Thursday, July 26, 2012

Does the Fed Control Interest Rates?

Casey Mulligan goes to the New York Times to say that monetary policy doesn't work. This annoys Brad DeLong:
... The third joke is the entire third paragraph: since the long government bond rate is made up of the sum of (a) an average of present and future short-term rates and (b) term and risk premia, if Federal Reserve policy affects short rates then--unless you want to throw every single vestige of efficient markets overboard and argue that there are huge profit opportunities left on the table by financiers in the bond market--Federal Reserve policy affects long rates as well. 
Casey B. Mulligan: Who Cares About Fed Funds?: New research confirms that the Federal Reserve’s monetary policy has little effect on a number of financial markets, let alone the wider economy…. Eugene Fama of the University of Chicago recently studied the relationship between the markets for overnight loans and the markets for long-term bonds…. Professor Fama found the yields on long-term government bonds to be largely immune from Fed policy changes…
Krugman piles on [1]; the only problem with DeLong's post, he says, is that
it fails to convey the sheer numbskull quality of Mulligan’s argument. Mulligan tries to refute people like, well, me, who say that the zero lower bound makes the case for fiscal policy. ... Mulligan’s answer is that this is foolish, because monetary policy is never effective. Huh? 
... we have overwhelming empirical evidence that monetary policy does in fact “work”; but Mulligan apparently doesn’t know anything about that.
Overwhelming evidence? Citation needed, as the Wikipedians say.

Anyway, I don't want to defend Mulligan -- I haven't even read the column in question -- but on this point, he's got a point. Not only that: He's got the more authentic Keynesian position.

Textbook macro models, including the IS-LM that Krugman is so fond of, feature a single interest rate, set by the Federal Reserve. The actual existence of many different interest rates in real economies is hand-waved away with "risk premia" -- market rates are just equal to "the" interest rate plus a prmium for the expected probability of default of that particular borrower. Since the risk premia depnd on real factors, they should be reasonably stable, or at least independent of monetary policy. So when the Fed Funds rate goes up or down, the whole rate structure should go up and down with it. In which case, speaking of "the" interest rate as set by the central bank is a reasonable short hand.

How's that hold up in practice? Let's see:

The figure above shows the Federal Funds rate and various market rates over the past 25 years. Notice how every time the Fed changes its policy rate (the heavy black line) the market rates move right along with it?

Yeah, not so much.

In the two years after June 2007, the Fed lowered its rate by a full five points. In this same period, the rate on Aaa bonds fell by less 0.2 points, and rates for Baa and state and local bonds actually rose. In a naive look at the evidence, the "overwhelming" evidence for the effectiveness of monetary policy is not immediately obvious.

Ah but it's not current short rates that long rates are supposed to follow, but expected short rates. This is what our orthodox New Keynesians would say. My first response is, So what? Bringing expectations in might solve the theoretical problem but it doesn't help with the practical one. "Monetary policy doesn't work because it doesn't change expectations" is just a particular case of "monetary policy doesn't work."

But it's not at all obvious that long rates follow expected short rates either. Here's another figure. This one shows the spreads between the 10-Year Treasury and the Baa corporate bond rates, respectively, and the (geometric) average Fed Funds rate over the following 10 years.

If DeLong were right that "the long government bond rate is made up of the sum of (a) an average of present and future short-term rates and (b) term and risk premia" then the blue bars should be roughly constant at zero, or slightly above it. [2] Not what we see at all. It certainly looks as though the markets have been systematically overestimating the future level of the Federal Funds rate for decades now. But hey, who are you going to believe, the efficient markets theory or your lying eyes? Efficient markets plus rational expectations say that long rates must be governed by the future course of short rates, just as stock prices must be governed by future flows of dividends. Both claims must be true in theory, which means they are true, no matter how stubbornly they insist on looking false.

Of course if you want to believe that the inherent risk premium on long bonds is four points higher today than it was in the 1950s, 60s and 70s (despite the fact that the default rate on Treasuries, now as then, is zero) and that the risk premium just happens to rise whenever the short rate falls, well, there's nothing I can do to stop you.

But what's the alternative? Am I really saying that players in the bond market are leaving huge profit opportunities on the table? Well, sometimes, maybe. But there's a better story, the one I was telling the other day.

