Good news: lower interest rates. . . . Even better news: higher interest rates.

It seems like lots of commenters are insisting that QE2 is failing because interest rates have risen since the November 3rd announcement.  If course most of the interest rate effect was already priced in by November 3rd.  But they are also missing a more important distinction—higher rates can be good news, or more specifically a reflection of good news.

Take yesterday’s big move in the bond markets.  Five year T-note yields jumped 17 basis points, from 1.47% to 1.64%.  But the yield on 5 year TIPS only rose by 10 basis points, from -0.22% to -0.12%. Thus 5 year inflation expectations rose 7 basis points, from 1.69% to 1.76%.  That’s good news folks.

Now some people might say; “Sumner, you can’t have it both ways.  The QE2 proponents have been arguing that the falling rates of September and October showed QE2 was working.”  Actually I can have it both ways.  In the months before QE2 was announced TIPS yields fell much more sharply than nominal yields and thus 5 year inflation expectations rose from about 1.2% to 1.7%.

Message to QE critics (and proponents); stop focusing on interest rates.  Here’s what Milton Friedman had to say in 1997:

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.

The stock market understands that message; they brushed of the higher interest rates and rose 2% yesterday.  And stocks also rose when rates fell on earlier rumors of QE2.

Then there is the argument that the rising dollar (against the euro) shows QE2 isn’t working.  I admit to arguing that the strong dollar was a sign of tight money in the spring of 2010.  But I wasn’t basing that argument solely on the movements in the exchange rates, which are always an ambiguous signal.  A rising dollar can reflect tighter money here, or easier money in Europe.  In the spring it seemed to reflect tight money in the US, as other asset prices were confirming that signal.  And my initial reaction was that the same was occurring in response to renewed problems in the eurozone.  But a good macroeconomist will never fall in love with an explanation.  It seems like the eurozone troubles may be becoming so severe that the ECB will have to become more accommodative.  If there is anything the ECB hates more than easier money, it would be a crisis that ripped the eurozone apart.  Here’s a recent story hinting that ECB easing may be necessary to save the euro:

NEW YORK (AP) — U.S. stock futures are rising, building on gains overseas as the European Central Bank meets to discuss its plans to support the euro zone.

Investors are hoping that the bank will take additional steps to prevent the European financial crisis from spreading to Spain and Italy.

I’m not saying I have high confidence in this explanation, but rather that one must always remember to look at a wide variety of variables when analyzing a situation.  Even the very best macroeconomists can become a little too obsessed with one variable, Milton Friedman with the money supply, Robert Mundell with exchange rates.  But where they differ from their followers is that they generally knew when to look beyond that one variable, and which other variables were relevant to the problem at hand.

Yesterday a commenter named Leo made this interesting observation:

Readers should not (as I’m sure you don’t) confuse Hayekian pragmatism for Misesian logic.

I can’t comment on Mises, but I do consider myself a pragmatist.  In any given macroeconomic situation there are at least 10 models and variables that need to be considered.  Some people will ignore 9 of the 10, and then methodically apply Cartesian logic to the one variable that they consider “the real problem.”  That’s not my style.

PS.  What am I monomaniacally focused on?  NGDP expectations?

Update:  This article has a bit more info on the ECB:

LONDON (AP) — The European Central Bank stepped up efforts to contain the continent’s government debt crisis, as bank president Jean-Claude Trichet announced it would prolong measures to provide ready cash to banks and steady the financial system.

Markets were initially disappointed Thursday when Trichet did not say the bank would go even further and increase its purchases of government bonds. The euro sagged almost a cent during his news conference.

But it quickly bounced back, trading higher on the day on market chatter that the bank might in fact be quietly buying bonds of financially troubled eurozone countries — despite Trichet’s reticence on the issue.

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18 Responses to “Good news: lower interest rates. . . . Even better news: higher interest rates.”

  1. Gravatar of Mike Sandifer Mike Sandifer
    2. December 2010 at 08:29

    Scott, could the dollar also strengthen vis-a-vis the Euro due to unmet increasing demand for dollars in the EU?

  2. Gravatar of Joe Joe
    2. December 2010 at 10:32

    Professor Sumner,

    What I don’t get is, since asset prices (of non-physical purchases) and interest rates are not sticky, shouldn’t any change in money demand automatically cause interest rates and asset prices (of claims to real stuff) instantaneously to adjust thereby always have monetary equilibration.

