Tag Archives: Interest rate

Reading List on ‘Free’ or ‘Not-so-free’ Public Debt

Risk, Discounting, and Dynamic Efficiency

In the presence of risk, a comparison of the risk-free interest rate and the expected growth rate is insufficient to assess whether an economy is dynamically efficient or inefficient. Stochastic discount factors—not risk-free interest rates—enter the government’s budget constraint, even if debt is safe.

These points are made, for example, by Andrew Abel, N. Gregory Mankiw, Lawrence Summers, and Richard Zeckhauser (Assessing Dynamic Efficiency: Theory and Evidence, REStud 56(1), 1989),

the issue of dynamic efficiency can be resolved by comparing the level of investment with the cash flows generated by production after the payment of wages … dynamic efficiency cannot be assessed by comparing the safe rate of interest and the average growth rate of the capital stock, output, or any other accounting aggregate,

or Henning Bohn (The Sustainability of Budget Deficits in a Stochastic Economy, JMCB 27(1), 1995),

discounting at the safe interest rate is usually incorrect. … popular fiscal policy “indicators” like deficit levels or debt-GNP ratios may provide very little information about sustainability. … the intertemporal budget constraint imposes very few restrictions on the average primary balance.

Recent work in which these themes appear include papers by Zhengyang Jiang, Hanno Lustig, Stijn Van Nieuwerburgh, and Mindy Xiaolan (Manufacturing Risk-free Government Debt, NBER wp 27786, 2020), Robert Barro (r Minus g, NBER wp 28002, 2020), or Stan Olijslagers, Nander de Vette, and Sweder van Wijnbergen (Debt Sustainability when r−g<0: No Free Lunch after All, CEPR dp 15478, 2020).

Intergenerational Risk Sharing

With overlapping generations the way the government manages its debt has implications for intergenerational risk sharing, see for example Henning Bohn (Risk Sharing in a Stochastic Overlapping Generations Economy, mimeo, 1998), Robert Shiller (Social Security and Institutions for Intergenerational, Intragenerational, and International Risk Sharing, Carnegie-Rochester Conference on Public Policy 50, 1999), or Gabrielle Demange (On Optimality of Intergenerational Risk Sharing, Economic Theory 20(1), 2002).

Long-Run Debt Dynamics and Fiscal Space

Dmitriy Sergeyev and Neil Mehrotra (Debt Sustainability in a Low Interest World, CEPR dp 15282, 2020) offer an analysis of long-run debt dynamics under the assumption that the primary surplus systematically, and strongly responds to the debt-to-GDP ratio such that the government’s intertemporal budget constraint is necessarily satisfied:

Population growth and productivity growth have opposing effects on the debt-to-GDP ratio due to their opposing effects on the real interest rate. Lower population growth leaves the borrowing rate unchanged while directly lowering output growth, shifting the average debt-to-GDP ratio higher. By contrast, when the elasticity of intertemporal substitution is less than one, a decline in productivity growth has a more than a one-for-one effect on the real interest rate, lowering the cost of servicing the debt and thereby reducing the average debt-to-GDP ratio. To the extent that higher uncertainty accounts for low real interest rates, we find that
the variance of the log debt-to-GDP ratio unambiguously increases with higher output
uncertainty. However, uncertainty also has an effect on the mean debt-to-GDP ratio that
depends on the coefficient of relative risk aversion. Higher uncertainty lowers the real
interest rate but this effect may be outweighed by an Ito’s lemma term due to Jensen’s
inequality that works in the opposite direction.

Sergeyev and Mehrotra also consider the effects of rare disasters as well as of a maximum primary surplus which implies that debt becomes defaultable and the interest rate on debt features an endogenous risk premium, generating the possibility of a “tipping point” with a slow moving debt crises as in Guido Lorenzoni and Ivan Werning (Slow Moving Debt Crises, AER 109(9), 2019).

Ricardo Reis (The Constraint on Public Debt when r<g But g<m, mimeo, 2020) analyzes a non-stochastic framework under the assumption that the marginal product of capital, m, exceeds the growth rate, g, which in turn exceeds the risk-free interest rate, r. Reis considers the case where m is the relevant discount rate, for example because r features a liquidity premium:

there is still a meaningful government budget constraint once future surpluses and debt are discounted by the marginal product of capital.

