Archive for the Category Exchange Rates

 
 

Two examples of low interest rate monetary policies

I’ve done a number of posts comparing New Keynesian and NeoFisherian views on the relationship between monetary policy and interest rates.  Here I’d like to illustrate the problem with a picture, as people often have trouble understanding this issue.  It’s really hard to not reason from a price change.  It’s hard to stop thinking of interest rate movements as a “policy” rather than an outcome.

These two graphs show the path of the exchange rate (E) over time, under two different monetary policies.  In both cases a higher exchange rate (E rising) reflects domestic currency appreciation.  Importantly, both of these examples are “low interest rate policies”, when the central bank reduces interest rates to a lower level than before.  But case #1 is an easy money policy, whereas case #2 is a tight money policy:

Screen Shot 2018-05-26 at 4.51.28 PM

To focus on the essentials, I’d like to assume that a policy change occurs at time = T’, and that the following movement in the exchange rate is anticipated, once policy has shifted.  (The policy move itself was unanticipated beforehand.)

Notice that in both cases, the exchange rate is expected to appreciate after time = T’.  Because of the interest parity theory, this expected appreciation means that interest rates will be lower than before the policy change, when the exchange rate was stable and interest rates were the same as in the other country.  So from the interest parity theory we know that these two cases are both shifts to a lower interest rate policy.

But now let’s look at the long run impact of the two policies on the level of the exchange rate.  In case #1, the exchange rate ends up lower (depreciated) in the long run, despite the near-term expectation of appreciation.  Because of PPP, that means the policy is expected to increase the price level in the long run.  In other words, it’s an expansionary monetary policy.

In case #2, the exchange rate appreciates in the long run, yielding a lower price level.  That’s a contractionary policy.

Because the first case looks so convoluted—a currency that is expected to appreciate over time but still end up lower than before—you might think it represents the “weird and controversial model”.  Just the opposite, the first case is the New Keynesian model of easy money, and more specifically the Dornbusch overshooting version.  The second more straightforward case reflects the weird and controversial NeoFisherian model.  Just looking at the second graph, it’s easy to see how the NeoFisherians are able to get their result from mainstream mathematical models of the economy.

Here’s another way of thinking about the two cases.  In case #1, there is a one-time increase in the money supply (and/or reduction in money demand).  It reduces interest rates (due to the liquidity effect.)  But it also leads to expectations of a higher price level in the long run, due to currency depreciation and PPP.  Because prices are sticky in the short run, the effect of easy money is to initially depreciate the currency, not raise the price level in proportion.

In case #2, there is a permanent decrease in the growth rate of the money supply (and/or increase in money demand growth).  Because of the quantity theory of money, that leads to a permanent decrease in the inflation rate.  And because of the Fisher effect, the lower inflation leads to lower nominal interest rates.  And because of interest parity, lower nominal interest rates lead to an expected appreciation in the currency.  But you don’t even need the interest parity relationship.  By itself, the lower expected inflation combined with PPP leads to the expected appreciation in the currency.

So how does this help us to better understand the New Keynesian/NeoFisherian dispute?  It may be helpful to contrast the “highly visible” with the “highly important”.  The New Keynesians are focused on the highly visible, while the NeoFisherians are focused on the highly important.

The vast majority of specific, short-term decisions by central banks are better viewed as one-time shifts in the money supply, rather than permanent changes in the growth rate of the money supply.  Thus “easy money” announcements often make short-term interest rates fall, even as inflation expectations rise.  At the same time, the truly major moves in interest rates over time largely reflect longer-term changes in the growth rate of the money supply (and money demand—in more recent years).  Thus the low nominal rates in Japan are primarily due to tight money, not easy money.

Both the New Keynesian and the NeoFisherian models are wrong, as both sides engage in reasoning from a price change.  The correct (market monetarist) model says that low rates can reflect easy or tight money, and that one should not draw any inferences about the current stance of monetary policy by looking at interest rates.

If one cannot draw any inferences about the current stance of policy by looking at rates, can one draw any inferences at all?  I see two:

1.  On any given day, a decision by a central bank to cut rates by more than the market expected is usually (not always) expansionary.  It reflects “expansionary intent” and may be viewed as a signal by the central bank of a desire to make policy more expansionary.  This is, of course, consistent with New Keynesianism.  But it does not mean the current stance of policy is expansionary.

2.  When nominal interest rates fall persistently over a long period of time, it is usually (not always) evidence that monetary policy has been contractionary.  (This is more consistent with NeoFisherism).  But it does not mean that the current stance of monetary policy is contractionary.  As usual, Milton Friedman was decades ahead of the rest of the profession:

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.  .  .   .

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

In America, monetary policy in 2017 and 2018 became a bit more expansionary, despite higher rates.

