About those high interest rates

I’ve recently read lots of articles claiming that the emerging markets are being hurt by the high interest rate policy of the Fed.  Obviously they don’t mean short-term rates, which are near zero, but rather long-term rates.  But 10 year bond yields are 2.6%.  Since when does 2.6% 10-year yields prevent EMs from achieving prosperity?  Those are amazingly low interest rates.  Is there a model that explains why 2.6% 10-year bond yields cause an EM crisis, or are people simply making a correlation ==> causation argument?

Some might argue that while interest rates are a poor indicator of the stance of monetary policy; EMs are nonetheless being hurt by tighter Fed policy.  But if that were true then US NGDP growth should be slowing, whereas it has actually been speeding up slightly.  Don’t get me wrong, I think policy is too tight, and a slightly easier policy would help the EMs.  That’s true and that’s important. But that was even more true a year or two ago when EMs were doing much better.  So why have they done much more poorly in recent months, even as US growth has sped up?

Lars Christensen says EMs need to make sure NGDP growth stays fairly stable, and I agree.  He points to Colombia as a country that is responding in the correct way to the global EM confidence shock.

I’m also confused by the constant complaints that the Fed is changing its forward guidance.  It’s true that the Fed recently made its forward guidance a bit more specific, and it’s true that the forward guidance is far from optimal.  But they certainly have not made any major changes.  Here’s a typical report:

Its communication strategy has been less than stellar, however. A misstep last summer by former Chairman Ben Bernanke left the markets believing that tightening would come sooner than expected, while recent trends have shown that the Fed almost certainly will have to abandon its 6.5 percent unemployment rate target for beginning to consider interest rate hikes.

It did not “abandon” anything last month, it clarified that it would not raise rates until either inflation rose above 2.5% or unemployment fell well below 6.5%.  That’s a more specific guidance than the previous 2.5% inflation/6.5% unemployment threshold.  It’s not clear why the market was confused by this switch, it was entirely rational.  Before the market was uncertain what would happen in the scenario where inflation is 2% and unemployment is around 6.4% or 6.5%.  They didn’t know if the Fed would raise rates in that case or not.  Now the Fed has clarified things, they will not raise rates in that situation. No promise was reneged upon. Indeed it would be better if the Fed dropped the unemployment threshold entirely and went with inflation, or better yet NGDP. But things are slowly improving in the guidance area.


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30 Responses to “About those high interest rates”

  1. Gravatar of Jon Jon
    4. February 2014 at 07:14

    Market anticipated that many EM countries would drive their economy into the dirt by usibg monetary policy rules based on the exchange rate–sothey would tighten policy when the fed did despite unchanged conditions domestically.

    This is precisely what we saw unfold, so reaction seems very reasonable.

  2. Gravatar of Hafiz Noor Shams Hafiz Noor Shams
    4. February 2014 at 07:21

    I’m writing with a phone. So I apologize for the typos.

    I think the US tightening is affecting the financial side rather than the real economy. Yeah, I’m still separating the financial sector from the economy and calling the economy sans finance the real economy. The GDP growth itself is pretty respectable. It’s just the finance people have too much influence in the media, I think, and so, their concerns get aired pretty strongly and those concerns are mostly finance stuff and not the real economy.

    Yea, tightening is affecting the currency/current accounts but domestic demand itself is pretty strong. In fact, even for the current accounts, exports are doing so well that that itself is making the current accounts better.

    Some EMs like Malaysia are tightening up themselves because they are trying to address their household debt issues by making it harder to borrow. And rates are expected to go up mostly on demand-pull inflation. These have little to do with the QE taper itself.

    And many times, it’s an exaggeration/overreaction. The currency dropped by 1% and ohh god, it’s being reported like a currency collapse. Some EMs are no doubt have big issues but most of them, they’re doing alright.

  3. Gravatar of John Becker John Becker
    4. February 2014 at 07:40

    If we are encountering an Emerging Market problem right now, how come U.S. stocks are getting almost as hard? The Emerging Market Stock Index is down around 7.5% and the U.S. is down around 5%. Why is Japan doing so much worse than Malaysia? Japan has been the hardest hit in the last few days. None of this is making sense as an emerging market problem. Sounds like the problem is with the developed economies as much as emerging markets.

    As far as the actual emerging markets go, the problem is high inflation in well know trouble spots (Argentina, Russia, Turkey, and South Africa). I sold all my Emerging Markets ETF 2 years ago and I never should have bought it because too much of what is in there is companies from countries that are absolute crap. South Africa will continue its descent into being just another sub-Saharan African impoverished dictatorship. None of these countries have any hope of seeing the types of property rights and free markets necessary for businesses to grow on a worldwide scale.

