Scott Sumner points to David Glasner, who writes,
So, if the ability of the central bank to use its power over the nominal rate to control the real rate of interest is as limited as the conventional interpretation of the Fisher equation suggests, here’s my question: When critics of monetary stimulus accuse the Fed of rigging interest rates, using the Fed’s power to keep interest rates “artificially low,” taking bread out of the mouths of widows, orphans and millionaires, what exactly are they talking about?
I am not the person to whom this question is addressed. Anyway, read his whole post. Another excerpt:
Either the equilibrium real interest rate has been falling since 2009, or the equilibrium real interest rate fell before 2009, but nominal rates adjusted slowly to the reduced real rate.
In a number of posts, I have been saying that the closer you look at mainstream macroeconomics, the more incoherent it becomes. The issue of nominal and real interest rates is a case in point. Suppose you believe the following:
1. The Fed controls the short-term nominal interest rate, or at least a short-term nominal rate.
2. The long-term real interest rate is fixed by market conditions.
3. When the Fed lowers its interest rate, expected inflation goes up.
If you believe those three things, then when the Fed lowers the short-term rate,
(4) the long-term nominal rate has to go up.
Essentially everyone believes (1) and (3). But hardly anyone believes (4)*, so clearly (2) is what economists are least attached to. At least implicitly, macroeconomists believe that when the Fed lowers the short-term nominal interest rate, the long-term real rate goes down as well.
(*I tend to think of Scott Sumner as having coherent views, with which I disagree. Accordingly, I think of him as believing (4). What taking this view means, though, is that relative to other macroeconomists, one needs higher expected inflation to do most of the work in driving up aggregate demand. Expecting more inflation, people attempt to unload their money holdings onto goods. Since you don’t get a drop in real interest rates, it seems to me that the only reason for stock prices to go up is if you think that investors like it when people unload money and go into goods.)
My own idiosyncratic view is that I prefer to hold onto (2) and let go of (3). I would explain the drop in long-term real interest rates since 2009 by appealing to a drop in demand for investment relative to the supply of (savings minus government deficits). I assume this is worldwide, not just limited to the U.S. I would not credit the Fed with any of it. I am not sure that I would label it as an “equilibrium” phenomenon, because I think that bond buyers were not entirely rational. I know that for a while I had a really big exposure to TIPS, but as they went up in value (because real rates were declining), I thought to myself, “Hmm. Capital gains on a ‘risk-free’ asset. How nice. But if they can go up, can they not also go down?” So when the recent bond market sell-off hit, I had much less exposure (not that what I switched into worked out any better).
I view QE as the Fed swapping short-term debt (interest-bearing reserves) for long-term debt. The Fed gets to ride the yield curve in exchange for taking on huge market risk in its portfolio. This might reduce long-term real rates a bit, although I have always leaned toward skepticism on that score.
I lean to the view that inflation is a fiscal phenomenon. I have never heard of a country that cranked up the printing presses while running a balanced budget. I have never heard of a country running hyperinflation that was not fiscally profligate. There might be instances of countries running deficits of 100 percent of GDP or more who were able to return to balance without undertaking a formal default or going through a period of high inflation, but I cannot think of any.
Taking the view that inflation is a fiscal phenomenon does not help with short-term inflation predictions. For example, in the U.S. these days, we don’t know exactly when or how the fiscal imbalance will be resolved.
They will tear up my libertarian union card for saying this, but I do not believe that the Fed’s buying and selling of securities are a big distortionary factor in the financial markets. I think that the Fed could get us above the 0-2 percent inflation rate if it really wanted to, and maybe it should try, in case the AS-AD model turns out to be correct. But if you believe PSST, it could turn out that higher inflation would produce no increase in employment, and it might even make it worse.
Not every libertarian believes that the Fed is that important, I think there are a variety of views within the community. I would certainly agree with you, both that the Fed’s moves don’t affect financial markets much and that they are just as likely to hurt employment as help it, because PSST is closer to the truth.
Where I disagree is that fiscal deficits will lead to inflation, as times have changed. Most of the federal govt’s future liabilities are in SS and Medicare, both of which would not be reduced one bit by inflation. You’re not going to pay out any less on TIPS if inflation goes up. Given the havoc that hyperinflation would cause in certain areas of the market while providing little benefit to the govt, I think it unlikely that Bernanke or the federal govt would go for it these days.
Everybody is always fighting the last war, inflation is not a real concern. The giant govt spending, 42% of GDP this year, and deficits are.
3 and 4 are trickier than that. Goes up relative to what it was doing before. In lowering rates, the Fed is signaling both the near term economy faces weakness if not outright weakening and it wants a strengthen it in the intermediate term. Whether it goes up depends both on whether the market believes the Fed prediction and that their response is adequate. Other than crises, they usually believe the former but often have problems believing the latter. Rarely, if ever, do they ever consider their response excessive. And the Fed has to be able to lower rates. No one believes the Fed controls the short term interest rate after it reaches zero except to raise it. I wouldn’t view the Fed and economy as cause and effect, but as dynamically interactive but it is closer to the Fed lowering rates because long term rates have declined . One could say with the growth of reserves the Fed has tried mightily to create inflation and not succeeded, but no one really believes this is their intent either.
