Two visions of macro

There seem to be two approaches to macro policy, once interest rates hit the zero bound:

1.  The pessimistic view:  In this view, monetary policy can do no more.  Trade balances become a zero sum game.  The US gains from some (not all) contractionary policies adopted by other countries, such as currency revaluation.  If China sharply revalues its currency, it may cost millions of jobs in China, and hurt countries that export materials and machines to China, but it will boost jobs here.  It might not be accurate to claim this is a zero sum game view of the world, but it comes pretty close.  (By the way, I used the term ‘sharply revalue’, as I think a gradual revaluation is in China’s own interest.)

2.  The optimistic view:  Even at the zero bound monetary policy is still the most important factor driving NGDP growth.  It’s not a zero sum game.  A sharp Chinese revaluation might reduce world AD.  A dramatic easing by the Fed would not just depreciate the dollar against goods and services, it would sharply raise world AD, and world RGDP if there is slack in labor markets.  This could easily help overseas firms, even in countries whose currencies might rise a bit against the dollar.  In this view, you don’t look for jobs by trying to take them away from other countries, even countries that might be “misbehaving” according to some sort of arbitrary “rules of the game” that never did and never will exist, but rather you try to generate jobs in your own country by boosting your own AD.

Check out this recent news story—I could have found 100 similar ones over the last month (in case anyone thinks I’m cherry-picking.)

LONDON (AP) — World markets mostly rose Thursday as investors remained buoyed by the prospect of more monetary stimulus from the Federal Reserve. However, predictions of looser U.S. policy have not done the dollar any good as it slid to a 15-year low against the yen and multi-month troughs against the euro and the pound.

.   .   .

Once again the main focus in the markets is on what the Fed is planning to do at its next rate-setting meeting in early November to shore up the U.S. economy and prevent prices from falling. The minutes to the last meeting of the Federal Open Market Committee gave a big hint that the Fed is planning another monetary stimulus, that could involve the setting of an inflation target.

All eyes will be on Fed chairman Ben Bernanke Friday when he delivers a speech on monetary policy, more or less at the same time as monthly inflation figures are set to show price pressures in the U.S. economy remain subdued.

Analysts said it’s no longer a question of if but how and how much money the Fed will pump into the U.S. economy.

Stocks have been buoyant for over a week as investors have priced in the growing likelihood that the Fed would join the Bank of Japan in easing monetary policy further in an attempt to further drive down rates on mortgages, corporate loans and other debt in the ultimate hope of boosting economic activity and supporting prices.

For those who don’t follow world equity markets, the strong stock market rally since September 1 that most are attributing in large part to growing expectations of Fed easing, has been mirrored in the major overseas markets.  Yet a “beggar-thy-neighbor” view of economics would predict that foreign firms should be hurt if the US depreciates the dollar.

After my most recent defense of the EMH, some commenters asked me incredulously whether I really thought investors understood complex economic models as well as the model builders, who are some of the smartest people around.  You misunderstood my argument.  I’m not saying markets are as smart as elite macroeconomists, I’m saying they are much smarter.  Individual investors are often dumb as door knobs, but collectively they understand how the world works even better than some Nobel Prize-winning economists.

That’s why 1000 people can look at a jar of jelly beans and individually not have a clue as to how many there are.  But collectively they know the right answer.  It’s all about the wisdom of crowds.

PS.  Commenters;  I hope to catch up on comments this weekend.



49 Responses to “Two visions of macro”

  1. Gravatar of Rebecca Burlingame Rebecca Burlingame
    14. October 2010 at 06:56

    Nations would not need to be doing this nonsense to each other right now, if they had devised ways to measure value in use economies all along. Governments were afraid of economies that don’t use money, but their citizens could use skills to give 20 percent back to the causes they deem most important. The only reason zero sum got into peple’s heads is because of the resources that money is not capable of putting into use at any given moment. Nick Rowe posted the other day as to how much of the problems with destabilization lies in the fact that only money (value in exchange) gets measured. Value in use economies have the potential to create additional wealth, stabilize money, stabilize world economies and give globalization a chance in the 21st century.

  2. Gravatar of Benjamin Cole Benjamin Cole
    14. October 2010 at 09:14

    “I’m not saying markets are as smart as elite macroeconomists, I’m saying they are much smarter.”

    Great reading. Great stuff.

