Higher bond yields suggest Abenomics is working (but only a little)
Tyler Cowen recently linked to a FT piece that contains some great examples what goes wrong when one reasons from a price change:
It illustrates the natural tension that occurs when central banks seek to push investors out of government bonds into equities and other asset classes. The risk is that such an effort can quickly become counter-productive as bond investors dump their holdings and look for higher returns elsewhere.
Rising equity and real estate prices boost wealth, consumer confidence and overall economic activity, but there is a risk that higher government bond yields can weigh on the economy.
That’s pretty much a textbook example of how “reasoning from a price change” leads one to make fundamental errors. The rising rates don’t “weigh” on the economy; they are a sign of faster NGDP growth expectations. The FT confuses cause and effect.
In the US, the Federal Reserve’s initial rounds of quantitative easing pushed Treasury yields upwards, resulting in economic soft patches in 2010 and 2011.
That’s simply false. Rates fell during the “soft patches.”
At the same time, rising interest rates could undermine the government’s attempts to improve its own finances, precipitating a fiscal crisis.
More reasoning from a price change. The rates are rising from expansionary monetary policy, which creates expectations of inflation (or slower deflation.) And of course inflation helps debtors. Japan’s government is the world’s second largest debtor. The fallacy is to confuse nominal interest rates, which may indeed rise, with real interest rates. Inflation reduces the value of existing debt, which helps the Japanese government, and for new debt it’s a wash, as higher nominal rates reflect the Fisher effect.
Yes, the gains may be reduced if the Japanese government must bail out a few banks that suffer losses on their JGB portfolio, but at worst it’s a wash. And the real growth generated will help both the government and the banks.
It’s not a zero-sum game!
BTW, this seems wrong:
“Through dialogue with the market and more flexible operations, we will ensure the stability of financial and capital markets,” Mr Kuroda told a seminar in Tokyo on Friday.
His comments came as the BoJ stepped into the market to buy bonds for a second consecutive day. On Thursday, as fears over rising bond yields sparked a 7.3 per cent fall in the Nikkei 225 stock index, the BoJ was forced to supply Y2tn ($20bn) of funds to nervous investors.
The graphs I’ve seen recently show a positive correlation between stock prices and bond yields in recent weeks. Both rose over a period of weeks, and then both fell on Thursday. Is that wrong? Higher bond yields suggest faster NGDP growth is on the way. Unfortunately rates are still quite low, which indicates that NGDP growth will probably increase only modestly. The BOJ needs to do much more.
Update: Here’s Lars Christensen:
Yes, nominal bond yields are rising – as Friedman and every living Market Monetarist said they would. However, real bond yields have collapsed since the introduction of Japan’s new monetary regime as inflation expectations have picked up. Something Mr. Koo for years has denied the Bank of Japan would be able to do.
Isn’t Koo the guy that claimed Japan was stuck in a liquidity trap? How would he explain the recent plunge in the yen?
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25. May 2013 at 08:42
Krugman posted about the last part: http://krugman.blogs.nytimes.com/2013/05/23/elementary-my-dear-watanabe-san-somewhat-wonkish/
25. May 2013 at 08:47
There is a weird dynamic with interest rates because people often complain that low rates are caused by the central bank and are hurting savers. Yet, any sign of higher rates leads to fears, not of the central bank pulling out (which would fit their story) or of the economy improving (which would fit the story of economists advocating QE), but of the bond vigilantes. In fact, it’s unclear what “these people” think would happen if the central bank pulled out. On one hand, they say rates are only low because the central bank is keeping them there, but on the other hand they say that the central bank’s commitment to higher inflation will spark fears of inflating away the debt and push up interest rates.
25. May 2013 at 09:03
Right. And Koo´s wrong!
http://thefaintofheart.wordpress.com/2013/05/25/a-theory-is-put-to-the-test/
25. May 2013 at 12:02
Still, denominator effect of NGDP growth or not, they may need to throw in some financial repression.
http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100024696/the-bank-of-japan-must-crush-all-resistance-and-will-do-so/
25. May 2013 at 12:56
“That’s pretty much a textbook example of how “reasoning from a price change” leads one to make fundamental errors. The rising rates don’t “weigh” on the economy; they are a sign of faster NGDP growth expectations.”
