The Alice in Wonderland world of low interest rates

When interest rates go close to zero, it is possible that central bankers might just slip down a rabbit hole and discover that what used to be up might now be down.

There is a growing chorus of people arguing against central banks using low (even negative) interest rates to stimulate the economy.  One of the reasons that people point to is that when interest rates are low, cutting them further induces savers to save more.  The logic is that there are two offsetting effects a) a price effect — the lower return on savings makes people more inclined to consume today rather than wait for tomorrow; and b) an income effect where the fall in people’s income from lower interest rates induces them to have to save more today to satisfy their future spending needs.  Economists nearly always assume that the first effect (known as the substitution effect) outweighs the second effect (the income effect). This traditional assumption implies that the supply of savings in an economy is positively correlated with the interest rate.

But when this standard assumption does not hold, and the income effect more than completely offsets the substitution effect. In this case the supply of savings in an economy becomes negatively correlated with the interest rate.  It seems most likely that this could happen when interest rates start to get close to or below zero.  Figure 1 illustrates two savings supply curves, one for each of our two cases.

Figure 1

Fig 1

Whether the traditional assumption about the income effect holds or not when interest rates start to get close to zero is important for policy makers. To see why think about how monetary policy normally works.  Suppose that investment demand is shown as in the figure, and that the equilibrium real rate of interest is r0 (i.e. the rate of interest that equates savings supply with investment demand at A).

Now suppose that the economy looks like slipping into recession. The central bank sees signs of weakening demand for goods and labour. So the central bank intervenes and cuts interest rates below r0.  When it does this, there is an excess demand for investment over savings, which stimulates spending and boosts the demand for goods and labour.  Recession avoided. Good job central bank.

But now suppose that things are different and that investment demand is much lower. Indeed most economists believe that the equilibrium rate of interest has fallen in the last 20 years because of a shortage of good investment opportunities (i.e. a fall in investment demand).  This would shift the investment demand curve in Figure 1 to the left leaving Figure 1 to look like Figure 2 below.

Fig 2

In Figure 2 we see that in the traditional case, the new equilibrium interest rate is lower corresponding to the new equilibrium at point B. If the economy now started showing signs of recession, the policy prescription would be no different  than before — cut rates.

But if the non-traditional assumption held, then things get more complicated. Investment  demand and savings  supply now intersect twice at C1 and C2 and there are now two equilibrium interest rates associated with the two equilibria C1 and C2. But only the one associated with the higher interest rate (C1) is a stable equilibrium.  By this  we mean an equilibrium at which if the economy started to show signs of slipping into  a recession, the central bank could cut interest rates and thereby  create an excess of investment demand over savings supply and help to stimulate the economy to avoid recession. If the equilibrium was at C2 instead and the economy showed signs of recession. A cut in the interest rate in this case would cause savings to rise by more than investment and the recession would get worse, rather than being alleviated. This is the case that some economists are worried about.

The possibility that the savings supply curve might actually be backward bending (i.e. exhibit the non-traditional shape) means that there could  be a constraint on central banks abilities to prevent a recession and prices from falling.  Even if the economy is at an equilibrium like C1, the possibility of the negatively sloped savings supply curve limits the ability of central banks to make deep cuts to the policy rate for fear of driving the rate too low below C2 and creating a deflationary spiral.

Before ending this post, there are two last points to consider. First, it is possible that the slow fall in investment demand and rightward shift in savings supply that the world has witnessed in the last 20 years may continue (especially in countries where populations are starting to age dramatically, like Japan and Europe and even China).  In which case, it might be possible that there is no intersection between investment demand and savings supply (at least not at full employment, which we have been implicitly assuming in this post).  Second, it might be that at really low (say negative) interest rates, investment demand becomes infinitely elastic.  In which case, eventually the central bank could still achieve its goals of maintaining inflation and avoiding if it was willing to go negative enough.   Regardless, the simple analysis here is meant to highlight just one thing, that the economics of monetary policy could soon be much more complicated than one thought.


The global impact of the oil glut

As oil prices crawl around lows of $30 per barrel (making the recent oil price plunge possibly the most important global commodity price collapse in the last century), the economic implications remain unclear.  One thing is obvious though, a small economy model like that from the previous post is not terribly helpful, … except for residents of small island economies; and even then it fails to consider the interaction between the exporters and importers.

This post considers global implications of the recent unexpected increase in the supply of oil. To cut a long story short, for a global oil supply shock to increase global GDP, your author’s model suggests that certain things must be true:  Oil demand must be somewhat unresponsive to the oil price, and people in  oil importing countries must tend to spend more of their income than oil exporters do. Moreover, the impact on the global economy will be bigger if people in both types of country tend to save less.  But, as discussed at the end of the post, there are many caveats; we will consider a few that could reduce the size of the overall effect. As a result, it is perhaps not so surprising that the global oil glut is not boosting income as much as many people  had expected.

As in the last post, the analysis is technical and is here only to help the author think through the logic (it was written on numerous bus rides, he hopes it makes sense and is putting it up here so that anyone else that is interested can use it).  The model is linear, and there is no investment, but (as Jim Haley over at The New Age of Uncertainty noted) that would need to be the next step towards a more complete understanding of the matter. Still, this abstract model is still useful to understand the impact on global demand and GDP.

