It seems like the belief that low interest rates cause bubbles is all the rage. Its superficially such an obvious relation “low rates” means “easy money” which means people “bid up” assets and hey presto instant bubble.
Unfortunately, its all wrong. What really causes bubbles is too much saving. For a given level of technical progress, an economy has an optimal capital stock. We define the the optimal capital stock through its equilibrium condition: there is no productive investment (which can be made by the private sector) which has a risk adjusted return which is better than zero.
Now of course, in the real world there is always new innovation, and replacing deprecated capital, so we would really expect the optimal (real) rate to be slightly above zero. Nevertheless, zero real return on capital is where an economy wants to be, where it strives to be. However, the optimal stock is not fixed, it is in fact rapidly changing. New technology can create new possibilities for investment, or it can render old capital irrelevant. The new tech industries are much less intensive than the old “heavy” industries that they are largely replacing. Nevertheless, this capital stock represents the maximum stock of savings that can be carried into the future. If people want to save more than this, they have no choice but to invest in assets with a negative real rate of return.
Real capital investments are funded by foregoing consumption in the present in order to get more later. This is what the interest rate asks, it says, how much extra consumption do you need in the future to persuade you to forgo consumption now, so that we can build this useful investment. The more people want to save compared tot he optimal stock of assets, the more negative the real rate of return must become. The more the real rate or return becomes negative the more “bubbles” people will see.
There is really only one possible strategy for this, and it amounts to aligning the stock of capital investments with peoples desire to save. This is possible because:
(1) Often capital investments are inhibited by real world factors like unstable government, poor human capital, poor infrastructure. Stabilising Africa and parts of the IndoChina region would offer plenty of investment opportunities.
(2) Government funded spending. There are plenty of productive investments that only a government can make, and through either higher taxes (on those who over-save – the rich) or higher deficits (providing more safe assets). These include: Education – the state of UK and US public education is a joke, and severely inhibits future productivity; Infrastructure – some projects are simply too large for the private sector to undertake; Regulation – the UK house market is a typical example, where poor government regulation prevents housing stock being built at the required pace; Free trade – this is a little less obvious, but take for example, US energy protectionism (preventing the export of shale gas), this prevents the optimal level of investment in shale technology, by keeping the price artificially low. On the other hand, it raises the risk premium for investing in oil and gas outside the US (as it could be made unprofitable through an arbitrary regulatory announcement), which reduces investment outside the US aswell. Essentially, people aren’t stupid – they will not invest in a product which depends purely on regulatory trade barriers unless they are convinced that they are here to say.
(3) Transfer payments. By transferring income from those with a high propensity to save (rich people/middle class) to poorer people, you lower the overall savings rate.However, this is not likely to be too effective in a UK/US centric view, as most of the excess savings appear to be coming from Japan, Germany and China as a response to their coming demographic disasters. UK particularly does not suffer from excess savings
Any time the total quantity of saving is in excess of the total stock of capital, a bubble is guaranteed, by draining savings out the system through government investment, we get higher total productivity, higher interest rates for savers, and fewer bubbles. Win Win Win?
Endogenous money has been used to represent several slightly different things. In this post I am referring to the way in which a central bank moves the short term interest rate by controlling the money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government bonds.
This means that for any non zero short term interest rate, given a set of real factors in the economy, there is only one possible size of the monetary base. If you control interest rates the base is endogenous. Once the short term interest rate hits zero, this relationship breaks down, and once can expand the monetary base without lowering the short term nominal interest rate. That is the situation in which we find ourselves.
Now, my question is, when we raise interest rates off the zero lower bound, surely we will reenter the regime of endogenous money, in which case surely it is impossible to raise rates without at least partially unwinding QE?
It might seem obvious that the Fed can put upwards pressure on the interest rates while holding the monetary base constant by selling long treasuries and buying short ones, but that is not the case. Provided there are a large amount of excess reserves, any attempt to raise the short term interest rate above the interest rate paid on excess reserves (IOER), will result in money moving out of reserves into the short term treasuries, they being essentially perfect substitutes as a risk free interest bearing form of money.
