Lost in translation
This piece in the NYT made me smile:
While Mr. Bernanke will remain a full-time fellow at the Brookings Institution, the new role represents his first somewhat regular job in the private sector since stepping down as Fed chairman in January 2014.
His role at Citadel was negotiated by Robert Barnett, the Washington superlawyer who also negotiated a deal for his book, “The Courage to Act,” which Mr. Bernanke recently submitted to his editor and will be published in October.
Mr. Bernanke’s insights are already much in demand.
At a gathering at the Bellagio Hotel in Las Vegas last May, several hedge fund managers said they had attended dinners with Mr. Bernanke in the first months after he stepped down from the Fed.
“At those dinners he gave credence to the idea that the Fed believed in lower potential G.D.P. and lower potential inflation,” Mr. Novogratz told the audience of money managers. For many, that advice was well worth the cost of a seat at the time.
But one hedge fund manager missed out.
“He gave this stuff out,” Mr. Tepper said, “but I didn’t realize what he was saying at the time, so I didn’t do a great trade.”
I’m quite certain that Bernanke did not suggest that we were in an era of “lower potential inflation”, as there is no such thing as potential inflation. Looks like Mr. Tepper is not the only one who “didn’t realize what he was saying at the time.”
(I’ve been telling finance audiences that rates would stay low ever since I started blogging in 2009. Of course they don’t pay me as much as Bernanke (nor should they), indeed the London HSBC group I spoke to last year never paid me a dime.)
Tags:
17. April 2015 at 08:28
Macro trading is not about getting it right, it is about getting what others think is right. And that can be almost anything …
17. April 2015 at 09:18
Full disclosure, I work at a big bank, and everybody’s been convinced for years that “rates will start rising soon…..any time now…..just you wait….here they come! The insights I’ve gained here from Scott and this site have been very helpful.
17. April 2015 at 10:11
Scott I’ll give you credit you were not only right about rates not rising but honest as to the paucity of explanations for it.
17. April 2015 at 10:24
Cash in circulation rising sharply in high-tax deflationary, low interest-rate economies. Interesting.
17. April 2015 at 10:31
I’m not sure if any of you have seen this yet. Could it be true/is it true?
http://www.cityunslicker.co.uk/2015/04/moneys-too-tight-to-mention.html
17. April 2015 at 14:09
“I’m quite certain that Bernanke did not suggest that we were in an era of “lower potential inflation”, as there is no such thing as potential inflation.”
That is not true. The Fed must be considered one factor, albeit an influential one, that determines future prices. Other factors that cause lower prices are what can make future prices be lower than they otherwise would, all else equal.
For example, if there is a “potential” for people to increase their money to total assets ratio, or a “potential” for a rise in productivity, and so on, then what “lower potential inflation” here would mean is those other factors are potentially capable of making prices fall rather than rise. If the Fed does not print more money than it otherwise would, then prices will likely fall.
It can also go the other way, from varying money. For example, given a particular quantity of QE, we can ask what the potential effect on prices will be. This working paper explains:
http://www.iie.com/publications/interstitial.cfm?ResearchID=2269
It is a little awkward yes, but potential inflation is definitely a “thing”.
17. April 2015 at 14:23
“CMA, The financial sector does not grow faster with low rates.”
Ceteris paribus a lower rate will increase credit more than a higher rate. Greater credit creation grows the financial sector more because the finsector underpins credit creation and the activities accompanied with credit creation such as financial asset trading and creation.
A faster growing finsector undermines real gdp because it draws resources away from other sectors.
Thats why tools which stimulate AD while maintaining a higher interest rate (emoney heli’s) are superior tools for real gdp and stability purposes.
17. April 2015 at 19:48
Jose, No! I need to do a post on that.
Benny, A few years ago I did a post about the “Job-filled non-recovery.” I realized that if the unemployment rate was plunging and we were seeing 2% RGDP growth, then the trend RGDP growth must be really, really low.
But I have to admit I don’t fully understand why trend growth is so slow, beyond demographics.
Ben, I did my dissertation on currency hoarding, and found that low rates and high taxes lead to lots of hoarding.
Sean, Don’t know, but the UK is the most logical country to adopt it first.
