Negative Rates and the Thrift Imperative

18 Thursday Aug 2016

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Central Banking, Federal Reserve, Income effect, negative interest rates, Nominal Interest Rates, Rate Normalization, Reach For Yield, Real Interest Rates, Retained Earnings, Saving and Negative Interest Rates, saving behavior, Steven R. Beckman, Substitution effect, Supriya Guru, Thrift, Time Preference, Undistributed Corporate Profits, W. James Smith, Wall Street Journal, Working Capital

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 pnuetz in Central Planning, Monetary Policy

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Bank of Japan, central planning, Federal Reserve, Helicopter Drop, Income Effect vs. Substitution Effect, Interest Rate Manipulation, Intertemporal Tradeoffs, Malinvestment, Mises Institute, Monetary policy, negative interest rates, NIRP, Printing Money, Privacy Rights, QE, Quantitative Easing, Reach For Yield, regulation, War on Cash, Zero Interest Rate Policy, ZIRP

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 pnuetz in Central Planning, Monetary Policy, Price Controls

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Capital investment, Central Bank Intervention, central planning, negative interest rates, Price Ceilings, Price Controls, Ronald-Peter Stoferle, Saving Incentives, The Federal Reserve, Time Preference, Zero Interest Rate Policy, ZIRP, Zombie Banks

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.

Taking The Air Out Of The Deflation Scare

25 Wednesday Mar 2015

Posted by pnuetz in Macroeconomics

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Deflation, Demand-driven deflation, Federal Reserve, John Cochrane, Keynesians, Malinvestment, Mises Daily, negative interest rates, Public debt, rate of time preference, Science Times, Supply-driven deflation, Thorsten Polleit, Underconsumption, ZIRP

Deflation is not the evil so many journalists have been taught to believe. The historical evidence does not support the contention that deflation is always a consequence of “underconsumption”, that it leads to a self-reinforcing spiral, or that it is destructive in and of itself. A new academic paper on the costs of deflation is reviewed here by John Cochrane, who reproduces some of the interesting evidence from the paper showing that deflation is not correlated with output growth historically. Cochrane quotes the paper’s authors:

“‘The almost reflexive association of deflation with economic weakness is easily explained. It is rooted in the view that deflation signals an aggregate demand shortfall, which simultaneously pushes down prices, incomes and output. But deflation may also result from increased supply. Examples include improvements in productivity, greater competition in the goods market, or cheaper and more abundant inputs, such as labour or intermediate goods like oil. Supply-driven deflations depress prices while raising incomes and output.’”

The Science Times has a succinct review of the same paper:

“After analyzing figures going back to 1870 from 38 countries, Borio [one of the co-authors] concludes that declines in consumer prices are not actually the problem. He argues that the negative effects associated with deflation are in reality caused by huge declines in real estate prices and equity values. All this time, he posits, economists have been deceived by the fact that prices for goods and services have at times decreased at the same time that asset prices have gone down, especially during the Great Depression.”

An earlier op-ed on deflation by Cochrane was the subject of this Sacred Cow Chips post a few months ago, which noted an unfortunate tendency among traditional Keynesian economists related to the statist agenda they often support:

“Quick to blame insufficient private demand for economic ills, they propose to ratchet government to higher levels to make up for the supposed shortfall. That diagnosis is often debatable; the prescription may be a palliative at best and destructive at worst.”

Deflation is usually a symptom of other, more primary economic phenomena. Whether it can be taken as a sign of economic malaise depends on the underlying cause. Certainly, as noted above, deflation is quite welcome when it results from supply-driven growth of output, especially if wages are supported by advances in labor productivity.

On the other hand, deflation may be a demand-side symptom of weakness engendered by restrictive monetary policy, fragile confidence among consumers or employers, trade restrictions, excessive taxation, over-regulation, or adjustments to a binge of malinvested capital. It does not follow, however, that a resulting deflation is unhealthy. Quite the opposite: Downward price adjustments help to clear the economy of excesses and pave the way for renewal, as excess goods, capital and other resources are repriced to levels at which purchases become gainful. This may involve more severe declines in some relative prices due to specific excesses, such as real estate. Some recent examples of deflation and reversals of economic weakness are discussed in this post at The Mises Daily.

One consequence of expected deflation is that market interest rates are driven below “real” interest rates, or the rates at which economic agents are indifferent between present and future consumption (abstracting from risk and liquidity premia). The latter is sometimes called the rate of time preference, the natural interest rate, or the originary interest rate. Recently, some short-term market interest rates in Europe have been negative, prompting some to offer arguments that the natural rate may have turned negative. This post by Thorsten Polliet reveals these arguments as nonsense:

“If the originary interest rate was near-zero [let alone negative], it means that you prefer two apples available in, say, 1,000 years over one apple available today. A truly zero originary interest rate implies that the actor’s planning horizon or “period of provision” is infinitely long, which is another way of saying that he would never act at all but would continually push the attainment of his goals into the future.”

Polleit discusses the fact that market real interest rates may be negative, but that is a consequence of central bank manipulation of nominal market rates, including the Federal Reserve’s so called ZIRP, or zero interest-rate policy. Polleit has this to say about the destructive consequences of this kind of behavior, albeit in extreme form:

“Should a central bank really succeed in making all market interest rates negative in real terms, savings and investment would come to a shrieking halt: as time preference and the originary interest rate are always positive, “capitalistic saving” — the accumulation of goods designed for improving the production process — would come to an end.”

While Keynesians imagine that expansive government policy can rescue the economy from the ravages of weak private demand, they also know that accumulation of public debt is an unavoidable by-product. That reveals an underlying motive for policies such as ZIRP, as Polite explains:

“It is an actually perfidious policy for debasing the real value of outstanding debt; and it is a recipe for wreaking havoc on the economy.”

An otherwise innocuous supply-side deflation, or a deflation corrective of demand-side forces, may well be accompanied by intervention by an activist central bank. The ostensible purpose would be to stimulate the demand for goods, but a more direct consequence is a reduction in the government’s interest costs. If the policy succeeds in pushing real market interest rates to zero or below, the intervention may well undermine capital formation and economic growth.