This brings me onto forwards guidance. Many people have said that forward guidance is largely pointless. I wish to point out here, that as the economy strengthens, and spending increases, the quantity of base money consisted with a given non zero interest rate increases. Thus, the date of the first rise in interest rate wholly determines how much of the QE base expansion is permanent and how much is temporary. It is widely known that temporary expansions in the base are not inflationary, this also tails nicely with the apparent decreasing effectiveness of QE. If forward guidance means you think you know the MB at the date of the first interest rate rise, QE over and above that will do little. The only question is, are we there yet? The reaction of the stock markets to the taper talk in may strongly suggests that they believe that the US economy is not yet strong enough to withstand a tightening of policy.
In conclusion….I don’t know if I really believe the argument set out above. It seems to me, when I look at the comparative GDP paths of US, UK and EZ, or 1990′s Japan vs 2013 Japan, that those countries which have done more QE have better GDP growth. Economies are to complicated to be able to guarantee that we always have a concrete transmission mechanism and 100% understanding of the consequences of policies. For all that, it does not seem obviously wrong, and it does trouble me, and suggest that th eexit from QE may be harder than some in central banking assume.
The QE debate has spawned a renewed interest in the transmission channels of Central Banking. For a long time through the Great Moderation, all central banks were using the interest rate channel, and that alone was sufficient. In fact, so successful has this channel been, that people seem to have forgotten the other transmission channels. The diagram below summarises the traditional transmission mechanisms of central banking, courtesy of Mishkin:
These channels are separated into three broad channels, interest rate, other asset price effects, and the credit channel. In my view there is at least one more channel that should be mentioned explicitly, and that is expectations. However, expectations are implicit in nearly all of the channels. Even in the interest rate channel, expectations for the ten year yield often start falling dramatically even before the Fed cuts rates, since expectations of recession fuel expectations of a rate cut, and can ease policy dramatically even before the Fed takes any “concrete steppes”. It is for this reason that Lars Christensen and Scott Sumner continually say that Monetary Policy works with “long and variable leads”. Indeed, in the run up to the financial crises one could argue that the Fed’s decision to leave rates on hold at 2% in mid 2008 represented such a passive tightening compared to expectations, which led to a spike in the ten year yield. I would not argue thus, arguing quite the reverse, that the Fed’s belated cut to 2% showed the Fed was “taking it seriously” and this raised expectations of future growth, At that point perhaps most actors were still foreseeing a garden variety recession, then in late 2008 it all started getting worse again and long rates plunged and expectations fell. Then QE came along and raised them again. Let me note again for clarity, that I do not believe this argument, but if you think that the interest channel is the primary channel of monetary policy, as reflected in the long rates, then you must believe that the Fed tightened policy relative to expectations in mid 2008 when it lowered the Fed Funds rate to “only” 2%. My only point here is to shine a light on the difference in interpreting the effects of monetary policy moves. Market monetarists believe that lowering the fed funds rate always and everywhere leads to higher NGDP expectations and hence higher ten year rates.
At any rate, the main point of this post was to look at transmission mechanisms for QE. The first and most important thing to notice is that QE does not work by “holding down interest rates”. In fact it has the reverse effect. Every episode of QE has been associated with rising interest rates. To many people it seems “obvious” that buying securities “must” hold down the rate, so let us reflect on this, and the general unreliability of interest rates as a measure of, well, anything. Firstly, it is the case that ten year rates are highly correlated with expectations of NGDP growth. This is because if I expect ten years of 5% NGDP growth, then I can obtain 5% nominal growth risk free by buying a portfolio which is representative of the “whole economy”. Admittedly this is not likely true in practice, but any risk free security should be priced according to this ideal. Thus rising real rates are correlated with higher real GDP in the future. We should therefore conclude that if QE leads to rising nominal long rates, then it is because one of the other transmission channels overwhelms the interest rate channel, and leads to rising rates based on recovery expectations despite the headwinds that a rising interest rate has on growth. Indeed, some support was given to this view by a careful analysis of correlations between gdp growth and long interest rates by the econtrarian - which showed that rising 10 year interest rates are strongly correlated with GDP growth.