For the 23,875,623,987,528,397,564,987,623,497,586,423th time, inflation of the money supply does not affect all prices and incomes equally across the board over time.
Higher interest rates can very much “weigh” on “the economy”, if by “the economy” we refer to all those who heretofore depended on low interest rates, but now have to pay higher interest rates given that their nominal incomes have not yet risen due to the long and variable, heterogeneous nature of inflation of the money supply.
A higher aggregate spending does not imply every single individual in the economy is experiencing a growth in nominal income at the same time.
25. May 2013 at 13:26
An NPR commentator explained the other day how higher yields on Japanese bonds are problematic. After some thought, it occurred to me that he was reasoning from a price change. In other words: Thank you, Dr. Sumner.
25. May 2013 at 13:29
[…] Scott Sumner basically put out the same post at the same time (at least the headlines are very similar). Scott, however, is slightly less […]
25. May 2013 at 14:51
“Isn’t Koo the guy that claimed Japan was stuck in a liquidity trap? How would he explain the recent plunge in the yen?”
I finally went to the trouble of reading one of Koo’s papers recently just to see what all of the fuss was about and I’m almost sorry that I did. Koo’s paper is here:
http://snbchf.com/wp-content/uploads/2013/04/Koo-Ineffectiveness-Monetary-Expansion.pdf
The passage I take the most issue with is on pages 11-12:
“The post-1990 Japan managed to maintain its money supply (Exhibit 7) and GDP (Exhibit 4) from shrinking because the government was borrowing the deleveraged and newly saved funds from the private sector (Exhibit 9) Unfortunately there was a period in economics profession, from late 1980s to early 2000s, where many noted academics tried to re-write the history by arguing that it was monetary and not fiscal policy that allowed the US economy to recover from the Great Depression. They made this argument based on the fact that the US money supply increased significantly from 1933 to 1936. However, none of these academics bothered to look at what was on the asset side of banks’ balance sheets.
The asset side of banks’ balance sheet clearly indicates that it was lending to the government that grew during this period (Exhibit 10). The lending to the private sector did not grow at all during this period because the sector was still repairing its balance sheets. And the government was borrowing because the Roosevelt Administration needed to finance its New Deal fiscal stimulus. In other words, it was Roosevelt’s fiscal stimulus that increased both the GDP and money supply after 1933.”
There’s a reason why none of those academics attached much importance to the asset side of banks’ balance sheets.
Koo acts like there’s a one-to-one correspondence between the banking sector’s assets and public and private sector liabilities, but that’s not at all true. For example, as Koo shows in Exhibit 9, banks held about 500 trillion yen and 250 trillion yen in private sector and public sector debt respectively in December 2007. But at the end of 2007 the total amount of non-financial private sector and public sector debt was about 850 trillion yen and 900 trillion yen respectively.
Similarly in Exhibit 10 Koo shows that banks held about $16 billion in private and public sector debt each in June 1936. But in June 1936 the total amount of non-financial private sector debt and public sector debt was about $116 billion and $54 billion respectively.
(Incidentally, why did Koo put the cutoff in 1936 instead of 1937? The recession didn’t start until 1937 after all. It’s probably because the asset side of the 1937 bank balance sheets are a lot less supportive of his already flimsy argument.)
In both cases banks held only a fraction of each kind of outstanding debt. There is simply no clear relationship between debt and money supply. (Monetary policy is not credit policy.)
More importantly, the period 1997-2007 includes the first Japanese QE (2001-2006) and the corresponding Koizumi Boom (2003-2007), which was also a period of pronounced fiscal tightening in Japan. Similarly, although the Federal Emergency Relief Work and public works projects funded by the New Deal were helpful in creating the swift recovery experienced from the Great Depression during 1933-37, as several academic studies have shown (e.g. Romer, Eichengreen, etc.) the recovery was primarily due to FDR’s ending of the gold standard and the subsequent devaluing of the US dollar.
25. May 2013 at 14:52
I was startled by the following passage that I found from a report Koo wrote in December:
“But nightmare scenario awaits when private loan demand recovers. The problem is what happens when private loan demand recovers. Loan books could grow more than tenfold in the US and five fold in Japan and Europe if bank reserves remain at current levels, triggering inflation rates of 500% to over 1,000%.
