In this year of Trump, it has become fashionable to sneer at things you don’t understand.  Like the EMH.  TravisV sent me an example from the normally sensible Joe Weisenthal and Matthew Klein.  It’s also a good example of why I don’t use Twitter.  Lots of snarky comments that make a person look smart, but on closer examination merely show that the writer is witty.

JP Koning pointed out that I viewed yesterday’s market reaction as supporting the claim that the ECB actions helped European banks.  Stocks rose on the announcement, and bank stocks rose especially sharply.  I stand by that claim. Then Joe Weisenthal responded:

Almost all of the gains to which Sumner is referring to in this post were erased by the end of trading.

That’s true, but completely irrelevant.  The problem here is that people don’t understand markets.  Equity prices are always moving around.  When you do an event study, what matters is the market response immediately after the announcement, not later in the day.  You may “feel bad” that the stock rally didn’t last, but markets aren’t about feelings, they are about cold hard facts.  In fact, if markets never reversed gains made early in the trading day, then the EMH would be entirely false.  A few weeks back I was sent an email by a guy showing that previous BOJ surprises were followed by additional gains in the days and weeks ahead.  Free money?  Nope, right after making that observation, the Japanese markets reversed, and lost more than the initial gain from the BOJ’s recent decision to go negative. It’s just one coin flip after another.

Matthew Klein responds:

LOL

Joe Weisenthal responds:

Sumner’s insistence on using snap market reactions to judge policy a success or failure is head-scratching.

I’m honored that Joe thinks I invented “event studies”—that this is all my peculiar idea, but there are actually thousands of academic event studies.  I’ve seen Paul Krugman favorably discuss the outcome of event studies.  Then this was added to the Twitter thread, by someone else:

Sumner’s view is unfalsifiable. He will now say that ECB did not do enough.

Actually, event studies are among the most “falsifiable” of all academic studies. But notice how misleading this is.  I actually did say the ECB needs to do more, but the commenter is giving readers the impression that I use that as an excuse for the decline in stocks later in the day.  That is completely false, as it would not be consistent with the EMH.  Yes, they need to do more, but my explanation for the decline in stocks later in the day was exactly the same explanation as the financial press provided. That’s right, publications like the Financial Times are apparently just as clueless as I am.  I wonder why Weisenthal doesn’t say, “The mainstream financial press’s claim that asset prices reversed later in the day on Draghi’s comment that no further rate cuts were likely was head-scratching”?  Perhaps he doesn’t know that this is what happened.

Asset markets are ruthlessly efficient.  If they were not it would be easy to get rich. Just sell European bank stocks short after the “irrational” stock price run-up following an ECB announcement. Indeed I’d guess that even EMH skeptics like Robert Shiller mostly buy into the idea that markets respond immediately to new information.  What reporters don’t understand is that the real world is messy. Asset prices change all the time.  The standard deviation of daily changes in stock price indices is about 0.8%, which it pretty big (or at least it was last time I looked–for the 20th century).  But the average change in any 10-minute interval is far smaller, so when you have a dramatic policy announcement, it’s often possible to see the market response–it really jumps out when you look at the data.  And when you have many such announcements and the markets almost always respond as monetary theory would predict, then you can be especially confident.

Here is what apparently happened over the last couple of days:

1.  Stocks rallied and the euro fell on the more stimulative than expected ECB announcement.  Totally consistent with what we know about monetary policy.

2.  Stocks fell sharply and the euro rallied on Draghi’s (perhaps misunderstood) statement at a press conference.  Again, totally consistent with what we know about monetary policy

3.  I don’t know why the markets reversed course again today, but James Alexander watches these things more closely than I do, and here’s what he reports:

There seems to have been a lot of public and private follow upon Friday from the ECB to reinforce their original, positively-taken, message.

“The European Central Bank embarked on a rearguard action to win over skeptical investors on Friday, a day after chief Mario Draghi unveiled a new stimulus package but blunted its impact by suggesting the ECB would not cut interest rates again.

A number of top ECB officials, both publicly and behind the scenes, spoke out in support of the measures Draghi announced on Thursday although some recognized the ECB had muddled its message to financial markets.”
http://reut.rs/1U6EeID

I have absolutely no idea whether that Reuters story is right or wrong, but it’s the sort of information that moves markets all the time.  And markets should react to that sort of information, if it sends signals about future policy intentions. I’m sorry it’s so complicated, but that’s the world we live in.