Of course, it can be even more complicated than that. After all, the stimulative effect of low interest rates is driven by the difference between the current cost of capital and the Wicksellian real interest rate. As David Glasner has pointed out, if rising demand causes the Wicksellian rate to rise, the stimulative effect of low interest rates can rise even as long rates rise, if they rise less slowly, and it is perfectly consistent to believe that. I.e., to believe that QE does hold down rates relative to the counter factual where stimulating the economy was achieved through some other channel than buying securities.
Now there are several channels through which QE may effect the economy. The first is that by holding down MBS relative to other corporate credit, it has lowered mortgage rates and this has supported the housing market and allowed households to refinance at lower rates and so supported consumption. The second are portfolio balance and wealth effects, and the final one is the signalling effect(into which I group changes in inflation expectations).
The first of these needs little explanation, but there is some evidence that this has been a major factor. A recent Jackson Hole paper (this I think – same authors anyway), one criticism I would level is that their event analysis on QE announcements is very short term, and so misses the dominant narrative to liquidity effects. Nevertheless, by looking at many different channels, they find that QE has had a lot of small effects which adds up to quite a big effect, and it is an excellent paper for illuminating the many different effects that QE has in the economy.
Portfolio re-balancing effects are the Fed’s fancy name for what Scott Sumner calls “the hot potato effect”. Suppose that the public, in general, have some preferred portfolio of assets. If you go and buy some assets, you take them out of circulation, however, whoever you bought them off must now hold more cash than he desired. Said investor will now try to get rid of his excess cash by buying something else (either consumption or another asset). However, in aggregate the public cannot “get rid” of their cash, so they must return to their preferred portfolio through a complicated series of transactions that ends up, eventually, in the adjustment of prices. Part of this adjustment involves bidding up asset prices, in the expectation that in the new equilibrium there will be more spending, and hence a higher nominal return. We can see this in action in this graph of corporate profit forecasts in Japan, produced by Pragmatic Capitalism
Asset prices rise, because they forsee a future in which spending is higher, and hence revenues and profits are higher. Note that we expect this to be both nominal and real improvement, if the economy was at capacity already before QE was undertaken, we would expect only a rise in the price level, and no rise in output, with developed economies still far from capacity, we forsee both a rise in real output and a moderate increase in the price level, both of which drive corporate profits higher. (As previously pointed out QE does not actually improve corporations nominal financing position).
This is exactly Hume’s age old thought experiment about doubling the amount of gold in circulation will eventually double all prices and lead to no one being better off. Similarly, the creation of cash drives the economy towards a new equilibrium where every economic actor holds cash in the exact same proportion that they did pre-expansion. The process of adjustment is not guaranteed to be quick, but by controlling the stock of money the Fed can control the end point. Note that since M2 >>> Monetary Base, it requires incredibly large proportional expansions in base money to “make up for” quite small declines in lending. It was a failure to appreciate this point that has led to chronic deflation in Japan: Lars Christensen produced this scary graph:
We can understand this immediately by looking at the Japanese Money supply – the central bank made no attempt at all to offset the sharp departure from trend growth in the money supply, and the result was chronic deflation. Some of this was hidden by the divergence of the CPI and the GDP deflator shown above.
Note that since the money expansion in 2002 was expected to be temporary – money growth was restricted in the years following QE, and indeed, in 2006 the BoJ raised interest rates, as inflation was getting out of control, it almost reached one percent – it had little effect on the CPI. Indeed, the Japanese Phenomenon is best understood as BoJ targeting zero percent inflation in the CPI, which is exactly what it achieved.
We should also note that, quite apart from the portfolio affects listed above, higher equity prices makes investment cheaper. Not all investment is funded through bonds, and many actors prefer not to be over-leveraged, and so they may issue equity capital instead of bonds. Higher equity prices stimulate investment through this channel also. There may also be a “wealth effect”, in that those saving for pensions may save less on seeing their portfolio grow in value, and lower saving rates lead to more consumption.
