Category Archives: Monetary Policy

The Fed’s Balance Sheet: What’s the Big Deal?

08 Sunday May 2022

Posted by in Government Failure, Inflation, Monetary Policy

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The Federal Reserve just announced tighter monetary policy in an attempt to reduce inflationary pressures. First, it raised its target range for the federal funds rate (on overnight loans between banks) by 0.5%. The new range is 0.75% – 1%. Second, on June 1, the Fed will begin taking steps to reduce the size of its $9 trillion portfolio of securities. These holdings were acquired during periods of so-called quantitative easing (QE) beginning in 2008, including dramatic expansions in 2020-21. A shorthand reference for this portfolio is simply the Fed’s “balance sheet”. It includes government debt the Fed has purchased as well as privately-issued mortgage-backed securities (MBS).

What Is This Balance Sheet You Speak Of?

Talk of the Fed’s balance sheet seems to mystify lots of people. During the 2008 financial crisis, the Fed began to inject liquidity into the economy by purchasing large amounts of assets to be held on its balance sheet. This was QE. It’s scope was unprecedented and a departure from the Fed’s pre-crisis reliance on interest rate targeting. QE had the effect of increasing bank reserves, which raised the possibility of excessive money supply growth. That’s when the Fed began to pay interest to banks on reserves, so they might be content to simply hold some of the reserves over and above what they are required to hold, rather than using all of that excess to support new loans and deposits (and thus money growth). However, that interest won’t stop banks from lending excess reserves if better opportunities present themselves.

The Fed has talked about reducing, “normalizing”, or “tapering” its balance sheet for some time, but it only recently stopped adding to it. With inflation raging and monetary policy widely viewed as too “dovish”, analysts expected the Fed to stop reinvesting proceeds from maturing securities, which amounts to about $95 billion per month. That would shrink or “taper” the balance sheet at a rate of about $1.1 trillion per year. Last week the Fed decided to cap the “runoff” at $47.5 billion per month for the first three months, deferring the $95 billion pace until September. Monetary policy “hawks” were disappointed by this announcement.

Monetizing Government

So, one might ask, what’s the big deal? Why must the Fed taper its securities holdings? Well, first, the rate of inflation is far above the Fed’s target range, and it’s far above the “average Joe’s” comfort range. Inflation imposes significant costs on the economy and acts as a regressive form of taxation, harming the poor disproportionately. To the extent that the Fed’s huge balance sheet (and the corresponding bank reserves) are supporting incremental money growth and fueling inflation, the balance sheet must be reduced.

In that connection, the Fed’s investment in government debt represents monetized federal debt. That means the Fed is essentially printing money to meet the Treasury’s financing needs. Together with profligate spending by the federal government, nothing could do more to convince investors that government debt will never be repaid via future budget surpluses. This dereliction of the government’s “full faith and credit”, and the open-armed acceptance of the inflation tax as a financing mechanism (à la Modern Monetary Theory), is the key driver of fiscal inflation. Reducing the balance sheet would represent de-monetization, which might help to restore faith in the Fed’s ability to push back against fiscal recklessness.

Buyer of First Resort

Perhaps just as critically, the Fed’s heavy investment in government debt and MBS represents an ongoing distortion to the pricing of financial assets and the allocation of capital. Some call this interference in the “price discovery process”. That’s because the Fed has represented a market-altering presence, a willing and inelastic buyer of government debt and MBS. Given that presence, it’s difficult for buyers and sellers to discern the true values of alternative uses of capital, or to care.

QE was, among other things, a welcome institutional development for the U.S. Treasury and for those who fancy that fresh money printing is an ever-valid form of government payment for scarce resources. The Fed’s involvement also means that other potential buyers of Treasury debt need not worry about interest rate risk, making public debt relatively more attractive than private debt. This is a dimension of the “crowding out” phenomenon, whereby the allocation of capital and flows of real resources between public and private uses are distorted.

The Fed’s presence as a buyer of MBS depresses mortgage rates and makes mortgage lending less risky for lenders and investors. As a result, it encourages an over-investment in housing and escalating home prices. This too distorts the allocation of capital and real resources, at the margin, toward housing and away from uses with greater underlying value.

Conclusion

The magnitude of the Fed’s balance sheet is an ongoing testament to an increasingly dominant role of central authorities in the economy. In this case, the Fed has served as a conduit for the inflation tax. In addition, it has unwittingly facilitated crowding out of private capital investment. The Fed’s purchases of MBS have distorted the incentives (and demand) for residential investment. These are subtle effects that the average citizen might not notice, just as one might not notice the early symptoms of a debilitating disease. The long-term consequences of the Fed’s QE activities, including the inflation tax and distorted allocations of capital, are all too typical of failures of government intervention and attempts at central planning. But don’t expect anyone at the Fed to admit it.

Inflation Doomsayers and Downplayers

25 Friday Jun 2021

Posted by in Inflation, Monetary Policy

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There’s a big disconnect between recent news about escalating inflation and market expectations of inflation. In fact, there’s a big disconnect between market expectations and what we’re hearing from some conservative economists. The latter are predicting more inflation based on the recent spurt in prices and the expansionary policy of the Federal Reserve. Can these disparate views be reconciled?

Market Predictions

Market interest rates are considered pretty good predictors of inflation, at least relative to surveys and macroeconomic models. That’s because a fixed interest return is eroded by inflation, and fixed income investors will bid up interest rates to incorporate a premium to compensate for perceptions of increased inflation risk. This is known as the Fisher Effect, after the economist Irving Fisher. In fact, investors should bid rates up more than one-for-one with expected inflation, because the inflation premium will be taxed. A higher return must compensate for both higher expected inflation and taxes on the increased inflation premium.

