Results for “interest rates risk fed”
58 found

Don’t blame the Fed so much

Slow labor market recovery does not have to mean the core fix is or was nominal in nature, even if the original negative shock was nominal:

Recent critiques have demonstrated that existing attempts to account for the unemployment volatility puzzle of search models are inconsistent with the procylicality of the opportunity cost of employment, the cyclicality of wages, and the volatility of risk-free rates. We propose a model that is immune to these critiques and solves this puzzle by allowing for preferences that generate time-varying risk over the cycle, and so account for observed asset pricing fluctuations, and for human capital accumulation on the job, consistent with existing estimates of returns to labor market experience. Our model reproduces the observed fluctuations in unemployment because hiring a worker is a risky investment with long-duration surplus flows. Intuitively, since the price of risk in our model sharply increases in recessions as observed in the data, the benefit from creating new matches greatly drops, leading to a large decline in job vacancies and an increase in unemployment of the same magnitude as in the data.

That is from a new NBER working paper by Patrick J. Kehoe, Pierlauro Lopez, Virgiliu Midrigan, and Elena Pastorino.  Essentially it is a story of real stickiness, institutional failure yes but not primarily nominal in nature.

Perhaps more explicitly yet, from the new AER Macro journal, by Sylvain Leduc and Zheng Liu:

We show that cyclical fluctuations in search and recruiting intensity are quantitatively important for explaining the weak job recovery from the Great Recession. We demonstrate this result using an estimated labor search model that features endogenous search and recruiting intensity. Since the textbook model with free entry implies constant recruiting intensity, we introduce a cost of vacancy creation, so that firms respond to aggregate shocks by adjusting both vacancies and recruiting intensity. Fluctuations in search and recruiting intensity driven by shocks to productivity and the discount factor help bridge the gap between the actual and model-predicted job-filling rate.

Again, a form of real stickiness more than nominal stickiness.  The claim here is not that the market is doing a perfect job, or that the Great Depression was all about a big holiday, or something about video games that you might see mocked on Twitter.  There is a very real and non-Pareto optimal coordination problem.  Still, this model does not suggest that “lower interest rates” or a higher price inflation target from the Fed, say circa 2015, would have led to a quicker labor market recovery.

Even though the original shock had a huge negative blow to ngdp as a major part of it (which could have been countered more effectively by the Fed at the time).


I am not sure there is any analytical inaccuracy I see on Twitter more often than this one, namely to blame the Fed for being too conservative with monetary policy over the last few years.

And please note these pieces are not weird innovations, they are at the core of modern labor and macro and they are using fully standard methods.  Yet the implications of such search models are hardly ever explored on social media, not even on Facebook or Instagram!  You have a better chance finding them analyzed on

How should the Fed respond to Trump’s comments?

The president tempered his criticism by saying that Chairman Jerome Powell — his own appointee — is a “very good man.” He also stopped short of directly calling on the Fed to stop raising interest rates.

“I’m not thrilled,” he said. “Because we go up and every time you go up they want to raise rates again. I don’t really — I am not happy about it. But at the same time, I’m letting them do what they feel is best.”

Here is the story.

It is probably best for the Fed to simply pretend he did not say this.  Trying to respond simply escalates the dispute and risks a repeat comment.  That said, the Fed may make its future plans concerning interest rates hazier, thereby offering less forward guidance.  That will give Trump less of a target in the short run, and furthermore “the market,” with fuzzier expectations to begin with, won’t be able to estimate whether the Fed was swayed by Trump or not.

In any case, the end result will be a modest increase in economic uncertainty.

I would stress, however, that we do not have a politically independent Fed to begin with.  Such an arrangement is impossible in a democracy, given that current institutional protections for the Fed always can be taken away by Congress and the president.  What we do have is bounds for independence, and those bounds just narrowed, and not for the better.  If I were going to narrow the political independence of the Fed (and I am not advocating this), interest rates are not even the correct variable to choose.  Why not some measure of how much the Fed is aiding the economy in a downturn?  Interest rates may or may not be the most powerful tool there.

The White House itself is trying to pretend the event didn’t happen:

Shortly afterward, the White House issued a statement saying Trump’s comments were merely a “reiteration” of his “long-held positions,” and that his “views on interest rates are well known.”

“Of course the President respects the independence of the Fed,” it said. “He is not interfering with Fed policy decisions.“

And here is another recent remark by Trump, or was it?

Why Germany doesn’t like negative interest rates

The business models of German financial institutions depend critically on the presence of positive nominal interest rates. The International Monetary Fund noted in its latest Financial Stability Report that the pre-tax profits of German and Portuguese banks are most affected by negative rates.