DeLong says that if rates are set by rational, profit-maximizing agents, then -- setting aside default risk -- long rates should be equal to the average of short rates over their term. This is a standard view, everyone learns it. but it's not strictly correct. What profit-maximizing bond traders do, is set long rates equal to the expected future value of long rates.

I went through this in that other post, but let's do it again. Take a long bond -- we'll call it a perpetuity to keep the math simple, but the basic argument applies to any reasonably long bond. Say it has a coupon (annual payment) of $40 per year. If that bond is currently trading at $1000, that implies an interest rate of 4 percent. Meanwhile, suppose the current short rate is 2 percent, and you expect that short rate to be maintained indefinitely. Then the long bond is a good deal -- you'll want to buy it. And as you and people like you buy long bonds, their price will rise. It will keep rising until it reaches $2000, at which point the long interest rate is 2 percent, meaning that the expected return on holding the long bond and rolling over short bonds is identical, so there's no incentive to trade one for the other. This is the arbitrage that is supposed to keep long rates equal to the expected future value of short rates. If bond traders don't behave this way, they are missing out on profitable trades, right?

Not necessarily. Suppose the situation is as described above -- 4 percent long rate, 2 percent short rate which you expect to continue indefinitely. So buying a long bond is a no-brainer, right? But suppose you also believe that the normal or usual long rate is 5 percent, and that it is likely to return to that level soon. Maybe you think other market participants have different expectations of short rates, maybe you think other market participants are irrational, maybe you think... something else, which we'll come back to in a second. For whatever reason, you think that short rates will be 2 percent forever, but that long rates, currently 4 percent, might well rise back to 5 percent. If that happens, the long bond currently trading for $1000 will fall in price to $800. (Remember, the coupon is fixed at $40, and 5% = 40/800.) You definitely don't want to be holding a long bond when that happens. That would be a capital loss of 20 percent. Of course every year that you hold short bonds rather than buying the long bond at its current price of $1000, you're missing out on $20 of interest; but if you think there's even a moderate chance of the long bond falling in value by $200, giving up $20 of interest to avoid that risk might not look like a bad deal.

Of course, even if you think the long bond is likely to fall in value to $800, that doesn't mean you won't buy it for anything above that. if the current price is only a bit above $800 (the current interest rate is only a bit below the "normal" level of 5 percent) you might think the extra interest you get from buying a long bond is enough to compensate you for the modest risk of a capital loss. So in this situation, the equilibrium price of the long bond won't be at the normal level, but slightly below it. And if the situation continues long enough, people will presumably adjust their views of the "normal" level of the long bond to this equilibrium, allowing the new equilibrium to fall further. In this way, if short rates are kept far enough from long rates for long enough, long rates will eventually follow. We are seeing a bit of this process now. But adjusting expectations in this way is too slow to be practical for countercyclical policy. Starting in 1998, the Fed reduced rates by 4.5 points, and maintained them at this low level for a full six years. Yet this was only enough to reduce Aaa bond rates (which shouldn't include any substantial default risk premium) by slightly over one point.

In my previous post, I pointed out that for policy to affect long rates, it must include (or be believed to include) a substantial permanent component, so stabilizing the economy this way will involve a secular drift in interest rates -- upward in an economy facing inflation, downward in one facing unemployment. (As Steve Randy Waldman recently noted, Michal Kalecki pointed this out long ago.) That's important, but I want to make another point here.

If the primary influence on current long rates is the expected future value of long rates, then there is no sense in which long rates are set by fundamentals.  There are a potentially infinite number of self-fulfilling expected levels for long rates. And again, no one needs to behave irrationally for these conventions to sustain themselves. The more firmly anchored is the expected level of long rates, the more rational it is for individual market participants to act so as to maintain that level. That's the "other thing" I suggested above. If people believe that long rates can't fall below a certain level, then they have an incentive to trade bonds in a way that will in fact prevent rates from falling much below that level. Which means they are right to believe it. Just like driving on the right or left side of the street, if everyone else is doing it it is rational for you to do it as well, which ensures that everyone will keep doing it, even if it's not the best response to the "fundamentals" in a particular context.