He shows the following:

  • The debt due to a one-time primary deficit can be rolled over indefinitely and disappears asymptotically as long as r<g.
  • With permanent primary deficits that grow at the same rate as debt and output, the government’s intertemporal budget constraint features a bubble component due to r<m. This corresponds to the usual seignorage revenue measure (see p. 173 in Niepelt, Macroeconomic Analysis, 2019).
  • Suppose that from tomorrow on, the primary deficit and debt quotas are given by d and b, respectively. Then, the present value of total net revenues in the government’s budget constraint equals [- d + (m – r)*b] / (m-g). Both m>g and g>r relax the constraint, as does a lower r.
  • Along a balanced growth path, b = [- d + (m – r)*b] / (m-g) and thus, d = (g-r)*b where d is assumed to be positive. Reis argues that b cannot be larger than total assets relative to GDP. Accordingly, the deficit cannot exceed total assets times (g-r).

Reis concludes that most of the bubble component “has already been used.” In addition to developing a model that yields m>g>r in equilibrium he also discusses the role of inflation (stable inflation generates fiscal space because it renders debt safer and thus increases demand for debt) and inequality (more inequality increases fiscal space).

Blanchard’s Presidential Address

In his presidential address, Olivier Blanchard (Public Debt and Low Interest Rates, AER 109(4), 2019) argues that the risk-free interest rate has fallen short of average US growth rate (and similarly, in other countries). Importantly—and implicitly addressing Abel, Mankiw, Summers, Zeckhauser, and Bohn (see above)—he also argues that risk is not that much of an issue as far as the sustainability of public debt is concerned:

Jensen’s inequality is thus not an issue here. In short, if we assume that the future will be like the past (admittedly a big if), debt rollovers appear feasible. While the debt ratio may increase for some time due to adverse shocks to growth or positive shocks to the interest rate, it will eventually decrease over time. In other words, higher debt may not imply a higher fiscal cost.

Most of his formal analysis doesn’t focus on debt though. Instead he analyzes the effects of risk-free social security transfers from young to old in a stochastic OLG economy. (There are close parallels between debt and such transfers to the old that are financed by contemporaneous taxes on the young.) In a steady-state with very low interest rates higher transfers have two effects on welfare, by (i) providing an attractive substitute for savings and by (ii) reducing capital accumulation and thereby lowering wages and raising the interest rate. If the economy initially is dynamically inefficient both effects are welfare improving because (i) capital accumulation with a low return is replaced by higher yielding intergenerational transfers and (ii) lower wages and higher interest rates are attractive, starting from a situation with a low interest rate. In a stochastic economy the first channel yields welfare gains as long as the growth rate exceeds the risk-free rate, and the second channel yields welfare gains (approximately) when the growth rate exceeds the marginal product of capital. Blanchard argues

[b]e this as it may, the analysis suggests that the welfare effects of a transfer may not necessarily be adverse, or, if adverse, may not be very large.

In the corresponding case with debt there is another effect because the intergenerational transfer is not risk-free; the size of this additional effect depends on the path of the risk-free interest rates (Blanchard assumes that the debt level is stabilized which requires net tax payments by the young to reflect the contemporaneous risk-free rate). In the slightly different case where debt is increased once and then rolled over, without adjusting taxes in the future, the sustainability and welfare implications are ambiguous and critically depend on the production function:

In the linear case, debt rollovers typically do not fail [my emphasis] and welfare is increased throughout. For the generation receiving the initial transfer associated with debt issuance, the effect is clearly positive and large. For later generations, while they are, at the margin, indifferent between holding safe debt or risky capital, the inframarginal gains (from a less risky portfolio) imply slightly larger utility. But the welfare gain is small … . In the Cobb-Douglas case however, this positive effect is more than offset by the price effect, and while welfare still goes up for the first generation (by 2 percent), it is typically negative thereafter. In the case of successful debt rollovers, the average adverse welfare cost decreases as debt decreases over time. In the case of unsuccessful rollovers, the adjustment implies a larger welfare loss when it happens. If we take the Cobb-Douglas example to be more representative, are these Ponzi gambles, as Ball, Elmendorf, and Mankiw (1998) have called them, worth it from a welfare viewpoint? This clearly depends on the relative weight the policymaker puts on the utility of different generations [my emphasis].

Blanchard argues that the marginal product of capital may be smaller than commonly assumed, implying that it is more likely that the welfare effects working through (ii) are positive (those working through (i) are very likely positive). Finally, he also presents some additional potential arguments pro and con higher public debt.