German life insurers are also vulnerable. They have to guarantee a minimum rate of return, which is now 1.25 per cent a year. This is hard to do when the yield of the 10-year German government bond is only 0.13 per cent. Germany and Sweden are the two EU countries where life insurers face the biggest gap between market rates and guaranteed rates. To achieve the promised returns, the insurers have to take on more risk, for example by buying corporate bonds or tranches of complex financial products. If, or rather when, the next financial crisis arrives and triggers a change in the valuation of these assets, we may find that sections of the German financial sector are insolvent.

Of the German banks, the Sparkassen and the mutual savings banks are most affected. They are classic savings and loans outlets in that they lend locally and fund themselves through savings. Credit demand is more or less fixed. So when savings exceed loans, as they now do in Germany, the banks deposit their surplus with the ECB at negative rates — known as “penalty rates” in Germany. They cannot offset the losses by cutting interest rates on savings accounts because of the zero lower bound. Savers would switch from accounts to cash in safe deposit boxes.

That is from the always superb Wolfgang Münchnau at the FT.  Regulatory and federalistic issues are another and underdiscussed reason why the eurozone is not an optimal currency area.

The verdict on the Fed’s interest rate hike

Good job, people.  Just to recap what has been my perspective, here is from my September post, The Paradox of No Market Response:

…the good news scenario is if the Fed’s decision doesn’t matter much for the markets.  Woe unto you if your economy is so fragile that a quarter point or so in the short rate, mixed in with some cheap talk, were to matter so much.

So if at first prices were to stay steady, following any Fed decision, then equities should jump in price.  That is the “no news is good news” theory, so to speak.  It’s a better state of the world if it is common knowledge that the Fed’s actions don’t matter so much in a particular setting.

Equity markets did in fact rise across most of the world, after a slight period of no reaction.  And I wrote:

If I were at the Fed, I would consider a “dare” quarter point increase just to show the world that zero short rates are not considered necessary for prosperity and stability.  Arguably that could lower the risk premium and boost confidence by signaling some private information from the Fed.

Someone at Bloomberg — I can no longer remember who — wrote at the time that this was the worst possible argument they ever had heard in favor of what the Fed was thinking of doing and subsequently did.  Was itOther commentators today have called this a “risk rally,” namely that fear of a prior risk seems to have diminished.

And to recap some broader points:

1. In most periods of crisis, central bankers are too reluctant to use expansionary monetary policy soon enough or strong enough.

2. However true that may be, it doesn’t describe our current situation.

3. Beware of models which rely too heavily on the Phillips curve, and two-factor “inflation rate vs. unemployment” considerations, especially in “long run” situations.  I don’t see that any of the commentators working in this tradition had good predictions this time around.

4. The successful “lift off” still probably won’t matter very much, but better a success than not.  Don’t think that America’s major economic problems somehow have gone away.

The housing shortage and low real interest rates

The mystery of low natural interest rates has become the topic of the hour, and everyone is perplexed by the mystery.  Why are interest rates so low?  Has anybody mentioned housing?  This virus infected everyone’s brain so that we can only believe houses are too expensive or too plentiful, but not the other way around.  So, nobody seems to notice that the return on real estate investments is very high.

I have posted some version of this graph several times.  In the 1970s & 1980s, its tough to get a read on it because there weren’t markets in inflation-adjusted treasury bonds at the time.  But, there is clearly a relationship between real estate returns and real interest rates.  Why wouldn’t there be?

And this relationship broke down at the end of 2007 when we shut down real estate credit markets.  The lack of access to home ownership made real estate returns go up while bond yields were going down.  This is an important signal of financial breakdown, and nobody seems to notice.

So, no.  Natural interest rates are not low.  The real long term natural rate right now is about 2.5%.  If you have tons of cash or you can run the gauntlet and get a mortgage, or if you are an institituional investor going through the difficult organizational process of buying up billions of dollars of rental homes, you get the preferred rate of 4% real returns.

If you aren’t, then you get the “class B” shares of low risk fixed income, which pay about 1% real (3% nominal).

The real estate market is much larger than the treasuries market.  This is a big deal.  This should be just about the only thing anybody is talking about regarding natural rates.  Household real estate is worth about $25 trillion.  If we hadn’t stopped building homes a decade ago, and if home prices did not contain an access premium, there would be more than $40 trillion in real estate.  It dwarfs the size of the treasury market.  That’s why rates have not reacted to large deficits.  The federal government couldn’t realistically accumulate enough debt to make up for the gaping hole we have created in real capital.

We need to make some mortgages and build some houses.  We will not be doing that, because of the virus.  So, it looks to me like we will be wondering about the big interest rate mystery for another decade.

That is all from the always-stimulating Kevin Erdmann, additional graph at the link.

