Don’t raise rates in order to be able to cut them later

W. Peden sent me the following from the British Shadow Monetary Policy Committee:

In its latest email poll, the Shadow Monetary Policy Committee (SMPC) voted to raise Bank Rate by 0.25% in October, the second consecutive month it has voted for an increase. The vote came against the backdrop of the US Fed leaving rates on hold, citing China as one reason.

Those voting for a rate hike continue to warn – amongst other things – that in any future economic slowdown, the UK would not have the flexibility to respond by cutting rates if they are not raised soon. One argues that recent data revisions show that there is no negative output gap in the UK, and that is why earnings growth is rising so quickly, a sign that monetary policy is too loose. Those voting for unchanged rates continue to cite little price inflation in the actual data, slow growth in monetary statistics and signs that the economy may be losing momentum.

I don’t know enough about Britain to have an opinion on where they should set rates (although I do have the opinion that they should not target interest rates at all.)  But there is one serious flaw in the quote above.  And before explaining the flaw, let me point out that it is not one of those debatable issues, like whether QE is a good idea, or whether Switzerland should have abandoned the peg.  There’s a basic economic error in this part of the quote:

Those voting for a rate hike continue to warn – amongst other things – that in any future economic slowdown, the UK would not have the flexibility to respond by cutting rates if they are not raised soon.

That’s just wrong.  Monetary stimulus does not come from cutting interest rates; it comes from cutting them relative to the Wicksellian natural rate.  You can raise rates to 1000% if you want, but then cutting them back to 2% doesn’t make policy expansionary.  The problem with raising the target interest rate is that this would reduce the Wicksellian equilibrium rate.

If they are worried about having enough room to stimulate the economy in the next recession, before hitting the zero bound, then they should unquestionably NOT raise interest rates right now.  Raising them would reduce the Wicksellian equilibrium rate, and give the BoE less future room to maneuver. Period. End of story. I see this mistake all the time, and I don’t understand why it keeps being made.

Just to be fair and balanced, the other information in the quote does support a rate increase.  The rapidly rising wage growth is more important than the inflation, money supply, and real GDP data.  So I’m agnostic on the rate question.  But please, don’t raise rates to give yourself room to cut them in the future.

PS.  Don’t believe me?  Check out what the ECB and Riksbank rate increases of 2011 did to their Wicksellian equilibrium interest rates.

PPS.  I’ll be at a conference, and thus comment replies will be slow for a few days.


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58 Responses to “Don’t raise rates in order to be able to cut them later”

  1. Gravatar of marcus nunes marcus nunes
    8. October 2015 at 03:57

    “Pay the arsonist do do his thing so you can then call in the firemen!”

  2. Gravatar of W. Peden W. Peden
    8. October 2015 at 04:16

    Thanks Scott, that makes a lot of sense. I particularly like the reduction ad absurdum of the 1000% rate hike, and bringing it back to the central issue you need to think about if you really have to think of macro in terms of interest rates, i.e. the natural rate.

    On people not realising the right relationship between tight/loose monetary policy and interest rates, I think we can go back to a point Thomas Sowell once made about economic reasoning: he once proposed an idea to a tutor at Chicago, and the tutor asked him what he thought would happen. He described what economic theory would say would be the initial effects. Then the tutor asked, “And then what?” This process repeated, and gradually the policy looked less and less attractive.

    Similarly, if you don’t follow that procedure with interest rate rises/reductions all the way to equilibrium and the Fisher effect, then it does look like a question of easy money = low rates.

    Economics can be very complex, but unintended consequences (in this case, the possibility of raising/lowering nominal rates by changing the equilibrium nominal rate) always need to be part of the story.

  3. Gravatar of Benjamin Cole Benjamin Cole
    8. October 2015 at 04:52

    Well, excellent blogging.

    1. So, we have to raise rates, so we can have room to cut them later.

    2. Also, we have to raise rates now, or else we will really have to raise them later to cool off a too-hot economy.

    You know, I want sex every day, and other people want to raise interest rates every day.

    I try to keep my urges out of policy discussions.

  4. Gravatar of marcus nunes marcus nunes
    8. October 2015 at 05:10

    OT: http://www.vox.com/2015/10/8/9472807/ben-bernanke-ngdp-targeting

  5. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    8. October 2015 at 06:06

    Thanks for the link to the Yglesias piece, Marcus. Though I disagree with this from him;

    ‘Central banks’ current practice of fighting inflation with higher interest rates and fighting recessions with lower interest rates has run aground recently on the fact that interest rates can only go so low.’