Model Setup

The setup of the model is Keynesian, and mathematical, building on the small island case from the previous post. Now, however, there is an oil exporter. The oil exporting economy is just like the oil importer from the previous post except, in addition to producing a consumption good similar to the one that the oil importer produces, it owns an oil well (a very big oil well, capable of supplying the world). There are no resources used in pumping oil (except the run down of reserves) and it is assumed  that the pump can be regulated to open wider when the price is high, or closed off when prices fall. The exporting country decides how much to export based on its national  income and the oil price. It exports oil to the oil importer and imports the consumption good to supplement its domestic production.  The oil exporters’ import demand for consumer goods must equal the exports of the oil importing country, and its exports of oil must equal the oil importer’s demand; the oil price (and changes in global income) adjust to ensure that the global markets for goods and oil clear.

In mathematical terms, using the same notation as we did in the last post, we have the following:

Y=C+X-p.M                                                                         (1)

Y*=C*+p.X*-M*                                                                (2)

We also have the following conditions that must hold since one country’s exports are the other’s imports.

p.M=pX*                                                                            (3)

M*=X                                                                                   (4)

If we use the d notation to represent changes, we can write (1) and (2) as

dY= dC+ dX– dM – M.dp                                              (1a)

dY*= dC* + p.dX* +X*.dp – dM*                                (2a)

dX=dM*                                                                             (3a)

dX*=dM                                                                             (4a)

dC=c.dY                                                                             (5)

dM=m.dY                                                                          (6)

dC*=c*.dY*                                                                      (7)

dM*=m*.dY*                                                                   (8)

dX*=dS – x*dY*                                                             (9)

Equation 9 is the only equation that is much different from the model in the earlier post.  It simply says that the oil exporters exports go up by the increase in the oil supply, dS, offset by the increase in its own oil demand coming from an increase in its own income (x* is the propensity to consume oil out of income).

We can use this model to work through a number of questions. Let’s start with considering how opening the oil tap up affects world GDP. This is analogous to think about how removing sanctions on Iran affects world GDP. To keep things short, the math is left out, but your author plans to scan in his scribblings at the end of the post.

The impact on world income

With some manipulation of equations (1)-(9) the change in world income works out to be as follows:

d(Y+Y*)/dS =(1+E).(c-c*).(1/A)                      (10)

Mathematically, there are three parts to equation 10 that combine to determine the overall impact  on global GDP. The first (1+E) depends on E, the price elasticity of demand for oil (= p/M . dM/dp or the percentage change in the  oil importer’s demand for oil due to a 1 percent increase in its price).  If oil demand is unresponsive to price changes, then E takes a value between -1 and 0.  That makes sense, so that is what we assume, so 1+E is positive.  If E is less than -1, then things get a whole lot more complicated. Nevertheless, it could be worth thinking about, because you could use this model to imagine the effects of an increase in supply of other goods that may not be so inelastically demanded (let’s just not do that now).

The third term in (10) is also interesting.  1/A is the “global multiplier”.  It is a fairly complicated expression.  It turns out that a sufficient (but not necessary) condition for it to be positive is if oil demand is relatively more sensitive to income in the importer than the exporter, and if the propensity  to consume out of income, c, is higher in the oil importing country than the oil exporting country, i.e. c>c*.  That is important because if that is true and if the (1/A) term  is positive, then the term (c-c*) is positive and our model predicts that global income will rise in response to an oil price shock. It is generally  true that the share of spending out of income is higher in oil importers (like Europe) than exporters (like Saudi Arabia) (though it is worth  remembering that some advanced countries like the US are major oil producers, and have high propensities the consume).  One last observation; generally speaking, given our assumptions, the overall size of the multiplier (1/A) will be  larger the higher are the propensities to consume in both  countries.  

So there we have it. The global oil shock should boost global demand.  But there are some clear caveats that could imply that the overall impact is not so big.

Caveat 1

One reason that the boost to  global demand might not be so big is that the fall in the oil price might be thought of as temporary. If so, importers will be tempted save the windfall, and spread the spending of the gains out over their lifetimes, while exporters could do the opposite. The propensity to consume in the importing country, c, would then be smaller than normal and the  propensity  to consume in the exporter, c*, would be bigger. In other words, there might not be too much difference between the oil importer’s marginal propensity to consume out of the oil price shock (which is what matters) and the oil exporter’s. if c=c*, then the impact on global  GDP is zero!

Caveat 2

The global impact could also be reduced if the uncertainty created by the shock encouraged everyone to save more. That would leave the differential between the spending shares roughly the same, but reduce the size of the global multiplier.

Caveat 3

Yet another reason is because with globally integrated capital markets, the fall in oil income could be transferred to the oil importing country if it’s households happen to own shares in oil companies.

Caveat 4

The last reason is that investment could fall. Nowadays, oil production is an extremely capital intensive venture. Exploiting the more marginal oil reserves often involves building an offshore oil platform, or a facility to convert oil sands into oil. As such cuts in oil prices resulting from the reentry of oil producer like Iran, will lead to a disproportionately large cut in global investment, compared with a shock to other sectors of the economy.

Once you take all this into account, its not clear that in the short term, in a world where there is high implement and insufficient demand, that the oil fall in oil prices should result in a significant boost to growth.

Tumbling oil prices and what it means for GDP

The collapse in oil prices has been truly remarkable and it get TH wondering how the oil price shock would affect a country’s income, so he cracked open his old textbooks and worked through what it should mean, at least in theory. The analysis here is for a country that imports oil. But the analysis goes in reverse for a country that exports oil (or another commodity, such as coal or iron ore, for that matter). This post is very technical and possibly boring, but TH thought it would be useful to write down and share what he figured out, just in case it is of use to anyone else.

Oil Price

Consider a simple small (island) open economy (call it Wallaby Island, or WI for short).  WI produces one good (bread) and imports oil. Some of the bread is consumed and the rest is exported. It can borrow from or lend to the rest of the world if exports don’t match up with imports. There is no investment. We’ll keep prices of the locally produced consumption good fixed at $1 each (apparently the central bank is really good at maintaining price stability), but let the price of oil, which we’ll write as “p”, be something that can change (in response to developments in the global oil market). This last assumption is what we need to investigate the oil price shock.

