Immaculate conception theories of real interest rate changes

by on July 8, 2013 at 7:07 am in Economics, Uncategorized | Permalink

David Glasner asks some very good questions about real rates of interest.  Here is one bit:

…what we see is a steady decline in real interest rates from over 2% at the start of the initial QE program till real rates bottomed out in early 2012 at just over -1%. So, over a period of three years, there was a steady 3% decline in real interest rates. This was no temporary phenomenon; it was a sustained trend. I have yet to hear anyone explain how the Fed could have single-handedly produced a steady downward trend in real interest rates by way of monetary expansion over a period of three years. To claim that decline in real interest rates was caused by monetary expansion on the part of the Fed flatly contradicts everything that we think we know about the determination of real interest rates.

These days, Fed policy is more contractionary (if only verbally) and real and nominal rates are rising.  The most plausible account of this process is that flows not stocks drive the market, and thus the Fed has enormous power over real rates, although like Krugman I find this tough to swallow.  “Most plausible” does not equal “plausible.”

(By the way, the older literature does find liquidity effects on short-term real interest rates, but it is not unusual for them to disappear well within the space of a year; see for instance this John Cochrane piece (pdf).  That said, Cochrane also finds a liquidity effect on the twenty-year note, which combined with the temporary nature of the short rate effect seems to suggest an unexploited profit opportunity.  Note by the way that Cochrane did his dissertation on this topic.  Or try this Grier and Perry paper (pdf).  Evans and Marshall (pdf) find no significant liquidity effect on long rates and that is the same Charles Evans who is now president of the Chicago Fed.)

Another possibility is that we are seeing a recovery and real rates of return are rising.  I don’t find that crazy per se, but it doesn’t explain why the rise in real rates marched in lockstep with Fedspeak.  I don’t think “the Fed has private information about the recovery, so their announced contraction caused everyone to break out the champagne” is going to work, especially once we look at asset price movements.

Krugman yesterday argued that his earlier prediction was not wrong about interest rates, but he doesn’t commit to a mechanism for what is driving real interest rates up as of late and the plausible mechanisms do seem to contradict his (and my) earlier views.  So what if the Fed backs off on QE over an extended period of time?  That shouldn’t be significantly driving real rates ten years out unless of course one believes in the “primacy of flows” view, which Krugman does not.  He’s already told us he doesn’t see a major recovery, or even much hope from the obsolescence of capital, so he can’t invoke rising returns from the real side of the economy either, even if we set aside the problems mentioned in the paragraph above.

Another “way out” is to claim we are mismeasuring inflation and also real interest rates, but I don’t see much promise in that.  The most plausible CPI mismeasurements span very long time periods (say now vs. 1900), not now vs. ten years out.  Alternatively, one might argue “inflation will be higher than we think in years 3-10 looking forward, so the ten year real rate isn’t actually up very much.”  That will fail on numerous grounds, for one thing, money just got tighter.

So we have one implausible theory — the primacy of flows view — and a lot of worse contenders.  The only people with a good predictive record on this particular issue are the Old Old Keynesians (e.g., money pushes around real interest rates more or less forever) and perhaps some of the cruder, pre-adaptive expectations Austrian views, although neither of those approaches has a good predictive record more generally.

Arnold Kling makes numerous good points here.  He suggests that the profession’s understanding of real and nominal interest rates is extremely poor.  He is right.

In the meantime, we should put more effort into thinking about how a version of the flows view could be made more plausible.

1 Josh July 8, 2013 at 7:35 am

TC,

Krugman has always argued that even long-term rates are driven by liquidity effects. Unlike, Sumner, he seems confident that more QE will push down 10-year rates. Suppose we are in a world in which investors expect that we can be at the ZLB for a long time without high inflation or completely eliminating the demand shortfall. An optimal Fed would keep nominal rates at zero for a long time, and any deviation from that policy leads to higher long-term rates. Normally, tighter money or signals of future tighter money might push down long-term rates because it would lead to a recession and then lower short-term rates to combat the recession. But the market may already believe that, even if the Fed did everything right, short-term rates must be at the lower bound for some time.

2 Tyler Cowen July 8, 2013 at 7:49 am

But “liquidity effects” are driven by the “flows view” which he rejects elsewhere. And we’re not at ZLB any more.