    As I’ve said here before, the problem is that interest rates are NOT the price of money. Conducting monetary policy through them is worse than pointless, it’s often counterproductive.

    What I did like from Yglesias was;

    ‘Bernanke’s broadest point of all “” that he didn’t just shy away from a fight, but that doing otherwise would have been futile “” seems at least debatable. The title of his book, after all, is The Courage to Act, and the entire point of having the Fed be an operationally independent central bank is that its leadership can be at least somewhat indifferent to congressional criticism. Bernanke has a reputation for politeness, and his book is exceptionally polite to most of his critics and adversaries. He’s clearly not the kind of person who would have been well-suited to conduct a giant fight with hard money advocates in Congress. But it’s at least possible that someone else could have waged such a fight successfully and done the country a lot of good.’

    In a way Bernanke reminds me of Arthur Burns who used to respond to criticism over high inflation by saying, in effect, ‘Don’t blame me, I’m just the Fed Chairman. Inflation is caused by labor unions and greedy industrialists.’

    I thought this was devastating too;

    ———quote——–
    Bernanke observes that “the Bank of Japan would adopt my suggestions some fourteen years later.”

    What he doesn’t say is that this came about not because white papers from American academic macroeconomists suddenly became more persuasive. It came about because Japan finally got its Franklin Roosevelt, in the form of Prime Minister Shinzo Abe “” a politician and elected official able to win a mandate for change. By the same token, most observers agree that Ronald Reagan’s backing of Paul Volcker was important to letting Volcker’s sometimes-controversial strategy for fighting inflation work.

    Reading between the lines, one can see the implication that Bernanke believes the Fed could have done more to boost the economy had there been more political support for additional action. But while the Fed faced significant political pressure from congressional Republicans to do less to bolster the economy, neither Barack Obama nor congressional Democrats were very interested in offering pressure from the other side. Before serving as Fed chair, Bernanke thought that central bankers alone could and should demonstrate “Rooseveltian resolve.” After doing the job, he seems to have adopted a more complicated view of the politics of central banking and now thinks leadership from elected officials is required “” leadership that did not exist during his tenure but that new activist groups like Fed Up are trying to create.
    ———endquote———-

  6. Gravatar of marcus nunes marcus nunes
    8. October 2015 at 06:46

    Patrick: I agree with your disagreements:
    https://thefaintofheart.wordpress.com/2015/10/07/bernanke-the-man-in-the-irony-mask/

  7. Gravatar of David de los Angeles David de los Angeles
    8. October 2015 at 07:09

    Dr. Sumner,

    In November 2008, the Federal Reserve Bank (FRB) and the economy of the United States were already at the Zero Bound. The Effective Federal Funds Rate was 0.38%, hardly much different from zero. That is why the FRB implemented the Quantitative Easing Policy. Normally, when the economy contracts, central banks attempt to “ease” monetary conditions by lowering interest rates, conducting “Interest Rate Easing”. Since this was not possible in November of 2008, instead of lowering interest rates to ease credit, the FRB increased the *quantity* of money to create credit easing, “quantitative easing” as it were. This is unconventional monetary policy for unconventional situations.

    So even if a central bank, such as the Bank of England, felt the need for easing in the future, they would simply extend the QEP further. They would not need to conduct Interest Rate Easing but rather Quantitative Easing. Raising interest rates to lower them again is completely unnecessary.

  8. Gravatar of Dan W. Dan W.
    8. October 2015 at 07:21

    Low rates foretell low NGDP growth, but the 30+ year of declining interest rates have boosted the expansion of credit by enabling more borrowing at the same payment. Without an increase of income people have been able to borrow more, spend more and invest more. This has been a virtuous cycle.

    The path to higher rates is a vicious cycle. Borrowing costs would necessarily increase. People would either have to spend more on interest or have to decrease borrowing. There would be great reluctance for people to increase borrowing in a cycle of increasing rates.

    Now we see why the central bank cannot figure out what to do. If they raise rates or if they actually create inflation that causes rates to rise there will be economic calamity. And they will be blamed. So they do little, talk a lot, and blame Congress. Why not? It’s what everyone else does!