To avoid this outcome, central banks will have to mop up excessive reserves by raising the statutory reserve ratio, raising the interest rate paid on reserves, and selling government bonds. All of these measures will serve to lift interest rates, sending bond yields sharply higher and triggering a possible crash in the bond markets.
A sharp increase in government bond yields could lead to fiscal collapse in countries with a large national debt. For Japan, where the national debt amounts to 240% of GDP, the results would be catastrophic.
Expanding quantitative easing because it appears to be doing no harm is grievous error. Mr. Abe and his advisors may believe that all they have to do once their anti-deflationary policies succeed and JGB yields start to rise is have the BOJ buy more bonds. However, bank reserves under quantitative easing have risen to a level capable of fueling a 500% inflation rate, in which case the BOJ would have to sell, not buy, JGBs.
Nomura | JPN”
http://moslereconomics.com/2012/12/13/koo-on-reserves-time-bomd-500-inflation/
Yes, you read that correctly. Koo is predicting that the current Japanese large scale asset purchases have the potential to create 500% to 1,000% rates of inflation, a crash in the bond market and a complete fiscal collapse.
I think it’s high time that people realize that the Emperor Koo has no clothes.
25. May 2013 at 15:04
@Mark
I sent you an e-mail. If you didn´t get it, contact me:
joaomarcus.marinhonunes@gmail.com
25. May 2013 at 17:47
Question: If market monetarism is advocating the fed use real time market signals to guide their path in determining NGDP growth. Isn’t that one massive reasoning from price changes? Not trying to be cute, it is something I’d like to have clarified.
25. May 2013 at 19:18
I still don’t see why you need a new theory to explain or predict that QE can raise rates(by changing expectations), in the New Keynesian model can’t you get the same result? I know NKs tend not to predict it, but even in the most myopically focused on interest rates theories, expectations can still change the Wicksellian natural interest rate. Am I missing something?
25. May 2013 at 21:04
Rob,
You are right that a standard NK models get to the same result as what Market Monetarists would say – that monetary easing increases nominal interest rates and lowers real interest rates.
HOWEVER, there are two important points to make. First, “practicing” Keynesian totally forget what the typical NK model is actually saying. Second, the NK description of the of the monetary transmission mechanism is extremely rudimentary as it only focuses on THE interest rate. Market Monetarists – and old-school Monetarist – tend to focus much less on interest rates and instead focuses on a much more broad range of assets. Furthermore, Market Monetarists stress the importance of markets as indicators of monetary conditions.
You can see my own discussion of the transmission mechanism here:
http://marketmonetarist.com/2011/10/30/ben-volker-and-the-monetary-transmission-mechanism/
and here:
http://marketmonetarist.com/2013/05/19/the-monetary-transmission-mechanism-in-a-perfect-world/
25. May 2013 at 21:32
Ha ha Richard Koo RIP.
Isn’t the FT piece committing the ECON101 Ch2 fallacy, “Q. Executives are worried that their advertising campaign is becoming so successful, that resulting higher prices will kill demand. Evaluate their concerns.”?
26. May 2013 at 06:29
J, Good point.
Marcus, Yes, Koo’s theories are not looking so good right now.
Thanks Josh.
Mark, Very good points. So Koo swings from the liquidity trap to hyperinflation? How does he justify that?
Daniel, you asked:
“Question: If market monetarism is advocating the fed use real time market signals to guide their path in determining NGDP growth. Isn’t that one massive reasoning from price changes? Not trying to be cute, it is something I’d like to have clarified.”
Good question. You don’t want to reason from a price change, or a quantity change. But it’s perfectly valid to reason from a P*Y or total expenditure change. P*Y is the best indicator of the stance of monetary policy.
Rob and Lars, A paper by Robert King (JEP, 1991?) claims that monetary stimulus can even raise real rates in a ratex NK model.
I agree with Lars that they tend to overlook the implications.
Saturos, Yup.
26. May 2013 at 06:46
Lars and Scott, thank you, that is kind of what I thought, most NKs I talk to just don’t seem to fully grasp their own models for the most part. Why is macroeconomics in such horrible shape?