  3. Gravatar of Ted Ted
    14. October 2010 at 09:37

    I’m almost wondering if this market optimism is a self-fufilling prophecy. I don’t see much evidence the Fed is going to do anything dramatic (there are hints here and there, but nothing major – maybe this is just investor animal spirits!) but I’m wondering if the market just starts believing the Fed is going to do something they can bully the Fed into doing it because the Fed doesn’t want to disappoint once expectations are built up. This, in turn, then makes the market look incredibly wise – look they predicted Fed action before the Fed did! – when in reality they just bullied the Fed into doing what they wanted all along.

  4. Gravatar of Rebecca Burlingame Rebecca Burlingame
    14. October 2010 at 10:00

    Speaking of the optimistic view, I thought this was noteworthy… Did you realize this was the best September on Wall Street in 71 years?

  5. Gravatar of marcus nunes marcus nunes
    14. October 2010 at 10:34

    Fed researchers are very much divided. Thornton does not believe in MP effectiveness (like the clan led by Hoenig).

  6. Gravatar of Doug Bates Doug Bates
    14. October 2010 at 11:33

    To Ted — for as long as market optimism (or pessimism) lasts, it *is* a self-fulfilling prophecy.

    Most debt creation and destruction (which is essentially the same as money creation and destruction) is done by private actors, so the Fed usually finds itself playing catchup, trying to moderate the bipolar swings of the market’s mood. There is no way any government agency can maintain an endlessly optimistic (or pessimistic) mood among private actors. But a market that is ready for a positive surprise will take what it can get, even if the surprise is an ultimately illogical piece of government-provided gold-colored straw 😉

  7. Gravatar of Aaron Aaron
    14. October 2010 at 14:12

    Speaking of markets being smarter…

    I think you know the answer to this one.

  8. Gravatar of rb rb
    14. October 2010 at 14:40

    Whats up with the link?

    It says, “LONDON (AP) — European and U.S. stock markets mostly fell Thursday as investors awaited a speech from the Federal Reserve chairman that is expected to give more clarity on what the central bank is planning to do to prop up the ailing U.S. economy.”

    Is that the wrong link?

  9. Gravatar of ang ang
    14. October 2010 at 14:51

    I like the jar of jelly beans example because it also illustrates some of the limitations of “wisdom of the crowd”. If, for example, the jar is deceptively designed, then there will be bias in the crowd’s estimate. In this example a savvy observer (or small group of savvy observers) may have a much better estimate than the crowd. See also for example the state of our democracy.

    One advantage that markets have is that it’s a *weighted* wisdom of the crowds, where weight is roughly correlated with interest (both natural and due to risk exposure) and ability.

  10. Gravatar of Steve Steve
    14. October 2010 at 15:52

    Scott, you have a peculiar view of EMH. Dare I accuse you of being academic?

    Actually, I’m a big fan of your blog, I’ve learned a lot from you, and I’d be interested in meeting you someday (I’m proximate enough).

    But getting back to my point. Here’s my Wisdom of the Crowds analogy. Suppose there is a contest to guess the number of jelly beans in a jar. In a blind experiment where I make a guess, and 99 other people make a guess, I would bet that the median of the 99 people will be more accurate than my guess.

    On the other hand, if 99 people make guesses, and you tell me the median of their guesses, I would bet that I can make a better guess. I will estimate which way they have erred, and add or subtract one. That I will call “The Wisdom of the Trader.”

    Now, consider QE. No one really knows how effective it will be. I certainly don’t. I don’t even have a PhD! But I have an exceptionally high degree of confidence that whatever the arrogant geniuses like Niall Ferguson think it will do to GDP, the result will actually be better. That is the Wisdom of the Trader.

  11. Gravatar of Alexander Hudson Alexander Hudson
    14. October 2010 at 17:14

    Steve, I don’t think Scott is saying that you couldn’t out-guess the crowd on a particular occasion. I think he’s saying that you couldn’t consistently do so. That is, if you were to conduct 100 experiments in which you try to out-guess the crowd estimate of the number of jelly beans, you’d be wrong as often as you’d be right.

    My understanding is that, under the EMH, the market cannot be systematically wrong about something for too long. Otherwise there’s a free lunch sitting out there somewhere that no one has discovered. But I’m not an economist and so my knowledge of this stuff is whatever I can glean off of Scott’s blog.

  12. Gravatar of OGT OGT
    14. October 2010 at 17:23

    As others have pointed out financial markets violate one of the tenets of ‘Wisdom of Crowds,’ independent observations. Once individuals are exposed to the opinions of others it is possible for information cascades to develop that swamp whatever incite the aggregation of opinions creates. Or what Soros refers to a reflexivity.

