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.

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.

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%.

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.

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.

If you want to argue against some view, as I am doing here, it is usually a good strategy to try to state what that view is. This is my best guess:

'The economy was humming along normally, with the Bank of Canada setting the actual rate of interest roughly equal to the natural rate of interest, so the output gap was roughly zero, and inflation was roughly at the 2% target. Then the financial crisis happened, so the output gap turned negative (a recession), and inflation started to fall below target. So the Bank of Canada needed to cut the actual interest rate below the natural rate temporarily to offset the recession. But now the economy has recovered, with the output gap back to roughly zero, and inflation roughly on target, it is time for the Bank of Canada to normalise interest rates, by raising them back up to the natural rate again.'

I don't want to quibble with the details of that view -- whether the output gap really is zero, or whether inflation really is back to target -- because the only difference that makes is whether we should normalise now or wait a few more months. I want to attack the idea of "normalisation" itself.

1. The natural rate of interest is a moving target. What was normal in the past won't be normal today or in the future. Almost anything that changes desired saving or investment, both in Canada or globally, will change it.

2. The natural rate of interest is a target we can't see, except looking backwards; we can see (roughly) where it was in the past, by looking at past output and inflation, but we can't see where it is now, and where it's going to be in the future.

3. The natural rate of interest is a target that moves when we miss it; even worse, it tends to move even further away from where we thought it was.

4. There is not just one natural rate of interest, because there is not just one actual rate of interest. There are many rates of interest, depending on the liquidity, risk, and term, of the financial asset in question. Each of those many rates of interest has its own natural rate, and the spreads between them will change over time.

5. But it's the bit I bolded above that shows what is really wrong with the "normalisation" view: "So the Bank of Canada needed to cut the actual interest rate below the natural rate temporarily to offset the recession."

Here's an alternative way of viewing the world: something (the financial crisis) happened that caused the natural rate to fall suddenly. The recession happened because the natural rate fell more quickly than the Bank of Canada cut the actual rate, so the actual rate was above the natural rate. Now that the economy has recovered from the recession, with the output gap roughly zero, and inflation roughly at target, this means that the actual rate of interest is roughly equal to the natural rate of interest. Normalisation of interest rates has already (roughly) happened. The new normal is not the same as the old normal. And what is normal next year, and the year after, will probably be different again.

If the natural rate of interest really were a constant that never changed over time, or always changed slowly and predictably, it would make sense to talk about "normalisation" of interest rates. But then recessions would only happen if central banks suddenly decided to raise interest rates above the unchanged natural rate.

If we had some sort of crystal ball, however imperfect, that could tell us what the natural rate was, it might make sense to talk about "normalisation" of interest rates. But we don't. We can only look at output and inflation to try to surmise where the natural rate is. If the output gap is zero, and if inflation is on target and looks like staying there, we can only surmise that the natural rate must be whatever the actual rate currently is.

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.