1. Summers says:
I doubt that, if rates were now 4 per cent, there would be much pressure to raise them.I think what Summers means is that, if everything else looked the same, and if the interest rate on reserves were at 4%, then people might be drawing different policy conclusions. But of course, that's an odd counterfactual to be thinking about, as it's hard to imagine how everything else would look the same. So, consider the following counterfactual. The last time the fed funds rate was at 4% was in January of 2008. So, suppose at that time that the Fed had not reduced the fed funds rate target, but had maintained it at 4%. Suppose all other aspects of policy were the same - the interventions during the financial crisis, the Fed's balance sheet expansion etc., and that the Fed commenced paying interest on reserves at 4% in fall 2008, and maintained that until now. What would have been different? A long history of research in monetary economics - theory and empirical work - tells us that the recession would have likely been more painful and perhaps longer. But as of today, six years after the recession actually ended, on the real side of the economy things would not have looked much different. But with nominal interest rates at 4%, standard Irving Fisher economics - which is built into every monetary model that I know about - tells us that the inflation rate would be 4% higher. So in that sense, Summers is absolutely right. If rates were now at 4 per cent, and given the Fed's 2% inflation target, we would be missing the inflation target on the high side, and the pressures would be quite different.
2. Toward the end of his piece, Summers says:
Much more plausible is the view that, for reasons rooted in technological and demographic change and reinforced by greater regulation of the financial sector, the global economy has difficulty generating demand for all that can be produced. This is the “secular stagnation” diagnosis, or the very similar idea that Ben Bernanke, former Fed chairman, has urged of a “savings glut”. - See more at: http://larrysummers.com/2015/08/23/the-fed-looks-set-to-make-a-dangerous-mistake/#sthash.iJYo0wau.dpufAs I pointed out to a commenter on this previous post, savings gluts and secular stagnation are actually quite different. Summers and Bernanke are thinking in terms of a simple model of the credit market. There is a demand for loans determined in part by the demand for investment, with demand depending negatively on the real interest rate. There is a supply of loans that depends on savings behavior, and loan supply depends positively on the real interest rate. Secular stagnation is low demand which makes the real interest rate low, savings glut is high supply that makes the real interest rate low. Entirely different. Note further, that the measurements reported here seem to put the kabosh on the secular stagnation idea.
Paul Krugman agrees with Summers:
I’m with Larry here: this attitude has the makings of a big mistake. Think Japan 2000; think ECB 2011; think Sweden. Don’t do it.I think what he means is that Japan in 2000, the ECB in 2011, and Sweden (presumably 2011 also), did the wrong thing, saw the errors of their ways, and went back to zero or lower nominal interest rates. Currently, the overnight interest rate in Japan is 0.1%, the ECB deposit facility rate (the counterpart of the interest rate on reserves) is -0.2%, and the overnight interest rate in Sweden is -0.35%. It seems that Krugman approves of that, but the Bank of Japan, the ECB, and the Riksbank have certainly not been successful in achieving their goals. All of these central banks would like 2% inflation, but inflation in Japan is currently 0.4%, inflation in the Euro area is at 0.2%, and inflation in Sweden is at -0.1%. I'm sure Krugman (and Summers too) is thinking that a long period with very low nominal interest rates makes the inflation rate go up, but the last 20 years in Japan and this recent experience in other countries might make him want to think twice.
I've never seen any actual model which shows higher interest rates causes more AD which causes higher demand induced inflation. An accounting identity is not a model. BTW, if the interest rate was at 4%, government finances would probably have been untenable, and there probably would have been much harsher fiscal austerity, leading to a huge collapse in GDP and demand, where would the inflation come from?ReplyDelete
"I've never seen any actual model which shows higher interest rates causes more AD which causes higher demand induced inflation."Delete
Seems you have a theory of inflation. Explain it to me.
"An accounting identity is not a model."
If you're suggesting Fisher effects are an accounting identity, that's incorrect. As I said, that's built into every monetary model I know - I could modify that to "serious monetary model."