Since all of WI’s income is derived from spending on the wheat it produces, we just add up that spending to get its national (gross domestic) income. Total expenditure on wheat equals WI’s total consumption spending (on wheat and oil), minus their spending on imported oil, plus their exports. Mathematically, where Y is income and M is the quantity of oil imports and the rest are what you think they are (C, consumption and X, exports), this is how we calculate income:

Y=C+X-p.M                         (1)

Next, we need to write down what determines spending on consumption and imports. We make the same assumptions as any first year textbook, and assume that the islanders spend a fixed amount (A) to cover basic needs plus a fraction of their income on consumption. They do the same for imports. Foreign spending on WI’s goods (i.e. WI’s exports) is assumed to be fixed for now.

C=A+cY                                 (2)

M=B+mY                             (3)

Now we can start to figure out how income changes in response to a change in the oil price. Mathematically, when we want to write a change in a variable, we put a d in front of it, so, in the language of mathematics, we want to figure out dY due to dp.

When one thing in the economy changes, everything else changes too, so the total change in WI’s income, we need to add up all the changes in consumption and imports (you’ll see that we separate the change in spending on imports into the change in the quantity and the part due to a change in the price):

dY= dC + dX – dM – M.dp                             (4)

This is a good moment to highlight an important problem with how terms of trade changes are measured by statisticians in charge of the national accounts. GDP, which is the standard measure of national income reported in the news, is generally measured keeping prices constant (to avoid confusing inflation with economic growth). That means that the last term in the equation (the M.dp bit) gets left out of the GDP calculation.  The statisticians are smart people and are fully aware of the short coming of the GDP measure, so they have an alternative measure, known as GDI, that includes the impact of a change in the terms of trade (i.e. the change on the price of imports). You will note that the change in GDI that we are calculating equals the change in GDP plus the change in import spending only due to the change in p.  That is, dGDI=dGDP+M.dp .

Getting back to how everything changes, note that since A, B, and X are assumed to be fixed, the only changes in C and M that are triggered by the oil price are those that flow through changes in income.

dC=c.dY                                (5)

dM=m.dY                            (6)

We can now work out how a change in the oil price affects income by substituting (5) and (6) into (4) and collecting terms.

dY=c.dY-m.dY – M.dp                    (7)

dY =-M.dp /(1-c+m)                        (8)

dY = -(c-m)M.dp/(1-c+m)  – M.dp                             (9)

What equation 9 tells us is that the change in national income equals an induced fall in GDP plus the direct reduction in income due to the higher price of oil. Of the total fall in income only a fraction, (c-m) of the total fall in income is accounted for in GDP statistics. For example, if c=0.7 and m =0.05, then only about two thirds of the total effect is captured by GDP.

We can multiply both sides of 8 by p/Y to work out the percentage change in GDP due to a one percent increase in the oil price as –pM/[Y{1-c+m)] =- m’/(1-c+m), where m’ is the share of import spending in income.  Let’s throw in some hypothetical numbers. Let m’ bet 0.1, c = 0.7, and m be 0.05, then the percentage change in income from a percentage increase in the oil price is minus 0.25.  So for our small open heavily oil dependent economy a 10 percent increase in oil prices reduces income by 2.5 percent. A 50 percent increase in the price of oil reduces income by about 12.5 percent (of which 8 percent shows up in GDP).

To do a fall in oil prices, we just reverse the sign, so a 50 percent fall in the price of oil causes a 12.5 percent rise in income (8 percent rise in GDP) for the residents of Wallaby Island.  Most economies don’t import only oil and so the effect is not likely to be so large. On the other hand, the reverse of this analysis largely hold for exporters, and some economies like those in the Middle East or Venezuela depend heavily on oil exports.  For these economies, large numbers like these seem reasonable. Either way, it gives you an idea of how important the oil price is.

This same simple technique can be used to figure out the impact on the world economy rather than the isolated effect on a small island economy.  But that is left until a later post.


Money and Sovereignty

It’s no wonder that Dr Varoufakis was quietly preparing a parallel currency. He was trying to safeguard Greek sovereignty.

roman coin

Even Julius Caesar knew that no government is really sovereign unless it has its own currency. If you use someone else’s then ultimately you are at their mercy, economically at least. Without its own currency, a country has no means of safeguarding its payments system. The reason is very simple. The little pieces of paper that we call money (along with the electronic bits of information that are central bank reserves) can only fulfill that function because we believe that they will. If ever we were to lose faith that money is money, the monetary system is pretty much doomed — valuable pieces of paper and electronic bits become worthless, and life gets pretty complicated since virtually every transaction we make is made with money.

Our faith in the currency ultimately comes from the knowledge that our government will do whatever is needed to safeguard the monetary system and has the power to do it. In Greece’s case, as became clear during the last few months of bailout negotiations, the government could not credibly backstop the Greek banking system, and so people lost faith in their money (the electronic bits used by banks) and a bank run ensued.  That is why the run continues today. The Greek people just can’t be sure that a euro deposit in the bank today will be a euro deposit in the future and the Greek government is powerless do anything about it. Unless, of course, it is willing to cede sovereignty to the Troika.

While this is an immediate problem for Greece, it is ultimately a problem for every euro area member. It means that no nation is truly sovereign.  Torrens reckons this is the reason why Greece captivates us all and explains the discussions about Greek democracy and sovereignty on the web. It also explains why, deep down, we all understand that Greece may be better off with its own currency.

