Models and Markets

Bruce Bartlett sent me a new paper by Peter Ireland.

This paper uses a New Keynesian model with banks and deposits, calibrated to match the US economy, to study the macroeconomic effects of policies that pay interest on reserves. While their effects on output and inflation are small, these policies require important adjustments in the way that the monetary authority manages the supply of reserves, as liquidity effects vanish and households’ portfolio shifts increase banks’ demand for reserves when short-term interest rates rise. Money and monetary policy remain linked in the long run, however, since policy actions that change the price level must change the supply of reserves proportionately.

I found the long run neutrality of monetary policy to be quite interesting, as I’d assumed that relationship broke down with interest on reserves.  The fact that IOR has little effect on inflation and growth is also interesting, but I would caution that this sort of finding needs to be interpreted with caution.

In December 2007 the Fed was trying to decide between cutting rates by 1/4 and 1/2 point.  They actually cut them by 1/4 point, and the Dow promptly fell by 300 points.  Because fed funds futures showed a 58% chance of a 1/4 point cut and a 42% chance of a 1/2 point cut, we can infer that the Dow would have risen about 400 points with a 1/2 point cut.  (One of the few things even anti-EMH types accept is that the expected return on the Dow over any 2 hour period is roughly zero.)

Are there any models that predict that a 1/4 swing in the fed funds target would mean 700 points on the Dow?  I doubt it, because most models look at these things rather mechanically.  But in the real world the effect of a change in almost any monetary policy variable (fed funds rate, the base, IOR, M2, etc) depends almost entirely on how the change impacts the expected future path of policy.

I agree with Peter Ireland that a decision to pay IOR will have very little macroeconomic impact, ceteris paribus.  On the other hand, ceteris is rarely paribus.  It’s possible that an IOR decision might lead to changes in the expected path of monetary policy.  For instance, it might lead to fears that future QE would be less effective, as banks would have an incentive to hoard any extra cash.  Or markets might have already been expecting QE (to provide liquidity during a banking crisis) and the additional step of IOR might lead them to think the QE will not immediately drive short term rates to zero.

Since the impact of a policy depends on its impact on the expected future path of policy, it is almost impossible to model these effects.  They are highly contingent on the economic situation in which they occur.  For instance, the December 2007 quarter point cut would normally have had little market impact, but coming on the edge of the Great Recession, its impact was greatly magnified.  It made investors far more pessimistic about future Fed policy (correctly pessimistic, I might add.)

Does this mean there is no hope of ever being able to estimate the impact of policy decisions?  Far from it.  Louis Woodhill looked at the only three IOR decisions in the Fed’s 98 year history.  In each case stocks fell very sharply around the time of the decision:

At the time of the Fed’s IOR announcement, the S&P 500 was down by a total of 12.18% from its pre-Lehman close, 15 trading days earlier. However, the day that the Fed announced IOR, the S&P 500 fell by 3.85%, and it was down by a total of 17.22% three days later.

On October 22, 2008, the Fed announced that it would increase the interest rate that it paid on reserves. The S&P 500 fell by 6.10% that day, and it was down by a total of 11.11% three days later. On November 5, 2008, the Fed announced another increase in the IOR interest rate. The S&P 500 fell by 5.27% that day, and it was down by a total of 8.60% three days later.

To play it safe it’s probably better to go with the single day returns, as the EMH suggests the effect on asset prices should be immediate.  On the other hand, the concept of IOR was fairly unfamiliar to Wall Street, so arguably there might have been some delay as the program was discussed and explained.  But even using the more conservative one day window, what are the odds of three drops like that occurring on the only three days in history when the IOR was raised?  I’d guess no more than 1 in 10,000.  Economists get published with results no more unlikely than 1 in 20, and yet I am so skeptical of statistical significance that even 1 in 10,000 seems merely suggestive to me.  I think IOR might have had a significant contractionary impact, but I am not certain.

Whenever the model says one thing and the markets say another, I always go with the markets.  The markets seemed to think the IOR program was a big mistake, and the QE2 program was an important step in the right direction.  That’s all we know right now, and probably all we’ll ever know.

PS.  After the third and final increase in IOR, the S&P500 actually fell 10% in just two days.  Thus the market declined over 38% in 10 trading days–October 6, 7, 8, 9, October 22, 23, 24, 27, and November 5, 6.  Think about what it means for US equities to lose 38% of their total value in 10 trading days.  Coincidence?  Maybe, but a pretty unlikely one.  Using 2 day windows the total drop was about 24%.  Even the three single day drops add up to more than a 15% decline.

And then there is Sweden, with its negative IOR and record RGDP growth.  Hmmm . . .

Memo to Bernanke:  Cut the IOR to 0.15%.  It will give banks a bit less incentive to just sit on all the QE you’re sending their way.  But it will still be high enough to prevent the MMMFs from going belly up.  And you guys at the BOG can do it on your own–no pesky regional bank presidents to deal with.  Even Ron Paul will approve—less subsidy to fat cat bankers.  Git er done.


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55 Responses to “Models and Markets”

  1. Gravatar of Student with too much time Student with too much time
    7. March 2011 at 07:54

    “And then there is Sweden, with its negative IOR and record RGDP growth. Hmmm…”

    Scott, I’m not an expert on this, but isn’t Sweden’s negative IOR a myth? Economix explained this back in October 2009. On the Riksbank website slightly more detail is provided: there is an interest rate for “fine-tuning transactions”, which include overnight deposits with the bank to mop up excess liquidity, that is kept within 10 basis points of the repo rate.

    “Negative IOR” in Sweden seemed to be a mechanical consequence of their rigid system of rates, where the “deposit rate” is always 50 basis points below the “lending rate”. This provides their “interest rate corridor”. As the bank website explains, however, this doesn’t mean a lot:

    “In practice, however, the deposit rate and the lending rate have very little impact on what the overnight rate will actually be, partly because the banks have more to gain from borrowing from each other and partly because the Riksbank is prepared to conduct so-called fine-tuning transactions every day. As a result, the overnight rate is kept within a narrower band than the interest-rate corridor, which contributes to clearer monetary policy signalling. “

  2. Gravatar of flow5 flow5
    7. March 2011 at 09:05

    Comparing IORs to economic activity is as meaningful as Hamilton’s comparison of FED-WIRE transfers to IORs.