Needless to say, the idea that that long-term rate of interest is basically a convention straight from Keynes. As he puts it in Chapter 15 of The General Theory,
The rate of interest is a highly conventional ... phenomenon. For its actual value is largely governed by the prevailing view as to what its value is expected to be. Any level of interest which is accepted with sufficient conviction as likely to be durable will be durable; subject, of course, in a changing society to fluctuations for all kinds of reasons round the expected normal. 
You don't have to take Keynes as gospel, of course. But if you've gotten as much mileage as Krugman has out of the particular extract of Keynes' ideas embodied in the IS-LM mode, wouldn't it make sense to at least wonder why the man thought this about interest rates, and if there might not be something to it.

Here's one more piece of data. This table shows the average spread between various market rates and the Fed Funds rate.

Spreads over Fed Funds by decade

10-Year Treasuries Aaa Corporate Bonds Baa Corporate Bonds State & Local Bonds
2.2 3.3
1950s 1.0 1.3 2.0 0.7
1960s 0.5 0.8 1.5 -0.4
1970s 0.4 1.1 2.2 -1.1
1980s 0.6 1.4 2.9 -0.9
1990s 1.5 2.6 3.3 0.9
2000s 1.5 3.0 4.1 1.8

Treasuries carry no default risk; a given bond rating should imply a fixed level of default risk, with the default risk on Aaa bonds being practically negligible. [3] Yet the 10-year treasury spread has increased by a full point and the corporate bond rates by about two points, compared with the postwar era. (Municipal rates have risen by even more, but there may be an element of genuine increased risk there.) Brad DeLong might argue that society's risk-bearing capacity has decline so catastrophically since the 1960s that even the tiny quantum of risk in Aaa bonds requires two full additional points of interest to compensate its quaking, terrified bearers. And that this has somehow happened without requiring any more compensation for the extra risk in Baa bonds relative to Aaa. I don't think even DeLong would argue this, but when the honor of efficient markets is at stake, people have been known to do strange things.

Wouldn't it be simpler to allow that maybe long rates are not, after all, set as "the sum of (a) an average of present and future short-term rates and (b) [relatively stable] term and risk premia," but that they follow their own independent course, set by conventional beliefs that the central bank can only shift slowly, unreliably and against considerable resistance? That's what Keynes thought. It's what Alan Greenspan thinks. [4] And also it's what seems to be true, so there's that.

[1] Prof. T. asks what I'm working on. A blogpost, I say. "Let me guess -- it says that Paul Krugman is great but he's wrong about this one thing." Um, as a matter of fact...

[2] There's no risk premium on Treasuries, and it is not theoretically obvious why term premia should be positive on average, though in practice they generally are.

[3] Despite all the -- highly deserved! -- criticism the agencies got for their credulous ratings of mortgage-backed securities, they do seem to be good at assessing corporate default risk. The cumulative ten-year default rate for Baa bonds issued in the 1970s was 3.9 percent. Two decades later, the cumulative ten-year default rate for Baa bonds issued in the 1990s was ... 3.9 percent. (From here, Exhibit 42.)

[4] Greenspan thinks that the economically important long rates "had clearly delinked from the fed funds rate in the early part of this decade." I would only add that this was just the endpoint of a longer trend.


  1. Nice takedown. As a non-economist (but an engineer) I continue to be amazed by the number of theories taken to be as true by modern economics despite there being not the slightest shred of empirical data to support them. If you can come up with a way to micro-found it, and stick it in a mathematical model, well, you are done. No further work required.

    It would be as if modern physics was still sticking with the ether wind theory despite 100 years of failing to measure its velocity.

  2. There is a point that is unclear to me: the role of supply of bonds.
    For example, suppose that the treasury can issue short term bonds at 2%, or long term bonds at 5%.
    Treasuries have reasons to prefer long term debt to short term debt, however if the difference is huge, treasuries could just issue "cheaper" short term bonds and not long term bond.
    Thus, if treasury acted as a rational private borrower, if the market was fixated on an excessive interest rate for long term bonds, we would see an increase in quantity of short term bonds and a decrease in quantity of long term bonds.
    But the treasury doesn't act as a private borrower, so I don't know what rules it as on issuing long or short term bonds - if it is fixated on long term bonds no matter how expensive, this could keep the difference between long and short unnaturally high.