Unfortunately, not all policy experiments are perfectly clean.  In the old days you could look at fed funds futures prices, and then see if the Fed cut rates more or less than expected.  The event studies were highly reliable.  I admit that announcements are now somewhat more complex, but let’s not throw the baby out with the bathwater; they are still far better than any other method.  What’s the alternative, wait 6 months and see what happens to the macroeconomy?  Really? Like we know what the macroeconomy would have looked like if the decision had been a few basis points loser or tighter?  That’s ridiculous.

This skepticism about market efficiency was one cause of the Great Recession (Joe’s probably thinking “Good Lord, Sumner’s now blaming me for the Great Recession, he really needs to take his meds.”)  The Fed scoffed at market predictions of sharply lower inflation, right after Lehman failed.  The markets were right and the Fed blew it.

Markets may look crazy, but only in the sense that an extraterrestrial being that was 100 times as smart as you or I would seem crazy.  Asset prices move around all the time because the future is highly uncertain, and seemingly innocuous comments (like Draghi’s suggestion that no more rate cuts are expected) are actually very consequential.

If the ECB skeptics are correct, and market movements are just so much noise, then I must be hallucinating to claim I can connect any given market movement to a specific policy announcement.  OK, then take a look at the graph below, showing the value of the euro against the dollar, which is from Timothy Lee’s excellent Vox story on the day’s events.  Suppose you didn’t know what time of day the ECB made it’s initial announcement and also the time when Draghi said this was going to be the final rate cut.  Do you think you could guess, just from the graph?  Maybe I’m hallucinating, but I think I see a meaningful fall in the euro at about 12:45, and a big jump just before 2PM.  Gee, I wonder what those correspond to? It turns out the original ECB announcement was at 12:45.  And Draghi’s statement that it was the final rate cut was at 1:56:30—just before 2pm.   Huge market moves right after important new information.  What an astounding coincidence!!  After all, event studies are useless, right?  Asset prices are just random noise.

PS.  People are always telling me to get on Twitter.  This is a perfect example of why I prefer blogging.  You can have the sort of serious discussion in blogs that’s just not possible in 140 characters.

It wasn’t expected by everyone, but MMs have been predicting this for quite some time (although they are even lower than I expected):

World markets may have recovered their poise from a torrid start to the year, but their outlook for global growth and inflation is now so bleak they are betting on developed world interest rates remaining near zero for up to another decade.

Even though the U.S. Federal Reserve has already started what it expects will be a series of interest rate rises, markets appear to have bought into a “secular stagnation” thesis floated by former U.S. Treasury Secretary Larry Summers.

Of course Summers was a latecomer to this idea; I’ve been talking about slower trend growth and low interest rates as the new normal for many years.  Tyler Cowen’s book entitled “The Great Stagnation” also preceded Summers.

If you believe the press (and many economists), this period of low interest rates represents “easy money”,  That’s right, the implied claim is that the “liquidity effect” (normally very transitory) has now lasted for a decade. And there’s more to come:

Take overnight interest rate swaps. They imply European Central Bank policy rates won’t get back above 0.5 percent for around 13 years and aren’t even expected to be much above 1 percent for at least 60 years.

Japan‘s main interest rate won’t reach 0.5 percent for at least 30 years, they suggest, and even U.S. and UK rates are set to remain low for years. It will be six years before U.S. rates return to 1 percent, and a decade until UK rates reach that level.

“Although interest rates are low, they’re not accommodative,” said Harvinder Sian, global rates strategist at Citi in London. “The era of zero rates will be with us for years and years, it wouldn’t surprise me if we’re looking at another five to 10 years.”

Sixty more years!?!?!  At least there is one guy dissenting from the view that low rates mean easy money.  It will be interesting to see how long it takes the others to figure this out.  Let’s hope it’s not 60 years.

Update:  Commenter BC pointed out that the US interest rate data looks fishy, given that 5 year T-notes currently yield well over 1%.  So the article I cited may not be accurate.

And as predicted by MMs, the Swiss decision to revalue the franc has backfired. Now that markets understand that the Swiss are willing to let the SF appreciate over time, Swiss interest rates are forced below the already very low eurozone rates (due to the interest parity condition.)  In contrast, the Danes fought the speculators off, and are now reaping the (admittedly small) benefits, of having slightly higher bond yields than Germany:

The five countries or economic blocs currently with negative deposit rates have yields below zero on all their bonds from a minimum of five years’ maturity (Denmark) to a maximum of 20 years (Switzerland).

The pro-revaluation crowd thought that the SF would no longer be expected to appreciate, if speculators could be placated with a revaluation upwards.  But that was like feeding meat to sharks, it just increased their appetites.

PS.  Here’s what Tyler Cowen said 13 months ago, about the ability of the Danes to fight off speculators:

I would bet against them [the Danes], in any case this will be a neat test case for our judgments of Switzerland.