Where the FTPL applies

The fiscal theory of the price level does not explain very much in the US.  Inflation often soars much higher during periods when the national debt is low and falling (the 1960s) and falls sharply when the deficit increases dramatically (the 1980s).  But the FTPL does explain the inflation dynamics of Argentina:

“The [peso] price action looks like a loss of confidence by foreign investors coupled with some form of “capitulation” by domestic investors,” he added. “Markets need to see a radical tightening in fiscal policy in order to stabilise the situation, and that includes cutting wage hikes in order to fight inflation.

There is also some data that sounds suspiciously NeoFisherian:

Argentina’s peso is again feeling the heat.

The currency has fallen to a new record low of 23 against the dollar after slumping 5 per cent in morning trade on Tuesday. . . .

The declines come despite massive intervention by the Argentine central bank, which hiked interest rates by an unprecedented 12.75 percentage points to 40 per cent in the space of just seven days last week.

As always, however, you need to keep in mind the correlation/causation distinction.  Most likely it’s the high inflation causing the high nominal interest rates, not vice versa.  (Or if you prefer, the budget deficits are causing both.)

Money is fundamental, interest rates are secondary

Let’s try one more time, with the dollar/yen forward exchange rate.  I’d like to make the following assumptions.  It doesn’t matter whether you think these assumptions describe the real world; I’d simply like you to consider them as a hypothetical.  When we’re all done, we’ll think about what it means.

1.  Let’s assume the BOJ is determined to adopt a very tight money policy, over the next 30 years.  This policy will be so tight that the yen will end up valued at 50 to the dollar, more than double its current value.

2.  This very tight money policy causes very low inflation and very low NGDP growth in Japan.

So far interest rates don’t enter the picture, indeed interest rates need not even exist—imagine a world with no debt. I’m trying to make the appreciation of the yen into the fundamental shock, from which everything else flows.

3.  Now let’s add interest rates.  Because of the ultra-low expected inflation, and the ultra-low expected NGDP growth, nominal interest rates in Japan are more than 200 basis points below nominal interest rates in the US.  These low rates are caused by a tight money policy that leads to yen appreciation.

I’m still assuming the tight yen policy that leads to yen appreciation is fundamental, and everything else is an effect of that policy.

4.  Now let’s assume that the US and Japanese debt markets are very deep and liquid, and the 30-year forward yen contract is very lightly traded and not very liquid at all.  Let’s also assume that the forward premium on the yen is linked to the interest rate differential according to the covered interest parity theorem, although the theorem doesn’t work perfectly due to various market imperfections caused by regulations.  It’s roughly true.

I’m still assuming the tight yen policy that leads to yen appreciation is fundamental, and everything else is an effect of that policy.

Now let’s take stock of where were are.  Thus far, I have NOT claimed to describe the real world.  I’ve described a scenario where, by assumption, the huge forward premium on the yen drives the interest rate differential.  Quite possibly, this imaginary scenario has nothing to do with the real world.

But here’s the problem.  Not one commenter has given me a single fact that would lead me to conclude that this imaginary scenario does not in fact describe the real world.  Note, for instance, that I assumed that the two bond markets are highly liquid and traders focus on the interest rate spread.  I assumed the forward yen is lightly traded, and hence considered peripheral in the world of finance.  But I’ve also constructed an example where, by assumption, that difference in liquidity between the two markets has no bearing on causality.

So what would count as evidence against my imaginary scenario?  Perhaps you could convince me that while the 30-year forward yen is 50, traders actually expect the yen to be trading at 105 in the year 2048.  And investors continue to buy low yield JGBs in any case, because of market segmentation, or some other reason.  So the differences in interest rates are unrelated to differences in inflation, etc. If you offered that sort of explanation, and backed it up with evidence, I would be persuaded.  But I’m not seeing people do that.  Until then, I’m going to assume the causality goes from an appreciating yen to a situation where Japanese interest rates are lower than American interest rates.

PS.  The “carry trade” may partly explain why people disagree with me, but carry trades suffer from the “peso problem”, so I’m not convinced the carry trade will “work” going forward.  If Japanese inflation stays well below US inflation (as I expect), then the carry trade will break down at some point.

PPS.  Financial variables may or may not be linked to macro events.  The 1929 stock market crash seems to have been linked to fears of depression, while the 1987 stock market crash seems to have been sort of random.  You can view my claim here as being that the 1929 case is more typical.  Asset prices move based on shifting expectations regarding economic fundamentals.  Even if a forward exchange rate market did not exist, I’d claim that expectations of the future spot rate drive the interest rate differential.

My vision of macro

The following Venn diagram helps to explain how I visualize macro:

Screen Shot 2017-03-26 at 3.17.11 PMThere are three basic fields within macro:

1.  Equilibrium nominal

2.  Equilibrium real

3.  Disequilibrium sticky wage/price (interaction)

I’ll take these one at a time.

1. Within equilibrium nominal there are important concepts:

A.  The quantity theory of money

B.  The Fisher effect

C.  Purchasing power parity

The first suggests that a change in M will cause a proportionate change in P.  The second suggests that a change in inflation will cause an equal change in nominal interest rates.  The third suggests that a change in the inflation differential between two countries will cause an equal change in the rate of appreciation of the nominal exchange rate.