After rising by about 1.2% from last summer through mid-March, interest rates on Treasury notes have declined slightly. The earlier run-up anticipated a strengthening economy, but if the increase was due to higher expected inflation, we could say it represented an added premium of about 1%, and that’s roughly in-line with changes in some other market-based gauges of expected inflation (ignoring pandemic lows).

Recent Inflation News

Meanwhile, measured inflation certainly has increased in 2021. I say “measured” because 1) “true” price changes are measured imperfectly, and 2) there is a difference between real inflation, which is a continuing process, and month-to-month changes in prices. Here, we’re really talking about the latter and hoping it doesn’t turn into a bad case of the former!

The green line in the chart below is the percent change in the consumer price index (CPI) from a year earlier. After declining during the pandemic, it rebounded sharply this year to almost 5% in May. The purple line is the increase in the CPI excluding food and energy prices, otherwise known as the “core” CPI. The jumps shown in the chart are well in excess of the market’s assessment of inflation trends.  

Both versions of the CPI have jumped in the past few months, but it turns out that durable goods like washing machines, TVs, and (probably) Pelotons have jumped the most sharply. Most of the weakness in prices during the pandemic was in non-durable goods, which stands to reason because so many activities away from home were curtailed. Also noteworthy about these price movements: when measured over a span of two years, prices excluding food and energy have risen at an annualized rate of only 2.6%. 

There are two other lines in the chart above that demonstrate much less alarming changes in prices: the orange line is so-called “median” inflation, which is the price change in the median component of the CPI. That is, half of all price components included in the CPI rose faster and half rose slower than the median. It has barely accelerated this year and stood at only about 2.1% higher in May than a year earlier. The blue line is the so-called “trimmed” CPI, or the average price change of the middle 84% of all CPI components. While it has accelerated in 2021, the year-over-year increase was only 2.6% in May. 

Thus, the breadth of the jump in prices was limited. The Federal Reserve and a lot of market participants insist that the uptick is narrow and temporary — a transitional phenomenon related to the sluggish recovery of supplies in the post-pandemic environment.

But again, the accuracy of price measures is always in question. For example, the housing cost component of the CPI was up only 2.2% in May from a year ago, but it is calibrated to actual survey data only twice a year, the survey is a weak data source, and we know home prices and rents have risen aggressively. Quality and quantity adjustments are always in question as well. An old approach for businesses dealing with rising costs is to reduce package size, which has been called “shrinkflation”. It seems to be back in vogue.

Inflation Drivers

It’s not yet clear how much wage pressure is occurring now. The economy-wide average hourly earnings data has been distorted over the past 15 months by the changing mix of employment, first shifting toward greater concentration in high-wage (work-at-home) occupations and now shifting back toward lower-wage jobs as the economy reopens. But we know many employers are facing a labor shortage, due in large part to extended unemployment benefits and other pandemic-related aid, so this puts upward pressure on wages. In 2021, minimum wage rates are undergoing substantial increases in 17 states, and a number of large employers such as Amazon have increased their minimum pay rates. That creates competitive pressure for smaller employers to boost pay as well.

The fundamental cause of an “honest-to-goodness” inflation is “too much money chasing too few goods”. The Federal Reserve has certainly given us enough to worry about in that regard. The basic money stock (M1) increased by four-fold in the late winter and early spring of 2020, just as the pandemic was spreading. Today, it is almost five times greater than in early 2020, so growth in the money stock remains quite fast even as the recovery proceeds. No wonder: the U.S. Treasury is issuing about $1 trillion of new debt every four-to-six weeks, and the Fed is essentially monetizing these deficits by purchasing a huge chunk of that debt.

That’s a lot of “helicopter” money… new money! But are there too few goods for it to chase? Or is it really chasing anything? Is it just sitting idle? First, GDP is likely to exceed its pre-pandemic level in the second quarter, despite the fact that private payrolls are still down by about 7 million employees. Of course, that doesn’t eliminate the ostensible imbalance between money and goods, and one might expect a veritable explosion in price inflation under these circumstances.

So far that seems unlikely. The so-called velocity of money (its rate of turnover) has plunged since the start of the pandemic, with no discernible rebound through the first quarter of 2021. That means a lot of the cash is not being used in transactions for real goods, but financial transaction volume has been quite strong in 2020-21. Daily stock trading volume was up by more than 50% in 2020 from 2019, and in the first quarter of 2021 it stood another 34% higher than the 2020 average (though volume tapered in April). This is to say nothing of the increased frenzy in cryptocurrency trading. So, while some money is turning over, the expansion of the money stock remains daunting and pressure might well spill-over into goods prices.

Caution Is a Virtue

So long as the Fed keeps printing money, and assuring investors that it will keep printing money, the equity markets are likely to remain strong. There are mixed signals coming from Fed officials, but the over-riding message is that the recent uptick in prices is largely temporary and limited in scope. That is, they assert that certain prices are being squeezed temporarily by rebounding demand for goods while suppliers play catch-up. 

Market expectations of inflation seem to agree with that view, but I have strong trepidations. There are cash reserves held in the private sector to support more aggressive spending. Large companies, consumers, and banks are still holding significant amounts of cash. The Biden Administration is doing its best to spend hand-over-fist. This administration’s energy policy is causing fuel bills to escalate. Home prices and rents are strong. The dollar is down somewhat from pre-pandemic levels, which increases import prices. Finally, the Fed is reluctant to reverse the huge increase in the money supply it engineered during the pandemic. If the recent surge in prices continues, and if higher inflation embeds itself into expectations, it will be all the more difficult for the Fed to correct. 