Blanchard’s work has attracted substantial criticism, for instance at the January 2020 ASSA meetings (see this previous post). In a short paper presented at the meetings, Johannes Brumm, Laurence Kotlikoff, and Felix Kubler (Leveraging Posterity’s Prosperity?) point out that a negative difference between average interest and growth rates is not necessarily indicative of dynamic inefficiency (see the discussion above) and that Blanchard’s analysis disregards tax distortions as well as the welfare effects from intergenerational risk sharing (again, see above):

To see the distinction between risk-sharing and a Ponzi scheme, modify B’s two-period model to include agents working when old if they don’t randomly become disabled. Now workers face second-period asset income and labor earnings risk. The government has no safe asset in which to invest. If it borrows, invests in capital, and taxes bond holders its excess return, “safe” debt is identical to risky capital. But if the net taxes are only levied on the non-disabled, bonds become a valued risk-mitigating asset and their return can be driven far below zero. This scheme could be, and to some extend it is, implemented through progressive taxation. If, observing this gap between growth and safe rates, the government decides to institute an “efficient” Ponzi scheme with a fixed pension benefit financed on a pay-go basis by taxes on workers, net wages when young will be more variable, raising generation-specific risk and potentially producing an outcome in which no generation is better off and at least one is worse off.

Brumm, Kotlikoff, and Kubler also note that the effective interest rate at which US households are borrowing is much higher than the borrowing rate of the government; this undermines Blanchard’s approach to gauge the welfare implications. And they point out that the scheme suggested by Blanchard could harm other countries by reducing global investment.

Jasmina Hasanhodzic (Simulating the Blanchard Conjecture in a Multi-Period Life-Cycle Model) simulates a richer OLG model and rejects the Blanchard conjecture of Pareto gains due to higher transfers:

It shows that the safe rate on government debt can, on average, be far less than the economy’s growth rate without its implying that ongoing redistribution from the young to the old is Pareto improving. Indeed, in a 10-period, OLG, CGE model, whose average safe rate averages negative 2 percent on an annual basis, welfare losses to future generations resulting from the introduction of pay-go Social Security, financed with a 15 percent payroll tax, are enormous—roughly 20 percent measured as a compensating variation relative to no policy.

Relative to Blanchard’s simulations, her model implies more negative consequences of crowding out on wages, a higher tax burden from the transfer scheme, and more induced old-age consumption risk.

Michael Boskin (How, When and Why Deficits Are Dangerous) offers a broad discussion of potential weaknesses of Blanchard’s analysis. Richard Evens (Public Debt, Interest Rates, and Negative Shocks) questions Blanchard’s simulations on calibration grounds and notes that he couldn’t replicate some of Blanchard’s findings.

On his blog, John Cochrane argues along similar lines as Ricardo Reis: Even if r<g, expected primary deficits are so large that debt quotas will explode nevertheless.

Note: This post was updated several times.

Debt, Deficits, and MMT

One of the American Economic Association sessions in this year’s ASSA Meetings focused on “Modern Monetary Theory” (MMT) and (maybe somewhat unfairly in the same session) on last year’s presidential address by Olivier Blanchard, which suggested that persistently low interest rates on public debt render government budget constraints non-binding.

Greg Mankiw concluded in his paper that “MMT contains some kernels of truth, but its most novel policy prescriptions do not follow cogently from its premises,” in line with my own assessment.

Papers by Richard Evans, Michael Boskin, Jasmina Hasanhodzic, as well as by Johannes Brumm, Laurence Kotlikoff, and Felix Kubler argued that Blanchard’s conclusions are not robust, for various reasons.

U.S. Money Markets

For over a year the federal funds rate has increased relative to the rate the Fed pays on excess reserves. In mid September 2019, the federal funds rate increased abruptly, triggering the Fed to inject fresh funds. In parallel, the repo market rates spiked dramatically.

On the Cato Institute’s blog, George Selgin argues that structurally elevated demand collided with reduced supply. He mentions explicit and implicit regulation; Treasury General Account (TGA) balances; the NY Fed’s foreign repo pool (Japanese banks); and the administration’s $1 trillion deficit which required primary dealers to underwrite newly-issued government debt.

The bottom line is that regulators have managed to raise the biggest banks liquidity needs enough to compel them to sit on most of the banking system’s seemingly huge stock of excess reserves, and to do so even as repo markets present them with an opportunities to earn five times what those reserves are yielding just by lending them out overnight.