    However, IORs are not only contractionary (absorb commercial bank deposits -just like reserve requirements & reserve ratios), they also induce dis-intermediation (an outflow of loan-funds from the non-banks, just like raising & eliminating REG Q ceilings). This assumes no offsetting action by the monetary authorities.

    Because IORs increase the cost of loan-funds (esp. mortgage rates), & the capitalization rates on company earnings, they thus cannot but have an overall deleterious effect upon the economy. But considering our budetary morass (& IORs potential to absorb Treasurys), they are probably a necessary evil.

  3. Gravatar of bertusmaximus bertusmaximus
    7. March 2011 at 09:37

    in accordance with Student, i am pretty sure no banks parked their cash with the central bank and paid interest for that privilege. instead they just bought government paper … i recall 2y government bond yields trading in teens when the base rate was 25 bp.

    in relation to the recovery … well sweden didn’t have a real estate bust and as far as i can tell no swedish banks went bust either despite the baltic exposure … the credit channels were maintained throughout the whole period domestically whilst in the US they froze. lets not cherry pick our facts.

  4. Gravatar of David Pearson David Pearson
    7. March 2011 at 10:20

    Scott,

    Stock market is experiencing a modest correction in reaction to higher oil prices. I know you favor an NGDP futures regime. The question is, in the absence of one, at one point should the Fed step in and signal QE3? A 2% S&P500 correction? 4%? 10%?

    And what would be the effect of a QE announcement (say, another $600b) on oil prices? Its not too much of a stretch to claim that it would be like throwing red meat to oil traders in the Chicago pits. So the solution — easing — creates the problem — higher oil. Which leads to…more easing.

    BTW, there are a number of ways in which the Fed influences the price of oil. One is through the expected path of future monetary policy; the second is through the portfolio balances channel (yes, investors do re-balance into commodities, not just stocks! If you doubt this, talk to a pension manager or, better yet, a pension consultant); and the third is by reducing the carrying cost of commodity inventories. Yes, there is rising real demand from BRICs and obvious supply issues; but wouldn’t theory predict that the Fed’s attempt to raise inflation expectations to have the most impact on tight, inelastic commodity markets?

  5. Gravatar of bertusmaximus bertusmaximus
    7. March 2011 at 10:32

    bingo! well said mr Pearson … Lockhart today suggested that if oil prices start affected RGDP, we should do more QE … so as to raise NGDP … of course, that would as you suggest, just raise oil prices further … what then?

  6. Gravatar of Robert Simmons Robert Simmons
    7. March 2011 at 12:29

    Scott, wasn’t the IOR rate 0.75% at one point, and now is 0.25%? I’ve tried searching for a good history of IOR, and it’s pretty sketchy (or my Googling skills have atrophied), so I may be remembering incorrectly. If I’m right, what happened when the rate dropped? Did the market shoot up? Either way, could you write a short summary of how the IOR program has evolved over the last 2.5 years?

  7. Gravatar of Ted Ted
    7. March 2011 at 12:49

    I’m going to assume you didn’t read the paper Scott, because it has very little implications for your argument.

    Ireland constructs a modified backward-looking Taylor Rule that relates a change in the nominal interest rate that relates the previous periods nominal interest rate, output growth, and inflation rate and then calibrates this rate to the data and designates this as his monetary reaction function. He then uses this monetary reaction function to estimate his impulse responses. And this explains why it has little relevance for your argument. He calibrates the coefficients of his Taylor Rule to match a steady-state inflation rate of 2%.

    So, essentially what is going on is his coupled Taylor Rule – IOR policy rule is saying that the Fed keeps inflation and nominal growth at their steady-state values and any change in either rules behavior will lead to adjustments in the other rule to accommodate the targeted steady-state growth.

    In short, this paper doesn’t have a lot of implications for your thesis. The behavior of the IOR and the federal funds rate has not been consistent with the described behavior in Ireland’s model. If the Fed did not move the IOR and FFR to be consistent with their steady state targets, I suspect IOR might have a much larger effect in a similar model to Ireland’s. Although, I’m not sure if his model can even handle what happened in 2008. Perhaps I’m mistaken, but it looks to me that it’s possible that the IOR and federal funds rate behavior we saw in 2008 would be dynamically unstable in his model and could not be anything but a very short-run phenomena.

  8. Gravatar of Benjamin Cole Benjamin Cole
    7. March 2011 at 15:38

    Fed timidity is lamentable. The weak, vacillating monetary policy of Japan is exactly the road we do not want to travel.

    Bernanke needs to pull out all the corks, tip the barrels over, crank up the music, set the damn house on fire, and then dance naked in the street. This is not a time for fine reflections on the process of hairsplitting.

    While some fret about oil and inflation, in truth higher oil prices are likely deflationary, by sucking so much money out of USA aggregate demand, and dampening growth. And we are just barely escaping in a deflationary recession now.

    Please Mr. Bernanke, I can’t imagine a more clear set of signals than now: Print money until the plates melt, and then start xeroxing the stuff, but keep the supply growing rapidly. This is your hour.

  9. Gravatar of Doc Merlin Doc Merlin
    7. March 2011 at 16:23

    1. If IOR has little effect in the long run, then we should expect to see rather massive inflation soon. We are already seeing it in certain commodities, I wonder how long before it spreads to the rest of the market?
    2. If IOR has little long run effect does that mean that really its just a bank subsidy?

  10. Gravatar of Mark A. Sadowski Mark A. Sadowski
    7. March 2011 at 16:54

    I’ve only had a quick glance at this paper, but I love these concluding quotes:

    “The analysis performed here, with the help of a dynamic, stochastic, general equilibrium New Keynesian model, shows that the Federal Reserve’s recent decision to begin paying interest on reserves is unlikely to have large effects on the behavior of macroeconomic variables such as aggregate output and inflation, once normal times return.”

    Suggesting that the times are living are not normal, and thus IOR has large macroeconomic effects under current conditions.

    And:
    “Specifically, the results obtained here show how the Fed can continue to adjust its target for the federal funds rate to achieve its goals for macroeconomic stabilization, while independently varying the interest on reserves, as necessary, to help enhance the efficiency of and reinforce the stability of private financial institutions and the financial sector as a whole.”