    For a Keynsian, he must explain why interest rates don’t instantly adjust. For a monetarist, he must explain why asset (claims on real goods) prices don’t instantly adjust.

    Where is the stickiness in those two markets that would happen if Ms or Md suddenly change, long before the stickiness in the labor market and goods market even occurs. Macro textbooks only explain stickiness in labor and goods markets, not in interest rate and asset markets. According to Mishkin’s textbook, we should never have monetary disequilibrium!



  3. Gravatar of Luis H Arroyo Luis H Arroyo
    2. December 2010 at 12:07

    Right. I agree. Some details:
    Trichet has gained time, nothing more. He does not have a monetary strategy does not believe that the fall in nominal GDP is a compelling reason to QE. In fact, until now he has sterilized the bond purchases.
    Therefore, we can expect is a very selective and sterilized buying bonds, which so far has involved only 1.4% of GDP in the euro area.
    Trichet is heavily guarded by Germany´s Government, which has no monetarist theory: only conservative instincts (and fear the electoral consequences). As you say, Scott, in the euro zone there are problems because the nominal GDP is weak, not only because the debt is high. Trichet & Co (Merkel) don´t understand that to save euro is necessary to devalue it.

  4. Gravatar of W. Peden W. Peden
    2. December 2010 at 12:21

    Professor Sumner,

    You are notable in looking at a range of variables (NGDP, NGDP expectations, NGDP trends, TIPS, broad money, narrow money, the monetary base, interest rates etc.) which makes for a very good analysis.

    Of course, this is because you’re not quite a Mundell or Friedman. 😉

  5. Gravatar of scott sumner scott sumner
    2. December 2010 at 19:03

    Mike, Yes, that’s probably part of it.

    Joe, I believe that the term ‘monetary disequilibrium’ refers to the fact that wages and prices are slow to adjust. Recall that 1/P is the “value of money,” thus when there is an increase in the supply of money the value doesn’t immediately change. Instead asset prices adjust to provide a short run equilibrium in the money market, as you say. But that is not the long run equilibrium, and in fact sets in motion a process that eventually changes wages and prices, providing long run equilibrium.

    Luis, That all sounds plausible to me (you know more about it than I do.)

    W. Peden, I’d be thrilled if I was “not quite a Mundell or Friedman,” I’m afraid I’m not even close.

  6. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. December 2010 at 20:57

    I’m still trying to get my students to disentangle what the interest rates are indicating. They see US and European long term rates go up and fail to make the distinction.

    I point to short term rates and the resulting yield curves. The US yield curve signals optimism. The European, dispair.

  7. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. December 2010 at 21:07


  8. Gravatar of James in London James in London
    3. December 2010 at 04:05

    If Germany benefits from a devaluation and starts growing, via manufacturing exports, that’s bad. If the US tries the same trick that’s good? Because it didn’t devalue properly, by promising to debase the currency? Of course, Germany also cheats in that it has retained a much larger manufacturing sector than US, so it also benefits more when manufacturing export demand kicks off.

  9. Gravatar of W. Peden W. Peden
    3. December 2010 at 07:14

    Professor Sumner,

    No, but I tend to find that insincere overstated flattery is the best form of sincere praise.

    Can I ask a rather obvious little question? When you and Friedman talk about interest rates in this context, do you mean nominal interest rates or real interest rates?

  10. Gravatar of Benjamin Cole Benjamin Cole
    3. December 2010 at 09:20

    BTW, latest issue of New Yorker has column by Surowieki (sp?) on QE2, excellent. Surowieki comes out and says the Republicans are against any policy that might be successful, as that would help Obama.


  11. Gravatar of rob rob
    3. December 2010 at 17:29

    If this “jobless recovery” turns into an outright “jobless boom” in a few years — what then? Has such a thing happened before? Should we consider it within the realm of possibility?

  12. Gravatar of scott sumner scott sumner
    4. December 2010 at 08:53

    Mark, Don’t feel bad about the difficulty of getting this point across–it is very counter-intuitive and hard for the average person to understand. It’s even hard for me to understand sometimes.

    James, You said;

    “If Germany benefits from a devaluation and starts growing, via manufacturing exports, that’s bad.”