    That’s one of the reasons financial markets are far more volatile than any Gaussian distribution would predict, and always dangerous to read too much into.

  13. Gravatar of OGT OGT
    14. October 2010 at 17:34

    On the pessimistic/optimistic economics idea, I think one has to have a semi-coherent political economy model in order to really pick one over the other.

    For example, any noticeable realignment of China’s real exchange rate is going to produce some losers in their tradable goods sector so policy makers and market participants there are likely to view the optimum revaluation to be slower and less pronounced than their trading partners, where there will be some winners even in a too fast process.

    So, does that mean a negotiated pace that finds an agreeable middle ground? Or mutual distrust, recriminations and over reacting?

    Also, most observers agree that this adjustment would be easier if the US NGDP was growing. So in that sense QE2 should help. However, most observers also seem to think the adjustment will be harder if financial liquidity flows over into emerging markets exacerbating currency movements (Possibly even inducing sharp contractionary currency appreciations in countries such as India, Korea, Thailand and Brazil, and further real appreciation in China). In that sense QE2 could hurt.

    I think the NGDP effect significantly out ways the ‘hot money’ effect, but I am less sure on the international political dynamics.

  14. Gravatar of scott sumner scott sumner
    14. October 2010 at 18:49

    Rebecca, I’ll have to catch up on Rowe’s blog, I’m way behind in my reading.

    Yes, I knew about September.

    Thanks Benjamin.

    Ted, There’s an article out there discussing the same topic, I would have blogged it if I’d had time. The problem is that “the market” isn’t a single person, and doesn’t coordinate its actions. The market would have been much better off doing that in the 1930s, but they couldn’t because you have to think the Fed is serious to move the markets. The Fed’s recently been sending out some very strong signals.

    Marcus, Another economist who’s less smart than the markets (nothing to be ashamed of, so am I.)

    Doug, I’d reverse that–it’s the Fed that has the irrational mood swings–the markets always know what they want. They have been right from the beginning, and the Fed’s been wrong.

    Aaron, Actually, that’s not an issue I follow closely. My hunch is our title system is just one more aspect of our economy that is totally screwed up. The real estate industry seems like something out of the middle ages (and my dad was a realtor.) Every time I did a refinance I did an expensive title search–I have no idea what that’s all about. If the bank owns my house, how could the title have changed between one refinance and another, without the bank knowing it? What was being searched?

    rb, No, every time I link to Yahoo they keep changing the story as the market evolves during the day. The stuff I quoted was in the story when I read it. I double-check my links now–the story may be lost forever.

    But there are 100 similar stories out there

    ang, Your second point is the key one.

    The problem with our democracy is that it is no where near democratic enough. We need to decentralize a la Switzerland.

    Steve, We all have our hunches, including me. If we are very smart, we might be right 53% of the time. So I always say the EMH is roughly true, not exactly true.

    Alexander, Yes, that’s about right.

    OGT, That’s why the markets are so far superior to government regulators, or academics. The group think in Washington and in academia is far worse than in the markets. But I do agree, group think can be a problem. To paraphrase Churchill, the EMH is the worst model, except for all the others.

    OGT#2, There is no such things as “financial liquidity flowing over borders,” that’s just man on the street macroeconomics. If people are talking about credit, they should say so. If they are talking about currency they should say so. Currency is not leaving the US in significant amounts, and credit is flowing into the the US. So under either definition people are talking nonsense.

  15. Gravatar of Andy Harless Andy Harless
    14. October 2010 at 19:50

    …the strong stock market rally since September 1 that most are attributing in large part to growing expectations of Fed easing, has been mirrored in the major overseas markets. Yet a “beggar-thy-neighbor” view of economics would predict that foreign firms should be hurt if the US depreciates the dollar.

    I would attribute the stock market rally primarily to a decline in required returns rather than an increase in expected profits. (In fact, given the dramatic decline in real interest rates, as represented by TIPS yields, I find the stock market’s performance relatively disappointing even under the assumption that there is no change in expected profits.) So even if the expected Fed action has a beggar-thy-neighbor effect, we should still expect foreign stocks to rise (provided that the effect is not too large), because the required return on all assets is going down.

    Also, I don’t think most “pessimists” believe this is a zero sum game. They think that renmenbi revaluation is a net winner, because China is on a steeper part of its aggregate supply curve than the US is (which is almost certainly true), so the US will gain more than China loses.

