TVHE

Interesting.  Both a Fed economist and Stephen Williamson (the author of one of my undergrad macro books) have been saying that persistently low interest rates “cause” deflation in the long run (ht Economist’s view) [Lots of others, WCI *, Money blog, Angry Bear, Paul Krugman, Money Illusion].  This seems a little counter-intuitive, but this doesn’t mean anything is wrong – I’m going to write down a few of my thoughts to see if I can figure out what is going on.

I mean, I agree that the Fisher equation must hold, and I agree that the long-run real interest rate will be exogenous.  But this ain’t enough to tell me that having the Fed keep rates at 0.25% forever “causes” deflation.

Why?  The average Fed rate and inflation expectations are both endogenously determined – they seem to be treating the Fed’s choice as exogenous, when they follow a decision rule. Yes it is true that the cash rate at a point in time is a choice variable – but the average cash rate in the long-run should effectively be determined by the real interest rate and long-run inflation target. [Update Think of it this way, I'm really assuming the central bank follows a Taylor rule and that determines the nominal rate given the inflation target.  The big kicker for any argument like this will be the way inflation expectations are formed].

As a result, we could just as easily interpret rates staying at 0.25% forever as an indicator that inflation expectations are -1.75% -> in other words we observe a low nominal interest rate BECAUSE there is deflation.  Fundamentally, this tells us nothing – as the Fisher relationship is an equilibrium statement, not a casual relationship.

In fact, if there is indeed a forecast of rates staying at 0.25% forever there is a STRONG argument for making policy more stimulatory now – is that what the guy is trying to say?

If we want to discuss a causal relationship we need a causal model of our endogenous variables right – the Fisher equation is not this.

Update: I see where they are coming from now.  However, I believe the key issue is with regards to current policy – fundamentally the mentioning of deflation was taken in context of the CURRENT disinflation going on in the USA, and it seemed like a statement that was pushing for an increase in rates to avoid deflation.

I’m also nervous about the use of the word “cause” when any observed relationship in the data will not necessarily be clear – but I’m always nervous about causation so oww well.  Namely, if I see an average cash rate of 0.25% and average -1.75% inflation I wouldn’t say “aha, having the cash rate at that level caused that” – I would want more information on how inflation expectations got there in the first place …

In praise of clear targets for monetary policy:  Money Illusion.

Trade-off between gaining knowledge and creating knowledge, at the margin:  Worthwhile Canadian Initiative.

These are both excellent posts that I agree with.

One of the things that I find fascinating at the current time is the enormous gap (see page 9 of link) that has developed between marginal bank funding costs and the official cash rate.

By setting the OCR the RBNZ commits to borrowing an infinite amount off banks for 25bps less, or loaning an infinite amount too banks for 25bp more than the OCR.  Of course, this is now constrained by prudential regulation – but at the margin, the RBNZ sets the opportunity cost of bank borrowing and lending, and so can move around interest rates (which also depend on borrowers risk profile etc).

The increase in the “margin” on top of this has been assumed by many people to be permanent.  The main calls are:

1. It is the result of higher risk, which is not going to abate soon
2. It is the result of new prudential regulation

In part these are true.  However, is the assumption that this increased margin will remain forever really the best assumption when looking at how the OCR translates into interest rates?  Furthermore, as the OCR rises, is it fair to expect that the margin will remain unchanged, and marginal costs will keep rising by 25bps?

I’m not so sure – as I’m not convinced the Bank completely controls the marginal cost of funding right now.  Here are a few reasons off the top of my head:

1. The Bank also focuses on financial regulation – as a result, borrowing from and lending too the Reserve Bank provides a signal of an individual banks quality.  Even though the RBNZ is willing to borrow and lend an infinite amount does not mean that individual banks will work on this basis – and marginal funding may infact come from other sources for new loans.
2. Individual banks are constrained in setting lending rates on what they have set for deposit rates.  As deposit rates have been pushed up due to prudential regulation this has set a “floor” on lending rates – even when the marginal rate is lower, implying that the reaction to a rising OCR will be muted.
3. International interest rates, even for moderately long maturities, are low.  This will, in turn, have an impact both on demand for funds from banks and the cost of funding from banks.  Note that, even with the new prudential regulation longer-term foreign lending can still often be used – and so could help to determine the marginal price for longer term lending.
4. The new prudential regulations (will) mean that a bank has to fund 75% of a loan (currently 65%) from outside the RBNZ right.  So if they loan a new $1, the marginal cost of that dollar will be 3/4 set by the underlying market and 1/4 set by the OCR – at least this is my impression of how banks have to respond.

