The professor vs. the markets

Turkey’s authoritarian leader sacked the central bank head just months after appointing him to the position:

When Turkey raised interest rates more than market expectations last week, Naci Agbal was cheered by investors who viewed the move as more evidence that the central bank governor was willing and able to pursue a conventional monetary policy.

Two days later, he was out of a job — the third governor President Recep Tayyip Erdogan has sacked in less than two years — and the currency was set to tumble as much as 14 per cent.

The shock decision announced in the early hours of Saturday has rattled investors who hoped the appointment of Agbal, a market-friendly economist, four months ago meant Erdogan was ready to cede a degree of autonomy to the bank.

The fact that Turkey’s currency depreciated does not necessarily mean it was a bad decision.  It would be good news if the yen depreciated 14% on news of new leadership at the Bank of Japan, an indication that the new central bank chief was likely to make progress toward Japan’s 2% inflation target.  But Turkey has 15% inflation, and doesn’t need monetary stimulus.

Sahap Kavcioglu, who has replaced Agbal, said in a statement on Sunday that monetary policy instruments would “continue to be used in an effective way towards the fundamental goal of a permanent decline in inflation”. He said the Monetary Policy Committee would meet as scheduled on April 15, suggesting there would no extraordinary MPC meetings.

But Kavcioglu, a little-known professor of banking, shares the president’s unconventional view that high interest rates cause inflation.

High interest rate don’t cause inflation, just as low interest rates do not cause inflation.

It’s one thing to advocate NeoFisherian ideas as a college professor.  But markets are quite efficient, too smart to engage in the fallacy of “reasoning from a price change”.  Mr. Kavcioglu is about to discover that the world doesn’t work the way he thinks it works.

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The Evidence Is in on Negative Interest Rate Policies

By Luis Brandao-Marques and Gaston Gelos عربي, 中文, Français, 日本語, Русский  Interest rates are low, and “lower for longer” has become something of a mantra among policy makers, regulators, and other market watchers. But negative interest rates raise an entirely new set of questions. After eight years of experience with negative interest rate policies, the initial skepticism (paying interest […]

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Interest rates and housing affordability

David Beckworth directed me to this Nick Rowe post:

Let’s start with land, and assume we are not living in the Netherlands. The supply of land is fixed and hence the price is 100% demand determined. If consumer preferences do not shift, then the affordability does not change at all. But the concept of “price” is tricky, as it may be a composite variable that involves both the size of a required down payment (a function of the price of land) and the annual cost of a loan to buy land.

Now assume the interest rate falls in half for reasons unrelated to the land industry (to avoid reasoning from a price change.) If the price of land were to double, then land would be less affordable for the reasons suggested by Nick. But if consumer preferences did not change, then this cannot be the equilibrium outcome. Instead, price will rise by less than 100%, and the added negative of higher down payments will exactly offset the added benefit of lower monthly loan payments (due to lower interest rates.) The price of land will rise, but the composite cost of owning land (down payment plus interest) doesn’t change.

Now let’s think about how lower interest rates affect the price of mobile homes. Assume these homes are manufactured in industries where the long run supply curve is perfectly elastic. (That’s actually a reasonable assumption.) In that case, cutting the interest rate in half has no long run effect on mobile home prices. But it reduces the total cost of owning a mobile home and thus demand shifts right, which in the long run means higher quantity sold at the same price per unit.

Now think about “housing” as a house/land hybrid. The land is fixed in supply, and the house can be produced in the long run at constant cost. Now when interest rates fall in half there is some net decline in the total cost of housing (down payment plus interest) and some net rise in house prices and house output. In Texas, the effect of lower interest rates mostly shows up as higher quantity. In California, the main impact of lower rates is to increase house (i.e. mostly land) prices.

PS.  This is not an academic exercise.  Lower interest rates are the new normal.

PPS.  Yes, it matters why rates fall.  In this example, assume the fall in rates is caused by some combination of more saving and fewer opportunities for business investment.