Why are short-term real interest rates so persistently negative these days?

Low productivity will get rates low but not consistently negative.  Why might they be negative is a question raised by Brad DeLong and also Paul Krugman, in response to my earlier post about the natural rate of interest.

The most obvious answer is “risk,” but unfortunately that is directly contrary to the data.  The domestic and global economies have become much less risky since 2008-2009, and yet if anything negative real rates for safe short term assets seem all the more ensconced.

VIX volatility indicators are down (admittedly there is a spike back up since August, but that is not going to do the trick, try the ten-year series too), consumer confidence is back up, and so are business confidence indicators.  The TED spread, Krugman’s own previously favored index of extreme volatility, has been way down for years.  The eurozone crisis of 2011 has passed, at least for the time being.  Some of the emerging economies aside, most market prices are signaling low risk.  So it is strange to invoke high risk to explain current asset prices, when the relevant prices and yields do not seem to be moving with that risk.  If it is indeed risk, it is risk of a kind which we do not know how to measure or perhaps even conceptualize.

The other hypotheses are interesting but unproven, let’s take a look:

1. The Fed.  There is a well-known liquidity effect on short-term real rates, but it is usually pretty small.  Plus German real rates were negative well before the ECB started its QE.  If there is something here, it remains to be shown.

2. Growing corporate demands to hold cash.  This is a secular long-run trend, and most corporations wish to hold safe assets for agency reasons, and that will depress rates of return on those assets.  Maybe there is something here, but again the connection remains to be shown.  But do read Richard Koo from 2004 (pdf) and also see Ed Conard’s book, which discusses why cross-border investment tends to “go safe.”

3. Growing legal and institutional requirements for T-Bills as collateral.  I have played around with this hypothesis, but still its relevance remains to be demonstrated empirically.  Furthermore commercial paper rates may be too low, and that gap too small, for this to be a major factor.

4. CPI mismeasurement.  Maybe the world is seeing more deflation than we are measuring, and short rates aren’t negative at all, as Arnold Kling has suggested.  I’m not myself convinced, but this list is a survey, not a summary of my opinion.

5. Other???

Given those options, it seems to me highly premature to assume we know what is going on with short-term negative real rates.  And it is all the more premature to imagine that a “more negative” set of rates is a solution to our remaining macro problems.  I also am not sure which of the above factors should count as “natural” or “artificial” determinants of rates, so again I find it wiser to not build in those concepts as part of one’s opening terminological gambits.  Most generally, if someone is telling you that the answer to a question about real interest rates is “simple,” they are likely wrong.  Especially these days.

Addendum: You’ll find various perspectives on negative real rates here.

Second addendum: This is not my main point for today, but I consider all of the above further reason for monetary policy to focus on ngdp rather than interest rates.

Should the Fed tighten?

1. I do not know what the Fed should do, and I do not know what the Fed will do.  I don’t even like that phrase “should the Fed tighten?,” but the superior “what kind of multi-dimensional expectational monetary path should the Fed indicate?” is awkward.

2. Starting in 2008, I thought money was too tight during 2007-2011, and in general I am not afraid of upping the dose of inflation, ngdp, however you wish to express it.  I have never had “tight money” in my blood, so to speak.

3. There is good evidence from vacancies and the like that labor markets are fairly tight right now, equities are high and apparently China-robust, and we just had a gdp report of 3.8%.  So something other than more monetary loosening ought not to be out of the question.  Those variables simply cannot be irrelevant for the Fed’s current choice.

4. There is not a stable Phillips curve.  So the lack of strong price inflation does not carry clear labor market implications, nor does it mean we can boost employment through looser money.

5. Often I buy the “asymmetry argument.”  That suggests more price inflation probably won’t hurt us much, but monetary tightening could damage labor markets, so why tighten?  Paul Krugman among others makes this argument.

6. Now the risks look fairly symmetric.  The first reason is that zero short rates for so long might be encouraging excess risk-taking in the financial sector.  This can be the “reach for yield” argument, which in spite of its lack of replicable econometric support commands a lot of loyalty from serious observers within the financial sector itself.

7. The second reason for symmetric risks is that zero short rates for so long might be encouraging zombie companies:

The end of ultra-low interest rates may bode ill for the productivity of British businesses, which is already poor. Output per hour is still lower than before the crisis of 2007, whereas in America and even France it has grown. Tight monetary policy should be bad for productivity, since it makes business investment more expensive. As the cost to businesses of borrowing has fallen by more than half since 2008, investment by firms has risen by 20%. The worry now is that dearer borrowing will curb the investment binge, making productivity even more dismal.

