Markets set interest rates
Patrick Sullivan sent me a link to a talk by John Taylor. Around the 15 minute mark Taylor recounts an amusing conversation he was part of with James Tobin and Paul Volcker, back in 1982:
I remember very well Jim [Tobin] asking Paul “Why don’t you lower interest rates, Paul?” And Paul Volcker said, “I don’t set interest rates; I set the money supply and the market reacts [with] the interest rate.”
John seemed to say “to” not “with”, but in context I think he meant, “reacts with changes in interest rates.”
I love that quote. Great to know that central bankers occasionally see the light.
Those who want higher interest rates need to tell me precisely what they want the Fed to do to cause rates to be higher.
PS. I have a new post at Econlog. The first of many, many posts to comment on Bernanke’s new memoir.
PPS. Bob Murphy has a new post criticizing my recent post on real shocks. He starts off as follows:
Sumner’s whole purpose with this post is to argue that shocks in “real” factors can have huge impacts on welfare. However, they do not correspond to the business cycle. So long as the central bank exercises wise monetary policy, real shocks can be offset and full employment can be maintained. In contrast, we don’t need a real shock to get a recession and rising unemployment; all we need is the central bank to stupidly let NGDP growth fall below trend.
Actually, there are real shocks like a $20 minimum wage that could cause recessions and much higher unemployment. I was trying to show that as a practical matter the fluctuations in unemployment in the US and Australia are mostly about NGDP shocks. I probably should have been clearer; sometimes I assume there are certain things that “go without saying.”
In the rest of his post Bob belatedly discovers something I have said dozens of times here over the past 5 years, that for commodity exporters like Australia I view total nominal labor compensation as better than NGDP. I’ve also explained why this compromise is a clear implication of the musical chairs model. Bob seems to think that somehow undercuts my whole message, but I’m not quite sure why nuance is worse than fanatical devotion to fitting one single model into all conceivable circumstances. I’m a pragmatist, so sue me.
But yes, I should have made that point explicit in the post.
Tags:
18. October 2015 at 11:04
“In the rest of his post Bob belatedly discovers something I have said dozens of times here over the past 5 years, that for commodity exporters like Australia I view total nominal labor compensation as better than NGDP.”
Did you read my Australia v. Russia comments on Bob’s post? How do you respond to them?
18. October 2015 at 12:30
“Those who want higher interest rates need to tell me precisely what they want the Fed to do to cause rates to be higher.”
Scott, you sound like a person of the concrete steppes here. The answer is that the Fed hires Chuck Norris, who creates expectations. Simple! You’ll know they’re not creating enough expectations if it doesn’t work.
18. October 2015 at 12:37
E. Harding, That doesn’t show any data for 2015:1, unless I missed something.
I’d need to know a lot more about Russia to comment.
What is the total nominal labor compensation growth rate? What’s the growth rate in average hourly earnings?
Tom, Touche.
18. October 2015 at 13:30
“Those who want higher interest rates need to tell me precisely what they want the Fed to do to cause rates to be higher.”
-Simple: unwind all QE in a day, and keep the monetary base low enough so that the Federal funds rate soars to 5%. That should raise interest rates, right?
18. October 2015 at 13:36
@Prof. Sumner
Off topic. From John Taylor’s EconomicsOne http://economicsone.com/2015/10/16/colliding-with-bill-dudley-at-a-crossroads/
Lot’s of handles to “jump in” with your model. To name 3: 1. Forward looking features (prediction markets), 2. adjustable inflation in a Taylor Rule and 3. Simplicity (NGDP targeting tackles the latter 2 points) …
18. October 2015 at 13:45
‘Simple: unwind all QE in a day, and keep the monetary base low enough so that the Federal funds rate soars to 5%. That should raise interest rates, right?’
Well, at the time, Volcker was engaging in tighter monetary policy…and interest rates were dropping.
18. October 2015 at 16:22
“I’m not quite sure why nuance is worse than fanatical devotion to fitting one single model into all conceivable circumstances.”
You mean like the fanatical devotion to fitting in central banking and Rortyianism in all conceivable circumstances?
18. October 2015 at 17:02
I think the Fed could raise rates. They could engage in quantitative easing at $50 billion a month for several years. This might lead to robust economic growth and lower unemployment rates.
After several years, such prosperity and boom times might lead to higher inflation and that might lead to higher nominal interest rates, Including an inflation premium.
We will have to endure huge increases in real output to get there, but maybe it is worth it.
18. October 2015 at 18:47
Spam filter triggered?
I was posting a link to Russian nominal wages.
18. October 2015 at 19:19
“Touche” to Tom Brown; but, after all, the more remote a magnitude is from the Fed’s direct control the more appropriate it is to ask for “concrete steps”! Money supply — quite direct; NGDP — almost as direct; interest rates (all maturities?) — much less direct. So, one should demand “concrete steps” only with respect to this last magnitude.