    In fact, some would argue that it is a winner even for China, because it will enable China to control inflation in a way that has fewer undesirable side effects than the alternatives. (The argument is that exporters in China have disproportionate political power and are pressuring the government into suboptimal policies.) I guess you might even agree to some extent: somewhere along the range between sharp and gradual revaluation, there is an optimum. It’s a question of where the optimum is and whether the optimum for China is the different from the optimum for the world.

  16. Gravatar of marcus nunes marcus nunes
    14. October 2010 at 20:03

    WoW! “Economy not weak enough”!!!
    As an academic, Mr. Bernanke argued strongly for inflation targets and urged the Bank of Japan to more forcefully demonstrate that it was prepared to generate a little inflation as it emerged from its economic slump. The trick for Mr. Bernanke is getting inflation a little higher but not a lot. (It also would be nice if the Fed could ensure it will get inflation in the right places “” like wages “” and not in places that would hurt the U.S., like oil prices. But it can’t ensure that.) Mr. Bernanke has already said he doesn’t support a higher inflation goal of 3% or 4%. He’s probably sympathetic to a “price level” target which would allow the Fed to overshoot on inflation for a little while but not permanently. But neither he nor his colleagues are likely to be ready to go there yet. The economy isn’t weak enough to justify it. So, for now at least, he is probably left with a commitment to the 2% goal and the suggestion that he will keep pushing on policy levers like quantitative easing until he’s sure he’ll get there.

  17. Gravatar of WhiskeyJim WhiskeyJim
    15. October 2010 at 00:28


    Why isn’t the market just saying that a weaker dollar is likely to help spur American economic activity, which would be good for most economies?

    Besides, with a world currency and globalization, I wonder if Bernanke can effect inflation as much as say, two decades ago.

  18. Gravatar of Lorenzo from Oz Lorenzo from Oz
    15. October 2010 at 02:55

    On title problems is the US: the answer is to adopt Torrens title.

  19. Gravatar of Lorenzo from Oz Lorenzo from Oz
    15. October 2010 at 02:56

    That should say “in the US”.

  20. Gravatar of OGT OGT
    15. October 2010 at 05:31

    Let me, rephrase the ‘liquidity’ comment, because I am sure it was mostly me being imprecise summing up the views of people concerned about the international finance effects of QE2.

    David Beckworth (someone not in that camp, obviously) does a good job here:

    Now because the Fed is a monetary superpower, its attempts to shore up U.S. AD will get exported to many other countries in the world, particularly those those dollar bloc countries that pegged in some form to the U.S. dollar and do so in a manner that maintains external competitiveness. It is these same countries that are a key part of the second rebalancing act. They are not pleased by this development as it implies either (1) letting their currencies appreciate against the dollar and losing some external competitiveness or (2) intervening in foreign exchange markets to prevent this appreciation from happening and allowing a large expansion of their domestic money supplies. Either way, the second rebalancing act will occur: dollar block countries’ currencies will appreciate or their domestic prices will increase.

    Here’s Rajan with a similar point though he assumes foreign government intervention is already the reason for the net capital import in the US and jumps to some odd conclusions:

    But industrial countries, too, intervene substantially in markets. For example, while US monetary-policy intervention (yes, monetary policy is also intervention) has done little to boost domestic demand, it has spurred domestic capital to search for yield around the world. The US dollar would fall substantially – encouraging greater exports – were it not for the fact that foreign central banks are pushing much of that capital right back by buying US government securities.

    All this creates distortions that delay adjustment – exchange rates are too low in emerging markets, slowing their move away from exports, while the ease with which the US government is being financed creates little incentive for US politicians to reduce spending over the medium term.

    Why would easier Fed policy slow currency adjustment? It should make it easier? And since when is monetary policy a legitimate tool to pressure congress over fiscal policy?

  21. Gravatar of Liberal Roman Liberal Roman
    15. October 2010 at 06:25

    OT: Oh boy, Bernanke’s speech underwhelmed and the market is tanking. Well, let’s hope he learns a lesson from this.

  22. Gravatar of Benjamin Cole Benjamin Cole
    15. October 2010 at 08:51

    “Federal Reserve Chairman Ben S. Bernanke on Friday laid out a case for the central bank to take further action to bolster growth, citing the risks of prolonged high unemployment and a U.S. economy slipping into a deflationary spiral.

    In a much-anticipated speech in Boston, Bernanke did not spell out details of how and when the Fed would take action. But the first option that he mentioned was a program of buying additional assets, namely government bonds, in an effort to drive down long-term interest rates and stimulate economic growth.

    The central bank is widely expected to announce such a program, known as quantitative easing, at the conclusion of its next policymakers’ meeting on Nov. 2 and 3.”