    Which gets to the heart of what IOR is really all about. It’s every credit-channel-loving monetarist’s wet dream of how to feed the banks under the pretense of more efficiently managing monetary policy.

    At the risk of sounding like a total philistine, it’s “doll house” economic models like these that turned me into an incurable empiricist. (They usually start with “we construct a typical model with perfectly-rational, infinitely-lived agents….” at which point they always lose me.)

    As for myself, all I ask is a tall database and an econometrics software package to steer her by.

  11. Gravatar of Mark A. Sadowski Mark A. Sadowski
    7. March 2011 at 17:23

    “the times are living are” should read “the times we are living in are”

    Where did all the words I was thinking go?

  12. Gravatar of Scott Sumner Scott Sumner
    7. March 2011 at 19:42

    Student with too much time, Yes, and I pointed that out back in mid-2009.

    I can’t say whether the policy was effective or not. The argument against is the one that you just made. The argument in favor is that the band was lowered below that of central banks like the BOE and ECB, which had a lower bound of at least zero. Could this have helped to hold down the value of the krona? I can’t say. I was tossing that in as a sort of throwaway, since so many other bloggers had recently mentioned Sweden. With monetary policy it’s always had to tell, as the important effect has to do with signaling. I vaguely recall that the krona fell on the news, but not all that much.

    I’m actually much more interested in the market reactions in America. My fellow economists seem to think 20-1 is statistically significant, so what does that make 10,000-1? And if 10,000 to 1 is highly significant, doesn’t that say IOR was a big negative here? (Of course statistical significance doesn’t impress me all that much.)

    BTW, I did write a very long reply to your question on an earlier thread.

    flow5, I don’t see how IORs “absorb Treasurys” or save us any money, as the rate on Treasuries is lower than the IOR.

    Bertusmaximus; You said;

    “in relation to the recovery … well sweden didn’t have a real estate bust and as far as i can tell no swedish banks went bust either despite the baltic exposure … the credit channels were maintained throughout the whole period domestically whilst in the US they froze. lets not cherry pick our facts.”

    I’m afraid you are cherry-picking as well, as Sweden was hit much harder than the US by the fall in world trade. In any case, I am pretty sure that most of the other economies similar to Sweden (Denmark, Finland, Germany, France, Holland, etc) also lacked an American-style housing crash. So why is Sweden doing better than those countries?

    Also see my response on negative IOR above.

    David Pearson. You said;

    “The question is, in the absence of one, at one point should the Fed step in and signal QE3? A 2% S&P500 correction? 4%? 10%?
    And what would be the effect of a QE announcement (say, another $600b) on oil prices? Its not too much of a stretch to claim that it would be like throwing red meat to oil traders in the Chicago pits. So the solution “” easing “” creates the problem “” higher oil. Which leads to…more easing.”

    I’d do it now, or a week ago, or a month ago. The Fed should target NGDP, and let oil go wherever it will go to make that happen. The Fed should not create a double dip to prevent oil from going above some threshold. Indeed they really shouldn’t pay any attention to oil prices.

    If I wanted to know how monetary policy affected the markets, I rather ask a homeless man than ask a Wall Street trader. Each individual brain cell has no idea how brains think. And each individual trader has no idea how markets operate. (OK, that’s a bit of hyperbole, but you get my point.)

    Robert, It’s complicated. The two increases discussed in my post essentially brought the rate up to the fed funds target. Once there, it moves automatically with the target. After it became 100% of the target (11/5/08), the Fed only cut rates once, in mid-December. That rate cut did increase stock prices substantially, if I’m not mistaken, despite being partially expected.

    Ted, No I did skim the paper, but I don’t see why your point conflicts with what I said. Critics of my position (like the commenter 123) constantly argue that IOR didn’t hurt as much as I claim, because it was undertaken in concert with other offsetting actions. So that is the hypothesis I was addressing. I think most people who read the Ireland paper would take it as arguing that the decision to institute IOR in late 2008 did not have a major impact. If that wasn’t the argument, then Ireland should have discussed 2008. That’s the only time in US history when the Fed has done IOR, so it would be odd to think that readers wouldn’t draw that implication.

    But my argument is broader than that. It also says that studies showing a 1/4 point change in fed funds targets have such and such an impact in terms of a VAR model are not very useful, as the impact is entirely dependent on changes in the expected future path of policy.

    That’s right Benjamin.

    Doc Merlin, The TIPS markets imply core inflation will stay low. (TIPS spreads are inflated by commodity prices that haven’t yet hit the CPI.)

    Mark, I didn’t notice that first quotation. I might have implications for Ted’s question.

  13. Gravatar of David Pearson David Pearson
    7. March 2011 at 21:05

    Scott,

    “The Fed should not create a double dip to prevent oil from going above some threshold.”

    Yes, but if oil goes above some threshold, it could create a double dip.

  14. Gravatar of Morgan Warstler Morgan Warstler
    7. March 2011 at 21:06

    The more we confront the reality of higher oil prices tamping down Econ growth, the more obvious it becomes we need signaling from the public sector that we can expect real productivity gains out that sector.

    Frankly, austerity is necessary to justify printing – it’s the only way the interests of banksters can be coordinated with the Tea Party.

    If the SMB right wing has total subservience from Ben, if he gets political I see this as possible, but that’s because I truly think the next boom is privatizing public service.

    Privatizing public service is the Right’s answer to infrastructure spending.

  15. Gravatar of CA CA
    7. March 2011 at 21:41

    Regarding oil prices I think Scott’s exactly right. It isn’t the Fed’s responsibility to worry about oil prices. It is up to our President and Congress to come up with a sensible energy policy. I wont hold my breath….

  16. Gravatar of Doc Merlin Doc Merlin
    8. March 2011 at 01:44

    @Scott
    “Doc Merlin, The TIPS markets imply core inflation will stay low. (TIPS spreads are inflated by commodity prices that haven’t yet hit the CPI.)”

    Meaningless as the fed buys TIPS too.