    1. An increase in the supply of long bond will tend to lower their price, and thus bring long rates up, not down. So if the Treasury acted as you suggest, this would tend to maintain spreads at their elevated levels. This is why -- as I think I've noted here before -- proposals to lower long-term borrowing costs by shifting federal debt toward longer maturities are, precisely, a form of anti-QE.

      The existence of conventions does not depend on anyone behaving irrationally!

      That said, in a Keynesian liquidity trap, we think the price of bonds has become almost entirely inelastic with respect to their supply. That's what defines it, in fact.

    2. Sorry, I misread your comment. There have been proposals to lock in current low rates by issuing more 30-year (or even longer) Treasury bonds. That's the anti-QE.

      Yes, if the Treasury issued more short-term debt and less long-term, that *might* reduce spreads -- altho, again, as you get to longer maturities stable expectations mean prices are quite inelastic. But this subjects the Treasury to a lot more risk of rising interest costs when rates rise again. It's not clear to me that this is the behavior of a "rational" borrower -- in fact I'm pretty sure it's not.

    3. When I said that the treasury doesn't act as a retional private borrower, I meant to stress the difference between the state and privates. The point is that the usual logic of supply and demand implies two entities that are trying to maximize profits and minimize cost, but the treasury isn't really trying to maximize profits and isn't really bound to the same constraints of a private entity, so the supply side doesn't really behave as supposed by the usual supply and demand logic.
      Since it is the supply side that tries to push down interest, if it behaves in a "weird" way then it is not obvious to me that the normal logic of pricing still applies.

    4. The major difference between the US Treasury and private corporations/households is that the US Treasury does not operationally need to borrow in order to spend (this goes for all monetarily sovereign nations, which excludes Europe). Therefore, Treasuries primarily function as a means of transferring interest income from the public to private sector and as a means for the Fed to hit its interest rate targets. Although selling larger quantities of long-term bonds would be anti-Operation Twist/QE, it could be beneficial by adding interest income to the private sector.

    5. "it could be beneficial by adding interest income to the private sector."
      But this interest income would go to those households (or businesses) that already hold a lot of treasuries, so it would be the usual case of upward redistribuition of income.
      As those households/businesses are precisely those that spend a smaller share of their incomes in consumption goods, and a bigger share on capital goods, the state would then need to sell even more debt in order to satisfy the demand for capital goods, with comparatively low increase in demand for consumption goods...
      It doesn't seem a good idea to me.

  3. JW - Thanks for all the great work and insights you provide through this blog (especially regarding household debt). I agree that affecting long-term rates requires a semi-permanence of policy and is poor for counter-cyclical purposes. Unfortunately I have to disagree with regards to expected short-term vs. long-term rates influencing long-term Treasury rates. IMO, there are perfectly good reasons for systematic over or under-estimations of short-term rates over long periods. Separately, the bond example you provide seems to overlook that after 9 years a 10-year Treasury becomes equivalent to a 1-year maturity. These arguments are elaborated further here (

    I may be missing something given your greater expertise, so it would be great to get your thoughts (and others).

    1. We are interested in newly issued long bonds, because that's what finances investment in housing and capital goods. Yes, a ten-year bond with one year to run is equivalent to a one-year bond, but that is irrelevant here. The question is whether the Fed can affect the terms on which real activity is financed.

      As I said in the post, whether you think, as Keynes (and I) do, that long rates are basically independent of even expected short rates, or whether you think, as you do, that short rate expectations are what matter but the central bank cannot change them on a business-cycle timescale, the negative conclusion about the effectiveness of monetary policy for stabilization purposes is the same.

    2. Also, thanks for the kind words.

      By the way, this is part of continued work on the household debt project, though it may not seem like it. One of the biggest, and least-recognized factors in increased household debt is the secular rise in real interest rates after 1980. So one thing we need to understand is how long rates facing private borrowers have remained high despite episodes of very low policy rates.

    3. Thanks for the replies. I would actually argue that the Fed can operationally set long-term rates (by promising to purchase unlimited Treasuries at a certain rate), but has not instituted such a policy and is unlikely to do so in the near future. Under current practices, I agree that the central bank cannot change them on a business-cycle timescale. However, newly issued long bonds are currently (IMO) reflecting the persistence of near zero short-term rates for many years into the future.