… So there you have it: a host of developments adding to banks’ demand for excess reserves, while others gradually chipped away at the stock of such reserves. Add a spike in primary dealers’ demand for short-term funding, a coinciding round of tax payments that transferred as many reserves to the TGA, and binding intraday liquidity requirements at the banks holding a large share of total system excess reserves, and you have the makings of last month’s perfect repo-market storm.

David Andolfatto and Jane Ihrig concur. On the Federal Reserve Bank of St. Louis’ On the Economy Blog, they already argued in March 2019 that banks feel compelled to hoard reserves rather than lending against treasuries:

Why should banks prefer reserves to higher-yielding Treasuries? One explanation is that Treasuries are not really cash equivalent if funds are needed immediately. In particular, for resolution planning purposes, banks may worry about the market value they would receive in the sale of or agreement to repurchase their securities in an individual stress scenario.

Consistent with this possibility, Federal Reserve Vice Chair for Supervision Randal Quarles noted, “Occasionally we hear that banks feel they are under supervisory pressure to satisfy their [high-quality liquid assets] with reserves rather than Treasury securities.”

To quantify this liquidity consideration, a recent post on the Federal Reserve Bank of New York’s Liberty Street Economics blog suggests that the eight domestic Large Institution Supervision Coordinating Committee’s banks collectively may want to hold $784 billion in precautionary reserves to cover their immediate liquidity needs in times of stress.

Andolfatto and Ihrig argue that the precautionary reserves hoarding by banks could substantially be reduced if the Fed offered a standing repo facility:

The Fed could easily incentivize banks to reduce their demand for reserves by operating a standing overnight repurchase (repo) facility that would permit banks to convert Treasuries to reserves on demand at an administered rate. This administered rate could be set a bit above market rates—perhaps several basis points above the top of the federal funds target range—so that the facility is not used every day …

With this facility in place, banks should feel comfortable holding Treasuries to help accommodate stress scenarios instead of reserves. The demand for reserves would decline substantially as a result. Ample reserves—and therefore the size of the Fed’s balance sheet—could in fact be much closer to their historical levels.

A standing repo facility could effectively impose a ceiling on repo rates. And as Andolfatto and Ihrig argue it would also have other benefits. In a follow up post, Andolfatto and Ihrig emphasize that,

[w]hile U.S. Treasuries are given equal weight with reserves in the calculation of high-quality liquid assets (HQLA) for the LCR, they are evidently not considered equivalent for resolution purposes.

Internal liquidity stress tests apparently assume a significant discount on Treasury securities liquidated in large volumes during times of stress, so that Treasuries are not treated as cash-equivalent. We have heard that banks occasionally feel under supervisory pressure to satisfy their HQLA requirements with reserves rather than Treasuries.

On the NewMonetarism blog, Stephen Williamson offers a longer-term perspective. He appears more skeptical as far as bank liquidity requirements as a possible explanation for the recent interest rate spikes are concerned. In Williamson’s view a floor system that requires even more reserves in the banking system than currently present is ineffective and should be replaced. He writes (my emphasis):

Before the financial crisis, the Fed intervened on the supply side of the overnight credit market by varying the quantity of its lending in the repo market so as to peg the fed funds rate. … a corridor system, as the central bank’s interest rate target was bounded above by the discount rate, and below by the interest rate on reserves, which was zero at the time. But, the Fed could have chosen to run a corridor by intervening on the other side of the market – by varying the quantity of reverse repos, for example. Post-financial crisis, the Fed’s floor system is effectively a mechanism for intervening on the demand side … With a large quantity reserves outstanding, those financial institutions holding reserves accounts have the option of lending to the Fed at the interest rate on reserves, or lending in the market – fed funds or repo market. Financial market arbitrage, in a frictionless world, would then look after the rest. By pegging the interest rate on excess reserves (IOER), the Fed should in principle peg overnight rates.

The problem is that overnight markets – particularly in the United States – are gummed up with various frictions. … Friction in U.S. overnight credit markets … is nothing new. Indeed, the big worry at the Fed, when “liftoff” from the 0-0.25% fed funds rate trading range occurred in December 2015, was that arbitrage would not work to peg overnight rates in a higher range. That’s why the Fed introduced the ON-RRP, or overnight reverse-repo, facility, with the ON-RRP rate set at the bottom of the fed funds rate target range, and IOER at the top of the range. The idea was that the ON-RRP rate would bound the fed funds rate from below.