  17. Gravatar of David Pearson David Pearson
    8. March 2011 at 06:07

    What TIPS spreads mask is a dramatic change in expected relative prices. Shelter is 40% of core cpi and is on a declining trend. Commodities and import prices are on a rising trend and are expected to feed through to non-shelter final goods prices. Fed-induced relative price changes matter, just as they did during the housing bubble. And just as during that bubble, the TIPS told you nothing about the underlying dynamic.

    The more the Fed tries to force up the cpi with a year or more of (true) housing inventory, the more they will achieve a lopsided change in relative prices. QE? Forget about Treasuries: they should just start buying houses.

    BTW, EMH “cheats” inflation expectations of their commodities component. That is, if you assume that all future commodities price expectations are already in the price, then there should never be any (market-traded) commodities price inflation expectations embedded in TIPS spreads (or any other inflation expectations measure). This would imply that none of the high inflation expectations we experienced in the 70’s was due to oil price expectations. True?

  18. Gravatar of Scott Sumner Scott Sumner
    8. March 2011 at 09:14

    David, You said;

    “Yes, but if oil goes above some threshold, it could create a double dip.’

    Yes, but if oil goes above that threshold because of easy money, it cannot cause a double dip.

    Morgan, I hope you are right about privatization.

    CA, That’s right.

    Doc Merlin, The Fed doesn’t buy enough TIPS to seriously distort the spread. It’s buying both types of bonds.

    David, If we had never had the severe recession in 2008, oil prices would have stayed high. If the Fed causes a recovery, and commodity prices go back up to “prosperity levels” (which are quite high now because of Asian growth) then they are doing their job, and those sorts of relative price changes are good. BTW, monetary stimulus also boosts housing prices, or at least keeps them from falling as fast.

    Until I see significant wage growth, I will continue to doubt the inflation worries.

  19. Gravatar of Bababooey Bababooey
    8. March 2011 at 09:20

    I think you just coined a new phrase: ceteris rarenter paribus.

  20. Gravatar of bertusmaximus bertusmaximus
    8. March 2011 at 10:03

    Scott,

    “each individual trader has no idea how markets operate”

    i feel almost offended here given my professional background and economic philosophical orientation … 🙂 but no matter, i have picked up a copy of woodford …

    “Yes, but if oil goes above that threshold because of easy money, it cannot cause a double dip.”

    is the implication that we can’t have a period of -RGDP whilst NGDP prints positive? do you have evidence for this across multiple countries, periods and regimes? what happened to argentina in 2003?

    and IOR at the zero bound is indeed just a bank subsidy and so is in part QE, via the mechanisms through which it is being conducted.

  21. Gravatar of dtoh dtoh
    8. March 2011 at 10:19

    Scott,
    You said, “If I wanted to know how monetary policy affected the markets, I rather ask a homeless man than ask a Wall Street trader. Each individual brain cell has no idea how brains think. And each individual trader has no idea how markets operate. (OK, that’s a bit of hyperbole, but you get my point.)”

    Unless of course, Wall Street traders act like lemmings (which they frequently do), in which case there is no need for macro-economists…all you need is to put one trader in a cage and watch.

    More to the point, I think David’s argument addresses a general characteristic about how large numbers of portfolio managers act, not about the action of a specific manager.

    I would also bet serious money that David is right, and that QE has a bigger impact on commodity prices than on other asset prices resulting in distorted pricing (which is above “prosperity level” pricing.)

  22. Gravatar of bertusmaximus bertusmaximus
    8. March 2011 at 10:24

    oh yeah, and all the baltics did have a US style housing crash and both estonia and latvia have bounced back even harder than sweden despite bigger RGDP and NGDP falls … and i don’t recall any aggressive monetary policy there from either … though unemployment remains high, a few more 29% YoY IP rates should help that out.

  23. Gravatar of Benjamin Cole Benjamin Cole
    8. March 2011 at 10:24

    Just For Fun:

    Wednesday, August 26, 2009

    Economist Allan Meltzer, a leading authority on the Federal Reserve, gives tough marks to the central bank for its handling of America’s financial crisis, and he has concerns about the road ahead.
    “My concern is the (policy) of controlling inflation is going to be extremely difficult,” Meltzer, professor of political economy and public policy at Carnegie Mellon University, said Tuesday.

    Okay. Since then (Aug, 2009) the CPI has roared ahead by …2 percent. That’s two percent over 18 months.

    Moreover, at the time of Meltzer’s doom-mongering, the CPI had fallen by 1.5 percent in the previous year.

    As of now, the CPI is barely unchganged from its reading in August 2008–that is, in the last 2 1/2years we have had no net inflation. We are back where we started in Aug 2008, as measured by the CPI.

    When will this doom-parade of inflation-scare-mongering end?

  24. Gravatar of Mark A. Sadowski Mark A. Sadowski
    8. March 2011 at 16:16

    bertusmaximus.
    You wrote:
    “oh yeah, and all the baltics did have a US style housing crash and both estonia and latvia have bounced back even harder than sweden despite bigger RGDP and NGDP falls … and i don’t recall any aggressive monetary policy there from either … though unemployment remains high, a few more 29% YoY IP rates should help that out.”

    The Baltic States are pegged to the euro so effectively the ECB decides their monetary policy for them. Sweden and Poland have flexible exchange rates. Sweden and Poland depreciated about 13% and 30% respectively relative to the euro between July 2008 and February 2009.

    Here are the most recent yoy RGDP growth rates by country according to Eurostat:
    Estonia-5.0%-(2010Q3)
    Latvia-2.5%-(2010Q3)
    Lithuania-4.6%-(2010Q4)
    Sweden-7.2%-(2010Q4)
    Poland-3.8%-(2010Q4)

    Here are their RGDPs indexed to pre-Great Recession peak via Eurostat:
    Estonia-83.7-(2010Q3, previous peak 2007Q4)
    Latvia-77.2-(2010Q3, previous peak 2007Q4)
    Lithuania-86.8-(2010Q4, previous peak 2008Q1)
    Sweden-100.1-(2010Q4, pre-Great Recession peak 2007Q4)
    Poland-106.4-(2010Q4, never had a recession but relative to 2008Q3 since RGDP was negative in 2008Q4)

    The IMF estimates that Estonia and Latvia will not exceed their previous annual peak in RGDP (2007) until 2014. Similarly Lithuania will not exceed its previous peak (2008) until 2013. Sweden exceeded its previous peak (2007) last year and it is estimated by 2014 its RGDP will risen about 23%. Poland’s RGDP never fell on an annual basis and it is estimated it will have risen about 43% between 2007 and 2014.