      Separately, I think you note an important distinction between the interest rate for private borrowers and Treasury rates. One speculative reason is that periods of low policy rates normally accompany financial distress and greater uncertainty. Banks maintain stricter lending standards during these periods which results in higher long-rates. I'm starting a PhD this fall and hope to work on these issues going forward.

    4. Congratulations on starting a PhD. It's a fun time to be studying economics.

    5. So after much thought, I think you are correct that in practice the market determines interest rates ( If the ECB elects to cap rates, however, it will be an interesting test of a central banks power to go against the market.

    6. The question is, what do you mean by "cap interest rates"? There are lots of different rates. There is no question that a central bank can, in principle, set interest rates for debt denominated in its own currency at any level it chooses by buying or selling a sufficient quantity of it. (This is what Keynes called "monetary policy a outrance.") But this might result in the central bank being the only party on one side or the other, if it tries to deviate too far from rates acceptable to market participants; and more to the point, it bears no resemblance to monetary policy as it is actually conducted. Even QE involves a realtively small fraction of the stock of a narrow range of instruments.

      It seems to me that monetary policy has operated historically by changing the quantity of the relatively small set of instruments used for interbank settlement and (more important for much of the 20th century) satisfying reserve requirements. When those constraints don't bind credit creation, central banks simply don't control credit creation.

    7. By capping interest rates I mean setting a limit on sovereign debt rates across the curve either based on a spread to Germany or a nominal value. I recognize that this would potentially entail being the only party on a given side of the market and would mark a sharp break from typical monetary policy. Further I understand this would not necessarily alter other market rates.

      Whether or not the ECB takes that approach, I think your conclusion is the important aspect. I'm currently reading Kaldor's, The Scourge of Monetarism, which offers immense support for the view that monetary policy can, at most, impact the demand for credit but not the supply.

  4. Hm, how did you really calculate spread? Did you take realized fed funds rate over the next 10 years and subtracted 10y yields at the beginning of the period? Could you also include interbank swaps into your table? Would be interesting to see the result. Tnx

    1. Yes, it's the 10-year rate at the beginning of the period minus the geometric average of the Fed Funds rate over the period. I'm pretty sure that's the right way to do it.

      Other overnight interbank rates hardly ever vary from the Fed Funds rate by more than a few basis points (fall 2008 was the dramatic exception) so using one of them instead is't going to change anything.

    2. That is not what I meant. I would be curious to see whether the whole interbank yield curve (or 10y point as you picked) shows similar dynamics as cash assets like treasuries. The 10y point on interbank curve is a non-cash off-balance sheet position. If it shows similar dynamics to cash assets then you can really argue that there is something intrinsic about the spread. However if interbank spread is closer to zero or even negative (very unlikely given the obvious secular trend but still) then the effect might due to the *cash* nature of instruments.

    3. And actually one more thought that I had. The problem might be also (partially) explained by different daycount conventions of different instruments. Additionally 1-2 bps is generally the range of differences between different payment frequencies. Treasuries pay semi-annualy, corporate - typically quarterly, and fed funds is money market. This is something you can be able to extract from the yield directly and need to use discount factors since discount factors abstract from such complexities.

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  6. I think this can be perfectly explained with the observation that households were consistently under-estimating inflation from 1950-1980 and consistently over-estimating it from 1980-present. Which is an argument that expectations are, in practice, adaptive.

    1. I think that in practice, the theory that long rates are just the average of expected short rates, but short rate expectations adjust only very slowly, and Keynes' theory about conventional level (or floor) on short rates, will yield very similar predictions. They are not quite the same, and the difference may be important in some situations, but both share the important implication that monetary policy cannot move long rates significantly at business-cycle frequencies.

      Which raises the question, does monetary policy work through some other channel, that relies only on current short rates? Or does monetary policy not work as well as we had thought, at all?

      An important point, emphasized by Leijonhufvud, is tat rate expectations aren't just of a level, but of a range. Within that range, expectations will be more elastic. So it is more practical to use monetary policy to maintain a desired level of output than to restore once the economy has moved far away from it.