The flip side of the problem is that there is no supra-national government that can legitimately supersede the authority of any euro area national government. People legitimately look to the only supra national organisations with power and credibility to do something. But no matter what they say, the ECB and IMF do not have the mandate to “do whatever it takes”. They can’t recapitalize banks, or restructure debt, or change laws. Their policy instruments simply weren’t designed to safeguard the entire monetary system of a whole country. As Mario Draghi said in the last ECB press conference, Emergency Lending Assistance (ELA), was designed to deal with runs on individual banks, not a systemic failure at the national level. Likewise, on of the main lessons from the 1997 Asian crisis, the IMF can lend to finance adjustment, but that commitment alone cannot stave off capital account crises.

Nevertheless, when a monetary crisis (like that happening in Greece) occurs the pressure to resolve it falls on the ECB and IMF to try. The sad fact, however, is that by trying, and not succeeding, the credibility of these vitally important institutions is eroded. (If you don’t think so you just need to watch the press conference. Poor Dr Draghi was like a deer caught in headlights — having to justify to the press corps why he had failed to prevent  the imposition of capital controls in Greece, which for all intents and purposes, amounted to a temporary, albeit, partial, suspension from the eurosystem, and a failure to preserve the integrity of the European monetary system as a whole).

The quandary that Europe finds itself in is that the loss of sovereignty that a country suffers from having no currency of its own can only be mitigated if other countries are willing to cede a little more of their their own to allow supranational institutions to do more to act in the interests of Europe. At the moment the members of the main decision making bodies — the Eurogroup of finance ministers and Euroarea leaders only have incentives to act in their national interests.

On the merits of Option #2

From his perch, Torrens reckons that Mr Tspiras should listen to the the advice of Marx (Groucho, that is) and choose not to belong to a club that would have Greece as a member. Particularly when that club is the euro zone, and the conditions of membership are those laid out by Mr. Schäuble (his Option #1, which Greece agreed to). Instead, Greece should take Mr Schauble up on his alternative offer (his Option # 2) for a “time out” from the euro as he put it.

Although the second option was most likely intended as a belittling negotiation tactic to force Greece to capitulate (had he been serious,  Mr. Schäuble would surely have put it on the table months before), there may be some merit to the option, and one should think it through before dismissing it.

In many respects, Mr Schauble’s Option 2 harks back to the Bretton Woods system in roughly 20 years before 1971 when most of the world had fixed, but adjustable exchange rates. Under the system, if a country’s exchange rate had become misaligned (typically over-valued and uncompetitive) leaving the county short of the money it needed to meet its import needs, it could have gone to the IMF for short term financing to cover the import bill while at the same time it took remedial measures to address its external imbalance. The adjustments typically included a devaluation of its exchange rate and reforms to reduce spending.

In addition, like the Bretton Woods system before it, Mr. Schäuble’s second option would also allow Greece to write down its debts. Right now, Greece cannot do this because doing so would force the ECB to withdraw its emergency lending assistance (this is what allows Greece to stay in the euro and ensures that its banks remain functional, albeit barely).

But if Greece exited the eurozone and had its own currency, Greece would be able to announce a standstill on its debt payments. It could use that time to renegotiate with creditors. This would put Greece in a fairly good bargaining position because it could conceivably threaten not to pay back anything.

Given that nearly all the debt is held by official creditors, writing off most of that debt would allow Greece to access private markets again. Moreover, if it also implemented many of the proposed structural reforms, Greece could also become a favourable investment destination.

Torrens reckons that it’s time to take Mr. Schäuble’s second option seriously.  To paraphrase Einstein, is it not insane to keep repeating the same mistakes over and over in the hope that the outcomes will change?

Some worry that the Greek currency would fall by 50%. But to put that into perspective the Australian dollar has fallen about 30% in the last year and no one has battered an eyelid (the RBA is even calling for more)!

Don’t get me wrong, eventually Greece will overcome the negative consequences of the bailout program and economic conditions in Greece will improve. Markets do work, even in the face of huge debt over-hang and excessive austerity. But that could take a long time and progress will be slow.  An exit and substantial debt write down would be better.

Last, is it just me, or is Varoufakis another incarnation Peter Garret, the leftist lead singer of Midnight Oil, and Australian Labor Party MP?

Life at the zero lower bound part 2: The inflation tax

In simple terms, most economists think that inflation is not really a good thing (as do many people TH has the pleasure of knowing: older folk, like TH’s dad and father-in-law, really don’t like inflation, and it seems neither do people from Germany, and many US republicans). The reason is that when there is inflation, money will earn a negative rate of return equal to the negative of the inflation rate.  This is the typically thought of as an inflation tax on cash (both TH’s father and father-in-law have a strong preference for holding cash as an asset and hate the idea of inflation eroding the value  of their savings). But inflation is only part of the inflation tax because even if inflation is zero, you could be holding other assets, which typically have earned a positive real rate of return.  Thus, even a zero rate of inflation means that money loses value over time relative to these other assets.   If, for example, the real rate of interest on other investments such as land was, say, 5 percent, then with a zero rate of inflation, money would lose out to land at a rate of 5 percent per year.

The inflation tax is truly only zero if the inflation rate is such that the real return on money equals the real return on other assets.  In the example just given, the deflation rate would have to be 5 percent (i.e. inflation of minus 5 percent) if money was to earn the same rate of return as land.  Any inflation rate higher than that would effectively be a tax on money and induce people to hold less of it.

In simple terms, the inflation tax is equal to the real rate of return that can be earned by investing in physical assets such as land) plus the inflation rate meaning that the inflation tax is lessened by two things: 1) a fall in expected inflation, and 2) a decrease in the natural real rate of interest.