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Global Policy Responses to Capital Flow Volatility

By Annamaria De Crescenzio,  Annamaria Kokenyne, Dennis Reinhart, and Julia Schmidt The COVID-19 health and economic crisis has once again focused attention on the fickleness of capital flows and the need to have an adequate policy toolkit to manage the risks that stem from these flows, while maximizing their benefits. A virtual workshop organized by […]

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What to do When Low-for-Long Interest Rates are Lower and for Longer

By Tobias Adrian Central banks have played a pivotal role in easing financial conditions in response to the COVID-19 shock, and helped avert a catastrophic downturn. However, their work is far from done. Yet more monetary stimulus will be needed to support economic recovery, and central banks are implementing innovative new strategies to provide it. […]

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The masquerading problem

For the past four decades, I’ve been complaining about the way the profession does empirical work on monetary policy. The studies often use “vector autoregressions” to estimate the impact of changes in the policy interest rate. Unfortunately, interest rates are not monetary policy. You can try to estimate the part of interest rate movements that are “exogenous” and hence reflective of monetary policy, but in practice this is almost impossible.

So after four decades of VAR studies by the best and the brightest in the economics profession, where are we? Here’s the abstract to a promising new paper by Christian Wolf of Princeton University:

I argue that the seemingly disparate findings of the recent empirical literature on monetary policy transmission are in fact all consistent with the same standard macro models. Weak sign restrictions, which suggest that contractionary monetary policy if anything boosts output, present as policy shocks what actually are expansionary demand and supply shocks. Classical zero restrictions are robust to such misidentification, but miss short-horizon effects. Two recent approaches – restrictions on Taylor rules and external instruments – instead work well. My findings suggest that empirical evidence is consistent with models in which the real effects of monetary policy are larger than commonly estimated.

Many previous VAR studies have found monetary shocks to have relatively weak effects on the economy.  But these shocks tend to conflate reductions in interest rates with expansionary monetary policy.  In fact, in the vast majority of cases a decline in interest rates reflects slower growth in aggregate demand, not easier money.  So it’s no surprise that lower interest rates don’t seem to provide much of a boost to the economy.  Lower interest rates are not easier money:

Sign restrictions, as in Uhlig (2005), are vulnerable to expansionary demand and supply shocks “masquerading” as contractionary monetary policy shocks, which then seemingly boost – rather than depress – output. . . . For monetary policy transmission, my results encouragingly suggest that, first, recent advances in identification effectively address the masquerading problem, and second, even small sets of macro observables may carry a lot of information about policy shocks. Viewed in this light, I conclude that existing empirical work quite consistently paints the picture of significant, medium-sized effects of monetary policy on the real economy.

This “masquerading problem” is sometimes called the identification problem; it’s what happens when people engage in reasoning from a price change.

After forty years, economists yet to develop a generally accepted VAR model of the monetary policy transmission mechanism.  Like fusion power, there’s a small chance that it may happen some day.  But there’s almost no chance I will live long enough to see this approach yield useful results.  The profession would be much better off switching to an approach that used NGDP growth expectations as the primary indicator of monetary policy shocks, and then develop models to estimate those expectations using real time data from asset markets.  Interest rates are not a useful variable when analyzing monetary policy.

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Living on a one dimensional planet

This post is a bit long and slightly technical, but I also believe it is important. Think about the following pairs of statements:

The Wicksellian natural rate of interest is the policy rate that leads to stable prices.

The Wicksellian natural exchange rate is the policy exchange rate that leads to stable prices.

Monetary policy affects the economy by moving the policy interest rate relative to the natural rate.

Monetary policy affects the economy by moving the policy exchange rate relative to the natural rate.

A fall in the policy interest rate does not necessarily mean easier money, as the natural rate is often falling even more rapidly.

A fall in the policy exchange rate does not necessarily mean easier money, as the natural rate may be falling even more rapidly.

You get the idea.  Monetary policy can be described in terms of either interest rates or exchange rates.  In both cases, they are subject to misinterpretation.  In fact, interest rates are far more inadequate.  To see why, consider one more pair of statements:

What matters is not so much the change in the current short-term interest rate, but rather the change in the entire path of expected future interest rates.

What matters is not so much the change in the current spot exchange rate, but rather the change in the entire path of expected future exchange rates.

This is where interest rates are radically different from exchange rates, and greatly inferior.  To simplify the explanation, consider a small country that does not impact other countries, and also assume the interest parity condition holds. (It doesn’t hold perfectly, but it holds well enough to justify the general points I plan to make.)

A monetary policy announcement at time=0 immediately impacts the current one-year interest rate, as well as the set of expected future one-year interest rates.

