Sunday, July 8, 2012

Interest Rates and Expectations: Responses and Further Thoughts

Some good questions asked in comments to yesterday's post.

Random Lurker doubts whether there is a strict inverse relationship between interest rates and bond values. Indeed there is not, apart from perpetuities (bonds with an infinite maturity, where the principle is never repaid.) I should have been clearer in the post, I was talking about perpetuities just as a simplification of the general case of long assets. But I would argue it's a reasonable simplification. If you think that the importance of interest rates is primarily for the valuation (rather than the financing) of capital goods, and you think that capital goods are effectively infinitely lived, then an analysisis in terms of perpetuities is the strcitly correct way to think about it. (Both assumptions are defensible, as a first approximation, and Keynes seems to have held both.) On the other hand, if you are thinking in terms of financing conditions for long but not infinitely lived assets, the perpetuity is only an approximation, but for long maturities it's a reasonably close one. For example, a 30 year bond loses 14% of its value when interest rates rise from 5% to 6%, compared with a 20% loss for a perpetuity. Qualitatively the story will hold as long as the interest rates that matter are much longer than the timescale of business cycles.

Max is confused about my use of "bull" and "bear." Again, I should have been clearer: I am using the terms in the way that Keynes did, to refer to bullishness and bearishness about bond prices, not about the economy in general.

Finally, the shortest but most substantive comment, from Chris Mealy:
Forcing Bill Gross to lose billions in slow motion is a crazy way to get to full employment.
It is! And that is kind of the point.

I wrote this post mainly to clarify my own thinking, not to make any policy or political argument. But obviously the argument that comes out of this is that while monetary policy can help stabilize demand, it's very weak at restoring demand once it's fallen - and not just because short rates can't go below zero, or because central banks are choosing the wrong target. (Although it is certainly true, and important, that central bankers are not really trying to reduce unemployment.)

Here is the thing: expectations of returns on investment are also conventional and moderately elastic. Stable full employment requires both that expected sales are equal to expenditure at full employment, and that interest rates are such that the full employment level of output is chosen by profit-maximizing businesses. But once demand has fallen - and especially if it has remained depressed for a while - expected sales fall, so the interest rate that would have been low enough to prevent the fall in activity is no longer low enough to reverse it. This is why you temporarily need lower rates than you will want when the economy recovers. But the expectation of long rates returning to their old level will prevent them from falling in the first place. "The power of the central bank to affect the long rate is limited by the opinions about its normal level inherited from the past." This is why monetary policy cannot work in a situation like this without Bill Gross first losing billions - it's the only way to change his opinion.

Suppose that a situation arises in which the State of Expectation happens to be "appropriate"... but that the long rate is higher than "optimal," so that asset demand prices are too low for full employment... Then it seems quite reasonable to demand that the Central Bank should go to great lengths in trying to reduce the interest rate... If, however, the actual interest rate equals the "optimal" rate consistent with the suggested "neutral state," while asset prices are too low due to a State of Expectation which is "inappropriately pessimistic"-what then? 
Consider what would happen if, in this situation, the long bond rate were forced down to whatever level was necessary to equate ex ante rates of saving and investment at full employment. This would mean that prices of bonds-assets with contractually fixed long receipt streams-would shoot up while equity prices remained approximately constant instead of declining. Through a succession of short periods, with aggregate money expenditures at the full employment level, initial opinions about the future yield on capital would be revealed as too pessimistic. Anticipated returns to capital go up. The contractually fixed return streams on bonds remain the same, and it now becomes inevitable that bond-holders take a capital loss (in real terms). 
The Central Bank now has two options. (a) It may elect to stand by [leaving rates at very low levels.] ...  Since the situation is one of full employment, inflation must result and the "real value" of nominally fixed contracts decline. (b) It may choose ... to increase market rate sufficiently to prevent any rise in [inflation]. Bond-holders lose again, since this means a reduction in the money value of bonds.
In other words, in our world of long-lived assets, if you rely only on monetary policy to get you out of depression, Bill Gross has to lose money. On a theoretical level, the fact that the lifetime of capital goods is long relative to the period over which we can reliably treat "fundamentals" as fixed means that the Marshallian long run, in which the capital stock is fully adjusted, does not apply to any actual economy. (This fact has many important implications beyond the scope of these posts.)

The key point for our purposes is that, in the slump, investment demand is lower than it will be once the economy recovers. So if the interest rate falls enough to end the recession, then you must have either a rise in rates or inflation once the slump ends. But either of those will mean losses for bondholders, anticipation of which will prevent long rates from falling the first place. Only if you successfully fool bond market participants can monetary policy produce recovery on a timescale significantly less than average asset life. The alternative is to prove the pessimistic expectations of entrepreneurs wrong by directly raising incomes, but that seems to be off the table.

This point is obvious, but it's strangely ignored, perhaps because discussion of monetary policy is almost entirely focused on how optimal policy can prevent slumps from occurring in the first place. The implicit assumption of Krugman's ISLM analysis, for instance, is that investment demand has permanently fallen, presumably unrelatedly to demand conditions themselves. So the new low rate is permanently appropriate. But -- I feel it's it's safe to say -- Krugman, and certainly market participants, don't really believe this. But if policy is going to be reversed, on a timescale significantly shorter than the duration of the assets demand for which is supposed to be affected by monetary policy, then policy will not work at all.

At this point, though, it would seem that we have proven too much. The question becomes not, why isn't monetary policy working now, but, How did monetary policy ever work? I can think of at least four answers, all of which probably have some truth to them.