    In short, are you sure that you know what you are talking about?

  25. Gravatar of bertusmaximus bertusmaximus
    8. March 2011 at 17:15

    mark,

    latest figures for IP for US:-0.1, Sweden 10%, Estonia 29% … but you are right and i should have not used IP as the basis of my argument. i stand corrected. i suspect, that the Q4 GDP print for Estonia may well be greater than 7% for Sweden once released but that doesn’t make up for lost output.

  26. Gravatar of bertusmaximus bertusmaximus
    8. March 2011 at 18:18

    digging around eurostat and a few other places seems estonian q4 2010 RGDP was 6.6%.

    according to eurostat, RGDP:

    2009 2010 F2011
    estonia -14 2.4 4.4
    latvia -18 0.4 3.3
    sweden -5.3 5.5 3.3

    http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&init=1&plugin=1&language=en&pcode=tsieb020

  27. Gravatar of David Pearson David Pearson
    8. March 2011 at 18:20

    Scott,

    EMH stipulates that markets discount known information about the future. Assume that RGDP growth is a proxy for oil consumption. In August, 2010, consensus expectations for Chinese (and Asian) growth were for a steady rate of increase. I am not aware that China RGDP or IP growth came in significantly above expectations, or that expectations were raised.

    The Shanghai Index is a proxy for Chinese growth, which, again, is a proxy for Chinese oil consumption. The index has had a modest rally since August, 2010 (around 10%). However, its also true that the index has been range-bound since the fall of ’09. Given the normal volatility of Chinese stocks, there is little to suggest that, since that time, markets have received new information about the pace of Chinese growth and oil consumption.

    What new information about “Asian Growth” caused oil markets to bid up the price of oil from $78 to $105 since Jackson Hole?

  28. Gravatar of Mark A. Sadowski Mark A. Sadowski
    8. March 2011 at 18:33

    bertusmaximus,
    I appreciate your enthusiasm. But 6.6% is still less than 7.2%. As for the rest, I’m not sure that it’s all that relevant.

    Think about this for a moment. Is it the asset prices that determines money or is it money that determines asset prices?

  29. Gravatar of bertusmaximus bertusmaximus
    8. March 2011 at 19:14

    mark,

    yes last time i checked 6.6 is less than 7.2 …. but they both still beat the US with its QE. estonia until a few weeks ago didn’t belong to the eurosystem in order to benefit all the liquidity provided by the ECB and its own version(s) of QE.

    as for the rest, my point if somewhat naive, is that RGDP went from -14 to +2.4 (+16.4) for estonia, -18 to to +0.4 (+18.4) for latvia whilst sweden went from -5.3 to +5.5 (+10.8) turnaround … but yes i acknowledge that stock and flow are not the same thing.

    the problem with getting back to the old “stock” of RGDP is that it was predicated on 6 years of abnormally high credit growth as most other countries with housing busts experienced. estonian RGDP growth for some time to come will be hampered by the housing/construction sectors and domestic consumption though it is making progress in getting the unemployment rate down … mostly through emigration like ireland.

    the narrow quantity of money is determined by the central bank whereas broad (uncovered) money is determined by the banking/credit system. asset prices are in part determined by money as its the numeraire or unit of measure which is different from its value … which is determined from access to future cash flows or utility of the asset.

    of course, if asset prices increase then i have more collateral which i can borrow against through credit channels which will increase broad money so there is a circularity. its late here and i am sorta rambling and getting lost in my thoughts …

  30. Gravatar of Mark A. Sadowski Mark A. Sadowski
    8. March 2011 at 19:36

    bertusmaximus,
    You wrote:
    “but yes i acknowledge that stock and flow are not the same thing.”

    Frankly, it’s a weird argument to make. And apparently you have seemingly finally acknowledged it. 1000% up from zero is still zero!

    And you wrote:
    “the problem with getting back to the old “stock” of RGDP is that it was predicated on 6 years of abnormally high credit growth as most other countries with housing busts experienced. estonian RGDP growth for some time to come will be hampered by the housing/construction sectors and domestic consumption though it is making progress in getting the unemployment rate down … mostly through emigration like ireland.”

    Except that until recently Ireland, unlike the Baltic States, actually had a problem with excessive immigration from Eastern Europe and China

    (“Those were the days my friends, we thought they’d never end…”):

    http://www.youtube.com/watch?v=AyaTIXdN5fI

    And you wrote:
    “the narrow quantity of money is determined by the central bank whereas broad (uncovered) money is determined by the banking/credit system. asset prices are in part determined by money as its the numeraire or unit of measure which is different from its value … which is determined from access to future cash flows or utility of the asset.

    of course, if asset prices increase then i have more collateral which i can borrow against through credit channels which will increase broad money so there is a circularity. its late here and i am sorta rambling and getting lost in my thoughts …”

    That’s OK. It happens to me all the time. Nice talking to you. We’ll get to this again some other time.

  31. Gravatar of Mark A. Sadowski Mark A. Sadowski
    8. March 2011 at 20:24

    Oh, my friend, we’re older but no wiser
    For in our hearts the dreams are still the same…

  32. Gravatar of bertusmaximus bertusmaximus
    9. March 2011 at 03:04

    mark,

    thanks for the clip. made me feel rather nostalgic and warm inside.

    i realized i forgot to mention one other aspect related to estonia in that it has been running a contractionary fiscal policy over the past 2 years whilst achieving positive growth recently. in fact, it has the lowest debt/gdp ratio in europe of under 8% vs about 40% for sweden and 100% for the USA.

    http://www.export.by/en/?act=news&mode=view&id=25155&page=19

    so whilst the USA has an estimated RGDP of 3% for 2011, that of estonia is, as noted above, 4.4%, whist sweden’s is 3.3% using eurostat and oecd estimates.

  33. Gravatar of jj jj
    9. March 2011 at 08:20

    Scott,

    Not related to this post, exactly, but you might be interested in this, from an old Krugman piece:

    “It is possible for economies to suffer from an overall inadequacy of demand–recessions do happen. However, such slumps are essentially monetary–they come about because people try in the aggregate to hold more cash than there actually is in circulation. (That insight is the essence of Keynesian economics.) And they can usually be cured by issuing more money–full stop, end of story.”