26. May 2013 at 20:56
[…] to as warning signs that the incipient boom in the Japanese economy might turn out to be a flop. Scott Sumner and Lars Christensen, among others, effectively demolished some of the nonsensical claims made […]
27. May 2013 at 08:32
If you properly understand the monetary transmission mechanism, everything else becomes very trivial. I tend to disagree a little with Lars because I think both consumers and companies hold the amount of cash they need for transactions (i.e. the purchase of real goods and services). So there is really no hoard of cash to be spent.
Monetary policy works through expectations (i.e. expected higher future NGDP growth), and as Scott always says, expectations have to be about something and that something is the real price of financial assets (1/the expected real risk adjusted return). If the real price of financial assets rises then (if you believe in negatively sloped convex indifference curves…a fundamental tenet of economics) there has to be an increased marginal exchange by the non-financial sector (primarily companies and consumers) of financial assets for real goods and services (both consumption and investment.) This exchange of financial assets can take many forms…. new stock issuance by a company, increased draw down of a line of credit, higher credit card debt, or a new car/home loan.
I think the point Lars makes about banks wishing to expand lending is valid, but it is fully incorporated by looking at the mechanism as working through the real prices of financial assets…an increased desire by banks to lend has no impact until it is reflected in lending rates (real asset prices).
I also think it’s unnecessary to make a separate argument about stock prices. Nominal stock prices will move more in response to monetary policy than the price of fixed income assets…just as long duration bond prices will move more than short duration bonds, but if we define the real price of financial assets as 1/expected real risk adjusted return, then all financial asset prices move essentially in tandem and you have a much more unified and easier to explain model for the transmission mechanism.
I agree with Lars and have repeatedly commented in this blog, that the biggest defect of MM has been its failure to adequately and simply explain how it actually works… i.e. the transmission mechanism. 99% of all arguments and objections to MM are due to a lack of understanding of this mechanism.
27. May 2013 at 12:25
dtoh, I think one problem is that the actual mechanism is so counterintuitive that most people don’t buy it, even if you explain it to them. Which partly explains why you want to talk about asset prices–those are understandable.
27. May 2013 at 21:20
Scott,
No I think the problem is that when monetarists discovered the correlation between the money supply and NGDP, they assumed causality or at least thought that correlation was sufficient for the purpose of explaining the theory. Since then the correlation is so ingrained in the thinking of monetarists, that they have not adequately thought about the actual mechanism, and the mechanism is in fact financial asset prices. I honestly think this theory is simple, obvious (once you have thought about it) and absolutely irrefutable. To date, you at least have not offered any kind of a substantial rebuttal, and your statements and comments are all completely consistent with a financial asset price model.
The problem with HPE is not that it is counter-intuitive. (In fact, it’s actually trivial.) The problem is that while from a predictive point of view it’s fine, it simply is not an accurate explanation of the actual mechanism.
28. May 2013 at 01:41
[…] Here’s David Beckworth arguing the same > […]
28. May 2013 at 03:38
[…] Here’s David Beckworth arguing the same […]
28. May 2013 at 05:30
dtoh, You said;
“No I think the problem is that when monetarists discovered the correlation between the money supply and NGDP, they assumed causality or at least thought that correlation was sufficient for the purpose of explaining the theory.”
That’s simply false. Monetarists do have a theory, and it’s essentially the same theory as is used to explain the correlation between apple price sand the size of the apple crop (which also does not rely on financial markets.)
28. May 2013 at 08:36
[…] Here’s David Beckworth arguing the same > […]
28. May 2013 at 12:42
Scott,
Apples would be a good model if the Fed was doing a helicopter drop (e.g. money farmers suddenly had a larger crop). OMP doesn’t work that way; it requires a voluntary exchange of money for securities. Securities holders don’t do this exchange because they want to hold more money…. they do it because they have been induced to spend more on real goods and services and they need the money for those purchases. The supply of money has no impact on that decision. What does impact that decision is the real price of financial assets relative to the price of goods and services (and expectations of higher GDP).
As I have said a model based on the mechanism of financial asset prices is 100% consistent with HPE in terms of predictive ability, but it’s a more accurate description of actual behavior and easier to explain.