Yet there is another side to the productivity equation. Kristin Forbes, a member of the MPC, points out that, as in Japan in the 1990s, cheap borrowing may allow inefficient “zombie firms” to survive for longer than they normally would. In Britain interest payments as a share of profits have fallen from about 25% in 2009 to 10% today, bringing down company liquidations with them. As they stagger on, zombie firms hold down average productivity levels in their industry and, as a result, put a lid on wage growth. Rising interest rates could slowly start to sort the wheat from the chaff.

That is from from The Economist and of course you can adapt it for an American context.

8. Those two arguments might be meaningful with only a chance of say fifteen percent each, but that still would put the risks in a broadly symmetric position.  I don’t see that the critics have made the case that a mere quarter point rate increase should be so damaging.

9. The contrarian in me rebels when I see article after article, blog post after blog post, consider the monetary policy problem in only two dimensions, namely as would be expressed by a Phillips curve.  See #4.  The “nice view” of monetary policy, as Faust and Leeper suggest (pdf), is probably wrong.

10. If I were at the Fed, I would consider a “dare” quarter point increase just to show the world that zero short rates are not considered necessary for prosperity and stability.  Arguably that could lower the risk premium and boost confidence by signaling some private information from the Fed.  But it’s a risk too — what if the zero rates are necessary?

11. The prospect of a stronger dollar, and the subsequent hit on American exports, remains a domestic reason not to let rates rise.  I doubt if it is a global Benthamite reason, but it is probably a reason held by some within the Fed.

12. The biggest piece of information here is that both Janet Yellen and Stanley Fischer both seem genuinely uncertain as to what the Fed should do.  No, they haven’t been absorbed by the hard money Borg.  They have their own version of these arguments and it seems they see the risks as being relatively symmetric, and thus the correct monetary policy choice is far from obvious.  No one has yet said anything that is smarter or more potent in Bayesian terms than what they probably are thinking.

13. Let’s say the Fed did decide to allow rates to rise.  How exactly would they make that happen?  How hard would it prove to accomplish?  That’s an under-discussed angle to all of this.  And the Fed might either wish to postpone this curiosity or get it over with, another set of symmetric risks.

We’ll know more soon.

What would Fedcoin look like?

JW,  a loyal MR reader, writes to me:

It’s 2018, Janet Yellen has been renominated to be Fed Chair by President Walker having served a successful first term of solid growth and low inflation.  However, to achieve such growth Yellen has had to maintain very low interest rates.  Then, disaster strikes.  France leaves the Euro unexpectedly and causes a world wide credit crunch.  It’s 2008 all over again.  President Walker is unwilling to do any stimulus.  Yellen decides that a regime change is necessary at the Fed.

Taking to heart MMT, Keynes, Bernanke, Yellen merges Keynes’ idea of burying money in jars with Helicopter Ben’s idea of dropping money from the sky.  The Fed announces that the United States is going to create its own cryptocurrency, which can be exchanged for US dollars at any US regulated depository institution.  No or minimal fees can be charged by the banks for this exchange.  They will be created just like Bitcoin, decentralized and according to a mining algorithm.  American citizens can mine them, create businesses to do so, and put people to work.  Unlike Bitcoin, the supply of DollarCoin will not be finite, capped at 21 million.  Instead, DollarCoin will be targeted to grow at an inflation rate consistent with an NGDPLT of 20 trillion US dollars.  Liquidity is restored.  No QE is necessary.  CNBC starts cheerfully referring to DollarCoin as YellenCoin.

Meanwhile, Bitcoin plummets in value.  With the US Government now accepting a cryptocurrency, its advantages vanish.  People’s belief in its value goes away, and looking down, it crashes.  Remittances are now sent to relatives in Africa and Latin America by YellenCoin, just as people once did briefly in Bitcoin.

It is interesting to think about why this is so implausible.  There are a few reasons:

1. YellenCoin would be a means of payment but not the medium of account.  This would move the economy into a currency substitution model, a’la Girton and Roper, but would not have the effects of a straightforward monetary expansion.

2. Cryptocurrencies are much more likely to be used for some kinds of transactions than others.  So this act of “monetary policy” would be very much non-neutral.

3. Central banks are not supposed to be seen as taking major risks or overturning the established order of things.  They are highly risk-averse when it comes to their public reputations, and their very much prefer sins of omission to sins of commission.  If the Fed established Fedcoin and something went wrong with the idea, they would be subject to especially heavy blame.  In the meantime, few people (are there exceptions?) are blaming them for not establishing a cryptocurrency.

From the comments, negative T-bill rates of return

On my somewhat complicated post on negative rates of return from last week, Robert Sams writes:

Very interesting post and #5 is crucial (it’s a geometric process). Two points.