The market and the Fed might be correct in predicting that the spike in measured inflation is temporary. The recent data show that these worrisome price trends have not been broad. Just the same, I don’t want to hold fixed income investments right now: if higher expectations of inflation cause market interest rates to rise, the value of those assets will fall. Stock values should generally keep pace with inflation barring stronger signals of tightening by the Fed. Unfortunately, however, many would suffer in an inflationary environment as wages, fixed assets, and benefits are devalued by rising prices.

The Federal Reserve and Coronatative Easing

09 Monday Mar 2020

Posted by in Monetary Policy, Pandemic

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Laughs erupted all around when the Federal Reserve reduced its overnight lending rate by 50 basis points last week: LIKE THAT’LL CURE THE CORANAVIRUS! HAHAHA! It’s easy to see why it seemed funny to people, even those who think the threat posed by Covid-19 is overblown. But it should seem less silly with each passing day. That’s not to say I think we’re headed for disaster. My own views are aligned with this piece by Michael Fumento: it will run its course before too long, and “viruses hate warm weather“. Nevertheless, the virus is already having a variety of economic effects that made the Fed’s action prudent.

Of course, the Fed did not cut its rate to cure the virus. The rate move was intended to deal with some of the economic effects of a pandemic. The spread of the virus has been concentrated in a few countries thus far: China, Iran, Italy, and South Korea. Fairly rapid growth is expected in the number of cases in the U.S. and the rest of the world over the next few weeks, especially now with the long-awaited distribution of test kits. But already in the U.S., we see shortages of supplies hitting certain industries, as shipments from overseas have petered. And now efforts to control the spread of the virus will involve more telecommuting, cancellation of public events, less travel, less dining out, fewer shopping trips, missed work, hospitalizations, and possibly widespread quarantines.

The upshot is at least a temporary slowdown in economic activity and concomitant difficulties for many private businesses. We’ve been in the midst of a “flight to safety”, as investors incorporate these expectations into stock prices and interest rates. Firms in certain industries will need cash to pay bills during a period of moribund demand, and consumers will need cash during possible layoffs. All of this suggests a need for liquidity, but even worse, it raises the specter of a solvency crisis.

The Fed’s power can attempt to fill the shortfall in liquidity, but insolvency is a different story. That, unfortunately, might mean either business failures or bailouts. Large firms and some small ones might have solid business continuation plans to help get them through a crisis, at least one of short to moderate duration, but many businesses are at risk. President Trump is proposing certain fiscal and regulatory actions, such as a reduction in the payroll tax, wage payment assistance, and some form of mandatory paid leave for certain workers. Measures might be crafted so as to target particular industries hit hard by the virus.

I do not object to these pre-emptive measures, even as an ardent proponent of small government, because the virus is an externality abetted by multiplicative network effects, something that government has a legitimate role in addressing. There are probably other economic policy actions worth considering. Some have suggested a review of laws restricting access to retirement funds to supplement inadequate amounts of precautionary savings.

Last week’s Fed’s rate move can be viewed as pre-emptive in the sense that it was intended to assure adequate liquidity to the financial sector and payment system to facilitate adjustment to drastic changes in risk appetites. It might also provide some relief to goods suppliers who find themselves short of cash, but their ability to benefit depends on their relationships to lenders, and lenders will be extremely cautious about extending additional credit as long as conditions appear to be deteriorating.

In an even stronger sense, the Fed’s action last week was purely reactive. Scott Sumner first raised an important point about ten days before the rate cut: if the Fed fails to reduce its overnight lending target, it represents a de facto tightening of U.S. monetary policy, which would be a colossal mistake in a high-risk economic and social environment:

“When there’s a disruption to manufacturing supply chains, that tends to reduce business investment, puts downward pressure on demand for credit. That will tend to reduce equilibrium interest rates. In addition, with the coronavirus, there’s also a lot of uncertainty in the global economy. And when there’s uncertainty, there’s sort of a rush for safe assets, people buy treasury bonds, that puts downward pressure on interest rates. So you have this downward pressure on global interest rates. Now while this is occurring, if the Fed holds constant its policy rate, it targets the, say fed funds rate at a little over 1.5 percent. While the equilibrium rates are falling, then essentially the Fed will be making monetary policy tighter.

… what I’m saying is, if the Fed actually wants to maintain a stable monetary policy, they may have to move their policy interest rate up and down with market conditions to keep the effective stance of monetary policy stable. So again, it’s not trying to solve the supply side problem, it’s trying to prevent it from spilling over and also impacting aggregate demand.”

The Fed must react appropriately to market rates to maintain the tenor of its policy, as it does not have the ability to control market rates. Its powers are limited, but it does have a responsibility to provide liquidity and to avoid instability in conducting monetary policy. Fiscal actions, on the other hand, might prove crucial to restoring economic confidence, but ultimately controlling the spread of the virus must be addressed at local levels and within individual institutions. While I am strongly averse to intrusions on individual liberty and I desperately hope it won’t be necessary, extraordinary measures like whole-city quarantines might ultimately be required. In that context, this post on the effectiveness of “non-pharmaceutical interventions” such as school closures, bans on public gatherings, and quarantines during the flu pandemic of 1918-19 is fascinating.