… if total reserves outstanding are constant and general account balances go up, then reserve balances held in the private sector must go down by the same amount. The Fed permits these large and fluctuating Treasury balances, apparently because they think this won’t matter in a floor system, as it shouldn’t. … Another drain on private sector reserve balances is the foreign repo pool. … if the problem is low reserve balances in the private sector, those balances could be increased by about $300 billion if the Fed eliminated the foreign repo pool.

… The key problem is that the Fed is trying to manage overnight markets by working from the banking sector, through the stock of reserves. Apparently, that just won’t work in the American context, because market frictions are too severe. In particular, these frictions segment banks from the rest of the financial sector in various ways. The appropriate type of daily intervention for the Fed is in the repo market, which is more broadly-based. If $1.5 trillion in reserve balances isn’t enough to make a floor system work, without intervention through either a reverse-repo or repo facility, then that’s a bad floor system. … Make the secured overnight financing rate the policy rate, and run a corridor system. That’s what normal central banks do.

Some background information:

  • NY Fed commentary on monetary policy implementation.
  • Description (2009) of the primary dealer system, by Barry Ritzholtz.
  • NY Fed staff report (2015) on US repo and securities lending markets, by Viktoria Baklanova, Adam Copeland and Rebecca McCaughrin.

In the FT, Cale Tilford, Joe Rennison, Laura Noonan, Colby Smith, and Brendan Greeley “break down what went wrong, what happens next, and whether markets can avoid another cash crunch” (with many figures).

This post was updated on November 21, 11:09 pm; and on November 26 (FT article).

How to Prevent Cash Hoarding when Interest Rates are Strongly Negative

On swissinfo.ch, Fabio Canetg explains how the Swiss National Bank prevents banks from hoarding cash rather than holding reserves at the central bank (which pay negative interest). He points to the following sentence in the SNB’s December 2014 press release (my emphasis) and he speculates that banks could, in principle, implement similar schemes to keep depositors from withdrawing cash:

The threshold currently corresponds to 20 times the minimum reserve requirement for the reporting period 20 October 2014 to 19 November 2014 (static component), minus any increase/plus any decrease in the amount of cash held (dynamic component). The change in the amount of cash held is calculated as the difference between the average cash holdings during the most recent reporting period for which the minimum reserve requirement is determined prior to the reference date (cf. section 5 below) and the cash holdings of the corresponding reporting period in a given reference period.

“Moderne monetäre Theorie: Ein makroökonomisches Perpetuum mobile (The Macroeconomic Perpetuum Mobile),” NZZ, 2019

NZZ, April 25, 2019. PDF.

  • Modern monetary theory (MMT) is neither a theory, nor modern, nor exclusively monetary.
  • I discuss fallacies related to MMT.
  • Dynamic inefficiency requires permanent, not transitory, r<g.
  • For now, policy makers should rely on common sense rather than MMT.

“Die SNB schuldet den Pensionskassen nichts (Nothing the SNB Owes to Pension Funds),” NZZ, 2019

NZZ, March 13, 2019. PDF. Updated: Ökonomenstimme, March 22, 2019. HTML.

  • Long-term real interest rates do not reflect monetary policy.
  • In the recent past, monetary policy has contributed to lower fixed-income interest rates but also to higher returns on other asset classes.
  • Complaining about low rates but not adjusting one’s portfolio makes little sense; there is no “financial repression.”
  • If politicians want to subsidize pension funds they should contribute funds from the government budget rather than asking the central bank to contribute.
  • Larger and earlier SNB dividend payouts to the government may not be in the government’s interest.

Sources of Low Real Interest Rates

In a (December 2015) Bank of England Staff Working Paper, Lukasz Rachel and Thomas Smith dissect the global decline in long-term real interest rates over the last thirty years.

A summary of their executive summary:

  • Market measures of long-term risk-free real interest rates have declined by around 450bps.
  • Absent signs of overheating this suggests that the global neutral rate fell.
  • Expected trend growth as well as other factors affecting desired savings and investment determine the neutral rate.
  • Global growth was fairly steady before the crisis but may (be expected to) fall after the financial crisis. Recently, slower labor supply (demographics) and productivity growth may account for a 100bps decline in the real rate.
  • Desired savings rose, due to demographics (90bps), higher within country inequality (45bps), and higher savings rates in emerging markets following the Asian crisis (25bps).
  • Desired investment fell, due to a lower relative price of capital goods (50bps) and less public investment (20bps).
  • The spread between the return on capital and the risk-free rate rose (70bps).
  • These trends look likely to persist and the “global neutral real rate may settle at or slightly below 1% over the medium- to long-run”.