3 david July 8, 2013 at 9:03 am

There’s a non-negligible probability of returning to the ZLB in near-term states of the world, so ZLB dynamics would still continue to influence the planned consumption path…

4 Doug July 8, 2013 at 11:42 am

I don’t see why economists think its so unlikely that QE lowers real rates, when virtually every bond trader takes it as a given. Analogously we see corporate stock buybacks sustainably raise the price of individual equities. So why wouldn’t “bond buybacks” have the same effect?

Yes there may be tons of treasury stocks sitting out there relative to QE flows, but the reality is the vast majority of those bond-holders are highly price inelastic. Many institutional holders are required to hold a certain percentage of their assets in bonds and match duration to the liabilities. They’re essentially forced to hold treasury exposure regardless of how expensive they are. Same pretty much holds true with foreign central banks.

At the end of the day the “elastic stock” of treasuries, investors tactically shifting their allocation based on bond richness, is actually relatively small and certainly on par with QE magnitudes.

5 Frederic Mari July 8, 2013 at 1:55 pm

+1.

I too don’t see what’s so mysterious about flows driving prices when stocks are, well, stocked somewhere and barely ever traded… To some degree, it’s also true for equities inasmuch as the market does follow mutual funds inflows/outflows and, whether rightly or wrongly, does attribute ‘some’ explaining power to these flows… And, again, while equity allocations are a lot more tactical than Treasuries’ ones, a lot of people do ‘buy and hold’…

6 Bryan Willman July 8, 2013 at 3:16 pm

Consider too the pool of investors engaging in revolving hold to maturity. You buy T-bills, tax-free-munis, whatever, and just collect whatever payment (sometimes 0) until they mature. Then you do it again.

While such investors may be very very sensitive to default risk, if they’re not trying to live on the interest but are simply “holding mattress money” they may care very little indeed about interest rates or market price change risk. They in effect add to the pool of entites that are one way or another required to hold treasuries as offsets, collateral, etc.

So in some sense prices will be set by some relatively small part of the flows (let alone the stock) trading amongst parties who are active traders.

Likewise, it’s been pointed out a couple of places that there’s a fair sized market based around short loans which are collateralized by treasuries. Participants in that market presumably need to hold a sizeable pool of treasuries to use as collateral in their repo and other market activities (related Doug’s base point)

So maybe the real question is – what have real interest rates on everything OTHER than treasuries done, and to what extent can be that be explained by real conditions versus Fed behavoir (or Fed proclimations.)

7 mark July 8, 2013 at 6:28 pm

Exactly right. All the Fed did was keep hitting the asking price until the rates went where it wanted. iThis is just supply and demand and marginal buyer / seller dynamics. It’s no different than the Hunts and silver, or JPMorgan and the credit derivative index. Frankly it’s no different than pump n’ dump schemes re penny stocks. If someone concentrates enough money on one type of financial asset, they can drive its price up. And the Fed has essentially unlimited funds so, duh, they drove the price up of what they wanted. And since they told the market the ultimate price they were aiming for, dealers could be sure to buy their inventory for less than what the Fed would pay. So the players that might otherwise have challenged them, a la Soros and the pound, were bought off and incented to play along. It helped that QE drove up all other financial asset prices, especially leveraged longs, so that the financial market players were incented to go along for the ride, which was making them all rich. Any theory at odds with the reality ought to be discarded as opposed to being defended.

8 Mark T July 8, 2013 at 6:43 pm

Recommend this Zero Hedge post on how QE worked operationally.

http://www.zerohedge.com/article/meet-feds-pomo-desk-which-doesnt-even-have-bloomberg-terminals

9 david July 8, 2013 at 7:58 am

Asking post-Samuelsonian-Revolution economics to explain how real rates come about is like asking it to explain how the real price of anything comes about: it just does, bugger if we know how preferences are formed! And this is exactly how a “demand for real money balances” turns up in household demand functions, don’t they?

The magic of business-cycle Macro being explaining how an ex nihilo increase in demand for real balances can explain everything else that happens to macro aggregates. We’re not then asked to explain where the increase comes from. Constructing consistent stories – consistent with non-datamined available evidence, and consistent with themselves – is hard enough. Explaining where long-term real rates come from is for the long-term growth guys – and god, if you think business-cycle macro is bad science, wait till you see long-term growth.

10 crs July 8, 2013 at 9:12 am

this is not an academic (or magical) question. what to expect going forward with rates should bear some connection to how we got here … unlikely to narrow down to one winning theory but can think (seriously) through some plausible, competing mechanisms. “unconventional” may apply to more than policy right now.