  7. Another good post! Question. Supposing that the zero bound didn't exist, wouldn't that rule out a liquidity trap, since the Fed would have the ability to inflict unlimited losses on cash holders, and therefore long term securities would be attractive even if losses are expected?

    1. This is a question I've thought about a lot too. I think the right way of framing it is, whether you think long rates are set at the average of expected long rates, or expected short rates, is the expected rate normally distributed around the current rate. The ZLB is just one possible reason expected future rates might be biased upwards from current rates.

      But I think there are good reasons, apart from the technical ZLB, that people do not expect future long rates to be negative. Whatever the Fed does, there is still the option of simply holding some very long-loved good -- land in the extreme case -- for a zero return. This, it seems to me, sets a practical floor of zero on long rates. And if long rates cannot fall below zero, then it is irrational to hold long bonds even when the return is somewhere north of zero. Because the capital loss from a future rise on long rates rises as long rates approach zero, while the gain relative to holding some long-lived physical asset falls. This was Keynes' argument, and it seems convincing to me. To avoid this, you have to postulate a negative natural rate, i.e. that there is no asset in the world that produces a constant real return, however small.

  8. I don't think there is such a thing as "normal or usual long[-term] rate". That's what 'long rate' means in this context, long-term rate, right? Over a long term there could be a war, revolution, oil embargo, a whole bunch of different kinds of shit might happen. Today's expectations of this shit (like a war with Iran, for example) would affect my decision to buy or not to buy much-much more than any expectation of short-term rates.

    1. Well part of Keynes' argument is that predictions of "fundamentals" over a horizon of decades is basically impossible. What is the probability of a war with Iran, anyway? Which is exactly why people fall back on conventions.

    2. What the probability of a war with Iran is I don't know, but the level of optimism/pessimism of the general public (or the bond traders among them specifically) certainly can be measured. And, I suspect, their optimism, their confidence (or a lack of it) is what determines the yields, rather than the short-term interest imposed by a bureaucrat. Which is, I guess, pretty much what you're saying too.

  9. One issue I didn't mention here but really ned to come back to is liquidity. Although that will be more of an issue in explaining the spread between federal and private (or municipal) bonds of similar maturities.

  10. "Whatever the Fed does, there is still the option of simply holding some very long-loved good -- land in the extreme case -- for a zero return."

    Zero yield, not zero return.

    Think about what would happen to paper money if reserves were not convertible into paper. It could trade above face, giving a negative expected return even though the yield is always 0%.

  11. Which raises the question, does monetary policy work through some other channel, that relies only on current short rates? Or does monetary policy not work as well as we had thought, at all?

    1. If the economy is really driven, over the short run, by self-fulfilling prophecies, then it is possible that small changes in long rates, as caused by larger changes in short rates, can influence the economy.

    2. You have the bank lending channel. The prime rate follows fedfunds and many firms are charged a premium over the prime rate.

    3. Monetary policy may not work all that well, and it may be asymmetric.

    4. Heavy lifting is happening behind the scenes via automatic stabilizers and trade channels.

  12. It seems implicit in everything you argue, and quite clear from your long term rate graph, that the Keynesian golden age was really achieved via the BW mechanism allowing central banks to keep the long term rate as low as it would go. Expectations were therefore anchored and corporate bonds moved far more closely with government bonds.

  13. "The actual existence of many different interest rates in real economies is hand-waved away with "risk premia" "

    Really? 'cause the classic explanation involves an analytic panoply of various related premia and risk factors, not a general "risk" premium -- the panoply aspect is kind of important. And, back in 1972, when I was taking Intermediate Macro in Ann Arbor, Gardner Ackley waved his hand at . . . (wait for it) . . . the yield curve. (Central banks cause recessions by inverting the yield curve. Shocking, I know. )

    "Since the risk premia depend on real factors, they should be reasonably stable, or at least independent of monetary policy. So when the Fed Funds rate goes up or down, the whole rate structure should go up and down with it."

    Well, no. This is just wrong; a serious misunderstanding. I'm not saying it is your misunderstanding, and I don't know what nonsense they may be teaching the young 'uns, but this isn't what a competent economist, taking a conventional view, should say. This is a straw man. (It may be what actual economists do say, which would be a serious indictment of their competence, but it is still an account made of straw, and devastating it may not be worth much time or trouble.)