PPS.  Lars Christensen says the US may be about to enter a recession.  Possibly, but I’m less confident than he is.  BTW, here’s the track record of IMF economists in predicting downturns:

As The Economist noted, between 1999 and 2014, the International Monetary Fund, in its April forecasts, failed to predict every one of the 220 instances in which one of its members suffered negative annual growth in the next year.

Ouch!  I wonder if they ever predicted anyone will have negative growth?  Kudos to Lars for going out on a limb.

PPPS.  Tyler Watts sent me a music video on “Tall Paul” (Volcker), which might be fun to use in undergrad money/macro classes.

Update:  Timothy Lee has a great post on Draghi’s screw-up today.

Today we saw not one, but two experiments on the impact of negative IOR on bank stocks.  In my previous post I pointed out that European bank stocks soared on a more expansionary than expected stimulus package from the ECB, including lower IOR and QE.

Shares in eurozone banks rallied sharply after the ECB announcement with Deutsche Bank up 6.5 per cent, Commerzbank up 4.9 per cent,Société Générale up 5.4 per cent and UniCredit up 8.2 per cent.

But how do we know that monetary stimulus helps the banks?  Maybe it was some other aspect of the package.  Fortunetely, we got another policy experiment soon after.  Again, here’s the FT:

The European Central Bank cut its benchmark interest rates to a new low and expanded its quantitative easing package, in a bolder-than-expected package aimed at boosting the eurozone’s flagging economy.

However, Mario Draghi, ECB president, played down the prospects of further rate cuts, swiftly reversing a sharp slide in the euro against the dollar.

They are talking about Draghi’s comments at the press conference afterwards, which suggested that further rate cuts were unlikely.  Big mistake.  And exactly as expected, European bank stocks fell on the contractionary announcement, wiping out the gains from earlier in the day.  You don’t get much better natural experiments than today.

I’ll say it again:  So do more!!

The ECB moved more aggressively than expected to cut IOR and increase QE. Today I will explore the effects, beginning with the banks.  Recall how negative IOR was supposed to be so bad for bank profits.  It seems those theories were wrong:

Banks have warned that negative interest rates are eroding their profitability. The rates cut into banks’ net interest margins as lenders have been reluctant to pass on the cost of negative rates to all but the biggest retail customers.

To offset some of the pain to banks, the ECB will provide cheap loans through targeted longer-term refinancing operations, each with a maturity of four years, starting in June 2016. These loans could potentially be provided at rates as low as minus 0.4 per cent, in effect paying banks to borrow money. Banks will also benefit from a refinancing rate of 0 per cent.

Shares in eurozone banks rallied sharply after the ECB announcement with Deutsche Bank up 6.5 per cent, Commerzbank up 4.9 per cent, Société Générale up 5.4 per cent and UniCredit up 8.2 per cent.

Over the years I’ve pointed out that there are things that central banks could do to offset the hit to bank profits. For instance, they could raise IOR on infra-marginal reserve holdings, while they lowered IOR at the margin. I did not propose the exact offset discussed above, but it seems that the general concept is workable. Negative IOR need not be a problem for banks, if done correctly.

European stocks rose sharply on the more aggressive than expected announcement and the euro fell in the forex markets. Oddly, however, for the 347th consecutive time the “beggar-thy-neighbor” theory was falsified by the market reaction.  Not only did Europe’s actions not hurt the US, our stocks soared higher on the news:

Dow futures added more than 150 points after the ECB cut the deposit rate to negative 0.4 percent from minus 0.3 percent, charging banks more to keep their money with the central bank. The refinancing rate was also cut, down 5 basis points to 0.00 percent.

I warned people to be careful after the Japan announcement; the EMH is not a theory to be trifled with.  As you recall, Japanese stocks soared and the yen fall sharply when negative IOR was announced in Japan.  But then a few days later both markets went into reverse (probably for unrelated reasons).  Many people assumed it was a delayed reaction to the negative IOR.  That’s possible, but markets generally respond immediately to news.  With the European moves today we see yet another confirmation of market monetarism:

1.  Policy is not ineffective at the zero bound.  So do more!!

2.  Reducing the demand for the medium of account (negative IOR) is expansionary.

3.  Increasing in the supply of the medium of account (QE) is expansionary.  I.e. the supply and demand theory is true.

4.  There is no beggar-thy-neighbor effect from monetary stimulus.

Market monetarists were the first to propose negative IOR.  It’s our idea.  When your ideas are correct, they help to explain how the world evolves over time. Things make sense.  In contrast, people with a more “finance view” of monetary policy have been consistently caught flat-footed.  Note that these people are represented on both the right and the left, and they have been consistently wrong in their views of monetary policy at the zero bound.