  9. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    8. October 2015 at 07:21

    That’s a great piece, Marcus. Starting with your oh, so appropriate title.

  10. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    8. October 2015 at 07:38

    More unintended irony from Bernanke (p. 47);

    ‘The innovative design of the Federal Reserve created a nationally representative and politically more sustainable institution. But it also created a complex system without strong central oversight or clear lines of authority. For a time, the [***]appropriately named Benjamin Strong[***], the head of the Federal Reserve Bank of New York, provided effective leadership. (…Strong…had helped [J.P.] Morgan end the panic of 1907.) But no one of equal stature stepped up after Strong’s death in 1928. The Fed proved far too passive during the Depression.’

  11. Gravatar of Ray Lopez Ray Lopez
    8. October 2015 at 07:42

    How many of you have read Bernanke’s 2003 FAVAR paper, which points out how weak Fed influence is over the economy?

    Sumner: “Monetary stimulus does not come from cutting interest rates; it comes from cutting them relative to the Wicksellian natural rate.” – and what is the Wicksellian natural rate for October, 2015? Don’t know? Just as I thought…

  12. Gravatar of TallDave TallDave
    8. October 2015 at 08:32

    I just can’t even believe anyone above the intern level at a CB would think “raise them now so we can lower them later” makes any sense at all.

    There are complex questions in economics, but can’t we at least get the simple things right?

  13. Gravatar of Dan W. Dan W.
    8. October 2015 at 08:50

    TallDave,

    It would be nonsensical for the central bank to raise interest rates now. Yet at the time of the financial crisis the central bank interceded to lower interest rates. Was that interference nonsensical too?

    Who here appreciates that the central bank has put itself in a corner precisely because it has repeatedly interfered with market interest rates and promoted the accumulation of debt above levels a normal market can accommodate?

  14. Gravatar of W. Peden W. Peden
    8. October 2015 at 09:39

    To avoid possible misunderstanding, I should point out that the Shadow Monetary Policy Committee is an informal group set up by the private think tank called the Institute of Economic Affairs (IEA), which has no direct relation to the Bank of England. One or two of the SMPC members (Tim Congdon and maybe Patrick Minford) were formally advising the UK on monetary policy in the 1990s prior to the Bank of England gaining control of interest rate targets.

  15. Gravatar of TravisV TravisV
    8. October 2015 at 09:42

    “Kocherlakota Says Fed Should Consider Negative Interest Rates”

    http://www.bloomberg.com/news/articles/2015-10-08/kocherlakota-says-fed-should-consider-negative-interest-rates

  16. Gravatar of TravisV TravisV
    8. October 2015 at 10:09

    Positive news or negative news? “Fed minutes: Members worried about slower global growth”

    http://www.cnbc.com/2015/10/08/.html.html

    http://www.cnbc.com/2015/10/08/fed-minutes-members-worried-about-slower-global-growth.html

  17. Gravatar of TallDave TallDave
    8. October 2015 at 10:17

    BTW China’s forex reserves down $43B in September. That’s a better trend than August.

    http://www.wsj.com/articles/chinas-foreign-exchange-reserves-drop-43-26-billion-in-september-1444199770

  18. Gravatar of TravisV TravisV
    8. October 2015 at 10:20

    Yglesias: “he doesn’t really take issue with the analysis of Sumner, Romer, Woodford, or anyone else who thinks NGDP targeting is, in principle, a superior framework. He just raises practical objections, based on his experience actually running the Fed.

    The recurrence of Congress as a theme, and Bernanke’s doubt that NGDP targeting would even be “feasible” whatever the “theoretical benefits,” is telling…..”

    http://www.vox.com/2015/10/8/9472807/ben-bernanke-ngdp-targeting

  19. Gravatar of TallDave TallDave
    8. October 2015 at 10:29

    Dan W. — It is entirely sensible and appropriate for the Fed to cushion reductions in GDP/employment with looser monetary policy. It is entirely senseless to impose tighter monetary policy now for fear that it may not be able to loosen later.

    The Fed lowered nominal interest rates primarily by reducing inflation expectations. Not sure why anyone thinks lower inflation would promote excessive debt.

  20. Gravatar of Brian Donohue Brian Donohue
    8. October 2015 at 10:53

    OT, Scott. Two questions.