I believe 2 only in the long run that never arrives. Markets will slowly shift real rates over time, generally down, but they are never fixed by them. This provides a window for the Fed to raise real growth and rates in the intermediate term and the long term never arrives, or it never arrives unless the output gap has closed. Inflation is never bad for employment though as the redirection of idle money to consumption and investment increases production and lowers investment risk.
“Inflation is never bad for employment though as the redirection of idle money to consumption and investment increases production and lowers investment risk.”
Does anybody actually believe this? More likely that money goes into gold, land, or other assets, causing asset bubbles but little consumption or productive investment.
I think you could also argue that based on a bunch of stuff that tends to get short shrift (such as signaling effects, herding, the anchoring and availability heuristics, the expectations theory of the term structure, other complexities with regard to inflation processes), that you shouldn’t wed yourself to either 2 or 3 or Glasner’s interpretation of the Fisher equation. There are times that 2 is more wrong than 3, times that 3 is more wrong than 2, and sometimes they’re both way off base.
BTW, at a threshold of debt-to-GDP > 150%, you’re right about every instance leading to default or inflation, at least based on review of every episode in the Reinhart, Rogoff database (link below). I haven’t looked at all instances over 100% but I think you’re right also that fiscal imbalances tend to be the more fundamental problem. I started going through hyperinflations to show this but didn’t finish – it’s slow going pulling together hyperinflation histories because it’s so many emerging countries w/limited data.
http://www.cyniconomics.com/2013/03/20/answering-the-most-important-question-in-todays-economy/
I’ll just quickly note that if there were such a thing as a libertarian union, it would most likely be a miserable failure of an organization.
OK it seems to me there’s a very plausible explanation, but not one you’ll like. Keynes was right, and Krugman is right.
The real interest rate is simply the reward for forgoing consumption today in exchange for being promised the ability to consume tomorrow. If the market is running at full capacity and expects demand to be higher tomorrow, it will offer a greater reward for those willing to give up consumption today so investment can be funded.
The reverse should also hold true. If consumption is too low today then the market is not going to reward those who are willing to give up consumption. Hence a low real rate of return.
The Fed, then, hasn’t been making the real interest rate lower by printing money. The Fed has been chasing the real rate downwards. The problem was the market realized that the stimulus on both the fiscal and monetary side was not enough (despite hyperbolic rhetoric about the size of gov’t and deficits) to stimulate sufficient consumption. As a result the market now sees lackluster growth as the new normal for the intermediate future. Since demand isn’t there, there’s no need to fund investment hence no need to reward savers with large real returns.
To the degree recovery appears stronger you may see some notches upwards in the real interest rate here and there but absent a seriously growing economy you’re just getting some noise.
“…the Fed could get us above the 0-2 percent inflation rate if it really wanted to.” Certainly any central bank running a fiat currency should be able to do a full Zimbabwe, but there is a big difference between being capable of raising the inflation rate (however measured) and having sufficient feedback and control authority to hit a particular target rate.
If you believe that “..do not believe that the Fed’s buying and selling of securities are a big distortionary factor in the financial market” isn’t the flip side that it can’t have a big positive effect either?
In the old days, bank notes got printed and passed around or customer balances at banks increased when money was “created”. Now its a pea under a shell. Interest on reserves seem little more than a backdoor way to fatten member bank balance sheets. CPI barely moves throughout it all.
Maybe that’s because its a Consumer Price Index and many things in are actually or methodologically deflating. What is happening to the prices of everything else in the economy (not just GDP; transactions of balance sheet items too) is not reflected at all.
…the Fed could get us above the 0-2 percent inflation rate if it really wanted to.” Certainly any central bank running a fiat currency should be able to do a full Zimbabwe, but there is a big difference between being capable of raising the inflation rate (however measured) and having sufficient feedback and control authority to hit a particular target rate.
Well there’s the good old ‘pushing on a string’ analogy from our friend Keynesian economics. Printing money isn’t going to make inflation if no one is willing to spend that printed money. In that condition trying to get from 0% to 2% is going to be very difficult even if you’re printing trillions of dollars. On the other hand it may very well be if you’re running at, say, 5% inflation it may not take much to get to 7%. If you’re already running hot a little bit of gas will pick things up, if you’re running dead cold, though, it takes a lot of gas to turn the engine over.
Well, I think it was very much the Fed. Their transparency as to how much they would buy and at what price basically enabled Wall Street to figure out what to offer Treasury for new issues, so as to be able to turn around and make a guaranteed profit by selling their inventory to the Fed. This Zero Hedge annotation of the New York Times story on how the New York Fed bought bonds pretty much gets it right.
http://www.zerohedge.com/article/meet-feds-pomo-desk-which-doesnt-even-have-bloomberg-terminals
Actually, I do not believe easier money always makes long term rates rise.
But I’m not quite sure why the effect is ambiguous.