 1. It didn't. The apparent stability of economies with active central banks is due to other factors. Changes in the policy not been stabilizing, or have even been destabilizing. This is consistent with the strand of the Post Keynesian tradition that emphasizes the inflationary impact of rate increases, since short rates are a component of marginal costs; but it is also basically the view of Milton Friedman and his latter-day epigones in the Market Monetarist world. I'm sympathetic but don't buy it; I think the evidence is overwhelming that high interest rates are associated with low income/output, and vice versa.

2. The focus on long-lived goods is a mistake. The real effect of short rates is not via long rates, but on stuff that is financed directly by short borrowing, particularly inventories and working capital.  I'm less sure about this one, but Keynes certainly did not think it was important; for now let's follow him. A variation is income distribution, including corporate cashflow. Bernanke believes this. I'm doubtful that it's the main story, but I presume there is something in it; how much is ultimately an empirical question.

 3. The answer suggested by the analysis here: Monetary policy works well when the required interest rate variation stays within the conventional "normal" range. In this range, there are enough bulls and bears for the marginal bond buyer to expect the current level of interst to continue indefinitely, so that bond prices are not subject to stabilizing speculation and there is no premium for expected capital losses or gains; so long rates should move more or less one for one with short rates. This works on a theoretical level, but it's not obvious that it particularly fits the data.

 4. The most interesting possibility, to me: When countercylclical monetary policy seemed effective, it really was, but  on different principles. Autonomous demand and interest rates were normally at a level *above* full employment, and stabilization was carried out via direct controls on credit creation, such as reserve requirements. A variation on this is that monetary policy has only ever worked through the housing market.

Regardless of the historical issue, the most immediately interesting question is how and whether monetary policy can work now. And here, we can safely say that channels 2,3 and 4, even if real, are exhausted. So in the absence of fiscal policy, it really does come down to the capacity of sustained low short rates to bring expected long rates down. Sorry, Bill Gross!

UPDATE: I was just reading this rightly classic paper by Chari, Kehoe and McGrattan. They're pure freshwater, everything I hate. But New Keynesians are just real business cycle theorists with a bad conscience, which means the RBCers pwn them every time in straight-up debate. As here.I'm not interested in that, though, though the paper is worth reading if you want the flavor of what "modern macro" is all about. Rather, I'm interested in this subsidiary point in their argument:

as is well-known, during the postwar period, short rates and long rates have a very similar secular pattern. ... Second, a large body of work in …finance has shown that the level of the long rate is well-accounted for by the expectations hypothesis. ... Combining these two features of the data implies that when the Fed alters the current short rate, private agents signi…ficantly adjust their long-run expectations of the future short rate, say, 30 years into the future. At an intuitive level, then, we see that Fed policy has a large random walk component to it.
In what sense this is true, I won't venture to guess. It seems, at least, problematic, given that they also think that "interest rates ... should be kept low on average." The important point for my purposes, tho, is just that even the ultra-orthodox agree, that for a change in monetary policy to be effective, it has to be believed to be permanent. "If that which is at all were not forever..."


  1. Hey Josh.

    Two quick comments that might miss the mark.

    First, where does the story that monetary policy works when monetary policy caused the recession in the first place fit in? To abuse the punch bowl metaphor, the Fed can easily bring the punch bowl back to the party after they have taken it away, but they may not be able to produce punch for a party that doesn't have one. Eventually they come back with an empty bowl, wondering why they can't get people drunk anymore.

    Second, I'm not confident about this, but in the context of the importance of heterogeneous expectations in the bond market, could you understand some types of QE as an instance of acting like bears in a market that "needs" them? I'm not really arguing for QE here, just trying to better understand the topic.

  2. There is one other channel, apart from bringing down long rates. The capacity of low short rates, especially negative ones, to erode risk aversion.

    This is consistent either with the state of the world that you are thinking about (low short and long rates), or a different one where the short and long rates are both more *normal*, but the increase in the natural rate has been brought about not (or at least not just) by fiscal policy, but by a destruction of the capital chasing stock safe returns.

  3. About hypothesis 1: maybe it is not low rates that causes high income but the lowering of the rates. When rates of interest fall the total amount of debt rises. the increase of debt causes a cash flow that boosts demand temporaneously, in the same way keynesian stimulus would.
    However when debt reaches its new maximum level aggregate demand falls again.
    I think this is Steve Keen's idea.

  4. Interesting set of posts. I question the attribution of views on the liquidity trap to Keynes (for one thing, the term did not come into use until after his death). He explicitly questioned the idea that the zero boundary on short term rates would necessarily prevent the central bank from reducing long term rates--on grounds that it could deal in long term debt, though, as he said, "owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test." This is in Chapter 15 of the GT. In other words, he advocated QE. So we are living through the experiment that JMK proposed. Perhaps QE has contributed to the low 10 and 30 year yields? That it has worked to reduce rates modestly seems to be the consensus at the NYFed (e.g., Sack, Gagnon), based on a modern version of the "preferred habitat" model of the yield curve. On my reading, Keynes' idea of depression economics, like Minsky's, rests on the IS curve, not the liquidity trap (LM curve).

  5. How do 14% or even 20% fall in value reconcile with YoY sales easily going +-20%? Isn't former 14% or 20% a rounding error in business decisions?

    1. There are two links that have to operate for monetary policy, as usually conceived, to be effective. First, changes in the policy rate have to affect long rates. And second, changes in long rates have to affect expenditures, especially expenditures on long-lived assets. If either is broken, monetary policy won't be able to move the real economy. There is an interesting debate about the second link, but here I am focusing on the first one.