    1. What do you think of the debt ceiling? As a fiscal conservative, I thought the sequester/shutdown of 2013 was a good thing, inasmuch as it temporarily reined in Leviathan, but if there’s one thing everyone in Washington seems to agree on, it’s that the debt ceiling is an awful idea.

    2. Kind of related: SWAPs used to trade at a premium to Treasuries. As far as I can tell, Prior to October 2008, this was always the case- 30-year SWAP yields were pretty consistently 0.5% higher than 30-year Treasuries.

    Since October 2008, 30-year SWAPS have carried lower yields than Treasuries. I interpret this to mean that SWAP counterparty risk is perceived to be lower than Treasury default risk. Curious, but there it is.

    In 2014, the spread moved back close to zero, but this year, SWAPS have again fallen to yields 0.3% below Treasuries.

    I guess my point is that the true “risk free” rate over 30 years is 0.3% lower than the 30-year Treasury yield right now.

    This tells me that real interest rates are even lower than they appear from Treasuries.

    OK, #2 isn’t a question. I guess my question is: does this mean anything to you?

  21. Gravatar of W. Peden W. Peden
    8. October 2015 at 11:01

    Brian Donohue,

    Obviously you’re interested in Scott’s view, but as far as I can tell, the debt ceiling has (a) not put a ceiling on the debt and (b) has helped undermine criticism of expansions of the debt because it tends to co-opt both parties into “approving” debt increases. So the issue in 2013 wasn’t Obama’s fiscal policy, but the Republicans refusal to be associated with it.

    A system that would better limit presidential power would be to allow the Federal Government to spend past the debt ceiling with automatic approval by Congress, but Congress gets to name the bill. (I remember seeing this proposed on Youtube once.) So if Congress wants it to be called “The Obama Debt Explosion Act” or the “Ronald Reagan Irresponsibility Act”, that’s their choice, but the bill passes automatically one way or another.

  22. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    8. October 2015 at 11:09

    Well, well, am I on the cutting edge of Presidential politics, or what;

    https://www.yahoo.com/politics/hillary-clinton-doesnt-support-revival-of-150542856.html

    ‘Hillary Clinton says she doesn’t support reinstating a Depression-era banking law that separated commercial and investment banks because her forthcoming proposal for U.S. financial reform is “more comprehensive.”

    ‘- What is it? The Glass-Steagall Act, passed in 1933, prohibited commercial banks from participating in the investment banking business and created the Federal Deposit Insurance Corporation (FDIC) to protect bank deposits from institutional failure. But major provisions of the law were repealed in 1999 under President Bill Clinton, a move some believe contributed to the 2008 global credit crisis because commercial banks “” now free to invest in things such as real estate….’

    I’ll give the author points for getting it right that the law wasn’t repealed, only two of its provisions. However, Glass-Steagall’s separation of commercial and investment banking never had anything to say about real estate lending.

  23. Gravatar of Njnnja Njnnja
    8. October 2015 at 13:21

    @Brian Donohue

    Since October 2008, 30-year SWAPS have carried lower yields than Treasuries. I interpret this to mean that SWAP counterparty risk is perceived to be lower than Treasury default risk. Curious, but there it is.

    It’s pretty close but it’s not as bad as it sounds. A Treasury yield is a very different number than a fair swap rate. A 30-year Treasury (in the current rate environment) will have something like 50% of its value packed into the very last cashflow, when par is paid back. But a fair swap has a relatively small cash flow going back and forth over the years, depending on the steepness of the yield curve. Not to mention swap arrangements such as collateral posting to daily mark to market values which further reduce the risk of nonpayment.

    It is correct to say that the market thinks that a 30 year Treasury is “riskier” than a swap (for a certain definition of “riskier”), but that is because you have a lot more at risk, over a much longer period of time, with a Treasury than you do with a swap. So it’s a little like saying that a 30 year Treasury has a higher yield than a 3 month GE bond because there is more risk in the 30 year Treasury. True, but not really an apples to apples comparison.