18. October 2015 at 21:51
“Actually, there are real shocks like a $20 minimum wage that could cause recessions and much higher unemployment”
I keep running into statements like this and not understanding.
If LNGDP is maintained why would a recession and unemployment be the consequence? I agree there will be impacts, but why don’t you look for inflation to rise a little and real wealth to redirect slightly towards different agents in the economy?
Isn’t that the whole argument for LNGDP; Convert recessions and unemployment into a little more inflation and avoid those sticky wages and prices?
19. October 2015 at 01:48
” . . . you should note – the central bank controls the short-term interest and all the rest of the rates largely follow suit.
In effect, the central bank sets the interest rates at the short-end of the yield curve and the term structure follows expectations of inflation risk rather than default risk.
The “balance sheet” operations of the central bank can then control any other interest rate at any maturity that the bank desires. How?
The central bank could announce, for example, a ceiling on a longer-term yield, which was below the current market rate if it wanted the longer-term – investment rates – lower.
It could enforce that aim by being prepared to purchase the targetted assets at the desired yield.
Mainstream economists repeatedly claim that this strategy would have to be ratified by the market for it to work. That is, the only way the central bank could cap yields on longer-term assets is it the target yield was consistent with the market expectations of the yield.
Which, of course, is pure nonsense. These economists mostly use so-called ‘frictionless financial market’ models where there is no time or transaction costs and everyone has perfect information and equal access. That is, they count angels on the top of pin heads.
Clearly that sort of model has nothing to say about the real world we live in.
The only consequence of a discrepancy between the targeted yields and the market expectations of future yields would be that the central bank would end up holding all of the targetted asset and the bond traders would not buy at all because they thought yields would have to rise and bond prices fall.
My assessment of that outcome – excellent.
The bond traders might boycott the issues and ‘force’ the central bank to take up all the volume on offer. So what? This doesn’t negate the effectiveness of the strategy it just means that the private buyers are missing out on a risk-free asset and have to put their funds elsewhere. Their loss!
Eventually, if the government bond was the preferred asset the bond traders would learn that the central bank was committed to the strategy and would realise that if they didn’t take up the issue the bank would. End of story – the rats would come marching into town piped in by the central bank resolve.
The BIS paper concurs that the central bank holds all the cards in this regard.”
http://bilbo.economicoutlook.net/blog/?p=32029#more-32029
19. October 2015 at 05:59
‘”Actually, there are real shocks like a $20 minimum wage that could cause recessions and much higher unemployment”
‘I keep running into statements like this and not understanding.’
Elwaily, If you make a large number of people unemployable by making it illegal for them to work–people who can’t product $20/hr in value to consumers–then their labor supply will disappear from the economy.
And that will also take their demand for what others produce away too. If the minimum wage is high enough, say $100 an hour, it COULD cause a recession.
19. October 2015 at 06:24
The Law of Unintended Consequences is alive and well;
http://www.wsj.com/articles/big-banks-to-americas-companies-we-dont-want-your-cash-1445161083
———quote——–
Many businesses have large sums on hand and opportunities to profitably invest it appear scarce. But banks don’t want certain kinds of cash either, judging it costly to keep, and some are imposing fees after jawboning customers to move it.
The banks’ actions are driven by profit-crunching low interest rates and regulations adopted since the financial crisis to gird banks against funding disruptions.
The latest fees center on large sums deemed risky by regulators, sometimes dubbed hot-money deposits thought likely to flee during times of crises. Finalized last September and overseen by the Federal Reserve and other regulators, the rule involving the liquidity coverage ratio forces banks to hold high-quality liquid assets, such as central bank reserves and government debt, to cover projected deposit losses over 30 days. Banks must hold reserves of as much as 40% against certain corporate deposits and as much as 100% against some deposits from hedge funds.
———–endquote———–
So some banks are charging ‘storage’ fees. AKA, negative interest rates.
19. October 2015 at 08:11
E. Harding, Hard to say. The fed funds rate yes, the 3 month T-bill yield? Probably not.
Thanks Jose.
Elwailly, The key variable is NGDP/W. Normally wages are sticky, and hence stable growth in NGDP leads to stable growth in hours worked. But if W rises sharply by government fiat, then NGDP/W falls, as does hours worked.
Thanks for the info Patrick.
19. October 2015 at 08:57
“The key variable is NGDP/W”
ssumner, Many recessions are caused because wages don’t fall sufficiently in response to some shock. Holding NGDP steady will cause a rise in inflation which erodes real wages. Nominal income and employment remains steady giving the economy room to adjust to the initial shock.
It’s not clear that hours worked will fall even if W increases in some sectors. They will fall in those sectors as they are substituted for, but overall demand will remain steady which means other jobs open up due to the FED reaction.
By example wages of many CEO’s have increased substantially over the last few decades, yet the economy chugs along with only some adjustments to where wealth goes.
I’m not saying there aren’t negatives to a higher minimum wage. I just think it’s unfair not to apply the FED’s reaction function to this shock as you do to other shocks.
