Fed tightening, asymmetric risks, and possibility of negative rates.

A quick comment on this thoughtful post by the great JP Koning, whose posts on monetary econ and finance have become regular reading for me since I found him on the internet.

JP makes the point that the possibility that rates could now safely go negative changes the calculation in the Fed’s mind, eliminating one particular concern that might prevent it from raising.  The concern, articulated by many, Krugman and others, is that if a rise proves to be the wrong choice, there is insufficient room to reverse course and cut to counter the ensuing slowdown.  Clearly, if rates can go negative, then there is more room to cut.

However, although rates have gone negative, it’s clearly the case that there is still a lower bound to rates.  In our standard model this will be equal to the marginal cost of managing cash.  In real life it will be connected with the same, real life counterparts.  If you think about the size of historical cycles in interest rates, [adjusting for the slow run changes in inflation regimes that have gone on], the Fed might want, in an ideal world, to be able to raise rates to say 10%, and cut them to -8%.  [I recall discussions at central bank conferences that -8% was a typical estimate of the amount of missing stimulus in 2009].  Say, at the outside, market rates could be tempted down to -1.25%.  That’s still a lot of missing stimulus to generate asymmetry in the risk calculation the Fed makes.

The story isn’t quite as stark as I have painted it, because there is the possibility of doing more quantitative or credit easing.  But i) there are still controversies about just how effective that might be and ii) there may well be political constraints on growing the Fed balance sheet even further from its current swollen state.

We might well also wonder whether a correction in rates following a mistaken rise would really need to be so large as to use up all the missing stimulus that the Fed was deprived of in the early stages of the financial crisis.  Surely this would not be another Lehman’s moment? Surely this time would be different [more moderate]?  Well, probably.  But then rates are starting out much lower to begin with.  So there does not need to be anything like another Lehman’s moment to push the desired Fed rate well below even -1.5%.

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17 Responses to Fed tightening, asymmetric risks, and possibility of negative rates.

  1. mrkemail2 says:

    ” is that if a rise proves to be the wrong choice, there is insufficient room to reverse course and cut to counter the ensuing slowdown. Clearly, if rates can go negative, then there is more room to cut.”
    This is crazy. Negative rates? And that is supposed to stimulate the economy how?
    I say it again – just use fiscal policy.

  2. JP Koning says:

    Hey Tony, good points & thanks for kind words. Tim Duy drew an interesting parallel to the 1990s Asian Financial Crisis to which the Fed responded with 75 basis points of rate cuts. If today’s Fed made a mistake that created a crisis of that magnitude, presumably it would have enough room to the downside to offset. ( http://www.bloomberg.com/news/articles/2015-09-15/why-the-fed-is-likely-to-stand-pat-this-week )

    Moving this from an either/or to a shades of grey debate over the existence of asymmetry, we can probably agree that if there are asymmetry risks when interest rates are at 0.25%, new data from Sweden/Denmark/Switzerland in 2014/15 would seem to indicate that those risks are smaller than central banks were led to believe during the 2009-2013 period.

  3. mrkemail2 says:

    It is time now for Tony to admit he wants to ban financial savings. No more euphemisms like “reducing the debt to GDP ratio.” People save money and may buy things with it in the future ahh INFLATION and that is a terrible terrible thing.

    The Post Keynesian view of endogenous money creation changes the view on the causal relationships within the economy. It brings money and finance centre stage, rather than abstracting it out of existence as the Neo-Keynesians do.

    Firstly it allows the build up of excess savings in the non-goverment sector – these ‘savings net of investment’ – and it allows them to build up first in the causal chain. That means that the non-government sector can be seen as ‘pushing’ money onto the government sector. This is the view that MMT takes and bases its economic model upon – the non-government sector is the one doing the ‘net saving’ which the government sector then has to react to.

    With a Neo-Keynesian model it cannot – the government has to be ‘pulling’ money from the non-government sector – the government sector is over spending and the private sector is reacting to that. The current Neo-Keynesian viewpoint is why all governments are talking about cutting spending, trying to avoid ‘pulling’ money from the private sector because they believe that is what is stopping the private sector spending.

    Secondly it allows the build up of an excess of private sector debt. Banks can push debt and are not constrained by having to fund the debt because the debt funds itself by its very creation. This leads to dynamic instability in the system and a collapse due to the funding of ponzi schemes. This is the area where Steve Keen and the Modern Circuit Theorists operate and drives their view that the level of private debt must be controlled to prevent any more ‘Minsky Moments’ like we saw in the GFC.

    In the Neo-Keynesian model the level of private debt is a distributional issue and has limited or no effect on the macroeconomy. Banks cannot lend in excess of savings and will be brought under control ‘in the long term’. And this is why government isn’t panicking about the 450% private debt levels in the UK, and its economic strategy involves pushing more debt onto the non-government sector in an attempt to kick-start the economy.