11 Max July 8, 2013 at 8:15 am

Economies don’t teeter on a knife edge between hyperinflation and hyperdeflation. They are more stable than that, which implies that central banks have some ability to set real interest rates, although not an unlimited ability.

12 JohnC July 8, 2013 at 8:41 am

The Immaculate Conception does not mean what you seem to think it means.

13 Andrew' July 8, 2013 at 2:03 pm

Yah, here’s a knock knock joke:

Knock Knock

14 Brian Donohue July 8, 2013 at 9:11 am

“[Kling] suggests that the profession’s understanding of real and nominal interest rates is extremely poor. He is right.”

This does not get in the way of confident assertions from Tinkertoy modelers.

Whatever else is going on, real interest rates must be much lower now than 30 years ago on purely demographic grounds.

15 Brian July 8, 2013 at 9:41 am

Real rates went down because investors feared inflation and were willing to accept a negative rate of return. Lots of people will accept negative real rates. Example: People who invest in gold, unrentable properties, and uncompleted property developments that stay uncompleted for years. This happens in Asia. Was this lock step with Fed Speak? If it did then it’s partly coincidental because the Europe sovereign debt crisis was still making headlines as rates went down.

Real rates went up because less bond buying by the Fed means that more investors believe in the recovery and demand real rates that are not as negative as before.

This is not a flows explanation. The entire inventory of bonds is assumed to be available for sale and therefore if held, it is willingly held at the rate that is current; at all times.

16 Andrew July 8, 2013 at 9:43 am

So, was his prediction wrong?

17 Edward Lambert July 8, 2013 at 9:54 am

Tyler, My view is that we are seeing a recovery, just at a lower level of labor and capital utilization due to low labor income share. It is still a recovery at this lower level with the dynamics of a recovery. I leave you my analysis of past time periods leading up to recessions where effective demand constrained utilization of labor and capital. We are actually nearing the top end of the business cycle according to the analysis.
http://effectivedemand.typepad.com/ed/2013/07/true-potential-real-gdp-looking-at-previous-recessions.html

18 Andrew' July 8, 2013 at 11:09 am

This looks amazing, though I’m not qualified to judge. You’ll know you’ve almost gotten somewhere when PK calls you a name.

19 Edward Lambert July 8, 2013 at 12:28 pm

I haven’t been called a name by PK yet.

20 Andrew' July 8, 2013 at 1:14 pm

The day is young.

21 bryan willman July 8, 2013 at 3:26 pm

Do you count household earnings via stocks, bonds, etc. are “labor share?” As the demographic drifts older, the cash available to create “effective demand” will rise somewhat because some part of the population is holding investments which pay returns.
(Though appreciation only stocks can create a real problem – “wealth” increases, but cash spendable as “effective demand” does not…)

22 Edward Lambert July 8, 2013 at 6:29 pm

Bryan, I use the labor share number from the Bureau of labor statistics. Specifically I use the business sector labor share. There are papers that describe how they determine labor share. And through history there have been changes how it is determined.
Between capital income and labor income there is a grey area where some funds from each cross over into the other’s income. Basically labor income should be spent on consumption, and capital income should be spent on the means of production to produce goods for consumption. The way that I determine the effective labor share is to graph labor share index with capacity utilization. Then I pull out the central tendency line with a y-intercept of zero.
http://effectivedemand.typepad.com/ed/2013/03/what-is-effective-labor-share.html

The slope of the central tendency line gives the “effective” labor share that determines the constraints of capacity utilization. So with all the mix of stock income, bonds income, rental income, retained earnings, etc… the economic data itself filters out the gray area. As long as the Bureau of labor statistics keeps the same system for determining labor share, the “effective” conversion will hold. One thing I know, government numbers are far from perfect. I have found lots of discrepancies where numbers that should match up don’t. But the conversion of labor share into effective labor share has been reliable for me. There is some wobble in the number through the years. It takes some research to understand the inaccuracy of the government numbers. But the principles of effective demand have held up well in spite of the bad numbers. It helps to know which numbers are bad too. Here is one example…
http://effectivedemand.typepad.com/ed/2013/07/real-compensation-per-hour-was-over-valued-from-the-1950s-to-the-1990s.html

23 F.F. Wiley July 8, 2013 at 9:57 am

I suggest starting with the expectations theory of the term structure, allowing for real life behaviors like anchoring and availability heuristics and herding, and then mixing in signaling effects. Also consider that for many fixed income traders and investors, carry trading and reaching for yield is just about the only strategy they know. This gets you fairly close to the risk-on, risk-off (or carry trade-on, carry trade-off) that we see.