    There's something missing here, and it cannot be left out. Necessary and sufficient, and all that. Let me see . . . what could it be? Hmmm . . . Oh, yeah, financial intermediation! Banking, as we used to call it, financial markets, that kind of thing. Financial institutions take the one interest rate of a theory of a money economy with prices, but not actual money, and, in a real world of actual money and credit, multiply out all those other interest rates.

    And, they do fan out in a regular, in not exactly "stable", way above the foundation of the risk-free rates of the yield curve, twisting its way into the future (it is way non-linear), because of the operations of financial intermediation (banking, financial markets, etc) The hand of the academic economist may wave, at this point, at "arbitrage" being the operation of financial intermediation at work, and that's not completely wrong, but, really, that hand should be cut off and thrown in a ditch, imho, because it misses the main event.

  14. [continuing my rant]

    Interest rates are, as you say, "conventional", but do you understand why they are conventions? It is because there is an administrative process in making investments, extending credit, giving mortgages, issuing credit cards, etc., in which the interest rate is an administered price, part of a bureaucratic scheme for controlling rates of default and loss, of avoiding the making of "bad" loans.

    It is way too easy to fall into the idiocy of loanable funds, where funds are scarce, and an interest rate is an market price equilibrating an hydraulic flow from ultimate savers to ultimate lenders -- just not the way it is.

    The more normal situation and problem is excess funds: way more financial capital flooding the system than can be safely parked in claims against actual ("real") capital assets and land, useful in producing goods. Everyone wants to put their money in places ("invest") where it won't simply disappear in some fraud or ponzi scheme, and there are only rarely enough such places over the course of the business cycle. (In other words, Kindleberger, Minsky and all that.) And, by itself, divorced from ownership claims on "real" capital, financial capital is not useful for anything, but insurance, and to make such insurance valuable, you need financial volatility, and pretty soon, if not properly regulated, the financial system becomes, itself, a volatility machine (to steal a great phrase), and various ponzi schemes and usury schemes are sucking the lifeblood out of the economy, and financial interests are pressing to eliminate all sources of public insurance (We can't "afford" Social Security, don't ya know?). U.S., 2012.

    (In other words, Kindleberger, Minsky and all that.)

    So, "independent of monetary policy"? -- sadly, no. Most definitely, no. Again, no. Many of the "risk factors" are financial, not "real", and involve both monetary policy in the sense of central bank control of interest rates, but also the effectiveness of financial institution regulation in ensuring the integrity of financial intermediation and credit creation.

  15. You are neglecting the most basic point in the argument. We do not live in a free market system with a federal reserve trying to accomplish its dual mandate. Currently the fed has openly admitted that lower interest rates will benefit the growth of the economy while "punishing" savers.
    At the very heart of their mandate is the directive to have a perpetual goldilox economy, which cannot be achieved in perpetuity so the fed has to manipulate the economy as best see fit. Four words come to mind,"Sub Prime is contained."

  16. Why does Krugman call people names?

  17. Hi JW Mason,

    Sorry to be communicating with you this way but, I somehow deleted your e-mail. We posted your article on Learn Bonds and are currently featuring it on our Homepage. As you will see, we very clearly provided attribution and link back to the blog. Thanks for contributing. Should you think of any articles that would be a good fit in the future. Please send it over.

    If you want to help promote Learn Bonds, we would appreciate that as well. Ironically, we just published an educational article that goes over the traditional view about the relationship between the FED and the yield curve

    Best regards,

    Marc Prosser
    Learn Bonds

  18. Wonderful series of posts. I'm reading Leijonhufvud on your rec and its a delight.

    Re: "If the primary influence on current long rates is the expected future value of long rates, then there is no sense in which long rates are set by fundamentals." Are you forgetting the IS curve (L. insists Keynes accepted the interest sensitivity of investment)? So if the interest rate settles on a level that creates robust accumulation (not Depression economics, i.e.) and that eventually generates inflation, what then?? Also, your own examples show that the Fed can eventually affect the markets understanding of the 'new normal' (e.g., the Bill Gross drama). So maybe there is a sense in which fundamentals enter in, in the long run.