  4. Gravatar of John Becker John Becker
    4. February 2014 at 07:42

    By the way, the VWO (Emerging Markets ETF is up 2.3% today. To make my point in the last comment better with financial data, over the past month, U.S. small caps have fallen about 1% more than foreign small caps.

  5. Gravatar of Bob Murphy Bob Murphy
    4. February 2014 at 07:46

    Scott I am not defending the article you quoted, but your response makes no sense. The quote says Bernanke made a communications mistake *last summer* and that it *will have to* abandon its target.

    In response you say that the Fed didn’t abandon any target or misstate anything *last month*. Do you see how that is confusing?

  6. Gravatar of John Becker John Becker
    4. February 2014 at 07:56

    Here’s a quote from a Forbes article that seems to be stating the argument that you were attacking.

    http://www.forbes.com/sites/steveschaefer/2014/02/03/why-panic-prone-emerging-markets-are-breaking-down-in-2014/

    “A confluence of factors is causing the emerging market panic. The first is the pull-back of stimulus in the U.S…Much of the capital that the Fed was infusing into the market through its bond buying flowed to emerging markets. With the Fed tapering off quantitative easing, that liquidity is drying up. In other words, no more easy money.”

    Here the author cites falls in currencies immediately following taper talk and taper announcements. He is right that there is a massive correlation between the start of taper talk in May 2013 and the fall in emerging market currencies and stocks.

    My question is how can he assert that the money from the Fed’s bond buying was flowing into emerging markets? The VWO moved from about 42 when the Fed announced QE3 to 44 when the Fed announced the coming of the taper in May. Where is the evidence of all this U.S. money flowing into the emerging markets? The U.S. stock market performed much better in this time period so couldn’t you argue that the Fed’s bond buying was putting more money into the U.S. than Emerging Markets?

  7. Gravatar of Lars Christensen Lars Christensen
    4. February 2014 at 07:56

    Scott,

    I think we need to focus much more on China to understand what is going on in EM at the moment.

    If we indeed had seen Fed tightening wouldn’t the dollar have strengthened much more than we have seen? I think it is notable that there has not been any real signs of dollar demand picking up. I personally fear that might happen, but so far so good. The weakness we have seen in recent days in the US stock market, however is correlated with a stronger dollar, but that is something that started to change in the end of last week and early this week. Initially we didn’t see anything like that. We however, have seen liquidity conditions (judging from money market rate) getting tighter in China for the past 6-8 months. That has coincided with the sell-off in Emerging Markets. I have talked about that in numerous blog posts. See here: http://marketmonetarist.com/2014/01/28/the-em-sell-off-and-china-as-a-global-monetary-superpower/

    The real concern to me is NOT weaker EM currencies. In fact we need to see currencies weaken if external softens due to the Chinese slowdown/monetary tightening. Unfortunately many EM central bankers don’t understand. The worst case is Turkey. See my discussion of that here: http://marketmonetarist.com/2014/01/30/the-sharply-rising-risk-of-emerging-market-policy-blunders/

    Anyway, Emerging Market central bankers should focus on nominal spending growth over the medium-term. For commodity exporting EMs like Brazil or Russia they should introduced what I have called an Export Price Norm pegging their currencies to the price of their main export (for example the oil price). That will ensure nominal stability. Hence, if Russia for example pegged the ruble to a basket of the dollar and oil prices then the ruble would automatically weaken if oil prices where to drop for example due to a monetary tightening in China. I have discussed this in a number of blog posts. See for example here: http://marketmonetarist.com/2013/09/22/ukraine-should-adopt-an-export-price-norm/

    Concluding, the EM sell-off only turns into a crisis for the Emerging Markets if central bankers tightens monetary policy in response to the currency sell-off. This is what New Zealand did in 1997 in response to the Asian crisis. NZ had recession. The Reserve Bank of Australia instead let the Aussie dollar weaken and growth was unaffected by the Asian crisis. See here: http://marketmonetarist.com/2014/01/31/four-graphs-em-central-bankers-should-study-lessons-from-two-reserve-banks-1997-98/

  8. Gravatar of Vivian Darkbloom Vivian Darkbloom
    4. February 2014 at 08:27

    The following Federal Reserve article has some nice graphs regarding capital flows to EME’s pre- and post- crisis. There were significant in-flow to EME’s and that in-flow was comprised primarily of portfolio investment. The Fed authors attribute this to a number of factors, one of which was the US “unconventional monetary policy” but they think the effect was not that great compared to other factors.