IMO the problem with much of the theory discussed above is that it doesn’t adequately differentiate between different parts of the yield curve or account for “irrational” behaviors, regime changes, global factors and more. It’s way too simplistic. Same thing about the ideas about inflation in some of the posts linked above – how can you possibly expect to capture inflation with really simple closed economy formulas when such a large piece of it is based on global factors?

24 jdm July 8, 2013 at 10:05 am

“In the meantime, we should put more effort into thinking about how a version of the flows view could be made more plausible.”

I find this formulation slightly unsettling. It sounds like casting around to find reasons to believe a hypothesis rather than thinking about how the hypothesis can be tested. How about: “In the meantime, we should put more effort into thinking about what well specified testable predictions are implied by the flows view and then look at historical and cross country data to see if these predictions are (were) correct.”

25 Boonton July 8, 2013 at 10:20 am

A decline in real interest rates does make sense from a Keynesian model combined with Krugman being right yet again (sorry to break it to those praying for a Krugman mashup). The gov’t is doing maybe a D+ to C- job addressing the Great Recession in Demand by stimulus (fiscal and monetary sides). Because the market expects demand to be less than it should for the next ten years or so, real interest rates are lower. Less demand means less need for investment goods to produce goods and services. Less need for investment goods means less need to reward savers for foregoing consumption today in order to boost production tomorrow.

The lower real interest rates aren’t being caused by the Fed printing money, they are caused by the Fed not printing enough money! (And the gov’t not spending enough money!). Signs of recovery may get real interest rates to pop up again but expected below average growth for a prolonged period of time would be expected to produce lower real interest rates.

Likewise the timing may be due to the realization of the nature of this recession. Back in 2009-2010 a sizeable portion of the market may have brought into both GOP and Democratic predictions…the Obama stimulus was ‘massive’, that this recession would look like other ones and generate a recovery in a year or two. Only by 2011-2012 did it sink in that not only was the recession massive, but the political system would freeze up and short-circuit real stimulus leading us instead to a prolonged period of very slow recovery.

26 Brian Donohue July 8, 2013 at 10:33 am

Tinkertoy to the rescue!

27 Boonton July 8, 2013 at 10:50 am

Perhaps but at the most fundamental level what is a ‘real interest rate’? It’s the real reward for deferring consumption today. Why would that be rewarded?

Well in a full employment economy, the market is pushing as hard as it can to keep up with demand for consumption goods. The ‘old widow’ who deferrs consuming all her savings is providing the market with valuable space to use that savings to add investment goods so production can expand. Her income represents a ‘real reward’ in future consumption for her decision not to blow her savings on consumption today.

If I said demand was esp. high, then it makes sense that her ‘real reward’ becomes even higher. That’s about as ‘tinkertoyish’ as supply/demand 101.

OK so why wouldn’t this model work in reverse? If the market generates a ‘real reward/return’ to savers in order to decrease the demand for current consumption in order to provide for investment for future production then why wouldn’t the market also generate lower ‘real returns’ should current consumption be too low and there is little need for investment to fund expected future production?

If I’m running an electric utility and I find customers are only demanding 80% of my potential output why would I pay Old Widow Martha 6% to loan me her nest egg so I could build a new power plant? Instead I’d rather Old Widow Martha crank up her central air, get a 700 inch flat screen TV and run it day and night and plug in dozens of other gadgets instead! I can’t force her to do that but I can say no to paying her 6% on saved money!

28 Brian Donohue July 8, 2013 at 10:57 am

“It’s the real reward for deferring consumption today. Why would that be rewarded?”

Because, all else equal, people prefer $1 of consumption today to $1 of consumption tomorrow. No long-winded Tinkertoy explanation needed.

29 Boonton July 8, 2013 at 11:15 am

OK but that doesn’t say why the reward is available? I may be willing to trade $1 today for $2 tomorrow but for that to happen I need someone else who is willing to give me $2 tomorrow in exchange for my $1 today. (And why $2? Why not $3 or $4 or $1.01?). The other side of the transaction happens if you have opportunities for investment and a reason to believe such investment made today would enable you to easily pay back the debt tomorrow. Only in that world does the electric utility take the widow’s savings, builds a new power plant, and in the future finds it easy to offer her more consumption than she gave up in the present.