    Like everyone reading this space, I also hope for a more-aggressive, confident Fed. But this is a big change. QE is becoming less and less “unconventional,” and less exotic.

    Good news. Yes, Caspar Milquetoast is alive and well inside of every central banker’s body, but at least we got them out on the dance floor….

  23. Gravatar of Aaron Aaron
    15. October 2010 at 09:43

    @Scott: I probably should have been less oblique in my comment about that link. The question Ezra Klein was asking was “Why aren’t the markets reacting badly to the foreclosure crisis?” He seems genuinely puzzled since the CW he probably hears all the time is that the housing bubble caused the recent downturn, etc. etc. However, if he were a regular reader of your blog, he would know that the Fed is creating greater NGDP growth expectations currently so whatever happens in the mortgage market won’t matter too much. Am I right?

    P.S. First time commenter, long time reader. I really enjoy your blog, although I’m not an economist. It’s really helped me understand monetary issues better.

  24. Gravatar of D. Watson D. Watson
    15. October 2010 at 11:00

    NY Federal Reserve Bank President Dudley will be speaking at Cornell on the 25th. If you had the chance to ask him one question in a large public setting like this, what would you ask?

  25. Gravatar of Alexander Hudson Alexander Hudson
    15. October 2010 at 11:06

    @Aaron: You and me both, i.e. this blog has helped non-economists like me understand these issues a lot better. I also saw Ezra Klein’s blog post wondering about the markets, and so I posted a comment saying something similar to what you just said. All the other comments were along the lines of “well the markets know that Congress will just pass another bailout.” I think the only other person who commented on the monetary issue was complaining about how Bernanke was trying to prop up a house of cards (i.e. the U.S. economy).

    Scott, thanks for putting so much time and effort into this blog. People like me really appreciate it. I know it must take a long time to respond to every comment the way you do, but it’s really helpful to those of us who want to understand these issues better.

  26. Gravatar of Mike Sandifer Mike Sandifer
    15. October 2010 at 18:17


    Regarding “wisdom of the crowds,’ I’m not familiar with the literature on the subject, but I certainly wouldn’t extend a crowd’s ability to estimate the number of jelly beans in a jar and generalize that toward much more complex, highly abstract challenges that require more than intuition.

  27. Gravatar of ssumner ssumner
    15. October 2010 at 18:22

    Andy, I see your point about the US, but are you also saying the Fed is lowering interest rates in other countries?

    The other problem I have with that argument is that monetary stimulus doesn’t always lower interest rates. But even when long rates rise as a result of stimulus, stocks respond very positively. Examples include January 2001 and September 2007.

    Both me and Chinese officials support a gradual appreciation, like what occurred in 2005-08. Krugman wants a sharp appreciation, and a trade war if they don’t do it. I predict both the US and Chinese markets would crash in a trade war, and American unemployment would rise.

    Marcus, Your comment from yesterday turned out about right.

    WhiskeyJim, I agree.

    Lorenzo, For some reason I can’t open the link.

    OGT, The first comment says the problem is that currencies in LDCs are becoming too strong, and the second comment says they are too weak. Countries should target NGDP or inflation, and stop worrying about exchange rates.

    Liberal Roman, It was underwhelming, but markets rose on the news, and fell later on other bearish news. At least he committed to acting.

    Benjamin, Yes, that was my view too.

    Aaron, Thanks for following the blog. Now that you explain it, it makes sense. Yes, I think the markets are more focused on NGDP right now. But I am going to plead ignorance about the foreclosure issue. I am not an expert in that area, and I thus I won’t say it’s not important. It could become a big issue over time.

    D. Watson, I’d ask “Since the Fed is actually trying to directly boost aggregate demand, and inflation only indirectly, why not target a proxy for AD such as NGDP? Especially since the public would be less worried about hearing the Fed is trying to boost their incomes, rather than their cost of living?” Do they allow questions that long? If not, just work the second sentence into a question, like “wouldn’t it sound better to . . . ”

    Thanks Alexander.

  28. Gravatar of scott sumner scott sumner
    15. October 2010 at 18:25

    Mike, It’s not a proof, just an analogy. It shows that you can’t prove markets are inefficient just pointing to the fact that lots of individual people aren’t very good at determining the value of an asset. Sure, markets may be inefficient, but other evidence would have to be offered.