    If you take the EME performance (say VWO as proxy) since the Federal Reserve announced tapering, they have done much worse that the US markets.

    This is not about interest rate policy per se and I don’t think most of the critics of the Federal Reserve with respect to the effect it is alleged to have on EME’s attribute it to that.

    http://www.federalreserve.gov/pubs/ifdp/2013/1081/ifdp1081.pdf

  9. Gravatar of John Becker John Becker
    4. February 2014 at 08:33

    Good stuff Lars.

  10. Gravatar of ssumner ssumner
    4. February 2014 at 09:48

    Jon and Hafiz, I’m not seeing much evidence that the US tightened monetary policy to any significant extent.

    John, Good point about US stocks.

    Bob, I was referring to the 6.5% unemployment threshold.

    John, You quoted Forbes as saying:

    “A confluence of factors is causing the emerging market panic. The first is the pull-back of stimulus in the U.S…Much of the capital that the Fed was infusing into the market through its bond buying flowed to emerging markets. With the Fed tapering off quantitative easing, that liquidity is drying up. In other words, no more easy money.”

    Actually money was not easy, and the Fed doesn’t inject capital it injects money, and the money did not flow overseas it stayed in the US as excess reserves, and . . . well I guess that’s enough.

    I see you also question the money outflow argument. If capital was flowing out of the US we’d have a trade surplus.

    Lars, The China angle makes much more sense to me, as many EMs sell lots of commodities to China.

    Vivian, It it’s tapering, what’s the mechanism connecting tapering to EMs?

  11. Gravatar of Mark A. Sadowski Mark A. Sadowski
    4. February 2014 at 10:42

    “…Is there a model that explains why 2.6% 10-year bond yields cause an EM crisis, or are people simply making a correlation ==> causation argument?…”

    If so, where is the correlation?

    http://www.youtube.com/watch?v=Ug75diEyiA0

    I’ve done Granger causality tests on the US monetary base (i.e. QE) over the period since December 2008 and find that the monetary base Granger causes the real broad dollar index, the S&P 500, the DJIA, commercial bank loans and leases, the PCEPI, and 5-year inflation expectations as measured by TIPS. None of this should be terribly surprising from the standpoint of standard textbook monetary economics.

    I’ve also run such tests with respect to a variety of investment asset classes based on the claims of numerous financial analysts. I find that the monetary base Granger causes high-yield bonds, global equities, 3-month CD yields and 10-year T-Notes yields. The impulse response results show that QE significantly increases high-yield bonds (reduces yield), increases global equities, reduces 3-month CD yields and decreases 10-year T-Notes (increases yield).

    Of these, only the T-Note yield result is the opposite of what most financial analysts tell their clients, although this is entirely consistent with what standard textbook monetary economics predicts via term structure theory. The fact that US QE increases global equities is mostly attributable to the simple fact that US equities are a significant share of global equities.

    But there are lots (and lots) of things that the US monetary base does not Granger cause over the period since December 2008 that most financial analysts nevertheless insist QE has an effect on. In particular the monetary base does not Granger cause the price of gold, copper or crude oil, the Japanese Nikkei 225 index or emerging market equities. (To be specific, the measure of emerging market equities I looked at was Morgan Stanley Capital International (MSCI) Standard (Large + Mid Cap) Emerging Market Index.)

    Thus all of the turmoil being experienced in the emerging markets right now very likely has very little to do with what the FOMC has been deciding to do in the confines of the Eccles Building in Washington DC.

    P.S. I don’t think QE causes poor eyesight, male pattern baldness or halitosis either, but given that if you start with the conclusion that QE is bad, it’s pretty certain you’ll be able to find a reason to support your conclusion, it’s only a matter of time.

  12. Gravatar of benjamin cole benjamin cole
    4. February 2014 at 11:05

    Excellent blogging.

  13. Gravatar of Tommy Dorsett Tommy Dorsett
    4. February 2014 at 11:05

    Mark – I’d love to see you KO rick sentelli and deflate his paleo Austrian bubble on air with this data.

    On a serious note, if QE raises ‘riskless’ bond yields (by boosting NGDP expectations), then the entire edifice of the hard money Financial Stability Caucus on the FOMC (that posits QE=lower rates=bubbles) collapses under its own weight.

    On that score, Scott, how can we get Yichuan Wang appointed to the FOMC? See his most recent incredibly good piece where he blows the financial stability / hard money bubble poppers out of the fkn water:

    http://qz.com/171741

  14. Gravatar of Vivian Darkbloom Vivian Darkbloom
    4. February 2014 at 11:11

    “P.S. I don’t think QE causes poor eyesight, male pattern baldness or halitosis either, but given that if you start with the conclusion that QE is bad, it’s pretty certain you’ll be able to find a reason to support your conclusion, it’s only a matter of time.”