    Thirdly it allows these excesses to persist ‘into the long term’ (that favourite cop-out phrase of all economists). The Post Keynesian view doesn’t see an automatic return to equilibrium – savings can stay in excess of investment for a very long time indeed. Certainly long enough to affect pension planning and the like. So you get persistent trade deficits and you get persistent government deficits due to the dynamics of the money system. Therefore policy must deal with these conditions. MMT’s choice to accommodate those savings defers the issue of dealing with them to the future. You deal with them if and when they become spending in excess of your economy’s ability to cope in the future. Chances are they won’t and the impact will be smaller in the future because you’re building a stronger economy today.

    In the Neo-Keynesian view that must all resolve itself ‘in the long term’. So you get the line that the central bank ‘must’ put up its interest rates if government runs a persistent deficit and that the trade deficit ‘must’ be repaid in the future at some point. In their view you have to get rid of excess government spending/trade deficit now because you will have to deal with the results of that excess in the future and it’ll be a bigger problem then. Hence the lines about enslaving our grandchildren, etc.

    Why do you want to push households further into debt? Why do you want to pay foreigners to save, by issuing over half of Gilts to them, rather than having National Savings, worsening the UK’s current account deficit?

    You can’t push more debt on households. Can’t work. Won’t work. 2008 showed that. And why would you want to anyway?

    • Tim Young says:

      You need to be a bit careful about the 450% figure. This is a gross figure, and will be driven higher by intermediation.

      But personally, I don’t think that the growth of debt is a product of the present financial system. In my opinion, it has grown up because of unprincipled management by the economic authorities. Time and time again, going back to at least the LTCM crisis of 1998, the economic authorities have been faced with an incipient minor crisis associated with reckless growth of risky debt, and bottled it, compromising their policies to let the debtors, and therefore their lenders, off the hook, with easier monetary policy (eg the Fed cut interest rates in 1998 to “address the seizing-up of financial markets”, not because inflation was heading down). In short, the build-up of debt has been associated with moral hazard engendered by the reactions of the economic authorities.

      Central bank independence ought to be the rock that resists this backsliding, but it has become clear that central banks can be subverted by governments’ power to pack monetary policy committees with doves. As soon as I heard Bernanke’s “Deflation: making sure it doesn’t happen here” speech, I was sure that he was going to be made Fed Chairman. Janet Yellen spoke against the Fed resisting the US housing bubble in 2005. In Japan, we have Kuroda; in the Eurozone we have Draghi. More recently and relevant to the UK, we had the appointment of another obscure economist to the MPC, who, according to the FT’s report of his appointment, had done research on “…..how monetary policy should be set optimally following an adverse productivity shock”, which concluded that “the central bank should allow for a temporary rise in inflation, as this will lead to more stable output and asset prices.” So brazen has the present government become about his process that George Osborne can declare his approach to be “fiscal conservatism and monetary activism” without demur from the BoE, The MPC has got itself into a trap in which it would probably be impossible for the MPC to respond to any emerging inflation threat without precipitating another financial crisis. My prediction is that our host, 4% Tony, will in due course, join the MPC.

      The problem is not the financial system, but the people that are put in charge of it.

      • mrkemail2 says:

        “The problem is not the financial system, but the people that are put in charge of it.”
        You don’t like democracy much do you?

      • Tim Young says:

        Independent central banks are not really undemocratic, as their policymakers are appointed by democratically elected politicians to pursue a mandate and remit established and updated by democratically elected politicians. The trouble, I think, is that this is not being operated honestly. The politicians know that it would be politically costly to openly change their central bank’s objectives, so they appoint people who, for whatever reason, signal that they would be inclined to err on the easy side when pursuing those objectives, thus allowing politicians to have their cake (a claim to be prudent economic managers) and eat it (buoyant asset prices and economic activity for the voters).

      • mrkemail2 says:

        “independent central banks are not really undemocratic, as their policymakers are appointed by democratically elected politicians ”
        In other words it is a total sham. Close the sham please.
        Vote for Corbyn if you dislike current policy.

      • mrkemail2 says:

        Why do you think we need to raise interest rates?
        Leave them at zero.

      • Tim Young says:

        Why do I think that we need to raise interest rates?

        Actually, I would start tightening by unwinding QE, but let’s consider why I believe we need to tighten monetary policy in some way.

        Because, as I mentioned above, the BoE is getting itself into a trap in which, it could not respond to an emerging inflationary threat without precipitating a financial crisis. Even if we disregard the BoE’s financial stability responsibilities, the least line of resistance in such circumstances would probably be to let inflation rise. In my view, therefore, given that the BoE’s remit says that the inflation target is supposed to be met “at all times”, even if present inflation is close to zero and market expectations of inflation are not way above the target (they are above it from the short-term out), there is a case for even a single mandate inflation-targeting central bank to tighten now.