Finally, we get to signalling effects. Signalling effects on real interest rates are important, because they help to shape future expectations. The Evan’s rule, in which they promised not to taper until unemployment reached a certain threshold resulted in a larger move in yields than either of the previous rounds of QE, as it helps shape expectations of future fed policy. In particular, if you as an individual have a worse expectation than the market consensus you will expect more asset purchases, which will moderate up your view of future growth, and so it acts like a positive feedback measure on expectations. Moreover, since expectations of future demand are exactly what drives investment now, raising expectations can have concrete effects in the present. I will write more on the expectations channel in a future post.
In conclusion then, I think that QE works neither through “holding down long rates” as some old style Keynesians apparently believe, nor through “expanding bank lending”, but through expanding the cash base of the economy, which leads to higher expectations of future nominal growth, and hence, more investment in the present. Added to this are the small but not negligible effects of holding down mortgage rates relative to other securities to allow cheaper refinancing, and the direct effect of rising wealth on consumption, mainly through a reduced saving rate for retirement by both persons and corporations (do not forget that low long interest rates make defined benefit plans much more expensive).
It didn’t exist. No Seriously. There was no boom in housing construction.
The constructing in US housing was exactly what was needed to maintain the housing-population ratio in the face of increased population growth. You cannot have an “unsustainable boom” without oversupply. If you are building exactly the amount that you need, and prices are rising anyway, it is the very definition of a sustainable boom.
Its true that housing prices rose and then fell, but they fell exactly the amount that you would expect when there was a peak to trough fall in national income. What does that prove except when people are poorer they will pay less for housing. A change in prices is never the cause of anything, it is always the result of something. The correct way to reason is not “why did an asset crash cause a recession” it is “what caused asset prices to crash”.
Aggregate demand is the only story. The world’s central banks let it fall off a cliff in 2008, when they could have prevented it, purely because they were focused on inflation and forgot about nominal income. They assumed that because, historically, inflation and NGDP had been pretty well correlated, that controlling inflation would automatically control aggregate demand at a healthy level. They, in fact, made exactly the mistake that others accuse banks of having made – that they showed too much trust in their theory and didn’t have enough prudence. If the central banks had been watching aggregate demand, this recession could have been a non event.
So there has been a lot of chatter on the blogosphere about “where is all the inflation” that QE was supposed to be generating. Frances Coppola thinks QE may be deflationary. FT Alphavilla commentator Kaminska seems to have a similar view. A lot of people think that the purpose of QE is to generate higher inflation, which I am not convinced is possible in the current environment. This post sets out my view.
I never expected either deflation or inflation. My view is that we have suffered a deflationary shock, and in a frictionless environment prices and wages would have fallen rapidly to reflect the new, higher, price of money. Along with plenty of painful defaults. However, that is not the world we live in. Prices are downwards sticky, and as a result, we have had a protracted unemployment crises. There are two ways for this to end, either the central bank, perhaps in concert with fiscal agencies, ups aggregate demand (spending) to the point where wages are sufficient to purchase all output at the given value of money, or prices fall until wages are sufficient to purchase all output at the given level of spending.
I should briefly mention what I consider a deflationary shock to mean. In essence, if you define Say’s Price of Money as Potential GDP/NGDP , then you get the value that money would have to have in order to purchase all of the output (i.e. enforce Say’s Law), at the given level of spending. Any time this value rises sharply, you are in a deflationary shock. So Deflation = Falling NGDP.
The US is currently doing both, slowly. QE has raised NGDP, at least compared to the obvious counter-factuals of 1990s Japan and the current Euro Catastrophe. Thus, NGDP is rising, and wages are falling, and when they meet, then QE will become inflationary, until they meet (at the level sufficient to purchase all output), wages will keep falling as fast as they can (until the output gap has closed). Thus, a need for QE precludes it from being inflationary. It is not an accident that headline inflation in the EZ and in the US are very similar despite vast US QE.