1. I think that we can substitute “ability to leverage at near-treasury rates” for “special trading technologies” and get the same implied predictions yet put the relevant institutional factors into relief.

2. Your #1-3 still works with the wrong model of Treasury returns, as it implicitly models demand as if it’s coming from a “real money” portfolio sort of buyer. Those guys exist of course, and they’re basically buyers at any price (central banks, regulatory demand, etc.). But if we ignore CB policy expectations, the valuation is set in the leveraged market, which is much larger, and treasuries trade rich /not/ so much b/c people want safety and therefore want to buy them, but rather they trade rich because people want to /short/ them for hedging purposes (e.g., investor wants corporate credit w/o the interest rate risk.)

Sounds paradoxical, I know, but failure to appreciate this fact is the basic misconception of the entire “risk premia” way of modelling this stuff.

For any given treasury issue, X billion were sold by Treasury, but the outstanding amount of people long the issue will be many times X because of all those repo leveraged buyers of UST’s, and for every one of those repoed longs, there is a short on the other side doing reverse repo. The market clears with the repo rate, which can often be much lower than fed funds and indeed can go up to -300bps at times if the (primarily hedging) demand from shorts is extreme. (The effective repo rate in this market is rather different from the general collateral series you can pull from public sources.. it’s hard to get good data as it’s proprietary to the big IDB’s… why the Fed tolerates this degree of opacity, I’ve never understood.)

Treasuries can therefore be seen as a special financial “currency”, and the treasury market can be modeled as type of free banking regime, where the public debt is base money, the much larger qty of leveraged UST positions is broad money, and the repo market is an interbank lending market where USD cash is collateral instead of money.

Looked at this way, the phrase “shadow banking system” is a quite literal description. Turn a market monetarist lose in this parallel universe, and the low rate conundrum is due to UST “base money” not keeping up with demand and the Treasury is a tight fisted CB.

In this universe, the real return of treasuries isn’t the relevant variable, it’s the spread between the repo rate and the treasury yield, which acts as a sort of “fee” for the guy who wants a hedged Investment in a riskier asset and pari passu a benefit to the party who wants a leveraged bet that the Fed means what it says about ZIRP. In finance-land with its UST currency, that spread /is/ the ST interest rate, which is volatile and well-above zero.

Now we can define quite precisely your “entry fee” thesis: the entry fee is the relative credit terms (haircut’s, etc) you’ll get in this repo market. In a world of only non-bank dealers and traders, those terms are symmetrical b/c counter-party risk is broadly symmetrical. In the world of TBTF, naturally only the bank holdco’s get the best terms. So, to win the wealth-accumulation game in this world, be a bank or be a very good client of a bank.

Ponder at your leisure!

An “entrance fee” theory of why some real rates of return are persistently low

Some portion of the negative real returns on U.S. government securities can be explained by risk premia, but yet many other indicators of risk are these days not so extreme.  Times appear pretty stable, if not exactly what we had hoped for.  So how else might we fit these negative returns into a theory?  Here is one attempt, by me:

1. Imagine that financial institutions and traders have to hold large quantities of T-Bills (and similar assets) to participate in financial markets.  That may be to satisfy collateral requirements, to meet government regulations, to be credible in private market transactions, and so on.

2. The demand for these assets is now so high and so persistent that the assets have persistently low nominal returns and often negative real returns.

3. The holders of these assets do not however receive negative returns on their portfolio as a whole, when deciding to hold these T-Bills.  Holding the T-Bills is like paying an entry fee into financial markets.  And once they are in financial markets of the right kind, these market players can earn high returns by possessing special trading technologies (the technology may vary across market participants, but think HFT, hedge funds, prop trading, employing quants, and so on).

4. Let’s say you are not a major financial institution.  Then you really will earn negative returns on your safe saving.  You might try holding equities, but a) you are not wealthy and thus you are fairly risk averse, and b) as a small player you do not have access to these special trading technologies and indeed you must trade against those who do.  You thus will often earn negative or low returns on your portfolio no matter what.

5. The implied prediction is that differential rates of wealth accumulation will be a driver of inequality over time.  This seems to be the case.

6. This equilibrium is self-reinforcing.  The crumminess of T-Bill returns drives some individuals into trading against those with special trading technologies, even though that means they do not get a totally fair deal.  The ability to trade against these “suckers” increases the value of paying the entrance fee into the higher realms of financial markets and thus increases the demand for T-Bills and keeps their rate of return low.

6b. Bailouts and moral hazard issues may reinforce the high returns to the special trading technologies, at social and taxpayer expense.

7. In this equilibrium this is a misallocation of talent into activities which complement the special trading technologies.