" if the interest rate was at 4%, government finances would probably have been untenable, and there probably would have been much harsher fiscal austerity..."
Sure, monetary policy and fiscal policy are tied together. But any of these effects would be temporary. Again, after six years, in real terms we should be in roughly the same place.
"Seems you have a theory of inflation. Explain it to me."ReplyDelete
Too much money chasing too few goods.
"Sure, monetary policy and fiscal policy are tied together. But any of these effects would be temporary. Again, after six years, in real terms we should be in roughly the same place."
Why would you think that? I think 6 years of heavy austerity would have output lower than it is now. Anyway didn't you say previously you thought real GDP had a unit root?
"Too much money chasing too few goods."Delete
Good. I thought you were going to give me a Phillips curve theory. Then I would have given you a hard time. Fundamentally, an expansion in nominal assets used in exchange has to be at the heart of the inflationary process, though we know that standard old monetarist (i.e. quantity theory) views of the world don't work so well. In a world in which the central bank treats the nominal interest rate as its policy instrument, any path for the nominal interest rate and inflation has to be supported by appropriate expansion in the stocks of nominal assets. So, for example, if the central bank raises the nominal interest rate, and keeps it at this higher level for, say, seven years, to sustain that higher nominal interest rate after seven years, nominal assets have to be growing at a commensurately higher level. That is, "money" is always working in the background to support the central bank's nominal interest rate target.
"Why would you think that? I think 6 years of heavy austerity..."
I don't entirely buy your fiscal story, only that monetary policy could have some consequences for fiscal policy. But those effects - whatever they are - would be temporary. That was probably Farmer talking about unit roots - certainly wasn't me.
Steve, I think some may be a bit confused by your response because in the mind of most people high growth in nominal assets is accompanied by lower, not higher, interest rates (the liquidity effect). Unfortunately, it is not emphasized enough that the response of interest rates is non-monotonic: the drop is followed by an increase as inflation rises (the Fisher effect).Delete
The puzzle here is that we have seen the initial drop as the rates of growth of M1 and, to a lesser extent, M2 increased, but not the long-run rise. Most people interpret this as evidence that monetary policy has been insufficient (the AD remains subdued leading to low inflation via some Phillips curve), so raising the interest rate will only make things worse. I think that your viewpoint, that in the current situation the low interest rate on government debt is a sign of low (as opposed to high) liquidity, if liquidity is defined more broadly, seems strange to many because it goes contrary to how they are used to think about this issue as well as past experience (outside a liquidity trap). I still can't get myself to put away my inhibitions, and I consider myself a pretty reasonable person, lol. Partially because some unanswered questions remain, like, why has Japan's CB been unable to raise inflation for so long? I mean, maybe Japan has been suffering from a shortage of domestic safe assets but until recently there was no global shortage. Why didn't Japanese intermediaries ameliorate the problem by turning to foreign safe assets?
P.S. I like the title, didn't know you were also a poet.
Yes, there are two effects - liquidity effect and Fisher effect, and the Fisher effect ultimately takes over, as the liquidity effect is short run. You would be puzzled if you are looking at M1 and M2 - that won't tell you much, especially post-financial crisis, for various reasons. What I'm saying is that any nominal interest rate target has to be accommodated by the appropriate open market operations (and it's obviously more tricky - but not fundamentally different with a large balance sheet and a lot of reserves in the system), and it's possible this also needs fiscal accommodation - nominal government debt growing at a sufficiently high rate to sustain the inflation. I know it sounds complicated. Sometimes, that's just how it is.Delete
"why has Japan's CB been unable to raise inflation for so long?"
Because they can't get off the zero lower bound.