 

 

 

 

 

Fiat Money, Government and Culture

24 Wednesday Aug 2016

Posted by in Monetary Policy

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The money we use every day has roughly zero intrinsic value. That includes paper, coins made from base metals, and electronic bookkeeping entries that can be drawn on via plastic cards and communication devices. We take it for granted that all of these forms of payment will be accepted in transactions. The dollars we use in the U.S. are backed only by the “full faith and credit” of the U.S. government, which is quite a bit of nothing when it comes right down to it. This form of money is called “fiat money” because it derives value essentially by decree, including the government’s willingness to accept your dollars in payment of taxes. It’s a fine thing that such a level of trust exists in society, and most important is trust that the next seller will accept your dollars in trade.

An old maxim in economics known as Gresham’s Law holds that “bad money drives out good”, particularly when the “good money” and the “bad money” are assigned the same legal value in exchange. The good money, having greater intrinsic value than the bad money, will quickly disappear from use as a medium of exchange. Like any asset, the good money will be held as a store of value, but not used in routine transactions.

In the past, our “good money” consisted mainly of claims on precious metals. However, the U.S. government stopped redeeming dollars in gold in the 1930s, silver in the 1960s, and silver coins stopped circulating at about the same time.

What’s so “bad” about fiat money, given that we trust its usefulness in the next transaction? The lack of intrinsic value places its issuing authority, the Federal Reserve in our case, in a position of tremendous power and responsibility as the keeper of the “full faith” of the U.S. government. However, the Fed is privately owned (by banks), and no one at the Fed is elected. The members of its Board of Governors are appointed by the President to 14-year terms. The lengthy terms are hoped to keep the Fed independent and immune to political manipulation. Ostensibly, the Fed conducts policy in the objective pursuit of price stability and full employment. (Never mind that the two goals may be incompatible.)

The Fed, as the authority responsible for the nation’s fiat money, has traditionally allowed the money supply to grow by issuing “new money” in exchange for federal debt obligations, like Treasury bonds. The Fed buys the bonds, and the payment becomes a seed for new money growth. For the Treasury, which raises funds to finance government activities by collecting taxes and borrowing, this mechanism is quite convenient. The Fed can act to “accommodate” the government’s needs, essentially printing money to fund deficits.

Does it happen? Absolutely, although in the past few years, the Fed has demonstrated a more subtle variation on this theme, and one that is cheaper for the government. That will be the subject of a future post. The key point here is that with the cooperation of the monetary authority, the government avails itself of the so-called printing press. Thus, it is not answerable to taxpayers for any expansion in its spending. The government can commandeer resources as it sees fit, with no restraint from the governed.

That’s the key point made by Jörg Guido Hülsmann in a post on the Mises Wire blog, “How Fiat Money Destroys Culture“. On that note, I’d say first that enabling the displacement of private commerce for government-directed activity is a sure-fire prescription for degrading the culture. Government is not and never will be a font of creativity. Capitalism and markets, on the other hand, deliver an astonishing degree of cultural wealth to every segment of society. The freedom to create and share art, cuisine, customs and technology, without interference by government, is the very essence of culture. Some might object that government often serves as a conduit for bringing cultural works to the public, and that government can and does direct resources to the arts. There is an extent to which that’s true, of course, but it may be a deal with the devil: public sector support for new art is often subject to strings, politicization, and favoritism. That’s crony culturalism, to coin a phrase.

Hülsmann discusses other cultural repercussions of fiat money. By enabling the government to compete for resources with the private sector, and by swelling the quantity of money relative to goods and assets, fiat money puts upward pressure on prices. This might manifest in the prices of goods, the prices of assets, or both, and it might be very uneven. This changes the distribution of rewards in society in fundamental ways.

Price inflation penalizes those who hold currency. Hülsmann says:

“In a free economy with a natural monetary system, there is a strong incentive to save money in the form of cash held under one’s immediate control. Investments in savings accounts or other relatively safe investments also play a certain role, but cash hoarding is paramount, especially among low-income families. … By contrast, when there is constant price inflation, as in a fiat-money system, cash hoarding becomes suicidal.“

Price inflation also rewards those in debt. Strictly speaking, this is true only when inflation accelerates unexpectedly, since lenders tend to demand sufficient interest to offset expected inflation. Hülsmann blames the widespread growth of debt financing in modern society on fiat currency. There is an element of truth to this assertion, but it strikes me as an exaggeration, given the advances in financial markets and technologies over the past century or so. We are much better at allocating resources inter-temporally than in 1900, for example, so the growth of consumer and business debt over the years should be viewed in the context of future earning power and enabling technology. Still, there are those for whom these markets and technologies are out of reach, and the destructive effect of inflation on their ability to save should not be minimized. This contributes to greater dependency at the lowest levels of the socioeconomic spectrum, a very regrettable kind of cultural change.

Growth of the money stock tends to reward many at the top of the socioeconomic spectrum, partly because it is associated with stock market appreciation. Again, when the Fed buys government bonds, or mortgage bonds, or any other asset, it always finds willing sellers, usually brokers/dealers and banks. Successful bidding by the Fed for assets is the first step in lifting asset prices (and reducing yields). But market participants tend to know all this in advance. Therefore, private traders will bid up asset prices in advance, assuming that the Fed has indicated its intentions. Other assets, being substitute vehicles for wealth accumulation, will also be bid upward, as a given amount of income produced by an asset is valued more highly when competing yields are low. After the Fed completes a round of asset purchases, the process can repeat itself.