8. Imagine a third class of agent, “Napoleon’s small shopkeepers.”  These individuals earn positive rates of return on invested capital, though those returns are not as high as those enjoyed in the financial sector.  You become a shopkeeper by saving some of your earnings and then setting up shop.  Yet now it is harder to save and accumulate wealth for most people (the rate of return on standard savings is negative!), and thus the number of small shopkeepers declines.  This hurts economic growth and it also thins out the middle class (“Average is Over”).  Most generally, the quality of your human capital determines all the more what kind of returns you will earn on your financial portfolio and that is a dangerous brew for the long term.

9. Business cycles may arise periodically if those who control the special trading technologies periodically “empty out” the real economy to too high a degree; you can think of this as a collective action problem.  Then the financial sector must shrink somewhat, but unfortunately the game starts all over again, following a period of recovery and consolidation.

10. The John Taylors and Stephen Williamsons of the world are right to suggest there is something screwy about the persistently low interest rates, and thus they grasp a central point which many of their critics do not.  Yet they don’t diagnose the dilemma properly.  Tighter monetary policy would simply add another problem to the mix without curing the underlying dysfunctionality.

11. In this model, fixing the negative dynamic requires financial sector reform of such a magnitude that real rates of return on safe assets rise significantly.  That is hard to pull off, yet important to achieve.

11b. It would help for the Chinese and some other East Asian economies to diversify their foreign holdings into riskier and higher-earning investments.  They need a new trading technology in a different way, and you can think of their demands for safe assets as a major market distortion.  Edward Conard saw a significant piece of this puzzle early on, by noting that a globalized world will skew real rates of return on safe assets (it is easiest to overcome “home bias” on the safest and most homogenized assets of a foreign country).  Singapore and Norway are to be lionized in this regard for their risk-taking abroad.

12. If you so prefer, monetary and fiscal policies can have the “standard” properties found in AS-AD models.  Yet in absolute terms they will disappoint us, and this will lead to fruitless and repeated calls to “do much more” or “do much less,” and so on.

13. In this model, the activities of the Fed can be thought of in a few different ways.  In one vision, the Fed is the world’s largest hedge fund and has the most special trading technology of them all.  Forward guidance on rates is actively harmful and the Fed should instead commit to a higher rate of price inflation or a higher rate of ngdp growth.

13b. Under another vision of the Fed, they understand this entire logic.  Interest on reserves is a last resort “finger in the dike” attempt to keep rates higher than they otherwise would be.  Of course both visions may be true to some extent.  (And here I am expecting Izabella Kaminska to somehow make a point about REPO.)

14. Unlike in models of demand-side “secular stagnation,” the observed negative real rates of return do not imply negative rates of return to capital as a whole and thus they do not have unusual or absurd implications.  They do require some degree of market segmentation, namely that not everyone has access to the special trading technologies, but those who do have enough wealth to push around the real return on T-Bills, especially if China is “on their side.”

That is what I was thinking about on my flight to Tel Aviv.  It should be thought of as speculative, rather than as a simple description of my opinions.  Still, it fits some of the data we are observing today.  Another way to put it is this: the recent secular stagnation theories need a much closer examination of the financial sector and its role in our current problems.  We should focus on the gap in returns, rather than postulating a general negativity of returns per se.

My model for how the Fed thinks about withdrawing QE

Bernanke believes QE works, but having been caught off-guard once before, in 2007-2008, he doesn’t fully trust his own judgment.  He fears some risk of bubbles, or excess private disintermediation, in either case resulting from low interest rates.  He lets Tarullo and Stein carry related messages to the markets to signal possible fears without having to endorse them.

Let’s say he assigns these risky scenarios a fairly small p = 0.05.  Still, another financial collapse would be a disaster, all the more for political economy reasons.  Bernanke has spent down his own political capital and these days Republicans are more likely to be obstructionists.  Fear of that disaster leads him to withdraw QE sooner than his “most likely to be true” opinion thinks prudent.  Economists respond by defending the “most likely to be true” opinion, and by arguing moralistically rather than probabilistically.  That doesn’t convince Bernanke, because said economists can only convince him that they are likely right, not that he should obliterate his p = 0.05 fear of being wrong.  The current policy course continues, early withdrawal from QE is contemplated, and economists complain all the more.  Outside observers find it hard to understand the disconnect.

Here are some related probabilistic considerations from Brad DeLong.

Is this as good as it gets? How much can social risk ever decline?

Karl Smith reports:

Are we so sure there is a better way?

Real interest have famously been on the decline for thirty years. A rougher historical record suggests that English real interest rates may have been in decline since at least 1600.

The standard explanation here is better governance and lower systemic risk.

Yet, lets imagine a simple model where we have two sources of risk. There is background you cannot avoid. And, there is personal risk that you create by through your own choices.