CMA, You said:
“Ceteris paribus a lower rate”
When ceteris is paribus then interest rates CANNOT change. Never reason from a price change.
17. April 2015 at 21:32
“When ceteris is paribus then interest rates CANNOT change. Never reason from a price change.”
OK I will try explain in a different way. If the FRB expands money by 1 billion into depostiory accounts without purchasing bonds the demand for bonds will be lower than if it purchased bonds with the 1 billion.
Lower demand for bonds means lower prices and higher interest rates. If money is expanded into depository accounts at fed then loanable funds dont increase so less downward pressure on rates.
18. April 2015 at 03:46
Scott Sumner: I wonder if your dissertation is online. I think the next step is here:people and businesses that have hoarded cash conduct transactions in cash.
18. April 2015 at 04:13
CMA has it right.
18. April 2015 at 04:25
@scott
If you raise the tax rate on capital by 60%, the trend growth rate is going to go down.
18. April 2015 at 04:33
Ceteris paribus is however a tricky tool. Oftentimes when one variable changes, it is logically necessary that two, three, or more variables must change. This happens because economic concepts are often complex and structured. For example interest rates are not merely abstract floating percentages. When we talk about interest rates, we are taking about lenders and lending, borrowers and borrowing, loans, etc.
So if we consider lower interest rates, and we say ceteris is paribus, we are not actually saying that interest rates are lower while everything about lenders and lending, borrowers and borrowing, loans, etc are all remaining equal. They cannot logically remain equal. What saying ceteris paribus actually means when we say lower rates and ceteris is paribus, is that there are lower rates, and everything else that is logically connected to interest rates are changed, and then those variables NOT so logically connected to interest rates, those are held constant.
Thus, when CMA talks about lower rates, he already had in mind but did not explicitly mention, that there must be a higher demand for loans. That is how CMA imagined rates being lower. Where did that higher demand come from? From the Fed. But he did not consider supply. Lower rates could be associated with a lower supply of loans. And a lower supply of loans would not grow the financial sector like you imagined it must with lower rates.
So CMA you got it right in your second post, but not your first. Ceteris paribus is a powerful tool, and I sometimes make mistakes using it because the concepts I am considering are sometimes complex and interrelated and cannot logically be held constant when other things change.
18. April 2015 at 10:00
CMA, So what’s your point.
dtoh, Yes, but by a very small amount.
18. April 2015 at 12:57
“The Economy Has Slowed Because the Fed Has Already Tightened”
http://blogs.wsj.com/economics/2015/04/17/the-economy-has-slowed-because-the-fed-has-already-tightened/
18. April 2015 at 13:37
Scott,
You said, ” Yes, but by a very small amount.”
A 60% increase in the rate is a small amount?
18. April 2015 at 15:13
“CMA, So what’s your point.”
My point is that emoney helicopter drops increase demand while maintaining a higher interest rate than policy tools such as quantitative easing or current rate targeting tools.
Therefore less credit and financialization. Less financialization means higher real GDP. Less credit means more stability and less lending to unproductive sectors.
18. April 2015 at 16:51
Disagree with CMA on that point.
18. April 2015 at 17:40
Major.Freedom
Helicopter drops of central bank e-money (hel-e’s) stimulate aggregate demand (AD) by increasing people’s monetary wealth, therefore the interest rate doesn’t need to go down to stimulate. Under rate targeting it does need to go down to stimulate. Therefore under hel-e’s the rate will be comparatively higher for any given level of AD stimulus. A higher interest rate will reduce credit growth and hence financailization and non productive lending.
An increase in the money supply under hel-e’s will not affect interest rates in the same way as an interest rate targeting regime involving open market operations (OMO).
If 1 billion dollars is created and brought into circulation through bond purchases this will affect rates differently to 1 billion just placed into people’s central bank depository accounts. Under an OMO any bonds purchased by the CB adds to the total demand for bonds. This reduces rates more than if the CB did not purchase these bonds. Under a hel-e drop people will use some proportion of their money on bonds and the rest will be spent, therefore the demand for bonds will be lower and AD higher comparatively. Lower demand for bonds will put less downward pressure on rates while higher AD and inflation will place more upward pressure on the rate. Rates may actually go up under hel-e drops if the upward pressure from extra spending is greater than the downward force of extra loanable funds and bond demand by people.