Sorry for being long winded but at its core it’s very simple. Today we aren’t consuming enough so the market is providing no or very slim rewards for deferring consumption. Hence very low real interest rates. The Fed isn’t causing low real rates, the Fed is chasing the real rates down with additional money printing

30 KT July 8, 2013 at 11:26 am

Boonton, please give me all of your savings. I promise to return to you 100% of the nominal amount 10 years from now.

31 Boonton July 8, 2013 at 11:35 am

Sounds great KT, except over there is a chap who will return 110% in ten years…why would I go with you rather than him?

But then if there’s no chap over there, I’m stuck with just your offer and my general inclination to enjoy that money today versus enjoying it ten years from now. If I’m esp. worried about consumption 10 years from now I may have to accept your offer even if I fear I may lose something to inflation or if the reward is pretty pathetic compared to what I could have earned in other periods of history.

32 mulp July 8, 2013 at 1:05 pm

But if you can return the money in ten years, you already have the money and don’t need it.

If you really need the money, you are earning $100 with bills of $150, and you would like to spend $200.

Your advantage is the people with money are so desperate to do something with it, they might loan you the money in the hope Obama beats the Republicans and showers you with $500 somehow.

In 1980, you made $100 in goods and services and got paid $100 and bought $100. But the theory since is all increase in productivity belongs to the capitalists, today you produce $200 in goods, but get paid $100, and struggle and buy $110. Which means there is excess, so only $150 is sold, the $50 goes to the capitalist who spends $10 of it buying, but then puts $40 in the bank, which loans it to the government to give money to the guys he laid off, and loans $10 to you to buy a bit more – your consumer surplus. A third of the workers are now unemployed and getting money from government that is borrowed from the capitalists who get all the productivity gain but can’t possibly spend it.

What do you think Mitt Romney does with all his returns to capital in the tens of millions? Step up his buying of iPhones to two per week? Or he goes to Burger King five times a day and buys two burgers each trip? No, he put in someplace where their loan it to the workers at Staples working for just over minimum wages with expectations of living like their union factory worker dad in the 60s who earned four times the minimum wage.

33 Boonton July 8, 2013 at 1:54 pm

mulp

I don’t think it really has anything to do with those who have money being ‘desperate’ to do something with it. Saving can just as easily be channelled into consumption. For example, the ‘old widow’ can opt not to consume today but her bank will give credit cards to 20-something kids with that savings. In that case one person’s savings is offset by someone else’s consumption. Or the guy running the electric company may sell bonds to the widow, loot the company’s assets and ride out on a ‘golden parachute’…in that case too her lack of consumption was transmitted to someone else’s surplus consumption.

But barring fraud and confidence games, the interest rate is saying I will give you $X today and tomorrow you will give me $Y. In the case of 20-somethings and credit cards what you may have is simple consumption smoothing where the 20-somethings are making their lifestyle today somewhat nicer at the expense of their expected lifestyle in their 30’s. This is more or less offset by the ‘old widow’ whose willing to reduce her consumption today (no trip around the world) because she finds it more important to ensure ten years from now she can afford her heating bill. So let’s say one element to this story is a demographic piece. Lots of 20-somethings mean greater demand than there is supply, hence a higher rate. Fewer could mean the reverse. But demographic trends tend to move slowly.

The other component is the investment one. The old widow does without a vacation ’round the world this year. Her decision not to consume that means instead the electric company is able to by a piece of a new plant they are building via the financial system. Tomorrow the widow is able to heat her house because the electric plant made those investments in the past.

This piece is more critical IMO because it brings into consideration multiple factors. One is whether or not there are profitable investments to make. If the electric plant is brand new and is expected to be in great working order for the next 50 years why build a new one? The other side is demand related. If you build it will they come? If 40% of the houses on the grid are in foreclosure and vacant then what will demand for power look like in 5 years? 10 years?

If you’re projecting a fast recovery, then demand will ramp up quickly and in 5 or 10 years you may find your capacity beng taxed. Invest now to ensure you can meet it. if you’re projecting a slow recovery, then your existing plant is just fine. Don’t bother investing beyond what is absolutely necessary to keep the lights going.