The point here, is that for as long as spending is insufficient to purchase all output, wages will adjust downwards as fast as they can, given sticky wages, until the given level of NGDP is sufficient to purchase all output – i.e. the output gap is closed. The easy way to reduce the output gap is to increase spending. If you do too much, you get a little inflation, but that is a small cost compared to the trillions of dollars of lost output. Since inflation will remain stuck to the floor, the effect of QE is to bring forward the point at which the output gap has vanished by raising NGDP. Thus, our expectations for future inflation should look like this:
To ask, “when will this happen” is to ask when will the output gap close, for the US, at current rates, we are talking about a decade:
All in all, I am amazed that anyone things the FOMC is going to taper purchases at this meeting. They are more likely to expand the programme than to taper it in my view.
UPDATE: BB does not Taper, will do so when unemployment falls to 7%, maybe.
I always feel that these hearings are usually nothing more than a chance for political leaders to
grandstand portray their ignorance. It is usually always easy for a technical expert to come up with an answer which sounds impressive while not really saying a lot, and that most people will be unable to decipher. However, there was one great question, by Klobuchar, which deserved a follow up. (This was well covered by Yglesias):
[Mr Bernanke]… what would you have done differently under a single mandate to target inflation
and Ben Bernanke hummed and hawed and said, essentially, that he would have done nothing differently. This seems a pretty damning indictment of BB’s policy really, if, with unemployment high and inflation consistently below target, you are not going to take the opportunity to do extra stimulus to lower unemployment, what exactly is the point in a dual mandate?
The dual mandate exists because central bankers have known since forever that a little bit of extra demand, which usually creates a little extra inflation, is helpful in lowering unemployment. This is the wisdom of the Philip’s curve, which, for all its flaws, at least underlines the truth that very low inflation is nearly always correlated with high unemployment.
Of course, perhaps BB was aiming an under the radar shot at his FOMC hawks: I mean, with the board that he has, perhaps he is unable to force through policy that is expansionary enough for him to feel that he his fulfilling his legal mandate, but he could have chosen to put forwards the hawk’s argument, which would be that excess stimulus would not help unemployment fall any faster. This is a nice argument for this type of hearing, as there is clearly some empirical limit on how fast unemployment can fall – no matter how expansionary, the Fed could not restore full employment in one day. I am completely certain that it could do a hell of a lot better than it is doing, but I accept that falls in unemployment of more than 2% a year are fairly implausible. And if they attempted that they really might cause some inflation.
Nevertheless, I cannot help but think that BB’s decision to say nothing was itself an overtly political statement about his feelings on the manner. He is required to go and defend Fed policy, even if he was on the losing side of the FOMC consensus. Just as Mervyn King is forced to talk about how the committee feels there the “costs and risks” of further QE outweigh the benefits, even though we know he voted for more QE.
Finally, we can speculate on some nice follow up questions that I might have asked:
BB, do you believe that a more expansionary policy would cause unemployment to drop faster, while keeping inflation expectations steady?
He would almost be forced to answer yes, and now he would be in a really tight spot, then we could ask
BB, given that you believe that expansionary policy would bring down unemployment faster, while maintaining inflation expectations, do you believe that your policy is legal?
Could ask this instead:
BB, it is my understanding that the dual mandate exists because of the well known relationship between higher inflation and lower unemployment. Thus, logically, a dual mandate must lead to higher inflation than a single mandate whenever unemployment is significantly above its natural rate. Do you agree?
Or how about this one:
BB, which members of the FOMC do we need to impeach to enable you to legally fulfil your mandate?
Wouldn’t that have made great TV!
So I did not follow these in particularly great detail, but one thing did catch my ear. Senator McCain accused Apple of pernicious practices which violated the “spirit of the Law”. I really have no time for this argument. If they are interpreting the Law in a manner which the courts uphold as justified, then they are in the clear. In fact, I would say that it is an excuse that politicians use for writing law that is so riddled with contradictions and conflicts as to be essentially garbage.
It is literally the job of legislators and lawmakers to write laws which are clear, concise, and unambiguous. It is a basic requirement of competent government, that the powers that be should be capable of writing Law that does what then intend for it to do. Claiming that a company “violated the spirit if not the letter” is just having a tantrum because you aren’t willing to admit your own incompetence. Its childish and disingenuous.