        In terms of real people, every day that monetary policy is this loose, more people are taking in debt, especially mortgage debt, that they know, and I find readily admit, that they would be unable to service if mortgage rates returned to anything like their average in recent history. If the BoE raised interest rates substantially, there would be widespread defaults, likely precipitating a collapse in house prices, given their gross over-valuation in relation to income, which may bring down some banks, not to mention increasing the fiscal deficit, as tax income falls, welfare payments rise and the government sustains its own losses on its Help to Buy scheme.

        The UK is running along the edge of a cliff at the moment, and a responsible BoE (which it has ceased to be in my opinion) ought to be erring on the side of steering away from the edge.

      • Tim Young says:

        “”independent central banks are not really undemocratic, as their policymakers are appointed by democratically elected politicians”. In other words it is a total sham.”

        Would you say that the US Supreme Court, appointed in a similar way, is sham democracy?

      • mrkemail2 says:

        “Because, as I mentioned above, the BoE is getting itself into a trap in which, it could not respond to an emerging inflationary threat without precipitating a financial crisis. ”
        What inflationary threat?

      • mrkemail2 says:

        “Would you say that the US Supreme Court, appointed in a similar way, is sham democracy?”
        Yes the US Supreme Court is extremely undemocratic and has made decisions such as Citizens United that have benefited large corporations. They can overrule Congressional legislation.
        Same with gerrymandering in the house.
        US system was designed for gridlock.

      • mrkemail2 says:

        “The UK is running along the edge of a cliff at the moment, and a responsible BoE (which it has ceased to be in my opinion) ought to be erring on the side of steering away from the edge.”
        Creating a recession is “steering away from the edge”??

      • mrkemail2 says:

        All I can say is thank God you are not anywhere near the levels of power and don’t get to lord over the rest of us (except for people like you in the EU.)
        “In terms of real people, every day that monetary policy is this loose, more people are taking in debt, especially mortgage debt, that they know, and I find readily admit, that they would be unable to service if mortgage rates returned to anything like their average in recent history. If the BoE raised interest rates substantially, there would be widespread defaults, likely precipitating a collapse in house prices, given their gross over-valuation in relation to income, which may bring down some banks, not to mention increasing the fiscal deficit, as tax income falls, welfare payments rise and the government sustains its own losses on its Help to Buy scheme.”
        Quite a nice little dystopia you have there Tim.
        In other words deliberately push the economy into recession because it might hurt some people you dislike, making everyone absolutely worse off for no particular reason whatsoever.
        Those evil households have broken the sanctity of debt and deserve to be punished! Sinners!
        “Because, as I mentioned above, the BoE is getting itself into a trap in which, it could not respond to an emerging inflationary threat without precipitating a financial crisis. Even if we disregard the BoE’s financial stability responsibilities, the least line of resistance in such circumstances would probably be to let inflation rise. In my view, therefore, given that the BoE’s remit says that the inflation target is supposed to be met “at all times”, even if present inflation is close to zero and market expectations of inflation are not way above the target (they are above it from the short-term out), there is a case for even a single mandate inflation-targeting central bank to tighten now.”

        Whereas the blessed savers and creditors must preserve the real value of their savings and get free corporate welfare even if it means sacrificing real output.

        “Respond to future inflation” we have to raise rates so we can cut them what crazy logic is that.

        The “normal” rate is zero and without the corporate welfare it would be driven to zero.

      • Tim Young says:

        What inflationary threat? We do not know, but what we can say is that if one comes along, when people have come to plan on the basis of the present very easy stance of monetary policy being permanent, we are in trouble.

        And if moving monetary policy towards normal causes an economic downturn, I would argue that this is worthwhile to avoid a bigger one if monetary policy does get trapped. A stitch in time….

        It is not necessary to discuss monetary conservatism with reference to religion, morality etc; the idea just reflects time-honoured experience, formalised by economists in game theory, that predictability in repeated games tends to yield a better collective outcome, because people waste less resources considering, preparing for and even trying to engineer, changes of the economic framework in which they operate. I would attribute some of Germany’s economic success to their tradition of monetary stability.

      • mrkemail2 says:

        “What inflationary threat? We do not know, but what we can say is that if one comes along, when people have come to plan on the basis of the present very easy stance of monetary policy being permanent, we are in trouble.”
        What a load of complete nonsense.
        “X is right because maybe X is right.”
        You are not going to permanently depress the economy because there might be inflation in the future.
        You have demand and supply side inflation.
        Why are we “in trouble” due to demand side inflation, cut spending and increase taxes.
        How the hell is the central bank going to help with supply side inflation, due to lack of competition?
        “It is not necessary to discuss monetary conservatism with reference to religion, morality etc; the idea just reflects time-honoured experience, formalised by economists in game theory, that predictability in repeated games tends to yield a better collective outcome”
        Guess what is the most predictable? Zero interest rates permanently!
        Why Japan is considered stable.

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