    Mark,

    “I don’t think QI cures poor eyesight, restores male pattern baldness, or eliminates halitosis either, but given if you start with the conclusion that QE is good, it’s pretty certain you’ll be able to find a reason to support your conclusion, it’s only a matter of time”.

    Confirmation bias is not a one-way street.

    That’s a friendly joke, Mark. 🙂

  15. Gravatar of James in London James in London
    4. February 2014 at 12:53

    Scott. Surely it’s not your interpretation of what the Fed is saying that matters, but the market’s interpretation? US equities and US bond markets (including TIPs spreads) are telling you the market thinks the Fed is tightening. The Fed is not a robot. It is a vehicle with a driver, and we have a NEW driver. And we don’t really know her well, or how good a driver she will be. The car is going in one direction at the moment, towards ending QE3. That’s a very big decision. She and ALL her co-drivers agree on it. There is no dissent. The previous driver had built up a lot of authority over the co-drivers, can she? It’s pefectly rational to be quite worried about this new situation. And that’s what US markets are telling you.

  16. Gravatar of Doug M Doug M
    4. February 2014 at 15:01

    Suppose you are the central bank of Argentina.

    Your currency comes under attack. You can do nothing, and allow the currency to devalue, or you can buy ARS, tightening the money supply, to defend your currency.

    Which is going to have a greater impact on “demand”?

    If you allow your currency to devalue, then half of your citizenry cannot afford to buy the things they used to buy. And your producers who import some fraction of their raw materials cannot afford to operate. There is a drop in real demand. I don’t know if there is a drop in “Nominal Demand” because people are still spending all of the money that they have, it just isn’t going very far.

    If you tighten the money supply, the demand shock is less shocking. If we define “tight money” as a contraction in AD, then the “easy money” policy is the “tighter” policy by the definitions used on this site.

  17. Gravatar of ssumner ssumner
    4. February 2014 at 15:44

    Mark, Thanks for that info.

    James. I certainly agree we should trust the market more than our own judgment, but that wasn’t my point. The problem is interpreting market moves. You seem to think it’s easy. It is easy when the moves are large, such as the 30% rise in the S&P last year. But when they are small, such as the 5% drop this year, it’s much harder to figure out how much is the economy and how much is other market factors. Again, I agree that expected NGDP growth may have slowed a bit recently, perhaps 0.1% or 0.2%. And that would be unfortunate. But I don’t see any big shifts going on. Perhaps the market will fall much more, then you can say “I told you so.”

    Doug, You said;

    “I don’t know if there is a drop in “Nominal Demand” because people are still spending all of the money that they have, it just isn’t going very far.”

    Don’t confuse supply and demand shocks. A demand shock boosts both prices and output. An expansionary monetary policy is a demand shock. Movements in exchange rates are not policies, they are effects of policies.

  18. Gravatar of Major_Freedom Major_Freedom
    4. February 2014 at 18:36

    “But 10 year bond yields are 2.6%. Since when does 2.6% 10-year yields prevent EMs from achieving prosperity?”

    Since they became dependent on lower yields than 2.6%!

  19. Gravatar of Major_Freedom Major_Freedom
    4. February 2014 at 18:38

    “Don’t get me wrong, I think policy is too tight, and a slightly easier policy would help the EMs.”

    It was loose money prior that hurt the EMs, such that more inflation now is perceived as the best solution.

    A good rule of thumb is that if you believe inflation is the answer to sluggish growth, then chances are the reason for the need for more inflation, is too much inflation prior.

  20. Gravatar of Doug M Doug M
    5. February 2014 at 00:51

    “A demand shock boosts both prices and output. An expansionary monetary policy is a demand shock.”

    We are looking are radically rising prices and radically falling output. What do you want to call that?

  21. Gravatar of James in London James in London
    5. February 2014 at 01:19

    Scott. I take your point re: the 5% fall in US equities, but 10yr Treasury yield and 5yr breakevens inflation rates have also fallen back heavily, also around the FOMC January announcement. Treasuries are down to September taper tantrum lows and 5yr breakevens even further. Bonds tend to “get it” before equities, so we’ll see indeed.

  22. Gravatar of ssumner ssumner
    5. February 2014 at 07:00

    Doug, I’d call that a supply shock. But you don’t get that from an expansionary monetary policy, which was my whole point. Again, currency depreciation is not a policy, it’s an effect of policies.

    James, How much of that fall occurred on the day of the January announcement?