19. October 2015 at 09:33
Scott,
I think I need to call a blogging foul. I don’t mean I am a referee and have official authority; I mean we are playing a pickup game in the driveway and I’m saying, “Foul!”
This is how you opened your earlier post:
“Real shocks are far, far more important that nominal shocks, for long run growth in living standards. But for the business cycle, and especially for fluctuations in the unemployment rate . . . well, it’s all about the musical chairs model.”
Now just to bring my readers up to speed, I described the purpose of your post like this:
Sumner’s whole purpose with this post is to argue that shocks in “real” factors can have huge impacts on welfare. However, they do not correspond to the business cycle. So long as the central bank exercises wise monetary policy, real shocks can be offset and full employment can be maintained. In contrast, we don’t need a real shock to get a recession and rising unemployment; all we need is the central bank to stupidly let NGDP growth fall below trend.
I think that’s a pretty good paraphrase of how you yourself opened up your post, isn’t it?
Now to be sure, if I had gone on to criticize you by saying, “I can think of all sorts of ways that a crazy supply shock–like the president threatening to behead anyone who hires someone–could cause a recession, Sumner’s an idiot!” then it would be fair for you to say, “Some things go without saying.” But I was just bringing people up to speed, and then proceeded to debate the very issue that was the substance of your post.
So, it sounds like you’re criticizing me for paraphrasing what you definitely said.
Moving on to the substance, isn’t the following an accurate description of what happened?
1) You said that the data in Australia were a good piece of evidence showing that NGDP affects labor markets more than real shocks.
2) Someone pointed out that actually, the recent data in Australia do the exact opposite of the NGDP story.
3) You then explained that you never thought Australia went well with the NGDP story.
This doesn’t mean you’re wrong. But by the same token, Krugman wasn’t proven wrong when he said 2013 was a good test of his views, then switched and said no there were all these other extenuating circumstances to make it in invalid test.
If nothing else, I hope you can be more tolerant of Krugman. One man’s flip-flop is another man’s nuance.
19. October 2015 at 09:57
Bob Murphy’s riposte to Sumner –ouch! Payback is a bitch. Recall Sumner blasted Murphy a while ago, now Murphy counters with a hook, cross and uppercut that sends Sumner to the mat…. down and out for the count!
19. October 2015 at 17:24
Volckrer>Greenspan
20. October 2015 at 03:19
“I don’t set interest rates; I set the money supply and the market reacts [with] the interest rate.”
“Those who want higher interest rates need to tell me precisely what they want the Fed to do to cause rates to be higher.”
If increasing the money supply is causing rates to fall…
I’m less concerned with where rates are than I am with that they are being manipulated by the central banks – especially on the scale we’ve seen since the crisis. It is causing all sorts of distortions in financial markets.
20. October 2015 at 09:41
Elwailly, You said:
“I’m not saying there aren’t negatives to a higher minimum wage. I just think it’s unfair not to apply the FED’s reaction function to this shock as you do to other shocks.”
Monetary offset applies to demand shocks, not supply shocks. It’s not a question of fair or unfair, it’s a question of how the world works.
Bob, You said:
“I think that’s a pretty good paraphrase of how you yourself opened up your post, isn’t it?”
Yes it is.
You said:
“So, it sounds like you’re criticizing me for paraphrasing what you definitely said.”
Not my intention.
You said:
“This doesn’t mean you’re wrong. But by the same token, Krugman wasn’t proven wrong when he said 2013 was a good test of his views, then switched and said no there were all these other extenuating circumstances to make it in invalid test.”
I don’t see the comparison at all, but if you can explain it to me I’d be pleased to retract. I’ve frequently said over the years that what matters for a country like Australia is total nominal labor compensation. Normally that goes along with NGDP, so I just refer to NGDP as a shortcut. The data’s easier to find. But I’ve been very clear that if they diverge because of a commodity price change then you want to go with nominal labor compensation, not NGDP. Your post seemed to imply that I just made up this “excuse” on the spur of the moment, which is not at all the case.
Now please tell me which “extenuating circumstance” that Krugman warned about for years applied to the 2013 fiscal stimulus case. If so, I’ll agree with you.
PS. Don’t be concerned that Ray agrees with you, there is still a slim chance that you are right.
Steven, What sort of problems in financial markets are caused by central bank “manipulation” of interest rates? And actually, the Fed targeted interest rates prior to 2008, but since then they’ve targeted the money supply. So the manipulation claim would seem to apply better to the pre-2008 case.
20. October 2015 at 11:28
Ray knows a knockout when he sees it!
20. October 2015 at 16:44
@ssumner
-Examples on such a strong divergence happening? On a monthly basis, the gap was never more than 5.5 points:
https://research.stlouisfed.org/fred2/graph/?g=2cru
And that was in mid-1974!
But, yeah, that would result in the most inverted yield curve of all time.