Goods inflation and higher asset prices generated by continuing debt monetization and distorted interest rates tend to skew the distribution of wealth toward the top and away from the bottom. Moreover, if cost and pricing pressure build up in goods markets, those with the greatest market power always fare best. Thus, debt monetization has the potential to be a very inegalitarian process, and one not based on fundamental economic criteria such a productivity. This too represents a damaging form of cultural change.

A more accurate form of Gresham’s law might be the following: government ambition drives out “good money”. The existence of fiat money creates an avenue through which the expansion of government can be funded without approval by current or future taxpayers. This ultimately leads to a stagnant economic environment and a stagnant culture: government displaces private activity, the economy’s growth potential and vibrancy deteriorates, and society’s ability to support all forms of culture declines. To add insult to injury, the process of monetizing government debt punishes small savers and rewards the privileged. The distribution of cultural rewards will follow suit.

Negative Rates and the Thrift Imperative

18 Thursday Aug 2016

Posted by in Monetary Policy

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An article of faith among central bankers is that negative interest rates will stimulate spending by consumers and businesses, ending the stagnant growth that has plagued many of the world’s biggest economies. Short-term rates are zero or negative in much of Europe and Japan, and even the Federal Reserve holds out the possibility of bringing rates below zero in the event of a downturn. This policy is almost assuredly counter-productive. It very likely stimulates saving, especially in the context of an aging population, and it distorts the allocation of resources over time and across the risk classes to which saving is applied.

Real vs. Nominal Rates

A preliminary consideration is the distinction between the so-called nominal or stated interest rates, those quoted by banks and bond sellers, and real interest rates, which are net of expected inflation. If the short-term nominal interest rate is zero, but expected inflation is -2%, then the real interest rate is +2%. If expected inflation is +2%, then the real interest rate is -2%. When negative rates are discussed in the media, they generally refer to nominal rates, and central bank interest rate targets are discussed in nominal terms. Again, some central banks are targeting very low or slightly negative nominal rates today. In most of these cases, inflation is low but positive, indicating that real interest rates are negative. With that said, it’s important to note that the discussion below relates to real interest rates, not nominal rates, despite the fact that central banks explicitly target the latter.

Saving Behavior

Most macroeconomists casually assume that lower interest rates discourage saving and thus stimulate spending. However, this is being called into question by observers of recent central bank actions around the world. Those actions have been relatively futile in stimulating spending thus far. In fact, data suggest that the negative-rate policies might be increasing saving rates. These points are discussed in “Are Negative Rates Backfiring? Here’s Some Early Evidence” in the Wall Street Journal (or this Google search if the first link fails).

An examination of the microeconomic foundations of the standard treatment of saving behavior shows that it requires some limiting assumptions. We all face constraints in meeting our future income goals: our current income imposes a limit on what we can save, and the rate of return we can earn on our funds limits what we can accumulate over time from a given level of saving. Those constraints must be balanced against an individual’s preferences for present pleasure relative to future gain.

Time Preference

The rate at which agents are willing to sacrifice future for present consumption is often called the rate of time preference. This differs from one individual to another. A high rate of time preference means that the individual requires a large future reward to induce them to set aside resources today, foregoing present consumption. A low rate of time preference means that little inducement is necessary for saving, so the individual is “thrifty”. It’s generally impossible to directly observe differing rates of time preference across individuals, but they reveal their preferences for present and future consumption via their saving (or borrowing) behavior. If an individual saves more than another with an equal income, it implies that the first has a lower rate of time preference at a given level of present consumption.

Substitution and Income Effects

A lower interest rate always creates a tendency to substitute present for future consumption. That’s because the change is akin to an increase in the price of future consumption. However, that substitution might be offset, or more than offset, by the fact that total achievable lifetime income is diminished: the lower rate at which the individual’s use of resources can be transferred from the present to the future means that some sacrifice is necessary. In other words, the negative “income effect” might cause consumers to reduce consumption in the future and in the present! Thus, saving may increase in response to a lower interest rate. Perhaps that tendency will be exaggerated if rates turn negative, but it all depends on the shape of preferences for present versus future consumption.

Which of these two effects will dominate? The substitution effect, which increases present consumption and reduces saving? Or the income effect, which does the opposite? Again, consumers are diverse in their rates of time preference. There are borrowers who prefer to have more now and less later, and savers who might wish to equalize consumption over time or accumulate assets in pursuit of other goals, such as bequests. A shift from a positive to a negative interest rate would reward borrowers who wish to consume more now and less later. Both their substitution and income effects on present consumption would be positive! In fact, spending by that segment might be the only unambiguously stimulative effect from negative rates. But individuals with low rates of time preference are more likely to spend less in the present, and save more, after the change. Two individuals with identical substitution effects in response to the shift to negative rates may well differ in their income effects: the largest saver of the two will suffer the largest negative income effect.

Ugly Intervention

These uneven impacts on saving are a testament to the pernicious effects of central bank intervention leading to negative rates. Savers are punished, while those who care little about self-reliance and planning for the future are rewarded. Of course, at an aggregate level, saving out of income is positive, so on balance, agents demonstrate  that they have sufficiently low rates of time preference to qualify for some degree of punishment via negative rates. After all, savers will unambiguously suffer a decline in lifetime income given the shift to negative rates.

The Necessity of Thrift

The fact that a standard macroeconomic treatment of saving ignores negative income effects at very low rates of interest is surprising given the very nature of thrift. Savers obviously view future consumption as something of a necessity, especially as they approach retirement. Present and future consumption are locally substitutable, but large substitutions come only with great pain, either now or later. Another way of saying this is that present and future consumption behave more like complements than substitutes. (A more technical treatment of this distinction is given in “Complementarity, Necessity and Preferences“, by Steven R. Beckman and W. James Smith.) This provides a basic rationale for a conflicting assumption often made in macroeconomic literature: that economic agents attempt to “smooth” their consumption over time. If present and future consumption are treated as strict complements, there is no question that the income effect of a shift to negative  rates will increase saving by those who already save.