  24. Gravatar of Brian Donohue Brian Donohue
    8. October 2015 at 13:24

    @W. Peden,

    Thanks. As far as I can tell, the 2013 shutdown/sequester had a meaningful, if temporary, impact on federal government spending which, in my mind, is the key number to keep your eye on:

    Federal spending as a % of GDP (remember, this is during an economic recovery):

    FY 2010 23.2%
    FY 2011 23.2%
    FY 2012 21.9%
    FY 2013 20.6%
    FY 2014 20.1%
    FY 2015 20.9%

    To me, this is not a left/right issue so much as a Washington/us issue.

  25. Gravatar of Brian Donohue Brian Donohue
    8. October 2015 at 14:05

    @Njnnja,

    I don’t think that’s right. The 30-year SWAP describes the yield on a set of fixed cash flows that are swapped for variable cashflows. This security is nothing like a 3-month bond. I understand that posting collateral, marking-to-market and ISDA standardization have reduced counterparty risk, but I’m pretty sure a 30-year SWAP is a long duration asset and behaves like other long-term interest rates.

  26. Gravatar of marcus nunes marcus nunes
    8. October 2015 at 14:07

    Krugman, once again, tries to pull the “fiscal rabbit” from the hat. I contest:
    https://thefaintofheart.wordpress.com/2015/10/08/a-monetary-story-alternative-to-krugmans-fiscal-story/

  27. Gravatar of JonathanH JonathanH
    8. October 2015 at 15:34

    For those interested, you can watch the interview with Bernanke on Stephen Colbert:

    http://www.cbs.com/shows/the-late-show-with-stephen-colbert/video/FToLlnVhrnhpHjWHxRUeXlM7Ktn1cPhn/the-late-show-10-7-2015-gina-rodriguez-ben-bernanke-tame-impala-/

  28. Gravatar of TravisV TravisV
    8. October 2015 at 17:39

    Bernanke was also on Charlie Rose: http://www.charlierose.com/watch/60628338

  29. Gravatar of Ray Lopez Ray Lopez
    8. October 2015 at 17:42

    Vox, Yglesias article: “To grasp the significance of what Bernanke says about NGDP targeting, all you really need to know is that it’s an unconventional strategy that many distinguished outside observers believe the Federal Reserve could have used to reduce unemployment more rapidly” – ‘reduce unemployment’, the discredited “Phillips Curve” in another guise… and “The idea is that if the central bank prints more money, nominal spending will go up” – cite please? Nothing but Austrian internet theoretical ‘thought experiments’ for this. In fact, as Japan has shown, printing money does not make nominal spending go up. Pushing on a string. Sumner says–and this is dangerous–to keep printing until some NGDP target is reached, but Japan has shown this doesn’t work. Sumner is harmless (as money is largely neutral) but his “keep printing” strategy is a recipe for potential hyperinflation. When the doo-doo hits the fan, Sumner will have shut down this blog and be long gone to parts unknown, while Americans are left holding the bag.

  30. Gravatar of Ray Lopez Ray Lopez
    8. October 2015 at 17:59

    OT – Marcus Nunes’ article he linked above is very well done. Key sentence: “Again, Bernanke and company were right to step in forcefully. But I’d argue that the fiscal environment was probably more important than monetary actions in limiting the damage [compared to the Great Depression].” (since government is bigger now than in the Great Depression).

    Nunes is brave for posting this here; only his emeritus status keeps him from being branded an ‘idiot’ by Sumner. Professional courtesy. I will also add that a graphic from Forbes magazine, that I have linked to my blog, shows credit default swaps interest rates (a measure of risk) did not peak until the spring 2009, about the same time the stock market reached its lows, proving the bailouts of 2008 did not ‘stem’ the panic (arguably they even enhanced it by stopping liquidity, as bond traders refused to trade their junk paper knowing the government would soon step in and bail them out). Nunes further states that QE1, introduced in March 2009, was a reason for the turnaround but I disagree; it’s largely coincidence. If the bailouts did not work to stem panic, why would an unspecified QE do so, that Nunes himself says was “timid”? But still a good article with nice graphics.

  31. Gravatar of Steve Steve
    8. October 2015 at 20:43

    In other news, airplane pilots advocate aiming for ground in order to gain airspeed in preparation for possible engine failure.

  32. Gravatar of Njnnja Njnnja
    9. October 2015 at 05:08

    @Brian Donohue:

    The comparison to a 3 month risky bond is illustrative, not exact. The idea is that a 3 month GE bond has a low rate because even though the probability of default is higher than a Treasury, the fact is you aren’t really exposed very much and therefore don’t get paid for taking much risk.