From page 2 of the paper:
Untitled

See also the summary by James Hamilton; the White House CEA report; and the 17th Geneva report.

Marvin Goodfriend, the Fed’s Board of Governors, and Negative Rates

In the FT, Sam Fleming and Demetri Sevastopulo report that the White House considers Marvin Goodfriend for the Federal Reserve’s Board of Governors.

He has criticised the Fed’s crisis-era balance sheet expansion, saying the central bank should generally not purchase mortgage-backed securities, and has advocated the use of monetary policy rules to guide policy, as has Mr Quarles. …

At the same time, however, Mr Goodfriend has been willing to contemplate the use of deeply negative rates to stimulate growth — something that the Fed has thus far not embarked upon. In 1999 he wrote that negative rates were a feasible option, years before central banks started actually experimenting with them.

To implement negative rates while preserving cash, Goodfriend has advocated a flexible exchange rate between deposits and cash. On Alphaville, Matthew Klein quotes from a recent paper of Goodfriend’s:

The zero bound encumbrance on interest rate policy could be eliminated completely and expeditiously by discontinuing the central bank defense of the par deposit price of paper currency. … the central bank would no longer let the outstanding stock of paper currency vary elastically to accommodate the deposit demand for paper currency at par. …

The reason to abandon the pegged par deposit price of paper currency is analogous to the … reasons for abandoning the gold standard and fixed exchange rate: it is to let fluctuations in the deposit demand for paper currency be reflected in the deposit price of paper currency so as not to destabilize the general price level … the flexible deposit price of paper currency would behave as it actually did when the payment of paper currency for deposits was restricted in the United States during the banking crises of 1873, 1893, and 1907.

Monetary Policy Implementation in China

The Economist reports that implementation gradually changes:

[T]he way in which the People’s Bank of China conducts monetary policy is changing. It is beginning to look a little more like central banks in developed economies as it shifts towards liberalised interest rates. Rather than simply ordering banks to set specific lending or deposit rates—the focus for many years in China—it is altering the monetary environment around them. China does not yet have an equivalent of the federal-funds rate in America or the refinancing rate in Europe, but it has a few candidates for its new benchmark interest rate. The seven-day bond-repurchase rate, which influences banks’ funding costs, is in pole position.

There is also an element of political intrigue in this transition to a more mature monetary framework. The Chinese central bank sits under the State Council, or cabinet, which has the final say over lending and deposit rates as well as other big policy decisions. Repo rates, by contrast, are seen as sufficiently abstruse for the central bank to decide on its own when it wants to change them.

World War I Turned the Swiss Franc Into a Strong Currency

In Die Volkswirtschaft, Ernst Baltensperger and Peter Kugler summarize the history of the Swiss Franc since the mid 19th century:

  • After 1973, the Swiss Franc has been strong. Swiss Franc yields have been lower than what uncovered interest parity would suggest.
  • Before 1914, the Swiss Franc was weak in the sense that it enjoyed only limited credibility. In periods with fixed exchange rates, Swiss Franc yields typically exceeded yields in French Franc or Sterling.
  • Throughout the 20th century, the Swiss Franc appreciated by more than what inflation differentials would suggest, potentially reflecting the Balassa-Samuelson effect.

Negative Interest Rates vs. Higher Inflation

On his blog, Ben Bernanke weighs the pros and cons of negative (nominal) interest rates vs. a higher inflation target to create monetary “policy space.” His main points are:

  • Lower rates work immediately. In contrast, a higher inflation target only works once agents’ expectations adjust. A higher target may not be politically tenable a thus, not be credible. In contrast, “institutional changes … [such] as eliminating or restricting the issuance of large-denomination currency, could expand the scope for negative rates.”
  • Both negative rates and higher inflation have negative side effects. But the side effects of negative rates would materialize only during bad recessions.
  • There are reasons to expect that higher inflation would impose a relatively larger burden on the “poor” while negative interest rates would impose a relatively larger burden on the “rich.”
  • The political risks for the Fed associated with a higher inflation target may be substantial.