All three concepts implicitly hold something constant; either the real demand for money, the real interest rate, or the real exchange rate.  In all three cases the concept is most useful when the money supply and price level are changing very rapidly, especially if those changes persist for long periods of time.

2.  Equilibrium real macro can be thought of as looking at economic shocks that do not rely on wage/price stickiness.  These include changes in population, technology, capital, preferences, government policies, weather conditions, taxes, etc.  These can cause changes in the real demand for money, the real interest rate, the real exchange rate, the unemployment rate, real GDP, and many other real variables.

3.  Disequilibrium macro looks at nominal shocks that cause changes in real variables, but only because of wage/price stickiness.  Thus because prices are sticky, an increase in the money supply will temporarily cause higher real money demand, a lower real interest rate, and a lower real exchange rate.  These changes occur even if there is no fundamental real shock hitting the economy.  The effects are temporary, and go away once wages and prices have adjusted.

If wages and prices are sticky then an increase in the money supply will also cause a temporary rise in employment and real output.

And that’s basically all of macro.  (This is how I’d try to explain macro to a really bright person, if I were given only 15 minutes.)

I also believe that understanding the implications of this three part schema makes one a better macroeconomist. Talented macroeconomists like Paul Krugman tend to have good instincts as to which real world issues belong in each category. Here’s my own view on a few examples. For simplicity, I’ll denote these three areas: nominal, real, and interaction:

1.  Most business cycles in ancient times were real, with some interaction.  The 1500 to 1650 inflation was nominal.

2.  Recessions such as 1893, 1908, 1921 and 1982 were mostly interaction.

3.  The Great Depression was all three.

4.  The Great Inflation was mostly nominal, especially in high inflation countries.

5. The 1974 recession was more “real” than usual.  Ditto for the WWII output boom.

6.  The real approach works best for short run shocks to specific industries such as housing and oil, plus long run growth.  The nominal approach works best for high inflation rates and long run inflation.  The interaction approach works best for real GDP fluctuations in large diversified economies.

7.  If one set of economists say the Japanese yen is too strong, and another set say it’s too weak, they are probably using different frameworks.  Those who say its too strong are using a nominal framework, and are likely worried about deflation.  A weaker yen would boost inflation.  Those who think the yen is too weak are using a real framework.  Rather than worry about deflation, they worry that Japan has a current account surplus.  These views seem to contradict, but it’s theoretically possible for both to be right.  Perhaps the nominal exchange rate for the yen is too strong, and the real exchange rate is too weak.  You would then weaken the nominal exchange rate by printing money, and strengthen the real exchange rate by reducing Japanese saving rates.  (I don’t favor the latter, just saying that’s the proper implication of the misguided worry about Japanese CA surpluses.)

8.  Don’t let your policy preferences drive your analysis.  Throughout all of my life, it’s been assumed that monetary shocks drive real output by causing changes in the unemployment rate.  Not changes in trend productivity growth or population growth or labor force participation or any number of other variables.  Money matters because it affects unemployment.  If the unemployment rate is telling you that monetary policy is no longer holding back growth, the proper response is not to double down on your belief that we need easier money and then look for new theories to justify it, but rather to conclude that whatever problems we still have are now “real”, not “interaction.”

A good macroeconomist knows that all three fields of macro are very important, and which models apply to each of the three fields, and which field is most applicable to each real world macro issue.

Currency depreciation doesn’t offset tariffs

One of my few remaining thoughtful commenters (ChrisA) left the following comment:

On the UK exports being affected by tariff’s after Brexit – couldn’t that be taken care of by a fall in the pound vs the Euro? I don’t actually think a tariff war between the UK and the EU is actually going to happen, since the trade deficit is so much in favour of the EU they have a strong incentive to be sensible. But even in the worst case we couldn’t be talking about tariffs of more than 10%, which is easily taken care of by the fall in the pound that has happened over the last week. And remember that applies to all of the exports of the UK to all of the world, not just to the EU.

I see this claim quite often, but it doesn’t hold up to close scrutiny.  Tariffs on imports are essentially a tax wedge on trade, which reduces both imports and exports.  When people talk about using “currency depreciation” as a policy tool, they are often referring to an expansionary monetary policy.  However, although monetary stimulus does reduce the nominal exchange rates in both the short and long run, it only reduces the real exchange rate in the short run, until wages and prices have adjusted.  After that, the price level rises to restore the previous real exchange rate.

There’s no getting around the fact that trade barriers make economies less efficient, by diverting output from the tradable to the non-tradable sector.  This conclusion is not affected by whether the UK has a trade surplus or deficit, so I don’t agree that the EU has an “incentive to be sensible”.  Indeed, an import tariff might well reduce exports by just as much as it reduces imports, even if one’s trading partners do not retaliate.

Some commenters also criticized claims of a skilled labor shortage in Spain.  Over at Econlog, I have a new post that explains why they are wrong.