Placing people’s money into accounts at the CB wont increase loanable funds until money leaves those accounts and goes to accounts controlled by commercial banks. Without emoney, loanable funds do increase everytime the money supply is expanded which places more downward pressure on rates compared to an arrangement where money is expanded into depository accounts at the central bank controlled by people. Hel-e’s generate increased spending and less loanable funds increases on a comparative basis.
18. April 2015 at 18:30
@CMA
No. Helicopter drops done on a regular basis will simply make money super-neutral in the short term as well as in the long term (a la Zimbabwe).
18. April 2015 at 18:48
A tool which stimulates credit less while stimulating AD will grow the financial sector less and generate less instability. Do you disagree somehow?
18. April 2015 at 19:07
@CMA
What do mean by “stimulate credit.”
I believe a policy of level targeting of NGDP would reduce volatility in the price of financial assets, lower returns to financial institutions, and result in a shrinkage of the financial sector.
I don’t believe helicopter drops would be an effective tool for anything other than perhaps redistribution.
18. April 2015 at 19:48
For Scott Sumner (and anyone else): A gem–and printed in the The Wall Street Journal Oct 23 1992 by Milton Friedman.
Friedman bashed the Fed for being too tight in 1992, when inflation was at 3% and real GDP was growing at 4%.
And he says people who think the Fed cutting rates from 10% to 3% mean the Fed is easy are wrong. And he says the Fed can do more than cut rates, they can go to open market operations.
http://0055d26.netsolhost.com/friedman/pdfs/wsj/WSJ.10.23.1992.pdf
BTW, this is the fourth time I have been able to find of Friedman bashing central banks for being too tight: The Great Depression, the 1957 US recession, and 1990s Japan.
And now 1992 USA.
Man, would be great to have him back.
And what has happened to America’s right-wing economists, who have become monomaniacally fixated on 0% inflation, if not deflation (Charles Plosser)?
Is it a fad? A political badge on honor? They are secretly on Russian payroll to destroy America? I don’t get it.
18. April 2015 at 20:10
Ben cole,
Best not to dwell too long on the minds of the insane. The right only knows Friedman the crusader against inflation in the 1979s, and the crusader for small government. They completely ignore things that don’t fit their worldview
18. April 2015 at 20:29
dtoh
By stimulate credit I mean grow it.
“I believe a policy of level targeting of NGDP would reduce volatility in the price of financial assets, lower returns to financial institutions, and result in a shrinkage of the financial sector. ”
Yes and you could reduce financial excess and volatility even more if the tools employed to reach the target don’t grow the finsector or credit excessively. Asset purchases and the current rate targeting regimes do grow the finsector excessively.
18. April 2015 at 21:43
@CMA
Disagree. And how do you define “excessive” growth in the financial sector and credit.
18. April 2015 at 21:53
What do you disagree with specifically. Excessive finsector is when it undermines real gdp growth.
18. April 2015 at 23:30
Edward: then you think the righty-tighties are not Putin agents?
19. April 2015 at 00:09
CMA, how do you know that it isn’t low RGDP expectations that are causing the growth of finance, instead of the other way around?
19. April 2015 at 00:54
Kevin Erdmann
low RDGP is causing growth of finance and so is finance a cause of low rdgp. Its circular.
19. April 2015 at 06:47
Jim, Excellent piece.
dtoh, No, I said the effect on growth would be very small.
CMA, You have not presented any theoretical or empirical support for your claim. So I have no way to comment. What is the theory that shows higher interest rates lead to less credit? I’ve never seen one.
Thanks Ben.
19. April 2015 at 06:58
Scott, during /normal times/ higher risk free interest rates price some slightly riskier borrowers out of the market, that’s textbook economics (or portfolio theory if you like), so of course higher interest rates can lead to less credit.
19. April 2015 at 07:47
OT, but the real reason CA doesn’t want to cut agricultural water allocations comes out:
“The TIAA-CREF retirement fund also boasts of its California almond operation as one of the world’s biggest.”