    Why is that bad?

    W. Peden, He probably means nominal rates, I mean nominal rates, and sometimes real rates. The effect of tight money on real rates is ambiguous. If money is tight enough to cause massive unemployment and low investment, it will often reduce real reats as well, as there will be less demand for credit from businesses. On the other hand, in the short run tight money often causes higher real interest rates.

    Benjamin, I’m sure many Republicans are sincerely worried about inflation, but I don’t doubt that some are motivated by partisanship, even if only subconsciously.

    rob, Possible, but very unlikely, as it would require very rapid productivity gains in areas such as health and education. I don’t see it coming.

  13. Gravatar of james in london james in london
    4. December 2010 at 10:37

    I misread one of your earlier replies. And i was only being ironic, anyway. My point is that the Germans think their economy is doing very well now, not enough for growth junkies in the US, clearly. They achieved a very modest rise in unemployment because all shared the pain through short-time working (aka sharp cuts in take home pay), aided by a modest subsidy paid by all taxpayers. An almost free market solution … and without much recourse to QE. It can be done! There is no liquidity trap.

    Their NGDP probably grew less than your centrally-planned money economy in the US over the last few years. But who was growing at the right level and how do you KNOW? Overly pro-growth central bankers (aka central planners) are doomed to fail – this time when they when they were too accomodative for too long and their banking regulators too captured by the bankers they regulate.

    For an excellent blog by one of your liberals on this issue, see below. Here is eloquently put the moral hazard question of bailing out the banks I have not seen you comment upon. My solution is to let them fail, Johnson’s is to regulate more and better. Where do you stand,and where would do you reall stand on Lehman, GS and the other banksters?

  14. Gravatar of Lorenzo from Oz Lorenzo from Oz
    5. December 2010 at 06:11

    An aspect of prudential regulation in Australia is the “four pillars” policy, which basically says the Government stops any of the four major banks (ANZ, Westpac, Commonwealth, NAB) acquiring any of the others, or being acquired. This puts a limit on the size of the banks being regulated. The quid-pro-quo for this ring-fencing is fairly strong prudential regulation about what reserves they have, what assets they must retain, what liabilities they can take on. It seems to me to be a fairly pragmatic set of trade-offs.

  15. Gravatar of ssumner ssumner
    5. December 2010 at 06:30

    James, I don’t want to share the pain, I want to minimize the pain. Anyway, you can’t beat something with nothing. If you don’t like stable NGDP, what sort of monetary system do you like? What would be the medium of account?

    I am a strong opponent of government provided moral hazard. I favor a laissez-faire financial system with no government bailouts. But we will never get there without NGDP targeting. If NGDP plunges, then the public will demand government bailouts, at a minimum of depositors (FDIC.) In my view FDIC is the single biggest source of moral hazard. Far more money is going to bail out depositors, than “banksters.”

  16. Gravatar of ssumner ssumner
    5. December 2010 at 06:32

    Lorenzo, Yes, especially if you have deposit insurace. Any banking system with deposit insurance has already nationalized half of the banking system (liabilities) so it’s a little late for laissez-faire. It sounds like the Aussies have found a good compromise.

    We have something like 8000 banks, and a very ineffective federal government. I doubt prudential regulation would work here.

  17. Gravatar of Justin Justin
    6. December 2010 at 21:52

    Dr. Sumner,
    I’m a bit confused about what you and Milton Friedman are claiming about interest rates. It seems to me that short term rates like what the Fed manipulates (in normal times) are fairly unambiguous, am I wrong? Lower federal funds rates mean easier money/more stimulus and vice-versa.

    So it seems your point is that longer rates additionally reflect expected inflation, so that higher interest rate may mean either tighter money or higher expected inflation.

    Am I missing anything? Is there some other effect under QE that I’m not considering?


  18. Gravatar of ssumner ssumner
    8. December 2010 at 18:33

    Justin, Both short and long term interest rates are ambiguous. In December 2007 the Fed did a contractionary surprise, and 3 month T-bill yields fell. Other times a contractionary surprise will cause 3 month T-bill yields to rise.

    Falling short rates might reflect easy money, or they might be a response to tight money done 6 months earlier. It is very complicated–I’m not sure anyone completely understands the relationship.

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