    I've struggled w/ ch 19 ("Changes in money wages") of the GT for years, and it seems to me that (i) L. is right that that Keynes denied the 'liquidity trap' in which the monetary authority cannot lower the rate of interest so that (ii) Keynes must believe at some level in the insensitivity of investment in a Depression after all. That seems to be what Minsky thought, or at least what he thought Keynes should have said: a liquidity trap is a "present value inversion" in which no interest rate can make the valuation of capital items attractive relative to production costs. Doesn't look like a bad idea to me.

    1. Glad you're reading Leijonhufvud! This blog has accomplished something useful, at least.

      Seems to me that AL is pretty clear that Keynes *rejected* the idea that investment was interest-insensitive. He's very insistent that the problem with monetary policy is *not* that interest rates don't matter, but that the central bank cannot control the relevant rates. (Maybe I'm misreading what you wrote?)

    2. You read it right. I don't agree with AL. Keynes explicitly advocated QE, central bank purchases of risky debt, and denied that the interest rate floor had yet been achieved. If that's what he thinks, how can involuntary unemployment depend on the inability of the central bank to affect the long rate? You and AL are correct to emphasize the difficulty of affecting the long rate, but I am not persuaded that this is really what is holding back recovery. After all, the long rate has fallen a lot. I think Minsky's idea that a liquidity trap involves a vertical IS curve is closer to the truth (Joan Robinson said he had the best interpretation of Keynes available). So we need fiscal policy. It is interesting to see how hostile AL is to the 'stagnationists', BTW. He seems to me to be confused by marginalist capital theory (as was Keynes). But he is spot on when it comes to Walrasian theory--the auctioneer is like Maxwell's demon! Brilliant, and anticipating complexity theory. (Sorry to ramble--please don't feel obligated to respond.)

  19. JW - great piece, but...

    1. A more interesting rebuttal to DeLong is not to argue that long rates are unconnected with short rates, but to observe that even if they were connected, monetary policy wouldn't be effective at controlling inflation. This is because of good P-K things like (a) spending and investment being quite insensitive (at the moment) to long rates, and (b) the interest income channel.

    2. Surely there is in fact a connection between long rates and the Fed Funds rate - not a correlation, but in the sense that the long rates will express the view of inflation and the Fed's reaction thereto? There is still a valid arbitrage argument to be made: T-bill rates are clearly connected to the Fed Funds rate, and 2yr rates are connected by arb to 1yr rates.

    The analogy is surely a whip, where the locus of the end of the whip is entirely unpredictable from the locus of the handle, but the locus of various points on the whip will be predictable from other points nearby.

  20. Anders-

    I agree that interest-insensitive final demand, to the extent it's the case, is another rebuttal to the conventional view of all-powerful central banks. I don't agree it's more interesting -- I think both are interesting!

    On your last point, Keynes made a similar argument, using the analogy of an accordion rather than a whip. Again, the question isn't whether there is any connection at all between the policy rate and long rates -- obviously there is some -- but whether the connection is strong enough and fast enough to allow the central bank to reliably stabilize aggregate demand in the absence of a ZLB.

    I don't think inflation adds anything to the story. If you expect higher future inflation, you will presumably expect higher future short rates. The logic from there is the same as if you expected higher future short rates for any other reason.

  21. @JW - thanks for the reply

    "whether the connection is strong enough and fast enough to allow the central bank to reliably stabilize aggregate demand"

    I agree that the CB can only lower long rates slowly and unreliably, but the BoJ and Fed have nonetheless managed to get long rates to record low levels, which is presumably something they intended to do. And even this has failed to get demand going!

    I'm obviously largely agreeing with you - I do think the war against complacent reliance on monetary policy ought to be waged at multiple levels. (And I agree inflation doesn't add anything here; it only serves as an indicator that AD may be too high.)

    Regarding interest-insensitivity, I've often noted, as an equity investor, that discount rates applied in the real world as a hurdle for discretionary (as opposed to essential) capex projects, are typically much higher than a company's marginal funding cost or WACC - eg 25-30%, to allow for execution risk or inaccurate cost-benefit quantification. The idea that lowering WACCs by up to 1%, as the Fed effectively claims to, would encourage firms to materially increase their fixed capital formation, in nonsensical.

    This isn't an argument I see advanced much; not sure why...

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