“Other top almond producers include Stewart and Lynda Resnik, the politically influential Beverly Hills billionaires behind Fiji bottled water,”
“The governor and his cabinet secretaries defend almonds as a high-value crop.”
“Any talk of curbing almond growing by big investment firms “really just gets to be kind of un-American,” said Wenger, the head of the state Farm Bureau.”
http://www.seattlepi.com/news/science/article/Almonds-get-roasted-in-debate-over-California-6209631.php#photo-7844352
19. April 2015 at 08:31
Scott,
Why do you think the effect of a large increase in the tax rate on capital will have a very small effect on growth?
19. April 2015 at 08:44
@CMA
How does excessive growth of credit undermine RGDP growth?
19. April 2015 at 09:00
CMA:
I was only disagreeing with this point you made:
“Less financialization means higher real GDP. Less credit means more stability and less lending to unproductive sectors.”
I think it should be emphasized that “financialization” and “credit” do in fact raise real GDP, provided the financing of these industry expansions is through voluntary savings, not credit expansion and inflation brought about by the Fed system.
Credit markets are vital to efficiently allocating capital, diversifying risk, and providing knowledge of investment opportunities that is not shared by those who deposit money for the purposes of investing.
I disagree because the way you phrased it, condemns credit and finance as such. It is way too exaggerates/generalized. A bigger banking and finance sector are in principle vital to a growing “real” economy that becomes ever more complex.
We know this because millions of people voluntarily give their money to those offering credit and banking services. Clearly there is such a thing as there being too many “real” widgets and not enough entrepreneurial investment and risk taking that improves widget making. This is what a free market decides. You can’t just assert your own opinion that more finance means less real wealth. In certain circumstances the opposite is true. Credit is savings, and savings are indispensable means to increase productivity.
I will only agree with your point which I think you might be trying to say, which is that inflation and credit expansion which circumnavigates the constraints of the market test, expands the banking system more than what otherwise would have taken place on the basis of voluntary savings alone. I will strongly agree with you if your point is that the banking and finance sector expanding by non-market means does reduce real production, if we define real production as that which individual sovereign consumers want and are able to bring about because their property rights are respected and protected.
Too often there is a seduction of taking one’s own personal values and believing they should be imposed on everyone else. Let the market decide how much finance expands. If it expands the way all individuals want it to expand, which only a market can guarantee, then it would be very wrong to condemn this and say that what people want for themselves, and are able to get for themselves, is nevertheless reducing their “real” standard of living.
I agree with you very much though on how heli drops would increase interest rates compared to inflation taking the form of credit expansion. It is so obvious that increasing the demand for loans would depress interest rates, while increasing people’s ability to pay interest would lead to a rise in interest rates. Please note though that this is for the short term only. For even if inflation took the form of credit expansion, and lowered rates, the eventual increase in spending that would take place would put the same kind of upward pressure on rates as a heli drop. This is incidentally why the Fwd system has to accelerate inflation in the form of credit expansion in order to KEEP rates down. They have to accelerate credit expansion in order to keep reversing the inevitable resulting upward pressure on rates that comes from the eventual increase in aggregate spending.
But if there are deflationary forces from the market ( which of course MMs want the Fed to reverse) due to significant malinvestment that is need of correction, then significant credit expansion can take place for many years before that eventual increase in spending takes place that would have reversed it a long time before if the economy were more healthy and had less malinvestment.
MMs are blind to this. They see low rates as a symptom of too tight money, because they refuse to understand that the deflationary problems in the economy were caused by too much inflation in the past that distorted the real economy into deflationary pressure, but instead view the deflationary problems as problems with current Fed policy.
19. April 2015 at 09:09
Edward and Benjamin, you two are insane, if we use the common definition of the word.
You are both in the same insane camp as the so-called “righty tighties”.
You are insane because you reject the normal social interaction of live and let live. Your beliefs include a support for aggressive violence to be initiated by the executive and legislative branches of the national mafia family you call government, against those who only want to make their own choices for themselves on what they use for medium of exchange. For you both cannot even talk about any “optimal monetary policy” without that threat. The threat goes away, and poof goes your insane “pragmatic second best solution”.