Chart 1 shows a rough and ready estimate of the trend  inflation tax for the US using the Laubach and Williams natural real rate estimates and an estimate of long run trend inflation by your truly.

US inflation tax

From the chart you see that back in the 1970s, when the natural rate of interest was about 3 to 4 percent in real terms and the expected inflation rate in the United States was about 7 percent, the inflation tax amounted to about 11 percent.   Since then, it has come down considerably.  The inflation tax is now about between 1 to 2 percent – the lowest that it has been in the last forty years or more (and if you did this for just about any other advanced country, you would find the same thing).  If you used actual inflation and the current estimate of the short-term neutral rate (i.e. one that allows for temporary weakness in aggregate demand), then the inflation tax would currently be around zero maybe even slightly negative.  This situation is a result of low inflation and a low real rate interest rates and is very much a part of life at the zero lower bound.

Torrens reckons this is interesting.  Right now, we find ourselves in what according to Milton Friedman’s optimal quantity of money, is an almost perfect monetary equilibrium – where the inflation tax is zero and we hold just the right amount of cash.  Is this an unexpected silver lining of our times? Or could it possibly be a cause of our economic woes?

TH is not sure, but he is sure that this phenomenon is important and certainly warrants thinking about more because it raises all sorts of questions.  For example, perhaps the Federal Reserve’s balance sheet, which has expanded significantly from $869 billion on August 8, 2007, to almost $4.5 trillion, is now just as it should be.  Maybe the problem was that in the years leading up to the crisis, the amount of Federal Reserve liabilities was just too small (relative to the amount of leverage in the banking system for example).

Thinking of grumpy old men and taxes …





Life at the Zero Lower Bound

Torrens feels like he is in some topsy turvy Alice in Wonderland world.  It has been a year since he last wrote.  And, to be frank, Torrens reckons that maybe he went down a hole and came back in the past.  Twelve months ago, the global recovery that was meant to start in 2010, was faltering in much the same way as it is today.

Indeed, this situation has lasted not just one or two years, but much longer. For the last 5 years or so, central bankers in many countries have kept interest rates at close to zero (pretty much as low as they can go) and employed other tools in an effort to provide the support that the global economy needs.

This got Torrens wondering about life at the zero lower bound – how did we get here and what is different about  the world when interest rates are at the zero lower bound?

So why are interest rates at the zero lower bound?  Short term interest rates reflect a combination of two elements – the expected rate of inflation and a real return.  The real return is just the inflation adjusted rate of interest — the monetary interest rate minus inflation. The inflation rate is largely determined by central bank policy (and for now, let’s just assume that central banks are able to keep inflation on target at 2 percent per year). That leaves the real return as the main explanation behind the currently low level of interest rates. The real rate of interest reflects the ability and willingness of firms to invest today’s savings and transform them into future production and the willingness of households to save in the first place.   Right now, if you live in the UK, the yield on a 1 month government bond is just about 0.3 percent (see Chart 1) – pretty close to zero (its zero in the US, even slightly negative in Germany, but somewhat higher in the Lucky Country).  With UK inflation at about 1.2 percent, the inflation adjusted real return in the UK is minus 0.9 percent (i.e. = 0.3-1.2).

Chart 1FT Yield Curve


Source: Financial Times


That real interest rates should be so low is not really all that surprising. Of course the current poor performance of the global economy and the monetary policy response to that is one reason for low interest rates, but it is not the only one.  Real interest rates have been falling for a long time – long before the Great Recession and the current level partly reflects that long-run trend.

Figure 2 shows estimates by Thomas Laubach and John C. Williams of the US Federal Reserve for what we could term a cyclically adjusted real interest rate (also referred to as the natural rate), meaning the one that we would have if the economy wasn’t in a recession (or a boom).  Their estimates indicate that the real rate has been declining more or less since the late 1960’s and has recently gone to close to zero.  TH poked around and found some other research on the factors behind this “secular” decline.  This research suggests that the decline from the early 1990’s to around 2004, was largely due to weakening of investment demand. According to this hypothesis, firms in the 1970s were busy investing in machinery to equip the baby-boomers that were starting to enter the labour market at the time, so interest rates were high at the time. But as that cohort has aged, the need for investment diminished causing investment demand and interest rates to fall.   Now, as the baby boomers retire, investment demand has weakened even more, adding to the downward pressure. Other factors, such as the increase in savings supply from China that started 2004, have likely contributed to the downward pressure too. Interestingly, some findings suggest that easy credit policies in the 1990’s and early 2000’s may have helped to prevent interest rates from falling by keeping household consumption high and savings low, so it is likely that when easy credit came to an end with the crisis, the real interest rate fell.

Real Rate L&W


Source :Thomas Laubach and  John C. Williams. Board of Governors of the Federal Reserve System.

Some of those forces that have driven real interest rates down — especially the aging population — are likely to continue for some time to come.  And while TH has some difficulty believing that the inflation adjusted return on his investments will be negative, it is possible (especially once you adjust for risk) and it may have further to go.

The next post will try to think through some of the implications of the slow but continual decline in the real interest rates. But, in the meantime …


The ceiling can’t hold us: What to expect on D-Day and why it’s more likely than you think

TH woke up this morning with that catchy tune “the ceiling can’t hold us” and thought how apt it is to describe the behaviour of the US congress, which may soon recklessly drive the global economy into yet another financial crisis by choosing not to lift the US debt ceiling before October 17 (D-Day). It also got TH thinking about what would actually happen if no agreement is reached and congress actually failed to act, and how we might end up in that situation.