BTW, James Alexander has a post showing that eurozone growth has nearly caught up with the US:

Notice that at the beginning of 2012, NGDP growth in Europe had been running at less than 1% over the previous 12 months.  That’s the horrific situation that Draghi inherited from Trichet.  Draghi did move much too slowly at first, but at least things are beginning to look a bit better for the eurozone.  Still, Draghi needs to do more, as the eurozone is likely to fall short of its 1.9% inflation target.

Even better, the ECB needs to change its target, and set a new one high enough so that the markets are not expecting near-zero interest rates for the rest of the 21st century:

Take overnight interest rate swaps. They imply European Central Bank policy rates won’t get back above 0.5 percent for around 13 years and aren’t even expected to be much above 1 percent for at least 60 years.

Update:  The euro later reversed its fall.  But note that US stocks soared even after the initial plunge in the euro.  It’s interesting to think about why the euro reversed its losses–perhaps a view that the ECB action will make the Fed less likely to raise rates?  Or because it was expected that the action would lead to stronger eurozone growth?  What do you think?

Update#2:  Commenters HL and GF pointed out that the euro rose in value after Draghi indicated (in a press conference) that the ECB would probably not push rates any lower.

One of the most interesting things about the long Japanese deflation was the relative stability of the Japanese yen, against the dollar.  It’s depreciated about 1% since the end of 1993:

You’d have expected the Japanese yen to have appreciated strongly in recent decades, as the US price level (GDP deflator) has risen from 73 to 100 since early 1994, while the Japanese price level has fallen from 117 to 100.  Thus the ratio of US to Japanese prices has risen from 0.91 to 1.62. And that’s not because I cherry-picked the data, as of a month ago the yen was down about 10% against the dollar, since the end of 1993.  Thus the deviation from PPP would have been even bigger.

I frequently argue that inflation doesn’t matter, what matters is NGDP growth per capita.  Here is the NGDP of Japan since the beginning of 1994:

It’s up about 1%.  But Japan’s population is up about 1% or 2%, depending on the source, meaning that NGDP/person is either flat or down 1%.

How about in the US?  The following graph shows NGDP/person:

So in the US NGDP/person is up about 106.7%, versus at most zero in Japan. You might say that’s comparing apples and oranges, as one is in dollars and the other is in yen.  But as we saw the exchange rate is pretty stable since the end of 1993.  On the other hand, if PPP does not hold, what difference does that make?  RGDP in Japan has been rising, so Japanese living standards are on the way up.

Here’s how I would interpret this data.  This is telling us that compared with early 1994, Japanese tourists have become much poorer in a relative sense, every time they visit Hawaii.  Relative to American tourists, they have a hard time affording positional goods, like the best hotel rooms.

Just think about the size of this relative impoverishment of Japanese tourists.  In PPP terms, Japan’s per capita GDP (World Bank) is $36,426, a normal developed country.  What does it mean to lose half your purchasing power?  Here are some countries about half as rich as Japan:

Please don’t misunderstand me; I’m not saying that Japan is that poor, the $36,412 figure shows their current PPP income.  I’m just trying to give you a sense of how big a drop it is.  In fact, at the end of 1993 the yen was quite strong in real terms, so the Japanese seemed rich when they visited Hawaii.  But since then, the drop has been precipitous, with Japanese tourists losing over half their purchasing power, relative to Americans.

One silver lining is that Japan remains 50% richer than Borat’s home country (Kazakhstan) which has a GDP/person of only $24,228, so I don’t expect to see any Japanese tourists confusing the elevator with their hotel room.

Finally, I get to the point.  The PPP theory is pretty elastic, but not infinitely so.  The fall in the real value of the yen is probably close to the maximum possible.  If Japan were to simply to push the yen back to 125/dollar, and then peg it for several decades, they would likely experience at least as high an inflation rate as the US, probably higher.  Because the US is now out of the zero rate trap, I predict our inflation rate will average at least 1.5% over the next few decades.  If Japan doesn’t end up with significant inflation, it won’t be because they are unable to do it with monetary policy alone.  Rather it would be because they stupidly allowed the yen to appreciate over time.  It’s up to them.  The US may grouse, but as we showed with the Chinese dollar peg, we are (Thank God!) a paper tiger.

And if I’m wrong, and the real yen exchange rate keeps plunging, then Japanese workers will have Kazakhstani wage by 2040.  If those highly productive Japanese workers can’t take market share at Kazakhstani wage levels, then Japan should just fold up shop.