    Look at that, not a word about fiscal policy or the zero bound!

    The entire Krugman piece is here: http://web.mit.edu/krugman/www/hotdog.html
    I found it here: http://www.economist.com/blogs/freeexchange/2011/03/technology_and_employment

  34. Gravatar of flow5 flow5
    9. March 2011 at 09:17

    “flow5, I don’t see how IORs “absorb Treasurys” or save us any money, as the rate on Treasuries is lower than the IOR”

    Very true, but treasury yields are under the remuneration rate for 4-week bills, 3-month bills, 6-month bills, & 1 year bills, & the higher yields further out on the yield curve (now over the remuneration rate) might not be later. But I should consider my statements more carefully.

    & maybe opoeration twist was twisted the wrong way.

  35. Gravatar of Scott Sumner Scott Sumner
    9. March 2011 at 09:50

    David, You said;

    BTW, EMH “cheats” inflation expectations of their commodities component. That is, if you assume that all future commodities price expectations are already in the price, then there should never be any (market-traded) commodities price inflation expectations embedded in TIPS spreads (or any other inflation expectations measure). This would imply that none of the high inflation expectations we experienced in the 70’s was due to oil price expectations. True?”

    No, 100% false. The EMH does not imply that consumer prices respond immediately to economic shocks. When oil prices soar, the CPI responds with a lag. Furthermore, the inflation adjustment to TIPS adds another lag. The total lag is quite signficant, which is why TIPS spreads predictably soar after oil price spikes.

    bababooey, I take it ‘rarenter’ is ‘rarely.’

    bertusmaximus, I should have been clearer. Traders may understand how markets work in a supply and demand sense, I meant that they don’t necessarily understand why various policies affect prices.

    You said;

    “is the implication that we can’t have a period of -RGDP whilst NGDP prints positive? do you have evidence for this across multiple countries, periods and regimes? what happened to argentina in 2003?”

    No, that isn’t the implication, indeed it would be silly to claim that. The point is that if prices rise due to more AD, then those price increases won’t reduce output. “Never reason from a price change.”

    dtoh, You said;

    “Unless of course, Wall Street traders act like lemmings (which they frequently do), in which case there is no need for macro-economists…all you need is to put one trader in a cage and watch.”

    The problem is that when traders become like lemmings, those who observe them and regulate them become equally lemming-like.

    You said;

    “I would also bet serious money that David is right, and that QE has a bigger impact on commodity prices than on other asset prices”

    It depends which of the “other asset prices” you are referring to. QE affects commodity prices more than consumer goods and services prices.

    bertusmaximus, You said;

    “oh yeah, and all the baltics did have a US style housing crash and both estonia and latvia have bounced back even harder than sweden”

    You could hardly have picked a worse example. The depression in Estonia and Latvia was far deeper than in Sweden, it’s not even close. And even after the recent growth, those two economies are far more depressed than Sweden–again, it’s not even close. Your experiment shows that monetary stimulus is extremely helpful.

    Benjamin, When Meltzer made that statement I did a post claiming he was playing right into Krugman’s hands, that monetarists would look foolish prediction high inflation.

    David; You said;

    “What new information about “Asian Growth” caused oil markets to bid up the price of oil from $78 to $105 since Jackson Hole?”

    Even if you were right, (and the EMH doesn’t necessarily mean you are, as we don’t know how much Asian demand forecasts have changed since August), it wouldn’t imply the growth was due to easy money. It is quite plausible that half the increase in oil prices was easy money in the US, and half was worry about the Middle East, where oil production has been falling due to problems in Libya. If half the increase you described were easy money (which it might be) my response would be: So what? Don’t we expect commodity prices to recover somewhat as RGDP growth in the US accelerates? Why is that viewed as a problem?

    As far as the rise in prices due to Libya, that most certainly is a problem. There is a big difference between prices rising because of more oil demand, and prices rising because of less oil supply.

    jj, Thanks. I did see that one. He now insists that it doesn’t apply at the zero bound. I think it still does apply.

    flow5, Keep in mind that the expected rate of return on the longer maturities (over the next 12 months) is much lower than the average yield to maturity for the longer term securities.

  36. Gravatar of flow5 flow5
    9. March 2011 at 10:22

    True again, but once the FED owns the securities, the interest expense is recaptured anyway. By monetizing the debt, then sterilizing the operation, it should lower the demand for loan-funds (& lessen any crowding out).

  37. Gravatar of Mark A. Sadowski Mark A. Sadowski
    9. March 2011 at 15:28

    bertusmaximus,
    You wrote:
    “thanks for the clip. made me feel rather nostalgic and warm inside.”

    Thinking about the countries bordering the Baltic and the Great Recession last night put me in a wistful Balto-Slavonic mood. Mary Hopkins is Welsh of course but the tune (not the words) is Russian in origin (Dorogo Dlinnoyu). I love the instrumentation (clarinet and hammer dulcimer) and vocals (the children’s choir in the background). It almost makes me want to reach for a bottle of Wyborowa.

    You wrote:
    “i realized i forgot to mention one other aspect related to estonia in that it has been running a contractionary fiscal policy over the past 2 years whilst achieving positive growth recently. in fact, it has the lowest debt/gdp ratio in europe of under 8% vs about 40% for sweden and 100% for the USA.”

    You’ll find few people who are bigger fans of the Baltic States than myself. (In fact I’m an eighth Lithuanian.) I’m actually very distressed by what has happened, and is continuing to happen there.

    In my opinion the Baltic States (and Ireland) had a number of attractive supply side policies that contributed to their rapid growth in 1995-2007. These would include low marginal corporate tax rates, moderate sized public sectors, fiscal discipline, good infrastructure, and high levels of human capital. That’s why it’s all the more tragic that this has all been completely undone, and continues to be undermined, by the tight monetary policy of the ECB.

    It’s a terrible, awful waste.

  38. Gravatar of dtoh dtoh
    10. March 2011 at 02:06

    Scott,
    You said, “The problem is that when traders become like lemmings, those who observe them and regulate them become equally lemming-like.”