To think through, it is helpful to imagine what would happen if nothing else happened except that the  debt ceiling is reached and the government loses the ability to issue new debt. First, the US government shutdown, which is underway at present, would have to sharply accelerate to constrain expenditures to avoid new borrowing. The sharp acceleration will have all sorts of macro consequences, the most notable of which would be a sudden contraction in US GDP growth and loss of jobs. The more interesting and worrisome complication is that because certain expenditures can’t just be constrained or stopped, the US government will probably have to default on some liabilities.

Sovereign default is never good; especially for people who are holding the debt that the government defaults on.

So imagine that there you are on October the 16th (the date when congress votes (or doesn’t vote) to raise the debt ceiling. And as the votes come in, it becomes clear that you are holding debt that is due to be redeemed in the next few days and will therefore most likely be defaulted on. You are holding the hot potato. Of course you try and sell it, as does everyone else.  The price of the debt plummets; you wished you had sold the day before. Of course in reality, many people wouldn`t have been as optimistic as you, and would have sold the day or week before.  There will be a point where bond selling along with the various uncertainties will cause markets to start behaving badly. Something a kin to a run starts. Liquidity dries up, short-term interest rates spike, banks stop making loans, and so on.  You know the drill.  Something like what happened when Lehman Brothers was forced to default. It would be nothing short of a financial and economic calamity that could make the Lehman Brothers moment look good.

But that scenario assumes nothing else happens.  And of course something will.  The US Federal Reserve will have its “whatever-it-takes” moment and intervene to avoid disaster.  The simplest way would be for it to stand ready to buy any US Federal government debt, including (and most importantly) the debt that the government is about to default on. It would effectively take on the debts for the US treasury even the debt on which the government is in arrears on.  This would effectively amount to a new (fourth) round of quantitative easing – QE4

Some will no doubt worry that this will be inflationary.  It need not be.  The US Fed does not only have to issue money in exchange for those dodgy US Treasuries.  It can issue its own bonds instead. In practice it would probably to a bit of both.  The problem is that this will affect the well-being of the financial system in general, raising the overall costs stemming from the excessive reliance on monetary policy. But for now, calamity avoided.

Phew, so now you breathe a sigh a relief. You don’t need to panic now.  You can just wait until D-Day and for the Federal Reserve to come to the rescue.  The trouble is that you are not the only ones that can do the calculus.  The members of the US congress can too.  The fact that the situation has gone this far shows that congress is already willing to overburden the US Fed. The question is how much further they are willing – how much larger are the nips of liquidity going to get?

As the famous Mental As Anything song goes:

Started out, just drinkin’ beer
I didn’t know how or why
Or what I was doin’ there
Just a couple more
Made me feel a little better
Believe me when I tell you
It was nothin’ to do with the letter

I ran right out of beer
I took a look into the larder
No bones, nothin’
I’d better go and get somethin’ harder
Back in a flash
I started on a dash of Jamaica rum
Me and Pat Malone
Drinking on our ow-ow-ow-own

Woh-hoh-oh, the nips are gettin’ bigger
Woh-yeah, the nips are gettin’ bigger
Wo-hoh-oh, the nips are gettin’ bigger
Yeah-eah-eah, mmm they’re gettin’ bigger


Keep Calm, Cross Your Fingers and Press On — monetary policy in today’s world

That might have been the thinking of the Federal Reserve when it surprised markets and chose not to start tapering back its quantitative easing policy. It had no choice given its mandate to target inflation low support the economy.  But its decision reminded TH about the reason why we have inflation targeting central banks in the first place.

Just like as a wee scotch is for an alcoholic, what seems to be a good idea right now is often inconsistent with our longer term interest.  In the case of central banks, it could be appealing to keep interest rates low today to help create jobs and growth and worry about the inflationary hangover tomorrow. To deal with exactly this problem, the New Zealand government revolutionised macro-economic policy making forever way back in 1991 when it was the first place in the world introduce inflation targeting – a system that ties the hands of the central bank by giving it strict mandate to keep inflation low and stable and operational independence to achieve that objective.  It was a huge success and during the years since many other governments followed suit.  But these days, it is hard not to ask whether the ultra easy monetary policy that one seems to see almost everywhere in the advanced economy world (including the US Federal Reserve decision to postpone tapering for a while longer)  is best.  Indeed, the nips might not being getting bigger, but the drinking (or liquidity) sessions are lasting longer and some are asking whether unintended consequences might be starting to reveal themselves.

The problem

More often than not, pursuit of the inflation objective is quite consistent with growth and job creation.  This is especially true when the economy is suffering from the effects of a recession.  In that case, the excess economic capacity (i.e. weak growth and unemployment) puts downward pressure on prices and creates the potential for disinflation (falling inflation) or even deflation.  To combat this, the central bank will ease monetary policy, encouraging firms and people to borrow and spend; hopefully on productive investments and job creation. This is the situation advanced economies have been in for over  5 years now.

Generally speaking central banks have achieved their goals pretty well. The problem is that given that they have a mandate and a reputation to “do whatever it takes”, other branches of government may felt that they have had some scope to slacken off a bit.  This wouldn’t be a worry if using loose monetary policy to stimulate the economy was costless.  The truth though is that loose monetary probably does have some costs.  For example, if interest rates are too low for too long, it could create a bit of a housing bubble (and you will recall that it was the bursting of US and UK housing bubbles that was one of the factors behind the severity of the global financial crisis in 2008).