A monetary policy announcement at time=0 immediately impact the current spot exchange rate, as well as the set of expected future exchange rates.

Because of the interest parity condition, we know that these two sets will be closely related.  The change in the current one-year interest rate will be the negative of the change in the forward premium of the exchange rate over the spot exchange rate.  In other words, if the policy announcement causes current one-year interest rates to fall by 1%, then the one-year forward exchange rate will appreciate by 1% more than the spot exchange rate.  Investors must be compensated for lower interest rates with a higher expected appreciation in the currency.  (That’s what the interest parity condition means.)  And even if this is not exactly true, it is approximately true.

So far, it looks like the two data sets are telling the same story.  By looking at the change in the expected path of exchange rates we can “back out” the change in the expected path of interest rates.  But the opposite is not true!  That’s because the path of interest rates tells us nothing about the change in the level of exchange rates, only changes in the various forward premia—the differentials.

Consider a central bank that uses exchange rates as its policy instrument, such as the Bank of Singapore.  If there is a policy announcement, I can describe its effect by looking at the impact on the spot exchange rate, and all forward exchange rates.  From that data, we can back out the impact on interest rates.   But if I describe the impact on interest rates, we have no way on knowing the impact on the level of various exchange rates.

Alternatively, suppose I told you that the Bank of Singapore’s action had caused the forward premium on the one-year forward exchange rate to rise by 30 basis points.  I don’t know about you, but I’d be kind of exasperated by that information.  “Yes, that’s all well and good, but what happened to the actual spot exchange rate?”  That would be the information that I’d be most interested in learning.

When someone tells you what happened to the one-year interest rate in response to a monetary policy shock, it’s like telling you what happened to the forward premium on the exchange rate, without even describing the impact on the level of the exchange rate.  That’s just totally inadequate.  It’s not that the changes in the various forward premia are completely useless, but they certainly are not the key piece of information that you’d like to know.

In March 2009, the Fed announced its first QE program, and interest rates fell sharply.  In January 2015, the Swiss announced they were abandoning their franc/euro exchange rate peg, and interest rates also fell sharply.  If interest rates were actually informative, then those two policy shocks would have been kind of similar in a qualitative sense.  In fact, they were about as different as one can imagine.  The QE announcement caused the spot exchange rate for the dollar to suddenly depreciate by over 4%, whereas the Swiss policy change caused the franc to suddenly appreciate by over 10%.  Only by looking at changes in the levels of the spot and forward exchange rates can we actually see what happened.  The change in the path of interest rates (or the change in the various forward exchange rate premia) tells us very little of value.

Markets understand this distinction, even if economists are often confused.  Stocks rose sharply on the US expansionary policy of lower interest rates when QE1 was announced, and fell sharply on the Swiss contractionary policy of lower interest rates in January 2015.  Markets focus on levels.

If you’ve followed my argument, you’ll see that I’ve explained the dispute between Keynesians and NeoFisherians.  Neither side is correct, because both describe monetary policy in an inadequate way, using the language of changes in interest rates.  They are like beings who think they are on a one-dimensional planet trying to understand a two dimensional region.  They think in terms of X going left or right along as line, whereas monetary policy simultaneously impacts X (levels) and Y (rates of change.)

This confusion distorts monetary policy.  One useful reform would be to move back to targeting levels, as we did under the gold standard and Bretton Woods.  But those specific level targets weren’t optimal; we need to target the level of prices, or much better yet NGDP.

If we had an NGDP futures market, then monetary policy shocks could be well described by their impact on the level of expected current NGDP (this quarter) as well as the impact on the level of expected future NGDP in future quarters.  We need such a market.

Even more so, we need NGDP futures “guardrails” on monetary policy, to keep expected one-year forward NGDP growth from drifting outside the 3% to 5% range.

PS.  If you are confused by the two dimensional analogy, consider a two-period model.  There is one interest rate, for bonds bought today and maturing next period.  There are two exchange rates, the spot exchange rate and the one period forward rate.  Shocks to the spot and forward exchange rates would appear on a two dimensional diagram.  Shocks to interest rates would appear on a one dimensional diagram.

PPS.  In a closed economy model you can replace the exchange rate with the money supply, the price of gold, CPI futures prices or NGDP futures prices.

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