Policy makers have since Thomas Hobbes been attempting to drive down background risk. They have larger been successful. As a result our lives are getting more and more stable.

As that happens, however, folks are going to tend to take on more personal risk. There is a tradeoff between risk and reward. As you face less background risk, for which you not rewarded it makes sense to go for more personal risk for which you are rewarded.

When I take on more personal risk, however, it bleeds over slightly into everyone else’s background risk. People depend on me. If I take risks and lose so big that I debilitate myself then my family and my friends will surely suffer. But, so will my employer, my creditor and the businesses who count on me as a regular. When I go down, they go down.

So, putting it all back together and we come up with something of a risk floor, if you will.

Policy makers drive down systemic background risk. This makes everyone safer. In response, each individual takes on a little more personal risk and contributes slightly to the general background risk.

Eventually we will reach a point where policy makers have driven out so much systemic background risk that any marginal decrease systemic background risk will simply induce individuals to take on more personal risk until they raise the total risk level back up to where it was before.

Safer policy then has little net effect.

Said another way, attempts to prevent bubbles from forming will only make folks more complacent about bubbles. Eventually, a bubble will slip through the cracks. However, folks will deny it’s a bubble, because don’t you know, bubbles are a thing of the past. Even as it grows to massive proportions the smartest minds will argue that it only looks like a bubble. If it were a real bubble, surely the Fed would have popped it by know.

And, so it grows larger and larger and larger. When it pops the downdraft is so great that policy makers don’t have the tools to deal with it. Perhaps, in a technical sense they do. They could stand firm on an NGDP target or pass the mother of all stimulus bills.

However, emotionally they are at a loss. They have never seen anything like this and until recently thought it was impossible. Now, they are being asked to approve policies that no one has used since the dark ages, while in the middle of a crisis no living person understands.

This is a task few people have the nerve to handle. And, so they don’t handle it and the downdraft smashes the entire global economy to bits.

Such, is often the problem of “over-solving” the problems of the past.

Would more planned savings be good? How can we lower perceived risk premia?

One common claim these days can be put in terms of the expectations theory of the term structure: since short-term rates cannot much fall, long-term rates cannot much fall either. 

Yet I would not put this argument forward as the best available understanding of the issue.  First, the expectations theory of the term structure has a dubious empirical record.  Long and short rates change for somewhat mysterious reasons and the long rates do not forecast future short rates very well.  Second, there is a distinction between Treasury and corporate rates and the latter are not zero, especially for small businesses.  

One possibility is that true corporate real rates are better reflected by the status of letters of credit, standby loan agreements, and the like.  One can view borrowing in terms of the value of an option, rather than a single numerical rate.  Many businesses no longer feel they have lots of liquidity "on tap" when they might need it from their banks and so they hesitate.

In general, I think of this crisis as having damaged a lot of agency relationships, and as having led to tighter leashes.  For instance, if you are a worker of um…"ambiguous" marginal product you may no longer get the benefit of the doubt.  The high perceived risk premium in the labor market is preventing a lot of reemployment.

Returning to interest rates, the question is what could call true real rates to fall.  The expectations theory of the term structure is not very useful in analyzing this problem.  Changes in the perceived risk premium have been an embarassment and a confounding factor for the expectations theory for a long time.

Given that background, should we plan to save more?  On the no side, I would not push "more savings" is the magical elixir in lowering real rates, since the major issue is again the perceived risk premium.

(By the way, if we lower real rates through Sumneresque inflation — which I favor — we are altering the spectrum of these agency dealings and injecting more risk into those relationships, possibly in a socially optimal manner; in any case that second-order effect has not seen enough analysis.)

Another anti-savings argument runs like this: if we switch from spending to savings, that requires longer-term production processes and resource reallocations.  The new market forecasts of what to produce involve greater risk, namely Keynes's "dark forces of time and ignorance".  If that increase in the risk is too stiff, an increase in planned savings could lead to a greater collapse in output, exacerbating both AD and AS problems.

A pro-savings argument runs like this: We're overly dependent on Chinese capital.  T-Bill auctions are now being soaked up much more by domestic lenders and that is a good thing for the world state where the Chinese economy implodes.

Another pro-savings argument is about balance sheet repair and about satisfying the preferences of consumers for greater long-term risk protection.

A major pro-savings argument is: If savings are not to go up now (and they have been rising since the onset of the crisis, supposed Keynesian paradoxes aside), then when?

The long-run boundary conditions require Americans to save more at some point and here's a fundamental point about macro.  I believe we are in a situation where the short-run and long-term boundary conditions are interacting.  People want to see the longer-term "we have to save more" problem (as well as some other longer-term problems) partially resolved before having much lower shorter-term risk premia and thus a freer flow of capital and private investment and also more ambitious hiring policies.