Here is a picture that illustrates the problems.    The illustration shows the “marginal benefits” and “marginal costs” from loosening monetary policy.  Each time the central bank adopts a looser monetary policy there is an extra cost (the marginal cost) of doing so shown by the height of the marginal cost curve. It slopes upwards because central banks choose the most effective way of loosening policy first, before moving to more unconventional and potentially costly means.  The cumulative, or “total”, cost of all the central banks actions (each quarter of a percent interest rate cut, each $100million in asset purchases etc.) is shown by the area under the curve.  Similarly the extra benefits of loosening monetary policy are shown by the height of the marginal benefits curve and the total benefit is shown by the area under that curve.

costs and benefits of monetary policy

The curves labelled MB* and MC* are the curves that reflect the costs and benefits when all policy makers (central banks, treasuries, and financial sector policy makers) make the best decisions to keep the economy fully employed and growing while maintaining low and stable inflation in the longer term.   If the central bank is doing its job to the best of its ability, it will loosen policy until the marginal benefits of extra loosening just equal the marginal costs of that loosening.  When you do that, the  total net benefits will be as big as they can possibly be and the central bank, along with all the other branches of policy, will have done as well as they possibly can.

When other macropolicy makers slacken off, however, the benefits of using monetary policy increase so that central bankers keep interest rates lower for longer or engage in more quantitative easing. The result of excessive reliance is a higher total cost from monetary policy.  This is shown by the blue area.

The problem for those evaluating the cost and benefits of monetary policy is that central banks always seem to  do what is “optimal” – equating marginal benefits with marginal costs so that the costs of monetary policy action will never seem to outweigh the benefits.  What they should really do is a counterfactual calculation which assumes that other macropolicy branches of government (the Treasury, financial regulators, etc.) are fulfilling their responsibilities and rather than relying on their central banks.  The problem is that this is almost impossible to do.  As a result, we will never really know whether monetary policy is excessive.  But given the state of the fiscal debate in the United States and efforts to deal with financial fragmentation in Europe, TH has some concerns — perhaps time inconsistency in monetary policy has given way to moral hazard in other policy areas.



How to balance inflation on the end of your finger

Five years after the  beginning  of the financial crisis, there are still a lot of people trying to come to grips with monetary policy and inflation. Here is an analogy that TH thinks might (usefully) help make monetary policy setting seem less like rocket science and more like child’s play.

Imagine that you have a stick balancing on the end of your index finger.  It’s a nice straight stick, about a metre or so long – perhaps a pool cue made for a child.  The stick is unstable, it could fall any which way, but for the sake of this thought experiment, imagine that it can only fall forwards, away from you, or backwards towards you.

If you are standing still and are lucky, you have it perfectly balanced, but at any moment, some random event could cause the still to fall forwards or backwards. If you do nothing, the force of gravity will quickly cause the pace at which the stick falls forwards or backwards to increase.  If the stick starts falling forwards, your natural instinct will be to push your finger away from you so that the base of the stick gets out in front of the top of the stick and halts the stick from falling over. With some skill, you’ll soon have it well-balanced on the end of your finger again.

By now, you have a pretty well-developed model in your mind of that stick.  It is also a pretty good model of (the Wicksellian cumulative process of) inflation and monetary policy. Where the bottom of the stick is and what it is doing (remember it can’t go sideways, only backward or forward) tells you about the nominal rate of interest; closer to you is a lower rate of interest, further away from you  is a higher rate of interest.  The top of the stick tells you about inflation – if it is falling forwards, inflation is increasing, backwards and prices are falling.  Clearly there is going to be a relationship between interest rates and inflation – you can play with the model in your head – or get a stick and try it out for yourself. The model has some pretty good predictive power. Try pulling the (virtual) stick towards you (cut interest rates) and what see happens to inflation.  Anyway, before going further you need two simple equations that might help to better convert our balancing stick into a model of inflation:


which simply says that the real rate of interest on a financial investment (a loan) is the nominal rate of interest (i.e. the interest rate on loans, which we will assume to be the same as the policy rate set by the central bank) minus the inflation rate, p*.

The other equation is


In this equation, R is the natural rate of interest – it is the rate of return on physical investments – from building a house or a factory.  The equation says that inflation is a function of (which is what the f stands for) the gap between the natural rate of interest and the real interest rate expected to be earned on a financial asset.  If r is less than R, so that it is profitable to borrow money and buy a real investment (a house or a factory), then the increased demand for goods such as these will cause the inflation rate to rise.

Let’s return to our stick analogy. Suppose you have the stick perfectly balanced on your finger.  It’s not falling forward or backward.  The base of the stick is right under the top. You are standing still. Remember that top of the stick tells you about inflation.  Since the top of the stick is not moving, inflation is currently zero. The real rate of interest is therefore equal to the natural rate of interest (this comes from the information summarised by Equation 2).  If you expect things to stay this way, or at least that the chances of the stick falling forward in the future to be the same as it falling backwards, then the expected rate of inflation would be zero too. And since the expected rate of inflation is zero, it is also the case that the nominal rate of interest must just equal the real rate of interest, which, as we said, is equal to the natural rate of interest.   Got it?     p* =0 and  p=0, so from Equation 2, R=r and from Equation 1, r=i, so i=R too.

Now all the hard work is done, try doing the same thought experiment again.  Imagine that you pull your finger towards you just a bit so that you pull the base of stick from under the top. This shock causes the nominal rate of interest and consequently the real rate of interest to fall below the natural rate and stimulates people to borrow and invest. It drives up demand in the economy and prices start to rise – i.e. inflation goes up.  The top of the stick starts falling forward.  Quickly, people start to realise that, unless something is done soon, there is going to inflation in the future.  The higher expected inflation means that, given the nominal rate of interest, the real rate of interest (real cost of borrowing) is now even less than before, which further fuels an increase in investment and inflation.   The process feeds on itself in a vicious circle, creating a process of accelerating inflation and the stick is soon accelerating rapidly towards the floor.