    What regulation are you talking about. The whole reason we had the financial crisis is because there wasn’t any effective regulation.

  39. Gravatar of Rafael Rafael
    10. March 2011 at 06:27

    It´s sad to note that elite macroeconomists (Woodford) would advocate such policies.

  40. Gravatar of Full Employment Hawk Full Employment Hawk
    11. March 2011 at 00:39

    “Cut the IOR to 0.15%. It will give banks a bit less incentive to just sit on all the QE you’re sending their way. But it will still be high enough to prevent the MMMFs from going belly up. And you guys at the BOG can do it on your own-no pesky regional bank presidents to deal with.”

    RIGHT ON!

    This will provide a monetary stimulus without raising concerns about a huge amount of excess reserves causing the danger of inflation when the economy really picks up.

    And anything that takes Fisher and Plosser, who represent bankers and not the people, out of the loop is a good thing.

    But I don’t understand why lowering the interest to zero would make the MMMFs go belly up. They didn’t go belly up before the Fed paid interest on reserves.

  41. Gravatar of Full Employment Hawk Full Employment Hawk
    11. March 2011 at 00:52

    “At the risk of sounding like a total philistine, it’s “doll house” economic models like these that turned me into an incurable empiricist. (They usually start with “we construct a typical model with perfectly-rational, infinitely-lived agents….” at which point they always lose me.)”

    The worst single piece of damage the New Classical Economists did to macroeconomics is to impose the DGSE models on it. They are a methodological straightjacket and are based on such blatently counterfactual assumptions that all of their conclusions are suspect. The New Keynesian Economists have made them less bad by adding sticky wages and prices, and even sticky expectations to them, but those paradigm patches do not overcome the basic defects of the models. Before macroeconomics can effectively deal with the kinds of problems that the economy is currently facing, they need to be scrapped.

    For a good criticism of the DSGE models, see ZOMBIE ECONOMICS by John Quiggin, Chapter 3.

  42. Gravatar of Mark A. Sadowski Mark A. Sadowski
    11. March 2011 at 12:26

    Full Employment Hawk,
    You wrote:
    “For a good criticism of the DSGE models, see ZOMBIE ECONOMICS by John Quiggin, Chapter 3.”

    I love Crooked Timber. Thanks I’ll check it out.

  43. Gravatar of Benjamin Cole Benjamin Cole
    13. March 2011 at 09:35

    Q for sumner and others:

    Human tragedy aside, could the tsunami at Japan prove to be good for the Japanese economy, as the BoJ will provide funds (they already have said so) and rebuilding will spur economic growth?

  44. Gravatar of Richard Allan Richard Allan
    13. March 2011 at 10:39

    God-damn Benjamin that is one seriously ignorant comment.

  45. Gravatar of flow5 flow5
    13. March 2011 at 11:32

    “But I don’t understand why lowering the interest to zero would make the MMMFs go belly up. They didn’t go belly up before the Fed paid interest on reserves”

    Seems impossible to me too. As long as the “real” rates are positive, savers will accept a competitive rate of return.

  46. Gravatar of Full Employment Hawk Full Employment Hawk
    13. March 2011 at 16:20

    “God-damn Benjamin that is one seriously ignorant comment.”

    No it is not. The damage to infrastructure and property will, of course lower Japan’s potential output. But the Japanese economy is far below potential output. Not only will the Bank of Japan follow a more expansionary monetary policy. In addition the increased government expenditures will increase the G component of aggregate demand while the expenditures by private firms to rebuild their property and home owners to rebuild theirs will add to the I component of aggregate demand. Therefore these increases in expenditures will give a sharp stimulus to aggregate demand (and, in a dynamic context, NGDP growth) that will not be offest by more contractionary monetary policy, but will, rather, be reinforced by more expansionary monetary policy.

    This will move the economy closer to potential output and full employment. It MAY even end Japan’s decades long stagnation. But Japan’s hapless central bank will probably put the monetary brakes on before that can happen.

  47. Gravatar of Mark A. Sadowski Mark A. Sadowski
    13. March 2011 at 17:11

    Richard Allan,
    Weirder things have happened. IMO Benjamin’s question is sincere and well intentioned. It’s hard personally for me to spin this positively but one can always hope. And FEH gives an explanation (although not one that I would have come up with).

  48. Gravatar of flow5 flow5
    14. March 2011 at 07:33

    Charging interest on inter-bank balances held in the District Reserve Banks (instead of paying interest on them), would reverse the flow of loan-funds in the economy. It would shrink the size of the commercial banking system while simultaneously increasing CB profits. It would increase aggregate monetary purchasing power (by releasing the volume of savings available for real-investment).

    Money flowing “to” (thru), the non-banks actually never leaves the CB system, as anyone who has applied double-entry bookkeeping on a national scale should know. I.e., the source of time deposits to the CB system is demand deposits, directly, or indirectly via the currency route, or the banks undivided profits accounts. The growth of the financial intermediaries (non-banks/Shadow banks, etc), will only increase the lending opportunities of the CBs.

  49. Gravatar of flow5 flow5
    14. March 2011 at 07:43

    The CBs can force a contraction in the size of the S&L system, and create liquidity problems in the process, by outbidding the S&Ls for the public’s savings. This process is called “disintermediation” (an economist’s word for going broke). The reverse of this operation cannot exist. Transferring saved TR or TD deposits through the S&Ls cannot reduce the size of the commercial banking system. Deposits are simply transferred from the saver to the S&L to the borrower, etc.

    The drive by the commercial bankers to expand their savings accounts has a totally irrational motivation, since it has meant, from a system standpoint, competing for the opportunity to pay higher & higher interest rates on deposits that already exist in the commercial banking system.

  50. Gravatar of flow5 flow5
    14. March 2011 at 08:12

    IORs are the FUNCTIONAL EQUIVALENT of required reserves, not short term T-bills. T-bills are settled upon maturity, or are liquidated at a discount. IORs sport a “floating”, overnight, remuneration rate (currently consonant with the 1 year “Daily Treasury Yield Curve Rate”).

    I.e., the policy rate “floats” (like an adjustable rate mortgage), via a series of either, cascading, or stair-stepping, interest rate-pegs. I.e., as with ARMs, a “note is periodically adjusted based on a variety of indices”.