  29. Gravatar of OGT OGT
    16. October 2010 at 05:09

    Sumner- I think you miss read Beckworth’s comments, maybe my excerpt was confusing. He is saying the Dollar block’s currency value is too low (ie “maintains external competitiveness”), but they view QE2 as a ‘currency war’ because it presents them with the options of allowing their currency to appreciate or allow higher inflation. Either represents a change in the real exchange rate and some sectoral readjustments.

    Again, I think one has to have some ideas how governments are likely to react to movements in order to qualify one’s self as a optimist or pessimist (as well as some expectation of the different economies’ flexibility).

    Andy Harless captured part of what I was trying to say in that China (or other countries whose real exchange rate is likely rise) have political incentives to under shoot any currency adjustment, as well as any related finance adjustments. While the US and other CAD countries have political and economic incentives to estimate high.

  30. Gravatar of Philo Philo
    16. October 2010 at 06:33

    “. . . collectively they [individual investors] understand how the world works even better than some Nobel Prize-winning economists.” An understatement; it should have read: “. . . better than *any* Nobel Prize-winning economist,” or even: “. . . better than *all Nobel Prize-winning economists collectively*.”

    Let me echo Alexander Hudson: “Scott, thanks for putting so much time and effort into this blog. People like me really appreciate it. I know it must take a long time to respond to every comment the way you do . . . .” But please don’t reply to this comment; I don’t want to add to your burdens!

  31. Gravatar of Andy Harless Andy Harless
    16. October 2010 at 15:22

    Of course the Fed is lowering interest rates in other countries. Foreign bonds and US bonds are substitutes. When the price of US bonds goes up (because of anticipated Fed action) the demand for foreign bonds goes up, and foreign interest rates go down too. (Of course this doesn’t work with short-term rates, because central banks will offset changes in private demand to maintain their targets, but central banks haven’t been targeting longer-term rates.)

    I agree that, in general, real interest rates don’t always go down in response to monetary loosening, but in this particular case, they did. That seems to be the mechanism that happens to be operating here, where TIPS yields fell quite dramatically, and stock yields fell much less. And the markets’ behavior is consistent at least with a mild negative effect on foreign aggregate demand.

  32. Gravatar of ssumner ssumner
    16. October 2010 at 18:15

    OGT, You said;

    “Sumner- I think you miss read Beckworth’s comments, maybe my excerpt was confusing. He is saying the Dollar block’s currency value is too low (ie “maintains external competitiveness”), but they view QE2 as a ‘currency war’ because it presents them with the options of allowing their currency to appreciate or allow higher inflation. Either represents a change in the real exchange rate and some sectoral readjustments.”

    I am having trouble following this, but maybe I am missing something. If the Chinese allow enough yuan appreciation to keep their CA deficit stable, then why would US dollar depreciation cause inflation in China? Of course it may be difficult to figure out how much is needed, but they face that problem anyway, as the Balassa-Samuelson effect forces them to appreciate the yuan if they want to prevent high inflation–regardless of the Fed policy.

    Philo . . . 🙂

    Andy, You said;

    “Of course the Fed is lowering interest rates in other countries. Foreign bonds and US bonds are substitutes.”

    Yes, but that doesn’t mean their rates move together, they are in different currencies after all. So if the interest rate changes due to easy money, it may well have little effect on foreign interest rates. When the yield on Greek bonds went up recently, the yield on US bonds fell. Even putting aside default risk, the mere fact that bonds are substitutes doesn’t imply a strong effect. Suppose the New Zealand governent reduced rates on bonds, and suppose there is no default risk (because they can print their own money.) Obviously that action doesn’t reduce interest rates on US bonds. So I’m not saying you are necessarily wrong, but you can’t just make that assertion, it is an empirical question as to how important the relationship is.

    Here’s another point. You said it’s not surprising that lower interest rates are associated with higher stock prices, because profits are discounted back at a higher rate. But what matters for stocks is the 100 year real discount rate, and I don’t know that’s changed much at all. Furthermore, during recent years stocks have tended to fall when nominal US bond yields have fallen—which suggests that it is not normal for lower bond yields to be asociated with higher stock prices. That’s why I think the business cycle effect is paramount in this case.

    Much of the fall in real rates this year has been due to the weak economy and slow recovery, but I’ll concede that easy money also probably played a role. But I don’t see the harm to other economies. When the weak euro was hurting the US in May and June, then US stocks were going down, despite much lower nominal interest rates. Again, the lower rates reflected the weak economy in the US, not easy money (in the spring). So if you are correct, why aren’t European stocks falling like American stocks fell when the Greek crisis created a weak euro? My answer is that it’s not a zero sum game. The Greek crisis increased the demand for dollars, thus in net terms tightened world monetary policy. The rumors of Fed easing are associated with expectations of more supply of dollars, and thus in net terms represents world monetary policy easing.