Freaks, insane, mad hatter psychopaths is perhaps a more accurate description of your “ideas”. Excellent blogging.
19. April 2015 at 11:31
Scott, it does seem to me that low long term real interest rates are related to credit expansion. The reason is that the income on real estate, rent, is relatively stable compared to other fixed income securities. For instance, if corporate bond rates drop from 6% to 3%, corporations don’t double their borrowing to keep their interest expense level. But rents remain level just because of the nature of real estate. So if real long term rates go from 6% to 3%, real estate values, and associated mortgage levels, are bound to expand. But I would put the causation from lower real rates to financial expansion. This seems like something that a lot of literature gets wrong. Putting the blame on some mystical political power of the finance industry is an easy way to gather bipartisan support for a hypothesis. So there is a presumption that speculative or monetary expansion leads to credit which leads to overexpansion and bust. But this is more likely a confirmation of EMH. Low expectations lead to low rates which leads to credit expansion (counterintuitively) which is followed by a confirmation of the low expectations.
19. April 2015 at 12:15
Your comments on lower potential inflation reminded me of an interview with Larry Kudlow and Alan Greenspan.
As far as I remember, Greenspan criticised QE for leading to a massively increased holding of excess reserves which heightens inflation risk. Is it possible that Greenspan is correct? Is there an inflation risk in the excess holding of reserves?
Or does such a conclusion rely on an explicitly creditist view that doesn’t align with the hot potato effect.
19. April 2015 at 16:07
SSumner
“What is the theory that shows higher interest rates lead to less credit?”
A higher interest rate will make some entities or projects ineligible for credit or incapable of servicing credit. For example if the fed maintained rates at around 5% through the great recession the contraction in credit should of been worse.
dtoh
“How does excessive growth of credit undermine RGDP growth?”
The financial sector draws on scarce resources that other sectors could use instead. For example instead of highly educated people working in tech or medicine or whatever we have them in banks.
Major freedom
Finance is vital for the economy. The most positive role it can play is by providing credit to most productive sectors and limiting credit to least productive.
If the CB attains its targets while stimulating the financial sector less it will improve the efficiency of credit markets because of higher real GDP.
Higher real GDP will make more entities more creditworthy due to higher profits/income. At the same time higher rates will limit credit to least productive areas.
Stimulating credit less will also contribute to stability more because a low rate must contribute to speculation more than a higher one. More stabililty means easier to hit targets and more investment because entities need future stability to invest.
19. April 2015 at 16:49
@CMA
The financial sector draws on scarce resources that other sectors could use instead. For example instead of highly educated people working in tech or medicine or whatever we have them in banks.
Totally agree. (I was one of them.) But the reason for that is primarily because TBTF and barriers to entry lead to artificially high profits and high wages in the financial sector. The problem is mostly independent of what targets and tools the Fed uses to achieve is goals of full employment and price stability.
Stimulating credit less will also contribute to stability more because a low rate must contribute to speculation more than a higher one. More stabililty means easier to hit targets and more investment because entities need future stability to invest.
This is not correct. Entities need high expected returns to invest. It mostly does not matter whether the returns are volatile (unstable) or not.
Also you should note that investment decisions depend not just on rates but also on expectations of future NGDP.
19. April 2015 at 17:08
“Totally agree. (I was one of them.) But the reason for that is primarily because TBTF and barriers to entry lead to artificially high profits and high wages in the financial sector. The problem is mostly independent of what targets and tools the Fed uses to achieve is goals of full employment and price stability.”
TBTF and barriers to entry contribute to financial excess. So does excessive low rates and the central bank not providing emoney.
“This is not correct. Entities need high expected returns to invest. It mostly does not matter whether the returns are volatile (unstable) or not.”
Several studies back the idea that stability is necesary for investment. Think about it. If the future is uncertain it is harder to establish whther its worthwhile investing in something.
Luigi Guiso and Giuseppe Parigi (1999), “Investment and Demand Uncertainty””¨, The Quarterly Journal of Economics, Vol. 114, No. 1 (Feb., 1999), pp. 185-227.
“Also you should note that investment decisions depend not just on rates but also on expectations of future NGDP.”
Im aware of this. Hel-e’s will grow RGDP faster which means higher NGDP growth expectations.