Monetary Policy When Interest Rates are Near Zero

In the 18th Geneva Report on the World Economy, Laurence Ball, Joseph Gagnon, Patrick Honohan and Signe Krogstrup ask whether “central banks can do [more] to provide stimulus when rates are near zero; and … whether policies exist that would lessen future constraints from the lower bound.”

They are optimistic and argue that the unconventional policies of recent years can be extended: “[I]t is likely that rates could go somewhat further than what has been done so far without adverse consequences” and “[m]ore stimulus can be provided if policymakers increase the scale of quantitative easing, and if they expand the range of assets they purchase to include risky assets such as equity.” While the authors concede that QE might have negative side effects they argue that the benefits are worth the costs.

To relax the zero lower bound constraint in the future, Ball, Gagnon, Honohan and Krogstrup argue in favor of a higher inflation target. They view cashless societies as not imminent but possible.

Developing Countries Issue Sovereign Debt (Lots of)

In the FT, Elaine Moore reports that “[d]eveloping economies are on course to raise a record sum on global debt markets this year, as ultra-low rates in the developed world cheapen borrowing costs for countries from Asia to South America.” By the end of the year, hard currency debt sales by countries such as Mexico, Quatar, Saudi Arabia and Argentina are expected to reach USD 125 billion.

Central Bank Independence, Old-Fashioned?

The Economist speculates that central bank independence might be on its way out. The article suggests that motives for independence (i.e., Sargent/Wallace or Barro/Gordon type arguments) might be less relevant given the environment of low inflation and interest rates.

See also my earlier, related blog post.

Money Demand

In a recent NBER working paper, Luca Benati, Robert E. Lucas, Jr., Juan Pablo Nicolini, and Warren Weber report estimates of long-term money demand. They write:

[U]sing annual data on money (M1, for us), nominal GDP, and short term interest rates from 31 countries over periods that range in some cases to over 100 years. We find remarkable stability in long run money demand behavior in many countries, and an equally surprising sameness across different countries. In some cases of instability, anomalies have straightforward explanations.

“Dirk Niepelt über die Folgen eines Brexit für die Schweiz (What Brexit Means for Switzerland),” SRF, 2016

SRF, Tagesgespräch, June 16, 2016. HTML with link to MP3.

  • Half-hour-long interview on the Swiss news channel.
  • Topics include monetary policy, exchange rates, financial stability, Brexit.

“Zinsen, Inflation und Realismus (Interest, Inflation and Realism),” FuW, 2016

Finanz und Wirtschaft, April 30, 2016. PDF. Ökonomenstimme, May 6, 2016. HTML.

The winners and losers of the current monetary environment are not that easy to identify. Investors holding long-term, non-indexed debt gain as unexpectedly low inflation shifts wealth from borrowers to lenders. Governments suffer from increased real debt burdens and reduced revenue due to effectively lower capital income tax rates. Policies that succeed in affecting the real exchange rate entail redistribution.

Neo-Fisherianism Turns Mainstream

On his blog, John Cochrane offers a stripped down model and some intuition for why inflation would rise after an increase in the interest rate. The model features the usual Euler (IS) equation and a Mickey Mouse Phillips curve—inflation is proportional to consumption (or output). The intuition:

During the time of high real interest rates — when the nominal rate has risen, but inflation has not yet caught up — consumption must grow faster [the Euler equation, DN]. … Since more consumption pushes up prices, giving more inflation, inflation must also rise during the period of high consumption growth.

Also:

I really like that the Phillips curve here is so completely old fashioned. This is Phillips’ Phillips curve, with a permanent inflation-output tradeoff. That fact shows squarely where the neo-Fisherian result comes from. The forward-looking intertemporal-substitution IS equation is the central ingredient.

A slightly more plausible model with an accelerationist Phillips curve and very slowly adjusting adaptive expectations yields the following responses to an increase in the nominal interest rate:

cochr

John writes:

As you can see, we still have a completely positive response. Inflation ends up moving one for one with the rate change. Consumption booms and then slowly reverts to zero. …

The positive consumption response does not survive with more realistic or better grounded Phillips curves. With the standard forward looking new Keynesian Phillips curve inflation looks about the same, but output goes down throughout the episode: you get stagflation.

A November 2015 paper on the topic by James Bullard.