Keynesian theory would say the demographic side changes very slowly so you wouldn’t expect dramatic swings to be attributable to it. On the investment side you may run out of ‘new investments’ to make but not investments to meet rising demand. Even if there’s nothing you can do to make your plant better, twice as many customers would justify building another plant. But falling or flat demand is fatal.

Previous recessions have been marked by fast recoveries after modest amounts of stimulus on the fiscal and monetary side. That would justify a positive real interest rate since when recovery happens you want to have the capital to meet the return of demand. But if the market unhappily discovers the political system will not act to correct a recession with aggressive enough stimulus, then the reward for investing falls. If that happens why pay savers a higher real return?

34 Joel W July 8, 2013 at 10:29 am

Andy Harless had a good post suggesting that this may be due to a shift from a bad equilibrium to a good one, and that this is under discussed: http://blog.andyharless.com/2013/07/taper-paradox.html
It explains, among other things why the suggestion of tapering 1) increased yields, 2) now seems not to have lowered inflation expectations (judging by 5 year and 10 year TIPS spreads), and 3) has not sent stocks plummeting despite increased yields.

35 Brian Donohue July 8, 2013 at 10:40 am

Interesting. Evan Soltas offered another interesting metaphor too in the comments section.

36 derek July 8, 2013 at 10:53 am

I’d look at literature describing the ups and downs of price fixing schemes.

First, I’d ask if the official interest rate is actually the going rate. It seems to be in one sense, high quality corporate bonds are about the same. On the other hand money isn’t being lent at a normal rate, which tells me that it isn’t.

Second, I’d look to see what proportion of the Treasury market is owned by the Fed. It is substantial, the price they pay is what the price is.

Third, what did the market tell us when the Fed hinted in the vaguest way that they would pull their price support for the 10 year? The market believed that they are setting the price because it moved almost a percentage point up in a very short time.

I suspect that there is much risk built on the stable foundations of the US Treasury bonds. Either off balance sheet or off shore, and it represents the real economy, the real rates at which folks are willing to lend their money. I suspect the Fed has watched this happen, it is the folks that they saved in 2009 who are doing it, and see that it is getting out of control and out of hand, and extremely fragile. I suspect it wasn’t the vastly improved US economy that moved them to suggest that they would be tapering back on their price controls, but their fear of this vast financial structure. They were seeing a divergence between their fixed rate and the real rate.

Isn’t a real rate and an official rate a characteristic of price control schemes?

37 mark July 8, 2013 at 6:32 pm

The Fed bought up more than half of all incremental Treasury issuance in recent years. John Taylor’s blog has more precise calculations, I believe in one year it was nearly 75%. Price fixing is a good way to put it.

38 Boonton July 9, 2013 at 9:48 am

Just a rough estimate, in 2008 the debt was about $10T. By the end of FY 2012 it was $16T. Say the Fed did indeed buy up 75% of the $6T increase. That would be owning $4.5T in a market of over $16T. Clearly there’s plenty of people owning debt who would sell to those seeking it and if they thought the Fed was on a wild ‘price fixing scheme’ by printing money they would have a big motivation to sell (most debt is not inflation protected). That’s just a rough estimate

http://www.usgovernmentspending.com/federal_debt says the Fed only owns $1.6T out of a debt currently between $17T-$18T. Buying 8% of the inventory on the market certainly does make one a major player but it seems hard to think that gives you power to set the price in the market, esp. if the market is for a very liquid asset and has many other large players in it.

39 Brian Donohue July 8, 2013 at 11:03 am

One caveat: TIPs only provide information about ‘real interest rates’ to the extent the CPI is an accurate measure of inflation.

At least part of the recent increase in observed ‘real rates’ reflects the possibility of adopting lower “chained CPI” measures.

40 Frank Somatra July 8, 2013 at 11:46 pm

TIPS are guaranteed to be delivered in terms of the real CPI, if I recall correctly. That’s written into their contract, and despite Republican willingness to play chicken otherwise, I don’t think we are going to default on that obligation.

Adopting chained CPI for social security benefits is a different matter entirely.

41 Brian Donohue July 9, 2013 at 8:14 am

Oh ah. Thank you. Not sure it’s completely clear cut though, particularly if CPI-U is discontinued.