    With a 30 year swap, you likewise aren’t really taking much risk (albeit for different reasons than the aforementioned GE bond – the GE bond has little exposure because it is only a 3 month tenor, but the swap is described below). Your only real credit exposure in a swap is the cost to novate it. And if you are getting daily mtm then your exposure is just the day to day change in the pnl. Even a big 30 bps one day change means that for every $1MM of notional you only have about $60K of credit exposure (which goes to zero the next day once the cp posts). But with a Treasury, for every $1MM of face you have about $1MM of credit exposure, all the way until it matures.

    True, the Treasury doesn’t have *much* probability of defaulting, but it’s not zero, and since you always have exposure to the full par value, there is more overall risk to a long term Treasury right now than a similar LIBOR swap.

  33. Gravatar of Derivs Derivs
    9. October 2015 at 05:56

    Njnnja is correct.

  34. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    9. October 2015 at 06:10

    For those who haven’t read it, Marcus’s piece here;

    https://thefaintofheart.wordpress.com/2015/10/07/bernanke-the-man-in-the-irony-mask/

    is the most astute commentary on the Bernanke book I’ve seen. Beginning with a perfect title; ‘The Man in the Irony Mask’, continuing with a perfect use of Christi Romer’s 2011 NY Times open letter/challenge to Ben to start targeting NGDP, and finishing with this coup de grâce;

    ——–quote——
    Romer´s article was published Oct 29/11. Just 3 days later, the FOMC met. They discussed NGDPT, but rejected it and 2 months later Bernanke realized his longtime dream: IT became official @2%!

    Again he forgot. This time his advice to Japanese monetary authorities. Final irony: when was inflation last at 2%? On the month (Jan/12) 2% became the target!
    ———-endquote——–

  35. Gravatar of Brian Donohue Brian Donohue
    9. October 2015 at 07:16

    @Ninnja,

    I understand with a 30-year SWAP is not underwriting credit risk: the fact that the yield on the SWAP is lower than the Treasury is indicative of the (small but increasing this year, presumably related to the debt ceiling thing) default risk in the Treasury bond.

    But, just like a 30-year Treasury, a 30-Year SWAP exposes the buyer to purchasing power/inflation/interest rate risk over the 30-year horizon. If nominal interest rates go up, the SWAP loses value, unlike a 3-month security.

  36. Gravatar of Ray Lopez Ray Lopez
    9. October 2015 at 07:36

    @Patrick R. Sullivan quoting Marcus Nunes – the Nunes piece reads like a Ripley’s Believe it or Not! with the excessive bolding and underlining. The biggest mistake however is the belief that the Fed can set interest or inflation rates–I think Sumner even agrees this is impossible. If setting interest or inflation is impossible for the Fed, it’s just a small step to conceded that in practice the Fed may not be able to influence NGDP much either. In short, money is neutral, as Bernanke’s FAVAR paper showed.

  37. Gravatar of Njnnja Njnnja
    9. October 2015 at 07:43

    @Brian Donohue

    You obviously don’t understand the reference I tried to make to a short term bond so forget about it. A 30 year treasury and a 30 year swap have about the same sensitivity to “purchasing power/inflation/interest rate risk” and therefore if there were no credit risk difference the curves would be the same (depending on how you define “curve” but let’s assume for now we define them to be consistent, say the zero curve for both instruments).

    Then the Treasury curve is different from the swap curve because of credit considerations. So if you understand the credit risk then you have your answer.

  38. Gravatar of Ray Lopez Ray Lopez
    9. October 2015 at 07:56

    @Njnnja – give it a rest, BD is just some Irish heavy drinker who thinks he knows economics. He’s a joke. I too took him seriously for a while until I realized he has little to no understanding of economics. Actually you can say the same thing about our host here, but I’ll stop…

  39. Gravatar of Brian Donohue Brian Donohue
    9. October 2015 at 07:58

    @Ninnja, Good idea to withdraw your poorly chosen reference.

    I also agree with the rest of your latest comment.

    But I knew all that before I posted my original questions.

    Thanks anyway.