This is not to imply that savers always respond to lower rates by saving more. In “Choice between Present Consumption and Future Consumption“, Supriya Guru asserts that empirical evidence for the U.S. suggests that the substitution effect dominates. However, extremely low or negative interest rates are a recent phenomenon, and empirical evidence is predominantly from periods of history with much higher rates. Moreover, the advent of very low rates is coincident with demographic shifts favoring more intense efforts to save. The aging populations in the U.S., Europe and Japan might reinforce the tendency to respond to negative rates by saving more out of current income.

Risk As a Relief Valve

Another complexity regarding the shape of preferences is that consumers might never be willing to substitute present consumption for less in the future. That is, their rate of time preference may be bounded at zero, even if the interest rate imposed by the central bank is negative. An earlier post on Sacred Cow Chips dealt with this issue. In that case, saving will increase with a shift to negative rates under two conditions: 1) there is a minimal level of future consumption deemed a necessity by consumers; and 2) that level exceeds the consumption that is possible without saving (endowed or received via transfers). That outcome represents a “corner solution”, however. Chances are that consumers, having been forced to accept an unacceptable tradeoff at negative “risk-free” rates, will lean more heavily on other margins along which they can optimize, such as risk and return.

That eventuality suggests another reason to suspect that very low or negative rates are not stimulative: savers face a range of vehicles in which to place their funds, not simply deposits and short-term money market funds earning low or negative yields. Some of these alternatives earn much higher returns, but only at significant risk. Nevertheless, the poor returns on safe alternatives will lead some savers to “reach for yield” by accepting high risks. That is a rational response to the conditions imposed by central banks, but it leads consumers to accept risk that is otherwise not desired, with a certain number of consumers suffering dire ex post outcomes. It also leads to an allocation of the economy’s capital that is riskier than would otherwise occur.

Furthermore, as mentioned in the WSJ article linked above, consumers might regard negative rates as a foreboding signal about the economic future. The negative rates are bad enough, but even reduced levels of future consumption might be under threat. Thus, risk aversion might lead to greater saving in the context of a shift to negative rates.

Corporate Saving and Capital Investment

A great deal of saving in the economy is done by corporate entities in the form of “undistributed corporate profits”, or retained earnings. It must be said that these flows are not especially dependent on short-term yields, even if those yields have a slight influence on corporate management’s view of the opportunity cost of equity capital. Rather, those flows are more dependent on the firm’s current profitability. To the extent that very low or negative interest rates discourage consumption, their effect on current profitability and the perceived profitability of new business capital projects cannot be positive. To the extent that very low or negative rates portend risk, their effect on capital investment decisions will be negative. Savings out of personal income and from retained earnings is likely to exceed the amount required to fund desired capital investment. The funds accumulated in this way will remain idle (excess working capital) or be put toward unproductive uses, as befits an environment in which real returns are negative.

We Gotta Get Out of This Place

Central banks will be disappointed that the primary rationale for their reliance on negative interest rates lacks validity, and that the policy is counterproductive. Statements from Federal Reserve officials indicate that the next expected move in their interest rate target will be upward. However, they have not ruled out negative rates in the event that economic growth turns down. Perhaps the debate over negative rates is still raging inside the Fed. With any luck, and as evidence piles up from overseas on the futility of negative rates, those arguing for a “normalization” of rates at higher levels will carry the day.

Central Banks Stumble Into Negative Rates, Damn the Savers

01 Tuesday Mar 2016

Posted by in Central Planning, Monetary Policy

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Dollar Cartoon

Should government actively manipulate asset prices in an effort to “manage ” economic growth? The world’s central bankers, otherwise at their wit’s end, are attempting just that. Hopes have been pinned on so-called quantitative easing (QE), which simply means that central banks like the U.S. Federal Reserve (the Fed) buy assets (government and private bonds) from the public to inject newly “printed” money into the economy. The Fed purchased $4.5 trillion of assets between the last financial crisis and late 2014, when it ended its QE. Other central banks are actively engaged in QE, however, and there are still calls from some quarters for the Fed to resume QE, despite modest but positive economic growth. The goals of QE are to drive asset prices up and interest rates down, ultimately stimulating demand for goods and economic growth. Short-term rates have been near zero in many countries (and in the U.S. until December), and negative short-term interest rates are a reality in the European Union, Japan and Sweden.

Does anyone really have to pay money to lend money, as indicated by a negative interest rate? Yes, if a bank “lends” to the Bank of Japan, for example, by holding reserves there. The BOJ is currently charging banks for the privilege. But does anyone really “earn” negative returns on short-term government or private debt? Not unless you buy a short-term bill and hold it till maturity. Central banks are buying those bills at a premium, usually from member banks, in order to execute QE, and that offsets a negative rate. But the notion is that when these “captive” member banks are penalized for holding reserves, they will be more eager to lend to private borrowers. That may be, but only if there are willing, credit-worthy borrowers; unfortunately, those are scarce.

Thus far, QE and zero or negative rates do not seem to be working effectively, and there are several reasons. First, QE has taken place against a backdrop of increasingly binding regulatory constraints. A private economy simply cannot flourish under such strictures, with or without QE. Moreover, government makes a habit of manipulating investment decisions, partly through regulatory mandates, but also by subsidizing politically-favored activities such as ethanol, wind energy, post-secondary education, and owner-occupied housing. This necessarily comes at the sacrifice of opportunities for physical investment that are superior on economic merits.

