If you think that the rest of the economy is normalised, so it is time to normalise interest rates too, you are wrong. If the rest of the economy is normalised, then interest rates must already be normalised.

Wicksell said there was some underlying "natural" rate of interest. If the central bank sets a rate of interest below the natural rate this would cause inflation; and if the central bank set an interest rate above the natural rate this would cause deflation. So any central bank that wanted to stabilise the price level should aim to set the actual rate of interest equal to that underlying natural rate of interest. And the actual rate of interest would need to be (roughly) equal to the natural rate on average over any extended period of time if we wanted price stability.

We haven't advanced much since Wicksell. The only important thing a Neo-Wicksellian would add is that it's important to distinguish between nominal and real rates of interest (real = nominal minus inflation), so if we have a 2% inflation target we add 2% to the natural rate to get the "neutral" nominal rate. And the actual nominal rate would need to be (roughly) equal to that neutral nominal rate on average over any extended period of time if we wanted to keep inflation stable at 2%.

You can see how this matches the idea of "normalising" interest rates. We've got "normal" both in the sense of an average over time, and in the sense of a desirable norm that central banks should aim for.

But when I hear the words "The Bank of Canada (or some other central bank) needs to normalise interest rates soon" I reach for my shovel. Let me try to tell you why.

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