    Don’t get me wrong, you raise very good questions, but my gut instincts from closely following the markets tells me that this isn’t a problem for Europe.

  33. Gravatar of Doc Merlin Doc Merlin
    16. October 2010 at 18:31

    ‘which suggests that it is not normal for lower bond yields to be asociated with higher stock prices. That’s why I think the business cycle effect is paramount in this case’

    Increase in money supply tends to decrease bond yields (and debt yields) but increase nominal stock valuations and the valuations of commodities.
    When bond yields and non-debt assets are moving in opposite directions, it has to do with the money supply.

    When the supply is too tight, it favors debt assets over non-debt assets, so people switch to them. When the money supply is too loose, it favors non-debt assets.
    We can see this in the crash when the Fed tightened money, bond yields skyrocketed, and the stock market, oil, metals, etc crashed.
    When the fed was too loose before the crash, debt assets yields were piddly and metals, oil, and stocks were hugely expensive.

  34. Gravatar of ssumner ssumner
    17. October 2010 at 07:07

    Doc Merlin, Those patterns are often the case, but not always.

    In December 2007 tight money caused both stock prices and bond yields to fall.

  35. Gravatar of 123 123
    17. October 2010 at 09:16

    Scott, you said:
    “But what matters for stocks is the 100 year real discount rate, and I don’t know that’s changed much at all.”

    People who calculate such things say the current duration of S&P 500 is approx. 50 years, i.e. it would be interesting to know what 50 year zero coupon TIPS yield would be at this time.

    Oh, and this 50 year real discount rate is very volatile, all those trillions of wealth created in the stock market by your blog mostly reflect shifts in this discount rate, changes in the expected future real profits are less important.

  36. Gravatar of Andy Harless Andy Harless
    17. October 2010 at 17:58

    it is an empirical question as to how important the relationship is

    There is certainly evidence that sterilized foreign exchange intervention for freely traded currencies is ineffective, which implies at least that short-term bonds denominated in different currencies are very close substitutes. I don’t know if there is evidence about longer-term bonds, but my presumption would be that the same is true for them.

    Much of the fall in real rates this year has been due to the weak economy and slow recovery.”

    I’m talking specifically about what has happened over the past month or two. Within nominal bond yields, there has been a very dramatic divergence between the real yield component (as measured by TIPS) and the residual inflation component. In fact, the inflation component has risen quite a bit, which would seem to imply that a weakening economy could not account for any of this fall in real rates (as it would require an implausibly large shift in the AS curve).

    Some data: since Aug. 23 (assuming I’m doing the math correctly), the yield on 30-year TIPS has fallen by about 30 bps, while the yield on the S&P 500 has fallen by about 15 bps. (Meanwhile the yield on 30-year nominal Treasuries has risen by about 30 bps.) Offhand, this seems like about the right proportion if the drop in stock yields is due primarily to a drop in required real yields rather than expected real dividend growth. I’ll grant (given that we believe in an AS-AD model of the economy, and that it is currently far below full employment) that the increase in expected inflation does suggest that at least part of the increase in stock prices is due to expected real growth, but that doesn’t seem to be the bulk of it.

  37. Gravatar of ssumner ssumner
    19. October 2010 at 05:13

    123, How do you know what’s happening to the expected change in real future profits? Don’t you think that would increase if the economy recovered from recession? During recessions interest rates and stocks often fall together–so it’s not a far-fetched claim I am making.

    Andy, I’m still confused. It’s generally understood that in the US the yield on short and medium term bonds reflects movements in the expected future fed funds rate. Are you saying that’s not true in Europe? I.e. could there be a situation in Europe where the yields on 3 year bonds was 5%, but investors all expected the ECB to keep the target rate at say 1% for the next three years?

    The standard model I teach my students holds foreign interest rates fixed. If we lower our rate via the liquidity effect, there is an offsetting move in the forward premium or discount on the dollar. Is this wrong?

    I agree that the recent move in rates reflects expectations of fed action–so we agree on that point. I mentioned the income effect to show that it is also very important, and thus one can’t assume that rate movements reflect monetary policy. It is entirely possible that recent declines in our bond yields reflect monetary policy, but in Europe there is falling growth expectations. It’s also possible that the Fed action has led Europeans to expect the ECB to do the same thing, and hold rate near zero longer than they had previously expected rates to be held near zero. Overall, however, I still think it is more useful to think of the ECB as driving monetary conditions in Europe, and the Fed as controlling the monetary situation over here.