The most self-defeating consequence of QE and rate manipulation, be that zero interest rate policy (ZIRP) or negative interest rate policy (NIRP), is the distortion of inter-temporal tradeoffs that guide decisions to save and invest in productive assets. How, and how much, should individuals save when returns on relatively safe assets are very low? Most analysts would conclude that very low rates prompt a strong substitution effect toward consuming more today and less in the future. However, the situation may well engender a strong “income effect”, meaning that more must be saved (and less consumed in the present) in order to provide sufficient resources in the future. The paradox shouldn’t be lost on central bankers, and it may undermine the stimulative effects of ZIRP or NIRP. It might also lead to confusion in the allocation of productive capital, as low rates could create a mirage of viability for unworthy projects. Central bank intervention of this sort is disruptive to the healthy transformation of resources across time.

Savers might hoard cash to avoid a negative return, which would further undermine the efficacy of QE in creating monetary stimulus. This is at the root of central bank efforts to discourage the holding of currency outside of the banking system: the “war on cash“. (Also see here.) This policy is extremely offensive to anyone with a concern for protecting the privacy of individuals from government prying.

Another possible response for savers is to “reach for yield”, allocating more of their funds to high-risk assets than they would ordinarily prefer (e.g., growth funds, junk bonds, various “alternative” investments). So the supply of saving available for adding to the productive base in various sectors is twisted by central bank manipulation of interest rates. The availability of capital may be constrained for relatively safe sectors but available at a relative discount to risky sectors. This leads to classic malinvestment and ultimately business failures, displaced workers, and harsh adjustment costs.

With any luck, the Fed will continue to move away from this misguided path. Zero or negative interest rates imposed by central banks penalize savers by making the saving decision excessively complex and fraught with risk. Business investment is distorted by confusing signals as to risk preference and inflated asset prices. Central economic planning via industrial policy, regulation, and price controls, such as the manipulation of interest rates, always ends badly. Unfortunately, most governments are well-practiced at bungling in all of those areas.

 

 

 

ZIRP’s Over, But Fed Zombies Linger Over Seed Corn

24 Thursday Dec 2015

Posted by in Central Planning, Monetary Policy, Price Controls

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Fed Rate Cuts

The Federal Reserve plans a few more increases in short-term interest rates in 2016, which should be welcome to savers who are not overexposed to market risk. The Fed took its first step away from the seven-year zero-interest-rate policy (ZIRP) last week, increasing its target rate on overnight loans between banks (“federal” funds) for the first time in almost ten years. ZIRP was grounded in the Fed’s desire to stimulate the economy after the last financial crisis, an objective that met with limited success. ZIRP’s most profound “success” was to distort prices, with negative consequences for conservative savers, those dependent on retirement assets, and the long-term growth of the economy.

ZIRP necessarily constitutes a price ceiling when expected inflation is positive. It implies negative real rates of return, but real rates of time preference are not and cannot be negative. Given the choice, no one intends to forego present pleasure to purposefully suffer a loss later. The imperative to earn positive real returns does not end simply because the Fed and ZIRP make it more difficult. 

Anyone with funds parked in near zero-return assets, such as money market funds and certificates of deposit, earned a negative real return during the ZIRP regime, as inflation remained positive despite misplaced fears to the contrary. Those kinds of savings vehicles earn relatively low returns and should carry little risk to savers.

What are savers and retirees to do under a ZIRP regime? If they absolutely must defer consumption, they can accept the predicament and leave funds to decay in real value. They can dis-save in response to the disincentive, consuming their accumulated wealth. Some, for whom retirement is near, might even put more aside with the full knowledge that it will erode in real terms. But many will seek out yield in other ways, investing in assets bearing greater risk than they would otherwise prefer. All of these alternatives are likely to be less-preferred by the public than rates of saving and portfolios constructed in the absence of the Fed’s rate distortions.

The Fed’s policies and zero rates have contributed to inflated equity prices over the past six years as savers sought enhanced returns, and those valuations are certainly vulnerable. Over the past week, market jitters have shown the extent to which traders and investors feel threatened by the Fed’s tightening move.

The impact of ZIRP on the well-being of savers is only part of the story, however. Such a regime compromises the fundamental process of aligning preferences with the physical transformation of present resources into future consumption. Like any price distortion, ZIRP misallocates resources, but it misallocates across time and across sectors of the economy. When discounted at ultra-low rates, the values of future financial flows are grossly inflated, diminishing the need to set additional amounts aside today. At the same time, zero or near-zero rate borrowing confuses the evaluation of alternative capital investment projects. Resources may be committed to projects that would be rejected given accurate price signals. The artificially-enabled bidding for resources prompted by ZIRP, and the distortion of the risk-return trade off, might even cause more worthy projects to be rejected. And there is every reason to expect that saving by some individuals will be channeled into immediate consumption by others.

Who would do such wasteful things, undertaking projects with low or nonexistent future returns? Those facing distorted price signals, most prominently government technocrats for whom meaningful price signals are seldom a concern. And that also goes for the subsidy-hungry private beneficiaries of the state’s tax-extracted and borrowed largess. The ultimate consequence of this behavior is a deterioration in the economy’s growth potential.