“If, while an inflation-protected security is outstanding, the CPI is (1) discontinued, (2) in the judgment of the Secretary, fundamentally altered in a manner materially adverse to the interests of an investor in the security, or (3) in the judgment of the Secretary, altered by legislation or Executive Order in a manner materially adverse to the interests of an investor in the security, Treasury, after consulting with the BLS, will substitute an appropriate alternative index.”

http://www.treasurydirect.gov/instit/statreg/auctreg/auctreg_gsrlist.htm

42 Brian Donohue July 9, 2013 at 8:21 am

Also, as you note, Social Security is based on CPI-W, TIPS are based on CPI_U. I only see reference to one “chained CPI”- not sure if it is a version of CPI-W, CPI-U, or something else altogether.

The differences between CPI-U and CPI-W are trivial anyway, as far as I can tell. The cumulative difference since January 1986 is 0.9% (CPI-U has been a little higher.)

43 Cyrus July 8, 2013 at 12:54 pm

Bond yields have recently risen sharply in spite of
* No change to the QE-infinity program.
* No change to public Fed statements about when QE-infinity might stop.

The only thing that’s changed is the calendar’s approach to that estimated stop.

Unless one subscribes to a theory that bond market participants only recently began believing the Fed’s previous statements about when QE might end, neither Fed policy nor Fed statements about Fed policy seem to be the direct determinant of bond yields.

44 mulp July 8, 2013 at 1:51 pm

Interest rates are low due to the excess supply in face of low demand.

Why this is happening goes to the fact the economics is all zero sum.

Workers can only consume what they are paid for what they produce.

Productivity of workers has doubled, but their pay has barely increased and prices for what they produce has not gone down.

Thus, workers have been borrowing increasingly over the past quarter century to buy more of what they produce.

You might ask why anyone would loan them money?

It is sheer desperation on the part of the banks holding the money of the capitalists who are getting all the money from the increased productivity.

In 2003-2006, bankers were loaning money to people who clearly would never be able to repay it, but the amount of money sloshing around in Wall Street demanded some place to go, so bankers made 99% change of loss seem attractive with 10% interest rates. Meanwhile government was borrowing at 2-3% to pay for consumption of production they intended to destroy, with no plan to repay it because no one wanted to pay for war.

In 2008, the folly of loaning money to people without money became clear, so you never loan money to anyone without money.

Unless it is the US government, which has no plan to repay it, but everyone votes and will vote to have government print money instead of default.

Look at Apple – it is borrowing billions of dollars from Wall Street bankers to pay dividends, secured by $50 billion in cash which they have put with Wall Street bankers.

But the dividends paid will mostly be put with Wall Street bankers, or used to bid up the prices of the declining number of shares because all the high profit cash rich corporations can’t sell more because workers can’t afford to buy what they produce because their wages are still based on producing half as much, and consuming what you make.

As long as wages are held down by the theory that increasing productive generates gains only to the capitalists who can’t possibly consume all the gains of increased productivity, so they put the profits in cash with Wall Street bankers who are pressured to lend to people so they can consume because they are paid far less than the produce, but also faced with government not bailing out either the depositors or the low wage worker borrowers.

Keep in mind the GM was reporting profits because GMAC, its bank, was lending money to workers who needed cars to get to work who were paid too little to buy a car. When “depositors” feared GMAC was a ponzi scheme, GMAC could not pay for buying GM cars so GM went bankrupt, which led to hikes in unemployment making GMAC insolvent. Obama got government to bail them all out from total liquidation using the same money that had been going to GMAC to pay poor people to prop up GM by buying cars they didn’t earn enough to pay for.

When workers produce more than they earn with the capitalists will all the accumulated profits fear lending to their workers so the stuff produced can be consumed, what possible price can that cash demand as interest? Zero percent seems too high – the bank has overhead.

45 Boonton July 8, 2013 at 3:00 pm

mulp

Why this is happening goes to the fact the economics is all zero sum.

This is directly contradicted by your statement that:

Productivity of workers has doubled, but their pay has barely increased and prices for what they produce has not gone down.

That would mean it’s not zero sum. If in year 1 workers produced 200, owners got 50 and workers got 150. Now in year N workers produce 400, they get 150 and owners get 250. It may be unfair that owners see such a dramatic increase in their standard of living but even in that extreme case the fact is it’s not zero sum. Workers are as well off as they were in year 1.