    Similarly, “Among the most common indices (for ARMs), are the rates on 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR).” – Wikipedia

    The remuneration rate is a monetary policy “tool”, it is the Central Bank’s target rate’s “floor” (a hypothetical policy otherwise known as the “Friedman rule”).

    I.e., IORs are not just an asset swap. IORs are assets defined by economists to be outside-of-the properties normally assigned to the money aggregates. I.e., IORs are a credit control device. IORs absorb bank deposits (offsetting the expansion of the FED’s balance sheet on the asset side, e.g., QE2), as well as impound consumer & corporate savings, and induce dis-intermediation among the non-banks. IORs increase the cost of loan-funds (mortgage rates), ceteris paribus. IORs increase the capitalization rate on company earnings.

    IORs are bank earning assets. IORs are investments. IORs are riskless, guaranteed, & are a hedge against higher interest rates (i.e., promise even higher, & safer returns as the economy expands).

    IORs eliminate the motivation of the banks to lend within the short-end segment of the yield curve. IORs are the bank’s primary liquidity reserves (clearing balances) – despite the day-light credit backstop, borrowing FED funds, etc. (i.e., both FED-WIRE & contractual clearing balances have declined conterminously).

  51. Gravatar of Scott Sumner Scott Sumner
    16. March 2011 at 10:35

    flow5, Sorry, it’s been so long I forgot the context.

    Mark, I agree about the good supply-side polices being undone by tight money. (Although Irish housing policy was far from ideal.)

    dtoh, You said;

    “What regulation are you talking about. The whole reason we had the financial crisis is because there wasn’t any effective regulation.”

    As of 2006 there were probably enough regulations of housing and banking to fill a room. If you mean “effective” regulation, or course I agree. My point was that the regulation was ineffective–the regulators encouraged banks to do as many subprime loans as they could. The regulators were lemmings. So the problem wasn’t lack of regulation, it was bad regulation. You can’t solve the problem of doing bad regulation by doing more regulation. We need much less regulation, and much more effective regulation. More like Canada, which does less, but is more effective.

    Rafael, Dod Woodford recommend it in the current situation? I hope not.

    Full Employment Hawk, You said;

    “But I don’t understand why lowering the interest to zero would make the MMMFs go belly up. They didn’t go belly up before the Fed paid interest on reserves.”

    But rates were well above zero at that time. Now they are near zero, and could go to zero without IOR. I’m not saying that’s a huge problem, but it’s what the Fed fears.

    I agree about DSGE models.

    Benjamin, Maybe, but I doubt it. The Kobe earthquake of 1995 didn’t solve their problems.

    flow5, Yes, IOR is similar to required reserves.

  52. Gravatar of Full Employment Hawk Full Employment Hawk
    16. March 2011 at 13:17

    “This will move the economy closer to potential output and full employment.”

    This assumed an earthquake and a tsunami, but not a major nuclear disaster. If there is a really bad nuclear disaster that makes large parts of the main island dangerously radioactive, that will cause a major drop in potential output that can largely destroy the Japanese economy.

    ” The Kobe earthquake of 1995 didn’t solve their problems.”

    The combination and earthquake was a lot worse than this. But the hapless Japanese central bank would be likely to kill off the recovery before the problems were solved.

  53. Gravatar of OneEyedMan OneEyedMan
    17. March 2011 at 12:13

    In December 2007 the Fed was trying to decide between cutting rates by 1/4 and 1/2 point. They actually cut them by 1/4 point, and the Dow promptly fell by 300 points. Because fed funds futures showed a 58% chance of a 1/4 point cut and a 42% chance of a 1/2 point cut, we can infer that the Dow would have risen about 400 points with a 1/2 point cut. (One of the few things even anti-EMH types accept is that the expected return on the Dow over any 2 hour period is roughly zero.)

    I like this method of reasoning but how do the fed funds futures rates rule out a 0% cut with some possibility or even a .25% increase (or .75% decrease) with some possibility? Isn’t this just comparing the future rate with the spot rate and saying that this is E(Rt+1) = .58*(Spot -.25) + .42*(Spot -.50)?, if you add some extreme possibilities you get a different effect.

    Also, isn’t the Dow response at least as much about what this says about future Fed action? I wonder if this proves only that the markets learned that the fed was more hawkish or foolish than they thought, not that the rate change mattered much.

  54. Gravatar of OneEyedMan OneEyedMan
    17. March 2011 at 12:15

    In December 2007 the Fed was trying to decide between cutting rates by 1/4 and 1/2 point. They actually cut them by 1/4 point, and the Dow promptly fell by 300 points. Because fed funds futures showed a 58% chance of a 1/4 point cut and a 42% chance of a 1/2 point cut, we can infer that the Dow would have risen about 400 points with a 1/2 point cut. (One of the few things even anti-EMH types accept is that the expected return on the Dow over any 2 hour period is roughly zero.)

    I like this method of reasoning but how do the fed funds futures rates rule out a 0% cut with some possibility or even a .25% increase (or .75% decrease) with some possibility? Isn’t this just comparing the future rate with the spot rate and saying that this is E(Rt+1) = .58*(Spot -.25) + .42*(Spot -.50)?, if you add some extreme possibilities you get a different effect.

    Also, isn’t the Dow response at least as much about what this says about future Fed action? I wonder if this proves only that the markets learned that the fed was more hawkish or foolish than they thought, not that the rate change mattered much.

  55. Gravatar of ssumner ssumner
    18. March 2011 at 10:58

    FEH, I’m pretty sure that wouldn’t happen in the main population centers, but I’m just as ignorant as anyone else. I vaguely recall that people claimed a worst case accident at say Long Island, might cause a million people to move, not 30 million. But the press has been maddeningly vague on all this, as other bloggers have also observed.

    OneEyedMan, I think markets were pretty sure it was going to be 1/4 or 1/2. But your point is valid.

    You said;

    “Also, isn’t the Dow response at least as much about what this says about future Fed action? I wonder if this proves only that the markets learned that the fed was more hawkish or foolish than they thought, not that the rate change mattered much.”

    This was precisely my point. Obviously the 1/4 point in and of itself was of trivial importance. But these policy decisions are nonetheless important, as signals of future Fed policy. Ditto for IOR.

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