  23. Gravatar of Mark A. Sadowski Mark A. Sadowski
    5. February 2014 at 08:24

    Scott,
    Check out this excellent article on the the role of US monetary policy in the Emerging Market (EM) turmoil.

    http://www.voxeu.org/article/understanding-emerging-market-turmoil

    Kristin Forbes points out four key things:

    1) EM exchange rate volatility was far higher during the Taper Talk (May-June 2013) than the actual Taper Start (November-December 2013).

    2) The correlation between capital flows to emerging markets and US interest rates from 1990 to 2013 is not only small it is the opposite sign of what would be expected if changes in US interest rates were the key factor driving capital flows. In contrast the correlation over this same period of capital flows to emerging markets with global growth and with global risk/uncertainty (as measured by the VIX) are not only significantly larger, these correlations actually have the expected sign if these were to be key factors.

    3) Exchange rate movements during the Taper Talk were significantly larger in EM countries which had current account deficits (e.g. Brazil, India, Mexico, South Africa) relative to those which had current account surpluses (e.g. China, Hungary and Vietnam).

    4) When compared with the 1990s, domestic investors in many EM countries (e.g. Chile, Malaysia, Mexico, Poland) have become much more important in determining how periods of volatility affect their exchange rates and equities, and they have become a stabilizing force in their own countries. This is in contrast to the “Fragile 5″(Brazil, India, Indonesia, South Africa, and Turkey) where the lack of a strong domestic investor base renders those countries unable to counteract shifts in foreign capital flows.

    In short, the evidence for a role of US monetary policy in the current EM turmoil is very weak, and the factors which characterize which countries are experiencing market instability are largely homegrown.

  24. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    5. February 2014 at 09:17

    I second the motion. Kristin Forbes (MIT) piece on Voxeu is quite comprehensive, and convincing.

  25. Gravatar of James in London James in London
    5. February 2014 at 10:07

    Mark, Patrick, guys. Kristin Forbes (and you) seem to have forgotten your expectations economics. The “taper talk” hit EM badly, as you’d expect, and as Forbes shows. It US markets too, at the time, leading to the “taper tantrum”. Actual tapering is merely the fact, and tells us nothing, it’s already in the price.

    The actual tapering announcement was more than offset by much softer talk about monetary policy, as Scott convincingly showed on December 18th. So no big EM effect or DM effect.

    My point now is that the Fed, by ignoring markets so wilfully and unanimously on January 29th, and continuing the taper has spooked the markets, both DM and EM, and will spook the economy.

  26. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    5. February 2014 at 14:22

    James, Forbes points out that the effects were different in different countries (Mark’s point #3).

  27. Gravatar of ssumner ssumner
    5. February 2014 at 17:56

    Thanks Mark, That seems plausible.

    James, Interest rates did not fall very much after the September surprise, which suggests that the taper talk played only a modest role in the earlier rise in rates. But I accept your argument that taper talk had some impact on the EMs, the market response was clear on that point. I just don’t see it as the main factor in the EM crisis.

  28. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. February 2014 at 12:54

    Scott,
    Kristin Forbes has an open in the NYT today where she repeats the same points:

    http://www.nytimes.com/2014/02/06/opinion/dont-rush-to-blame-the-fed.html

    It occurs to me that the sign on the correlation between US interest rates and EM capital flows is the opposite of what it should be for the usual reason: nominal interest rates are not a very good measure of monetary policy stance. Nevertheless the correlation is very weak so the point still stands.

  29. Gravatar of Major_Freedom Major_Freedom
    6. February 2014 at 20:43

    It did not “abandon” anything last month, it clarified that it would not raise rates until either inflation rose above 2.5% or unemployment fell well below 6.5%. That’s a more specific guidance than the previous 2.5% inflation/6.5% unemployment threshold. It’s not clear why the market was confused by this switch, it was entirely rational. Before the market was uncertain what would happen in the scenario where inflation is 2% and unemployment is around 6.4% or 6.5%. They didn’t know if the Fed would raise rates in that case or not.

    “The market” is not a homogeneous blob that has one and only one expectation, opinion, or valuation.

    The market consists of individuals, and individuals in the market are always always always disagreeing with each other when it comes to the future state of affairs. When you say “it is not clear why the market was confused”, you are both ignoring those market actors who were not confused, and you are over-estimating the impact of those market actors who were confused.

    NGDP

    GDP

    AD

    AS

    THE MARKET

    It seems there is no room for individuals in your economic analysis. It’s all just aggregates. Unfortunate.

  30. Gravatar of Scott Sumner Scott Sumner
    8. February 2014 at 21:33

    Mark, Thanks for the link.

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