A critique by Mariana García-Schmidt and Michael Woodford in an NBER working paper. Abstract:

We illustrate a pitfall that can result from the common practice of assessing alternative monetary policies purely by considering the perfect foresight equilibria (PFE) consistent with the proposed rule. In a standard New Keynesian model, such analysis may seem to support the “Neo-Fisherian” proposition according to which low nominal interest rates can cause inflation to be lower. We propose instead an explicit cognitive process by which agents may form their expectations of future endogenous variables. Under some circumstances, a PFE can arise as a limiting case of our more general concept of reflective equilibrium, when the process of reflection is pursued sufficiently far. But we show that an announced intention to fix the nominal interest rate for a long enough period of time creates a situation in which reflective equilibrium need not resemble any PFE. In our view, this makes PFE predictions not plausible outcomes in the case of such policies. Our alternative approach implies that a commitment to keep interest rates low should raise inflation and output, though by less than some PFE analyses apply.

On his blog, Stephen Williamson addresses “Neo-Fisherian Denial.” Williamson starts with the model analyzed by Cochrane (see above) featuring a Mickey Mouse Phillips curve. He argues:

[This] NK model actually doesn’t conform to conventional central banking beliefs about how monetary policy works. What’s going on? … an increase in the current nominal interest rate will increase the real interest rate, everything else held constant. This implies that future consumption (output) must be higher than current consumption, for consumers to be happy with their consumption profile given the higher nominal interest rate. But, it turns out that this is achieved not through a reduction in current output and consumption, but through an increase in future output and consumption. This serves, through the Phillips curve mechanism, to increase future inflation relative to current inflation. Then, along the path to the new steady state, output and inflation increase.

Williamson recalls the “perils” of Taylor rules. And he addresses the critique by Garcia-Schmidt and Woodford:

Some people (e.g. Garcia-Schmidt and Woodford) have argued that Neo-Fisherian results go out the window in NK models under learning rules. As was shown above, these models are always fundamentally Fisherian in that any monetary policy rule has to somehow adhere to Fisherian logic on average – basically the long-run nominal interest rate is the inflation anchor. But there can also be learning rules that give very Fisherian results. …

Williamson also argues that other (non-Keynesian) monetary models give neo-Fisherian results as well.

A few years ago, also on his blog, Stephen Williamson argued that lowering the interest rate (by engaging in QE) might also affect the real interest rate:

… short-run liquidity effects are short-lived. Further, my work shows that there is another liquidity effect, associated with the interest bearing liquid assets, that causes the long run real rate to increase as a result of QE. … which implies lower inflation.

Further, there are other forces in play … The destruction of private sources of collateral and the shaky state of sovereign governments in parts of the world gave U.S. government debt a large liquidity premium – i.e. those things reduced real interest rates. As those effects go away over time, real rates of return will rise, shifting up the long-run Fisher relation, and reducing inflation if the Fed keeps the nominal interest rate at the zero lower bound.

In a paper, Peter Rupert and Roman Sustek dig deeper. In the abstract they write:

The monetary transmission mechanism in New-Keynesian models is put to scrutiny, focusing on the role of capital. We demonstrate that, contrary to a widely held view, the transmission mechanism does not operate through a real interest rate channel. Instead, as a first pass, inflation is determined by Fisherian principles, through current and expected future monetary policy shocks, while output is then pinned down by the New-Keynesian Phillips curve. The real rate largely only reflects consumption smoothing. In fact, declines in output and inflation are consistent with a decline, increase, or no change in the ex-ante real rate.

Addendum (May 11–12, 2016): In the abstract of their NBER working paper, Julio Garín, Robert Lester and Eric Sims write:

Increasing the inflation target in a textbook New Keynesian (NK) model may require increasing, rather than decreasing, the nominal interest rate in the short run. We refer to this positive short run co-movement between the nominal interest rate and inflation conditional on a nominal shock as Neo-Fisherianism. We show that the NK model is more likely to be Neo-Fisherian the more persistent is the change in the inflation target and the more flexible are prices. Neo-Fisherianism is driven by the forward-looking nature of the model. Modifications which make the framework less forward-looking make it less likely for the model to exhibit Neo-Fisherianism. As an example, we show that a modest and empirically realistic fraction of “rule of thumb” price-setters may altogether eliminate Neo-Fisherianism in the textbook model.

In his 2008 textbook, Jordi Gali discusses the role of the persistence of monetary policy shocks (page 51). If it is sufficiently persistent, a contractionary monetary policy shock raises the real rate (and lowers output) but decreases the nominal rate, due to the

decline in inflation and the output gap more than offsetting the direct effect [of the shock].