  38. Gravatar of 123 123
    20. October 2010 at 05:07

    Scott, from the market top in 2007, the dividend yield of S&P 500 has doubled. This is a strong indication that the required return on stocks moves countercyclically.

  39. Gravatar of Scott Sumner Scott Sumner
    21. October 2010 at 05:39

    123, For some reason I’m confused. I thought you were saying the lower discount rate has propped up stock prices. Now you seem to be saying the discount rate doesn’t matter. Even though the discount rate has fallen sharply, the required return on stocks is actually higher than before. Hence stocks fall in recessions even as future profits are unchanged, because the relevant discount rate (required yield on stocks) has risen. What am I missing?

  40. Gravatar of 123 123
    22. October 2010 at 08:05

    Scott, variations in the required yield on stocks are more important than variations in the future expected profits. In the early stages of recession, required yield on stocks increases and future expected profits decrease. From August 2007 till March 2009 dividend yields have doubled, and dividend yields are a good proxy for discount rate. From March 2009 we are observing an opposite process.

  41. Gravatar of Scott Sumner Scott Sumner
    23. October 2010 at 05:52

    123, It seems to me you are just making assumptions about the link between real rates and stock prices that fit the actual performance of the market. When the market behaves one way a change in real rates must be the reason, when it doesn’t, some other factor is involved. That seems awful ad hoc.

  42. Gravatar of 123 123
    24. October 2010 at 05:59

    Scott, every significant market move contains both the impact of changed real rates and changed profit forecasts. It is very worthwhile to try to separate them, even if the proxies used (such as dividend yield) are imperfect. I am disagreeing with your attempt to attribute everyting to to the profit forecasts. You should be equally proud of stock market wealth created both when your QE proposals reduce real rates and when they increase profits 🙂

  43. Gravatar of ssumner ssumner
    25. October 2010 at 06:59

    123, What makes me uneasy is that faster economic growth should raise real rates in the long term. That’s why I am puzzled by any sign that monetary stimulus reduces long term real rates. I’ll try to keep an open mind on the issue.

  44. Gravatar of ssumner ssumner
    25. October 2010 at 08:33

    123, I just noticed this:

    “Some contrarians even advise buying 30-year Treasurys. The long bond has weakened in recent weeks: Yields, which move in the opposite direction of price, have leaped from 3.53% to 3.94% since Aug. 26, the day before Mr. Bernanke’s Jackson Hole speech.”

    If 30 year yields have been rising, then I’d say the September rally was driven by profit forecasts.

  45. Gravatar of 123 123
    26. October 2010 at 07:08

    Scott, 30 year nominal yields have been rising. 20 year real yields have been falling.

    You said:
    “What makes me uneasy is that faster economic growth should raise real rates in the long term. That’s why I am puzzled by any sign that monetary stimulus reduces long term real rates.”

    Faster economic growth should raise medium term real rates, and long term (10y10y) real rates should be unchanged, as money is neutral in the long run. Looks like the Fed is able to create long term real interest rate bubble. I prefer monetary policy (helicopter drops) that avoids this side effect.

  46. Gravatar of ssumner ssumner
    26. October 2010 at 11:31

    123, You don’t need helicopter drops to avoid buying lots of T-securities. There’s negative IOR. Or if you don’t like that, there’s higher NGDP targeting, level targeting. That would raise nominal short term rates above zero (if pursued aggressively enough.)

    I’m only in favor of helicopter drops if they occur over my house.

  47. Gravatar of 123 123
    26. October 2010 at 12:30

    Helicopter drops = tax cuts financed by the Fed. Your house will not be forgotten.

    If EMH is true, then it doesn’t matter if Fed does QE2, negative IOR, etc. If there is a clear communications strategy, arbitrage will do the rest.

    I’m afraid that EMH is not true, and all this arbitrage will not significantly affect the credit card rates.

  48. Gravatar of ssumner ssumner
    27. October 2010 at 17:20

    123, I meant ONLY over my house. If EMH is true and if the policy is credible. That’s a big if.

  49. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    28. October 2010 at 01:43

    Why only your house? The most important market that is signalling 2% NGDP growth is the credit card market. I know it is unfair, but perhaps helicopters should be dispatched only to those houses that have large credit card debts. Your house should be excluded, but don’t worry, credit card – stock market arbitrage will make you rich.

    I guess Fama does not think that EMH applies to credit card rates.

Leave a Reply