That makes the ride especially bumpy and the recovery especially slow.  Both the long-run and short-run conditions require partial resolution, at the same time, and yet the long- and short-run conditions point in some different directions.

I get nervous when I see Keynesian models emphasizing the short-term only or non-Keynesian approaches emphasizing the long-term only.  The more insightful approaches see the short-term and long-term factors interacting in a not always so helpful manner.

Addendum: Krugman has a recent post on savings.  I am confused by his insertion of the Fed into the classical loanable funds mechanism, which does not require a central bank.  I am also surprised that he associates the paradox of saving with the liquidity trap; Keynes for instance believed in the paradox of saving even though he thought he had never seen a liquidity trap.  It could be, however, that I am misreading him on both counts; I found the post difficult to parse.

Why hasn’t the Fed been targeting two or three percent inflation?

I've been thinking about this question more and I've come up with a speculative possibility.  Right now banks are earning their way back into profitability by playing the spread.  They're paying close to zero on deposits and earning fair sums on long-term loans.  Perhaps this term structure is sustainable because people are expecting little inflation in the short run but moderate inflation in the longer run, plus there is some risk on the loans.  (These inflationary expectations may be changing; if you wish pretend I am writing this six months or a year ago.)

So let's say we move from zero expected short-term inflation to three percent short-term expected inflation.  The nominal short rate rises to three percent and the real short rate remains more or less constant.  Long rates would go up a bit but not much, since beyond the short run there is already an expectation of moderate inflation.  In sum, the spread between short and long rates might narrow.

Here is the key point: from the bank's point of view, what is the correct measure of the real rate of interest?  Is it defined by the nominal rate relative to the expected growth in the CPI?  I doubt it.  When you're near the bankruptcy or nationalization constraint, it's often nominal profits that matter (relative to fixed nominal liabilities, accounting standards, capital standards, etc.), not "real profits" defined relative to the CPI.

In sum, maybe three percent expected inflation conflicts with the desire to rapidly recapitalize banks through maintaining a wide interest rate spread.  Maybe we need that zero nominal short rate or at least the Fed thinks we do.

I don't wish to push too hard on this hypothesis, it is speculative rather than confirmed by evidence.  And propositions about the term structure of interest rates do not always run the way you think they will or should.  I'm aware of other problems.  What kind of zero profit condition is imposed on the banks?  Given the odd objective function of the banks, how exactly does the Fisher effect work in the short run?  Or is it imposed from without by competition from non-bank lenders?  I'm not sure on these questions and they suggest possible holes in the above speculation.

I also regard this as a somewhat gruesome hypothesis.  It means that "Main Street" is paying for "Wall Street" (forgive me the use of those awful terms) in at least two ways: high unemployment and inability to earn much on one's savings.  Risk on the Fed balance sheet is also paying some big part of the bill, since presumably that is helping to maintain the interest rate spread.

The term structure also implies that the market is expecting rising short rates, so if the bank mess isn't cleaned up soon, heaven forbid.  The spread, as a means of restoring bank profitability, won't last forever.

Interest on reserves, continued

I was intrigued by this passage, from Interfluidity:

Interest rates are, for the moment, excruciatingly low. But a subsidy
to the banking system, once put into place, will be quite hard to
dislodge. So, let’s imagine that the Fed will pay interest on bank
reserves in perpetuity, that it will pay such interest at or near the
risk-free short-term interest rate, and that the expansion of the Fed’s
balance sheet is more or less permanent. How large a subsidy to the
banking system do the interest payments on reserves represent? Some
problems are arithmetically challenging, but not this one. The present
value of a perpetual stream of market-rate interest payments is
precisely the amount of the principal. Therefore, the present value of
the Fed’s de facto commitment to pay interest to banks on $800B
of freshly created reserves is $800B. We fought and wailed and gnashed
our teeth over potentially overpaying for TARP assets. Meanwhile, we
are quietly allowing the Fed give away, as a direct, literal subsidy,
more than the entire $700B that Paulson was allowed to play with. Note
there is no question about this being an "investment": The interest
payments that the Fed is now making to banks on its suddenly expanded
balance sheet are not loans. The banks owe taxpayers absolutely nothing
in return for this windfall.

I take that calculation to be a very rough one, and possibly an overstatement, but the point remains of interest.  It also can be argued that interest on reserves is a bad signal for at least two reasons:

1. It signals the Fed fears being left holding the intra-day Fedwire bag if a major bank goes under, and

2. It signals the Fed thinks major banks need such a subsidy.

The cited post is interesting throughout.