilk fail to understand is that the reason interest rates are wrong has little to do with the policies put in place by central bankers and everything to do with the situation that policymakers confront.