Ronald-Peter Stoferle provides a short catalogue of ZIRP’s destructive impacts in the “Unseen Consequences of ZIRP“. One of his more interesting statements is the following, with reference to “zombie” banks:

“Low interest rates prevent the healthy process of creative destruction. Banks are enabled to roll over potentially non-performing loans practically indefinitely and can thus lower their write-off requirements.“

Thus, ZIRP promotes economic rot in several ways. Last week’s rate move by the Fed is a step in the right direction, away from zero rates and drastic overvaluation of consumption flows now and in the future. However, the monetary excesses of the past six years will not be reversed by this one move. The Fed is still imposing an artificial ceiling on rates. Even if that restriction is eased in further steps during 2016, the Fed is committed for the long-term to the manipulation of interest rates in the execution of policy. That sort of activist market manipulation is likely to continue; like all forms of central planning, it will be based on woefully incomplete information, a poor understanding of individual and market behavior, and bad timing. It will degrade economic conditions and have the classic boom-and-bust repercussions typical of central bank intervention.

Central Bank Bubbles Pop On Our Heads

09 Wednesday Sep 2015

Posted by in Big Government, Macroeconomics, Monetary Policy

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boom_and_bust

Printing money is a temptation that central banks can’t resist. And they distort prices when they do it. The new “liquidity” finds its way into higher asset values: stocks, bonds, real estate, even art. But as Jim Grant points out (as quoted by Ryan McMaken), the inflated prices are artificial, decoupled from the actual value those assets are capable of generating. The high asset prices are unsustainable:

“The idea is that you put the cart of asset values before the horse of enterprise. By raising up asset values, you mobilize spending by people who have assets… It was otherwise known as trickle-down economics before the enlightenment, then it became something much fancier in economic lingo. But that’s essentially the idea. So what you have seen is an artificial structure of prices worldwide.”

This comports with the general drift one gets from chatting with financial market professionals about the Federal Reserve and other central banks. These advisors usually add a reflexive assurance that corporate earnings are adequate to support stock prices. So which is it? Those very earnings might reflect trading gains on assets held by financial institutions and others, so the “supportive earnings” argument is circular to some degree. That aside, it’s suggestive that the recent market selloff has been centered on tighter monetary conditions:

“‘The risk of global liquidity conditions swinging is real for the markets, justifying a significant reduction in exposure for all asset classes,’ said Didier Saint-Georges, managing director at Carmignac, in a note to clients.“

Likewise, significant rebounds have been attributed, at least in part, to softening expectations that the Fed will move to increase short-term interest rates next week. If asset values are so heavily dependent on a continuation of a zero-interest rate, easy-money policy at this stage of an economic expansion, then it looks like a bubble is waiting to pop. More liquidity might delay the inevitable.

How did we get here? Martin Feldstein describes the policy of “quantitative easing” (QE) in “The Fed’s Stock Price Correction“:

“When the Obama administration’s poorly designed 2009 stimulus legislation failed to produce a strong economic turnaround, then-Fed Chairman Ben Bernanke announced that the central bank would pursue an ‘unconventional monetary policy’ by purchasing immense amounts of long-term bonds and promising to hold short-term interest rates near zero for an extended period.

Mr. Bernanke explained that the Fed’s policy was designed to drive down long-term interest rates, inducing portfolio investors to shift from bonds to stocks. This ‘portfolio substitution’ strategy, as he labeled it, would increase share prices, raising household wealth and therefore consumer spending.“

Feldstein does not buy the contention that “earnings are supportive”. Despite his conventional demand-side approach to macroeconomics, he too emphasizes that loose monetary policy has distorted asset prices.

The process is exacerbated by the bloated federal government’s appetite for funds. The Treasury is able to float debt at very low interest rates, thanks to the Fed’s willingness to provide liquidity to the banking system. By that, I mean the Fed’s willingness to buy Treasury bonds and monetize federal deficit spending.

Jim Grant’s argument regarding price distortion goes further. Increases in the prices of financial assets artificially deflate the cost of raising new capital, translating into over-investment in physical assets such as office buildings and machinery. Here’s Grant:

The prices themselves are the cosmetic evidence of underlying difficulty. So if you misprice something, it’s not just the price that’s wrong. It’s the thing itself that has been financed by the price. So you have perhaps too many oil derricks, too many semi-conductor fabs. We have too much of something, which is financed by an excess of credit or debt.“

Thus, the boom feeds the inevitable bust. That is certainly a danger. I’m sympathetic to Grant’s reasoning, but we have not experienced much of a boom in physical capital investment in the U.S., except perhaps for commercial real estate and in capital-intensive oil and gas extraction, and the latter is now on the skids. China, however, has been aggressively over-investing, and that is coming to an end.

While asset values have likely been inflated, it is fair to ask why the Fed’s accommodative policy has not led to a more general inflation in the prices of goods and services. For one thing, the strong dollar has held import prices down. (The international value of the dollar has been buttressed by the view that dollar-denominated assets are relatively safe, despite the risks created by the Fed.) More importantly, aging baby boomers have contributed to relatively strong saving activity (and less spending). Paradoxically, it’s possible that saving has been reinforced by the zero-rate policy of the Fed, as noted before on Sacred Cow Chips. Buying extra comfort in retirement requires greater set-asides if rates are low.

I am not optimistic about the direction of asset values, but I am not adjusting my own investment profile. Market timing is generally a bad strategy, and I will do my best to ride out the market’s ups and downs, even if they are manipulated by the Fed. However, we should all demand more discipline from the federal government and more restraint from the Fed. Better yet, limit the Fed’s discretion in the conduct of monetary policy by relying on a monetary standard that is less prone to manipulation and seigniorage.