Ultimately, any factor that ensures that the “marginal $ borrowed or lent” is not coming from the RBNZ could also provide an explanation for why this “margin” has grown.  If this factor is the result of the OCR being historically low, then we can expect the OCR to have LESS punch as it rises.

This is fascinating – and I’m surprised that we haven’t seen more work come out about it.  By the end of next year, it will be very interesting to see how rates have responded to a rising OCR.  I am currently not convinced that the working assumption a perfect feed through is Bayesian rational

= Changing rhetoric to win votes.  I don’t know whether it makes me laugh or hit my desk angrily – I guess I’ll do both.

Listen to this:

Labour would broaden the Reserve Bank’s monetary policy targets, adding a requirement to aim for a stable currency, full employment, and the economic prosperity and welfare of the people to its existing inflation target

Yes, because determining how quickly to run printing presses can do all these things.

And has Labour figured out how to measure welfare in society?  If so I would like to meet them and congratulate them – that has been a vexing issue for economists AND psychologists for centuries.

Also:

“The Reserve Bank Act needs to be clarified to ensure the bank can use such tools primarily for the purpose of supporting Monetary Policy,” Labour’s associate finance spokesman David Parker said.

“Labour will make that change. Faced with rapid credit expansion, such as that in recent years, the change would cause the Reserve Bank to use prudential ratios, rather than rely solely on interest rates.”

Yes because, ex ante, when we have little information on the nature of the economy relative to its potential the Reserve Bank is incredibly well placed to determine the level of risk banks should take on.

Also, prudential regulation will change interest rates – acting like this is a “cost free” way to change monetary conditions is weird.

I realise the Bank is introducing prudential regulations, and I can see some potential for it theoretically.  However, I’m still not convinced at this level – and as a result definitely don’t think it should be made a central part of their mandate yet.  As I’ve said before, I think the organisations that determine monetary policy and prudential policy should be kept separate on transparency grounds.

You want more discussion on these issues – search the blog, we’ve written about these things repeatedly.  One day soon I may come back to it.  And if you think this “change” in policy make sense, feel free to email me/comment etc, but there is only the slimmest of chances I’ll ever agree with you – so keep that in mind.

So the OCR went up 25 basis points.  Cool, that is nice.

It was almost entirely in line with expectations so there isn’t much to say, except:

1. They more explicitly discussed Eric’s concerns regarding the impact of ETS increases into inflation expectations.
2. They put table 5.2 in which talked about “who got what” from tax cuts.  OMG, seriously – this table was unnecessary.
3. The continued to state that there is no real reason for our TOT to hold up – so a lot of the issues I’ve viewed as “structural” (rising commodity demand from China’s middle classes, Biofuels, falling subsidies on agriculture around the world) are being viewed as temporary by the Bank methinks.  This is why I will always disagree with their medium term forecasts …

I was about to post a comment on Eric’s blog – but then the comment got long, and I realised I needed a blog post.  So here it is.

Eric Crampton raises some important points regarding the Reserve Bank’s view on the ETS in New Zealand.  Essentially, they are ignoring it – a policy decision that a lot of analysts have disagreed with.  However, this is one of those cases where I would tend to side with the Reserve Bank, lets work through the discussion to figure out what value judgments I’ve made to get there

Update:  Eric discusses further here.

Read more…

The EU has decided it arbitrarily needs to protect the value of the euro.  Specifically:

We now see herd behavior in the markets that are really pack behavior, wolfpack behavior

Relevant picture:

Shirt source.

My question as a New Zealander who has experience the vicious swings in currency myself – why protect the value of the euro?  The euro is falling to help buffer the painful adjustment Europe is about to go through given their banking crisis, and they want to waste money trying to prevent this?  I don’t understand. Note: Krugman seems to feel a similar way.