In fact, they are better off since per you post there’s a fast conspiracy by Wall Street to take some of the ‘250’ owners are getting and loan it to workers that ultimately aren’t going to get paid off. So workers real condition would be more like in year 1 they got 150, in year n they still get 150 but they also get to have another 100 through the form of ‘loans’ which are really convoluted ponzi schemes created to rip off the owners.

46 Doug M July 8, 2013 at 3:03 pm

When we say interest rates, it is important to identify which rates we are talking about. The Fed only pins rates at one end of the curve, and the market set rates along the rest of the curve.

The Fed did not create negative interest rates via QE. The fed allowed the market to create negative rates — and might be said due to insufficient QE.

In the dark days of 2009, the expectation was the that the recession would be severe and short, with a rapid recovery. But that isn’t what we got. As market expectations came into line with economic reality, intermediate and long rates fell.

Rates rose over the last 6 weeks because the Fed announced its plans to taper. The Fed started talking about its plans to taper because economic fundamentals were improving. So, perhaps rates would have risen just as much had the fed been completely opaque, as the market sees the same indicators that the Fed does.

47 Bryan Willman July 8, 2013 at 3:33 pm

A repeating error worth thinking about -> Savings does NOT equal “investment” in the real economy.

Jo saver puts their money into treasuries, because that is “safe”. Jo has deferred current consumption to do that. But the vast majority of the money Jo lent to government isn’t spent on anything that creates or increases capacity. It’s mostly transfer payments. Any increase or maintence of capacity arises as a side effect of those transfer payments, not a direct effect.

So to some degree, low interest rates may reflect more fear about the future (storing mattress money) than hope for a better future (investing in the real economy.)

48 Boonton July 8, 2013 at 3:57 pm

You’re not noting the other side of the equation. ‘Joe Saver’ has saved by deferring some of his income from consumption and put his money in a bank. This is offset by “Sue Spender” who consumes more than her income by either withdrawing savings from the bank or tapping a credit card or loan provided by the bank. Sue’s negative saving offsets Joe’s positive to make net saving zero in that example.

Only if Joe Saver’s savings makes its way to a ‘Joe Investor’ for investment will the accounting say the economy has savings and savings will therefore always equal investment.

49 Yancey Ward July 8, 2013 at 6:09 pm

Glad to know that PK hasn’t admitted he is wrong. When he does, the universe goes “Pop!”

50 tom July 8, 2013 at 9:32 pm

I think what PK, Bernanke and other followers of the stocks not flows view fail to realize is that the underlying theory they are relying on is actually a theory of how market flows operate. Market prices are always set by flows and the stocks view is only an effort to explain flows. It can’t be a reason to ignore flows, that’s a basic misunderstanding of the theory.

Analysts who look only at the flows of selling by Treasury and buying by the Fed are of course missing the usually bigger flows of buying and selling by others aka the secondary market. Ignoring those latter flows leads to an overestimation of the importance of the former.

The stocks theory is a very simplistic model of the latter flows. Like all very simplistic models it oversimplifies. Reality is more complex. Surely Fed purchase flows matter, suppressing the market price but not as dramatically as an analysis that ignores trading of existing stoc

51 tom July 8, 2013 at 9:34 pm

ks would suggest. There are also more complex indirect effects on prices, which might go the other direction.

52 Jon July 9, 2013 at 9:17 am

How does treasury buying ever move the market ?

The market can remain irrational longer than you can remain solvent. With a rate target, the relevant market is the market for reserves. This is a tiny market which the fed pushes around easily. Since banks are in aggregate stuck with the ER, there will always be a hot potato of the banks trying to buy other short-dated assets to get more yield. Meanwhile IOR isn’t a market rate, it is prescribed.

Okay, now what happens on the long treasury bond market. Well this is bigger market but not much bigger. A mere 1T in long bonds is outstanding. The fed holds about 50% of the stock of marketable treasury bonds. Are you sure you need to resort to a flows argument? Keep in mind that the other major purchaser of this stuff is life insurance companies who must maturity match.

53 Boonton July 9, 2013 at 9:28 pm

According to http://www.usgovernmentspending.com/federal_debt the Federal Reserve only holds about $1.6T in debt compared to a total debt of between $17T-$18T. The increase in Federal Reserve holding has been smaller than the increase in total debt over the last few years. So both the stock and flow theories are misguided here. The Federal Reserve is NOT ‘fixing prices’. There’s more than ample room for players in the market other than the Fed. to buy or sell debt to counter act any ‘fixed price’.

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