19. April 2015 at 18:43
CMA: Corporations usually don’t borrow at overnight rates. Project based funding pays rates determined more by markets than by the Fed. In fact, both cyclically and over longer periods, commercial debt levels tends to be lower when rates are lower.
Do we really know if the financial sector is using resources that would be better utilized elsewhere? If your reason is that they are somehow getting bonus profits from Fed policy, then this decade surely isn’t the best example of that. If your reason is barriers to entry, then medicine and tech are probably not your best examples for alternative uses of capital.
19. April 2015 at 19:00
“Corporations usually don’t borrow at overnight rates. Project based funding pays rates determined more by markets than by the Fed. In fact, both cyclically and over longer periods, commercial debt levels tends to be lower when rates are lower.”
Lower ON rates to stimulate the economy will bring down all rates more than stimulating through hel-e’s. Lower ON rates bring down rates across maturities and risk levels due to portfolio rebalancing.
“Do we really know if the financial sector is using resources that would be better utilized elsewhere? If your reason is that they are somehow getting bonus profits from Fed policy, then this decade surely isn’t the best example of that. If your reason is barriers to entry, then medicine and tech are probably not your best examples for alternative uses of capital.”
If we generate spending while generating less finsector growth through hel-e’s then all other sectors of the economy have more resources to draw from. Those industries may be composed of whatever entities experience the most demand growth.
19. April 2015 at 19:38
CMA: Overnight rates have been higher than the Wicksellian rate for several years.
19. April 2015 at 21:41
“Overnight rates have been higher than the Wicksellian rate for several years.”
ON rates will be even higher under hel-e stimulus because the wickselian rate will also go up. Monetary policy can push up the wickselian rate.
20. April 2015 at 05:20
@Scott
Looking forward to your post on macro trading/investing. But when you do, bear in mnd that trading/investing time frame matters a lot. I used the term macro trading, implying a time frame of a few days to a couple of months. Macro investing could mean structural positions of much longer time frames. When one trades short term, you realize markets may price in all sort of expectations and ideas. You probably call those price movements white noise. But in the time frame I use to trade, that does not matter because when the market changes consensus again, positions were closed much earlier ….
20. April 2015 at 05:23
@ Scott
oh, and by the way, that idea I am defending here is not mine, it is Seth Klarmans’s (stated in his book, “Margin of Safety” ) … But I pretty much agree with him …
20. April 2015 at 05:46
Britonomist, No, that’s reasoning from a price change.
dtoh, Because I haven’t noticed much impact in the past.
Kevin, It depends why interest rates fall. If they fall because of a depression then real estate prices may also fall.
Ashton, I see no inflation risk from QE.
CMA, You said:
“A higher interest rate will make some entities or projects ineligible for credit or incapable of servicing credit. For example if the fed maintained rates at around 5% through the great recession the contraction in credit should of been worse.”
That’s reasoning from a price change.
Jose, It will be at Econlog, some time in the next week.
20. April 2015 at 07:52
Scott,
That’s an interesting point. That has certainly been the case in the current context. But, this reflects a disequilibrium in home prices because of the collapse of the mortgage market and frictions in the home buying market. In the past 60 years or so where we have decent data, home prices have moved roughly in line with the non-arbitrage level relative to treasury bonds.
In other words, with bonds, you can reason from a price change because the price and the yield are mathematically related. If bond yields go down, then bond prices go up. Since housing stock and rent levels are very stable, and since, in aggregate, they generally behave like very long duration inflation protected bonds, home prices and nominal real estate quantities have behaved in a predictable way, except for the past decade, where they have clearly been out of equilibrium and supply/demand models are not applicable.
20. April 2015 at 07:55
“Britonomist, No, that’s reasoning from a price change. ”
Sumner, this wasn’t retrospective reasoning. I was talking about a ceteris paribus unexpected change in interest rates.
20. April 2015 at 08:03
Scott,
You said, “Because I haven’t noticed much impact in the past.”
When was the last time they raised the capital gains tax rate by 60%?
20. April 2015 at 08:20
“I was talking about a ceteris paribus unexpected change in interest rates.”