  40. Gravatar of Derivs Derivs
    9. October 2015 at 08:24

    “little to no understanding of economics. ”

    It’s not an economics question. It’s a finance question related to a different time series of payments. Interesting to me was always how few swap traders understood swaps, much worse before they were cleared through a clearing house and most people miscalculated their delta sensitivities. Point is .. Njnnja is 100% correct.

  41. Gravatar of Brian Donohue Brian Donohue
    9. October 2015 at 08:49

    @Ray, What’s your windmill count for today, big guy?

  42. Gravatar of marcus nunes marcus nunes
    9. October 2015 at 08:55

    @ Ray, not a comment just a correction. The paragraph that you linked above (which would make me an “idiot”) is Krugman writing!
    “Again, Bernanke and company were right to step in forcefully. But I’d argue that the fiscal environment was probably more important than monetary actions in limiting the damage [compared to the Great Depression].” (since government is bigger now than in the Great Depression).”

  43. Gravatar of Brian Donohue Brian Donohue
    9. October 2015 at 08:56

    @Ninnja, one more try. Apart from credit/default/counterparty risk, are you saying that the difference between the Treasury and the SWAP is the prinicpal repayment on the Treasury at the end of 30 years? That the SWAP, basically, is just the 30 years of coupon payments?

    That, in essence, a 30-year SWAP is comparable to a 30-year Treasury bond with the principal repayment stripped?

    In this case, the SWAP sounds like a much shorter duration asset, in which case I’m surprised that, prior to 2008, the 30-year SWAP always traded at yields higher than the (longer duration) 30-year Treasury.

    Thanks.

  44. Gravatar of Justin D Justin D
    9. October 2015 at 09:40

    This reminds me of a scene from The Office:

    http://www.youtube.com/watch?v=Ytx1P7P4XXk

  45. Gravatar of Ray Lopez Ray Lopez
    9. October 2015 at 10:48

    @Marcus Nunes — sorry, I guess that makes me an idiot for not reading more carefully…

  46. Gravatar of Njnnja Njnnja
    9. October 2015 at 12:28

    @Brian Donohue:

    Try not to think of duration. Think of risk in terms of DV01 (interest rate) and CV01 (credit) instead.

    For a Treasury, the DV01 and CV01 are pretty much the same, and about $2,000 per $1MM of face. If the yield goes up by 1 bps, then the value of your treasury goes down by about $2,000, whether that yield goes up because the theoretical risk free interest rate goes up by 1 bps, or the credit risk of the USA goes up by 1 bps.

    But for a swap, DV01 and CV01 are very different. DV01 is $2,000 per 1MM notional, because, as you point out, they are both long lived assets blah blah blah. But the CV01 of the swap is really small because your exposure to cp default is much smaller than notional. Even if your credit duration is 20 years, if your uncollateralized mark is something like $10k per $1MM face, then your CV01 is around $2. Even if the cp changes from being a low risk to being a high risk, the structural features of the swap (1, the fact that there is no exchange of notional at the end and so it is just a series of “coupon” payments, and 2, mtm and collateral posting mean you are really only on the hook for a day until you find another counterparty in the case of a default), the value of your swap doesn’t really change too much. Even if the CDS spread on your cp blows out by 200 or 300 bps, the change in value of the IRS is about the same as if interest rates went up by less than 1 bp. (this is simplified and the correlation between interest rates and bank CDS blowing out makes this a bit worse, but the idea still holds)

    Anyways, put all that together and when you enter into a long term LIBOR swap, you are mostly taking pure interest rate risk, but when you buy a Treasury, you are taking both interest rate and credit risk. So a treasury has to have a higher yield to compensate you for the risk.

    PS if you want it to get really ugly, think about why shorter tenors exhibit the opposite pattern. For that, you need to remember that the LIBOR rate itself is not risk free, but rather, represents a (credit) risky rate. But it’s always only 3 months of credit risk (since the 3M LIBOR rolls), which is greater than, say, 3 years of US govt risk, but less than, say, 30 years of us govt risk

  47. Gravatar of Brian Donohue Brian Donohue
    9. October 2015 at 12:44

    @Ninnja, I appreciate your patience.

    In my previous comment, I asked the same yes/no question three different ways.

    Is the answer yes or no?

  48. Gravatar of TravisV TravisV
    9. October 2015 at 12:58

    David Beckworth reviewed Bernanke’s new book:

    http://www.alt-m.org/2015/10/09/the-courage-to-act-in-2008

  49. Gravatar of Steve Steve
    9. October 2015 at 14:41

    Justin D- Ahhh, the Office.