Re Japan, what I meant is that if we interpret Japan's low Treasury Bill yields as a sign of a shortage in government short-run securities, why couldn't Japanese banks purchase US T-Bills or US mortgage-backed securities between 1999 and 2006, and ameliorate the shortage of safe assets that way? Or are you saying that they did but that action was reversed by the bank of Japan through open market purchases? Hmm, it might be interesting to look at the historical composition of their balance sheets.Delete
There are two separate issues here - Fisher effects and safe asset shortages. Whether or not there is a safe asset shortage, the long-run effects of a change in monetary policy show up as Fisher effects on nominal interest rates (no liquidity effect in the long run). With regard to Japan, you might ask why inflation averages about zero over the twenty years when the overnight rate was close to zero, i.e. why wasn't the average inflation rate lower? I guess it's also surprising that Japan has a very large stock of government debt outstanding, but Japan also holds a lot of U.S. Treasury debt. How come? They're awash in their own debt and they want U.S. government debt too?Delete
Good questions, thanks!Delete
Professor Williamson, what is the difference between a savings glut and a shortage of safe assets? Could they be the same? Could they be observationally equivalent (but different)?ReplyDelete
With a shortage of safe assets, liquidity premia on safe assets rise, so the prices of these assets rise and the rates of interest on them fall. What Bernanke calls a savings glut is in principle different, but it could be related. For example, China has had very high savings, but its financial intermediation sector is very inefficient, so that savings does not flow into domestic investment as easily as it could. So, that high Chinese savings finds a home in domestic real estate, and in U.S. government debt. Then, a high demand for U.S. government debt in the world relative to the supply gives you a safe asset shortage. Other factors in the safe asset shortage are the financial crisis, which effectively destroyed some privately-produced safe assets (asset backed securities), sovereign debt crises in other countries, and bank regulation, e.g. required liquidity coverage ratios. Part of what's different about recognizing this as a safe asset shortage are the consequences for the functioning of U.S. financial markets, and implications for inflation and monetary policy.Delete
Maybe this is pedantry, but isn't it convention to refer to premia in rates-space not price-space? So a high liquidity premia would mean that the rate that compensates for holding a less liquid asset increases and the price falls.Delete
The first online dictionary definition of "premium" that came up was:Delete
"a sum added to an ordinary price or charge"
So, the idea that a liquidity premium is something added to the "fundamental" price of an asset certainly seems in line with that. And that's typically the way monetary theorists think about it. When people are talking in terms of rates, they might say there is a "term premium" or an "inflation premium," and that's something that is added. So, when we say "premium," that's adding something. If you say "liquidity premium" you better be talking about the asset's price, not its rate of return.
How would it be possible to have 4% nominal rates in our counterfactual world if the Fed's response are held constant?ReplyDelete
I'm not sure what you mean by the "Fed's response." The counterfactual is to hold constant what is going on with the Fed's balance sheet - asset purchases, lending, etc., but keep the policy rate at 4%.Delete
Perhaps it stems from some confusion on my part, but I'd have said that "what's going on with the Fed's balance sheet" is what enables the ZRP (you can't just hold that constant and suddenly have a 4% target rate). Instead, I read Summers as saying that based on economic conditions alone, there would be no pressure to raise the policy rate if it were currently at 4%. In other words, there is no justification to raise rates based upon the criteria of the Fed's dual mandate.Delete
Otherwise, I'm also a bit confused by the mixed use of the terms IOR and fed funds rate.
""what's going on with the Fed's balance sheet" is what enables the ZRP (you can't just hold that constant and suddenly have a 4% target rate)."Delete
In some sense, you have to have a large balance sheet (though it's not necessary for it to be as large as it is to get ZIRP) to have ZIRP. But once you have a large balance sheet, the Fed can make short-term interest rates go up by increasing the interest rate on reserves.
"I read Summers as saying that based on economic conditions alone, there would be no pressure to raise the policy rate if it were currently at 4%."
I'm saying that statement doesn't make any sense. If the policy rate were 4%, economic conditions would not be the same.
"Otherwise, I'm also a bit confused by the mixed use of the terms IOR and fed funds rate."
With a large balance sheet IOER controls the fed funds rate. In normal times, open market operations control the fed funds rate.
Hello Stephen. Are there any good empirical studies you know of that have actually quantified the impact of the safe asset shortage on term premia?ReplyDelete
Here is some empirical work related to this issue:Delete