The interest rate is a price (of borrowed money). How does one have an unexpected ‘ceteris paribus’ change of a price? Either the quantity supplied must change or the supply/demand curves must shift. So it seems ceteris can’t be paribus. And whichever of those things happens must do so for some reason, the details of which matter for the subsequent course of events. OTOH, if really ceteris paribus, then no price change.
20. April 2015 at 08:48
By the way, Scott, I wonder if the issue of bonds and housing is related to the yield curve and recessions.
http://idiosyncraticwhisk.blogspot.com/2015/03/housing-tax-policy-series-part-19.html
I have noticed that the yield curve is not an unbiased predictor of future rate changes when those changes are negative, especially during recent downturns. There seem to be some set of forces that prevent the yield curve from inverting as much as it sometimes needs to. We also have the (related) issue that inverted yield curves have been a good predictor of recessions.
I wonder if this is related to a lack of liquidity as a source of recent recessions. When liquidity dries up and NGDP expectations decline, forward interest rates should fall. But, in order for rates to fall, bond prices would need to rise. That would require liquidity. This is especially important in housing, where rents and housing stock are very stable. If long term bond rates were bid down, cash would be drawn to housing, which would be offering a better relative return.
So, my hypothesis is that in low inflation contexts, there is a relationship between low liquidity and the inability for long term securities (including homes) to move to equilibrium prices. The yield curve fails to invert as far as it needs to, and all of these factors worsen the correction.
20. April 2015 at 08:50
Is there any literature that anyone knows of that looks at this speculation?
20. April 2015 at 14:14
“The interest rate is a price (of borrowed money). How does one have an unexpected ‘ceteris paribus’ change of a price”
Unexpected central bank policy.
20. April 2015 at 18:26
Kevin, I’d still want to know why interest rates changed.
Britonomist. But that’s the problem, there are no ceteris paribus changes in interest rates. Changes in interest rates are caused by other factors, and it very much matters what those factors are.
dtoh. The “60% increase” doesn’t really matter, what matters is the rate rose by 8.8% points.
In 1986 the rate rose by 8.0% points.
If the cap gains tax rate rose from 1% to 2%, would you call that a 100% increase?
Kevin, Two comments:
1. The zero bound can prevent inversions.
2. Recessions are really hard to predict, and this is one reason why yield curves don’t invert very strongly before recessions.
I’m not sure if there is any literature on that.
Britonomist, Central bank policy is not “certeris paribus.” Does the central bank raise rates with easy money or tight money?
20. April 2015 at 18:50
“Britonomist. But that’s the problem, there are no ceteris paribus changes in interest rates. Changes in interest rates are caused by other factors, and it very much matters what those factors are.”
What if the factor is that Greenspan or whoever thought the economy was weak, and decided to increase AD by lowering interest rates?
20. April 2015 at 21:02
CMA:
“If the CB attains its targets while stimulating the financial sector less it will improve the efficiency of credit markets because of higher real GDP.”
A CB setting any target cannot promote efficiency. It can only hamper it. Efficiency requires unhampered economic calculation so that investors and consumers can both see and be constrained to market profit and loss.
Also, efficiency of credit markets is what in part causes higher real GDP. Real GDP merely increasing in the aggregate does not promote efficiency. The increase has to be balanced and stable in a relative manner, internally.
“Higher real GDP will make more entities more creditworthy due to higher profits/income. At the same time higher rates will limit credit to least productive areas.”
Still backwards. Better credit worthiness is what causes higher real GDP. Real GDP doesn’t just come out of nothing. There has to be good ideas, and good planning. Higher output is the result. Consumption is the end.
“Stimulating credit less will also contribute to stability more because a low rate must contribute to speculation more than a higher one.”
No, you cannot view interest rates in abstraction from other variables. It is possible for a 5% interest investment to be more risky, or earn a higher real return, than a 10% investment in a counterfactual world where prices and such are different.
You’re reeasoning from interest rates. Interest rates are an effect of something.
Less credit does not mean more stability. If people want to lend more, and they are willing to consume less, then there is no limit to higher stable credit.
“More stabililty means easier to hit targets and more investment because entities need future stability to invest.”