Were inextricably linked.  A quote that illustrates this to me strongly came from a Bloomberg article today.  The ECB decided to tell the countries that have high soverign debts to go to hell, and now that they aren’t going to take on the risk themselves private investors aren’t willing to and are selling.

This makes sense, previously people purchased the junk on the basis that someone else would pay for it – high return low risk!  Now that they have to face the real risk profile they are like “f**k that”.  However, Bloomberg (or at least David Kovacs) stated:

The reason the market is horrified now is Trichet said it’s not even being discussed. Smart investors are basically selling risk(y) assets

No s**t.  An asset appeared low risk, and now it is high risk, and the expected return is (at most) unchanged – so the risk adjusted return is lower.  No wonder they want to sell.

Now we are in a crisis, and if there is a run on good quality debt because of concerns we have to do strange things – sure.  But we need to come up with a system that rips this moral hazard out of the system.  It is the moral hazard that helps to drive crisis after crisis ultimately.

Note:  Apologises for the lack of action here.  If I was any busy I would become a singularity.  Regular posting will eventually restart.  Now for a post …

Bernard Hickey recommended sticking to floating mortgages for the long haul on Rates blog recently.  This is in stark contrast to Tony Alexander’s suggestion that, in a few months, fixing will be the way to go.

Now fundamentally, I think these two authors AGREE on the track for the official cash rate going forward.  The difference stems from the expectations for floating and fixed rates.  Personally I agree with Tony.  Why?

Bernards argument, in my opinion, hits a certain flaw right here:

If, for example, the Reserve Bank starts increasing the Official Cash Rate from its 2.5% to around 5% by the end of next year, then variable rates are expected to rise to around 8-8.5%. Given fixed rates are also expected to rise by a similar amount to around 9-9.5% the choice is clear for those simply looking for the cheapest rate.

This isn’t how floating and fixed rates work per see.  The current official cash rate influences interest rates now by providing some opportunity cost in sourcing funds.  The future official cash rate influences fixed interest rates now, by changing the opportunity cost of sourcing funds in the future.  As a result, the fixed rate depends upon expectations of the OCR in the future, while the floating rate only depends on the OCR now.

Given that everyone expects the OCR to lift appreciably in the coming quarters, it makes sense that the current floating rate is below the fixed rates.  However, as the OCR increases floating mortgage rates will lift by a greater amount than fixed rates.

Bernard Hickey is absolutely correct when he says that the world is different, and the make up and structure of interest rates will be different than we have experienced in the past.  However, as we move through the upward swing of the economic cycle I would expect fixed rates to become “relatively cheaper” than floating rates in a static sense.

Economist’s View links to a post on the Vox EU site by Hans Gersbach.  At the start of the post Mark Thoma states:

I have argued many times that the Fed should have two roles. It should conduct monetary policy, and it should be the primary regulator of the financial system. However, not everyone agrees. When I was at the What’s Wrong with Modern Macro Conference in Munich recently, I met Hans Gersbach — we were on a panel together — and he passes along his argument that monetary policy and banking regulation should be conducted by separate bodies

So the disagreement here is not about the two instruments for central banks – in fact in the monetary policy community there is a strong degree of agreement regarding these two roles.  The disagreement stems from who should be in charge of the instruments – should we have one authority controlling both, or separate authorities.

This is a fascinating issue, and I have previously said I am on the side of SEPARATING.

My reasoning is that separating “monetary” and “financial stability” issues is essential in order to create transperancy in the public regarding policy movements.  If we can make sure that changes in the Bank’s cash rate are related to “monetary” policy and changes in prudential regulation/settings are related to “financial stability”.  By doing this, the actions/intentions of the individual institutions are more obvious and are more likely to anchor expectations – which is the point.

Of course monetary and financial stability policies, and these instruments (interest rates and prudential policy) are heavily related.  But of course, we know that monetary policy and fiscal policy is as well.  The fact is that in order to signal policy and control expectations we NEED individual instruments to be targeted at individual variables – and having separate institutions helps to clarify this fact.