    Dwight: “I can raise and lower my cholesterol at will!”

    Pam: “Why would you want to raise it?”

    Dwight: “So I can lower it.”

  50. Gravatar of derivs derivs
    10. October 2015 at 02:12

    Brian,
    Same length of term, but on the payment date only the DIFFERENCE between the fixed and variable interest amounts is paid; there is NO exchange of the FULL interest amounts. AND most importantly (from a risk valuation perspective) there is NEVER the exchange of principal amounts.

  51. Gravatar of Major.Freedom Major.Freedom
    10. October 2015 at 12:01

    “I don’t know enough about Britain to have an opinion on where they should set rates.”

    You don’t know enough about people over any geographical location to have an opinion on where anyone should set rates. Indeed, no one person knows enough. Only the market process can provide you with the information needed to know what rates should be.

  52. Gravatar of Lorenzo from Oz Lorenzo from Oz
    10. October 2015 at 16:43

    On the political backing question, the RBA’s successful monetary policy is explicitly based on a written agreement between the RBA Governor and the Federal Treasurer. It is periodically updated, but the first in the series is here.
    http://www.rba.gov.au/monetary-policy/framework/stmt-conduct-mp-1-14081996.html

    On the other hand, the actual key policy shift was in 1993. But the then Governor, Bernie Fraser, was very well connected with the incumbent ALP Government.

  53. Gravatar of TravisV TravisV
    11. October 2015 at 08:24

    Has anyone written a good Bernanke review yet besides Nunes and Beckworth? I hope Glasner writes one…..

  54. Gravatar of Njnnja Njnnja
    12. October 2015 at 04:15

    @ Brian Donohue:

    Simple yes/no:

    Apart from credit/default/counterparty risk, are you saying that the difference between the Treasury and the SWAP is the prinicpal repayment on the Treasury at the end of 30 years?
    No I’m not saying that

    That the SWAP, basically, is just the 30 years of coupon payments?
    No.

    That, in essence, a 30-year SWAP is comparable to a 30-year Treasury bond with the principal repayment stripped?
    Yes, I guess.

    More detail:
    1) If you ignore credit/default/counterparty risk (and refinancing and collateral posting etc etc etc), then yes a receiver swap is just a fixed rate bond financed by short term borrowings rolled over until maturity. But I wouldn’t say to ignore those factors when trying to understand why those instruments are priced differently.

    2) By definition it’s not. The fixed leg is though.

    3) They are both financial instruments, they both have cash flows, so yes they can be compared. But if you want to ignore the important factors that make them substantially different securities then you are going to have a difficult time doing an accurate enough comparison to understand why they are priced the way they are. You won’t get it if you just focus on TVM.

  55. Gravatar of Scott Sumner Scott Sumner
    12. October 2015 at 09:09

    Dan, You said:

    “Low rates foretell low NGDP growth, but the 30+ year of declining interest rates have boosted the expansion of credit by enabling more borrowing at the same payment.”

    You are reasoning from a price change.

    Brian, Yes, the debt ceiling is idiotic. I can’t answer your swap question, maybe someone else can.

    Njnnja, Thanks for that info.

    Ray, you said:

    “I guess that makes me an idiot”

    Everyone, I’ll do a Bernanke review eventually, but you’ll need to be patient.

  56. Gravatar of Brian Donohue Brian Donohue
    12. October 2015 at 10:52

    @Scott,

    OK, to what do you attribute this pattern of federal spending (% of GDP):

    FY 2010 23.2%
    FY 2011 23.2%
    FY 2012 21.9%
    FY 2013 20.6%
    FY 2014 20.1%
    FY 2015 20.9%

  57. Gravatar of Scott Sumner Scott Sumner
    12. October 2015 at 18:01

    Brian, Growth in GDP and the end of the stimulus program.

  58. Gravatar of Jack’s Links | The Zeitgeist Log Jack’s Links | The Zeitgeist Log
    25. October 2015 at 17:34

    […] Don’t Raise Rates to Cut Them Later:  A rare article that I found good important enough to send around my office. It seems obvious, but somehow gets lost that just leaving rates low is a better strategy than raising them to cut them later in the case of ‘headwinds’. […]

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