Non-market institutions hitting their non-market determined targets has nothing to do with promoting stability. It can only destabilize credit markets.
21. April 2015 at 02:38
Scott, you said,
The “60% increase” doesn’t really matter, what matters is the rate rose by 8.8% points.
Yes that’s still huge, but even that assumes symmetric returns on investments. Assume you have one winner and a lot of losers….typically the case for start ups and new business formation (a big driver of growth).
Assume
10 Entrepreneurs
15% Tax Rate on Capital Gains
Each entrepreneur invests $100 ($1000 total investment). Nine of them lose all their investment ($900); the one winner realizes a gain of $1200.
Total aggregate pre-tax returns for the 10 entrepreneurs is $300 (30% average return.)
The losers pay no tax, but the winner pays $180 (15% on $1200). After tax, the aggregate return is $120 (12%).
—————
Now raise the tax rate to 25%, the winner pays $300. The aggregate return drops to exactly zero.
The nominal increase in the tax rate from 15% to 25% results in an effective expected tax rate of 100%.
21. April 2015 at 05:55
Britonomist, To the extent rates fell due to a weak economy you’d expect one effect, to the extent they fell due to easy money you’d get a very different effect.
dtoh, I certainly agree that cap gains taxes can be very important, but lots of things are very important. Other taxes are very important. So are entitlements, so is military spending, so is regulations, so is immigration levels, etc., etc.
21. April 2015 at 06:33
The problem is Sumner, what I saw wasn’t some context dependent comment, you made an absolute statement:
” What is the theory that shows higher interest rates lead to less credit? I’ve never seen one.”
That’s an absolute, you didn’t provide a context. It’s very easy to construct a model that shows how a central bank raising rates can lead to a contraction in credit. I mean, I find it hard to believe you’ve never seen a model that shows this, given that you’re a professional economist; I only have a masters but I saw PLENTY OF MODELS that showed this.
21. April 2015 at 11:14
@Britonomist,
Credit is a rationed “good”, its behavior is not like most other tradeable goods.
In my experience demand for credit is almost vertical, people (entreprenerus or consumers) will not change their plans because the interest rate went up by x%. Supply determines the prices. And factoring in risk perception into the equation, people will lend more at very low rates (have you seen this happening?) because that asset has a perceived risk they are willing to take, and sometimes, even very high rates will not persuade the highest risk taking investor, because the risk perception will be even higher …
21. April 2015 at 11:45
Jose, even if you deny that it affects the demand side (I reject this, I definitely don’t think the demand curve is vertical), it affects supply as well.
“Supply determines the prices”
It goes both ways, supply determines prices, and prices determines supply, it’s a simultaneous system. But since the central bank is a major player in the market, it can affect the supply or raise the cost of supply through its only policies, changing the price/supply for everyone else.
When the CB causes a higher rate of return on safe assets, this fundamentally changes the risk return trade-off of any risky asset, it will cause a shift in portfolios to account for this affect; people might increase their holdings of T-bills and similar and reduce investment/lending to some riskier assets who have now had their return reduced (after discounting with the risk free rate), not to mention they’d have no reason to lend to anything that can’t guarantee a return greater than the risk free rate.
21. April 2015 at 15:44
Scott
I certainly agree that cap gains taxes can be very important, but lots of things are very important. Other taxes are very important. So are entitlements, so is military spending, so is regulations, so is immigration levels, etc., etc.
Agree, but if you’re looking at productivity growth (the real driver of long term per capita RGDP growth) then cap gains taxes are critical. I’ve watched Japan strangle itself with bad tax policy. The U.S. is headed down the same road.
21. April 2015 at 16:21
@Britonomist
This view is not mine, although I agree with it. See “Towards a new paradigm in monetary economics” by Joseph Stiglitz. I don’t subscribe to all ideas in the book (Stiglitz tends to see everything as an adverse selection “problem”), but I do agree that borrowers tend to have very low sensitivity to interest rates, and therefore supply will end up defining rates.
23. April 2015 at 13:21
[…] Over at TheMoneyIllusion I received the following comment: […]
23. April 2015 at 17:34
Britonomist, Yes, tight money can have specific effects, but that’s very different from talking about the effect of higher interest rates.