The inflationary process can be stopped by pushing forward on the bottom of the stick – this is analogous to increasing the interest rate.  Just as you would have to push the bottom of the stick forward to get in front of the top to stop its fall, to make the real rate of interest equal to the natural rate of interest and set inflation back to zero, the increase in the interest rate will have to overshoot the rate of increase in prices. For example, if the shock has caused inflation to increase from 0 to 5%, then the increase in the nominal rate of interest – the policy rate – will have to be more than 5%.  This is because of the effect of inflation expectations.  Just like the stick has some momentum, so do expectations about future inflation, and the policy rate must increase by enough to offset not only the current rate of inflation but any expectations that are forming based on the current behaviour of the economy about future inflation.

So what does our simple model tell us about current monetary policy? TH reckons it tells us quite a lot. First, monetary policy, like balancing a stick on your finger, is more of an art than rocket science. You don’t need to know the laws of physics to balance the stick, you just need practice. There are also different styles too.  Some stick balancers (read inflation-targeting central bankers) could prefer slow graceful adjustments to the policy rate – that allows for longer periods of inflation away from the central bank’s target (Australia says inflation will be around 2 to 3 percent, on average, over the course of the cycle, which could be up to 10 years!). Others might prefer swifter, sharper policy adjustments and more stable prices.    Both could work. We could call the two types of policy reactions  as Type I and Type II. Australia would be a Type I inflation targeter.

Expectations about inflation

As you might have guessed, expectations about future inflation are also important in this model.  Suppose that the central bank has a zero inflation target, and people are firmly convinced that the central bank will keep inflation close to zero, then an inflationary shock won’t need such a swift or large interest rate response from the central bank because it won’t need to offset the stimulatory, self enforcing  effect of inflation expectations causing a reduction in the real interest rate and stimulating demand.  To make their life easier, central bankers will continuously remind you of their inflation objective to do what they can to keep you convinced that inflation expectations are “well-anchored.”

The zero lower bound on interest rates and forward guidance

You can do the inflation thought experiment for deflation too. Imagine that the stick starts falling towards you.  What do you do? The obvious thing is  to pull the base of the stick towards you and cut interest rates. With some manoeuvring, the deflation will be halted.  But what do you do if you can’t pull the still towards you.  If there was nothing else you could do, then there would be a deflationary spiral and you would have lost the stick. But of course there are other things you can do.  Suppose you were once a quick reacting (Type I) central bank that kept inflation close to target with swift and large if necessary interest rate responses.  Now you only have a little bit of lee-way, maybe to cut the interest rate to zero from say, 2%.  One trick is to switch type from a Type II central banker into a central banker that prefers slow and small adjustments (Type I).  If you don’t tell people that you have switched to Type II from Type I monetary policy, they may mis-read a small interest rate cut for policy ineffectiveness. Those deflationary expectations could start getting away from you, reinforcing the downward spiral.  So what do you do? You provide guidance to the markets that you are going to stay “low for long”, possibly until some condition outside of the control of the central bank like unemployment is met, and remind them of your inflation target to keep inflation expectations well anchored. This has become known as forward guidance. TH prefers Open Mouth Operations.

The zero lower bound on interest rates and quantitative easing

But interest rates are not the only game in town.    Everyone knows that printing money (aka quatitative easing) is inflationary right?  So another way to prevent deflation when you can’t pull back on the stick is to print money.  This will create the expectation that there will be some inflation, which will lower the real rate of interest for borrowers and stimulate demand.  Effectively, it’s finding a way to push on the top of the stick.  Again, by helping to anchor inflationary expectations (in this case offsetting expectations about deflation), quantitative easing can give help make the interest rate tool more effective at the lower bound.

Monetary policy to increase inflation with rational expectations

As noted above, inflation expectations are important in this model .  The momentum in the stick, which keeps it falling forward or backwards, even after some policy response, is a proxy for what economists call adaptive expectations. It simply means that people form expectations, at least partly, on the basis of what happened in the past.   What would happen if they were fully rational or forward looking? In that case, then things might be a bit topsy turvy. For example, suppose that the central bank announced a new inflation target of 10% (up from 0).  If the natural rate of interest was 3%, then, if everyone fully believed that the central bank would hit is target, starting a year from today (or tomorrow at annualised rates), all the central bank would have to do is INCREASE interest rates immediately to 3+10 = 13% to create inflation.  Using our stick analogy, the central bank would announce a new inflation strategy, which would stimulate demand and get the top of the stick moving forward, and then simultaneously start walking forward, pushing on the bottom of the stick.  The central bank would then just keep on walking forward at a constant pace that was analogous to constant increase in prices of 10% (perhaps ten steps a minute), with the top of the stick perfectly aligned with the bottom.

If you are quick, you might wonder whether the model with adaptive expectations could ever be consistent with the model with rational expectations.  After all, in the adaptive expectations case you cut interest rates to create inflation, in the rational case you raise them.  The answer is relatively simple, once you think of monetary policy as just balancing a stick on your finger.  After all, you know that you could, with practice initiate a process where you went from standing still while balancing the stick, to walking forward at a constant pace of 10 steps per minute. First you would cut interest rates, get inflation moving and soon adaptive expectations would learn that you were serious about targeting 10% inflation. Once you were advancing forwards at close to 10 steps per minute, you would tighten policy by pushing forward on the stick to alleviate the acceleration created by gravity and momentum. It might require a bit of back and forth, but eventually you’ll achieve  your goal.  You understand this, and so do market participants who seek to learn to come to rational conclusions through adaptive means.  All you need to know is that, in addition to cutting rates to increase inflation, you can raise them in the future to prevent accelerating inflation. So long as you know that, you will quite rationally understand that you can raise inflation by cutting interest rates.