David Beckworth linked to slide program by Michael Darda. I agree with Darda's analysis in general. I would emphasize that it is like 1936. Spending on output is far too low, but at least some at the Fed are worried that "loose" money is causing excessive speculation. We can only hope that we don't end up with the same result--a steep recession in an economy that is already below potential.
Still, I am more and more concerned that Federal Reserve policy tends to cause problems with financial instability. The problem, however, isn't maintaining the nominal anchor, but rather targeting interest rates. More generally, the problem is interest rate smoothing. However, in the current situation, the problem is an attempt to generate a recovery by promising to keep interest rates low.
Interest rate smoothing is a policy by a central bank to keep money market interest rates stable. Of course, there is probably no central bank today that tries to keep interest rates fixed beyond a very short time horizon. Typically, they adjust interest rates periodically in order to keep inflation on a target, though in the U.S. they also most promote full employment. What interest rate smoothing amounts to is a commitment to keep interest rates unchanged as long as inflation remains on target and real output at potential, and if deviations occur, adjust interest rates in a series of modest steps. Mainstream macro usually works on the assumption that the changes in interest rates occur once and for all based upon the size of the deviation of inflation or real output from target, and interest rate smoothing then is a modification of the Taylor rule so that the current interest rate is adjusted to the target through a series of modest steps. This should have little adverse effect because everyone is assumed to understand the underlying rule. Knowing that the policy rate will adjust soon, longer term rates adjust promptly to their expected long term level. And it is these longer term interest rates that impact spending decisions. And expectations about these spending decisions are what determine production and pricing decisions, and so real output and inflation.
So, why interest rate smoothing? In my view, it is one of those situations where mainstream macro is simply following the lead of central bankers. They like to smooth interest rates, and mainstream macro shows that it is consistent with macro stability. Rationalizing what central bankers want to do somehow ends up playing a key role in mainstream macro.
But why do central bankers want to smooth interest rates? Surely, the underlying reason is that money center financial institutions borrow on money markets. A key role of financial intermediation is to borrow short and lend long. Even traditional investment banking has involved borrowing short to underwrite stocks or bonds. If short term interest rates spike, this is costly to financial institutions. Keeping short term rates fixed avoids those problems. Of course, keeping short term interest rates fixed is a recipe for inflationary disaster, and impossible. Still, it is possible to manage the short term rates so that the adjustments are slow and steady. And this allows the financial intermediaries to make needed adjustments. While mainstream macro makes all of this very mechanical--rule driven--central banks have never implemented such a policy. And so, needed adjustments in interest rates can be implemented in a way that allows money center banks to make needed adjustments in their balance sheets in a smooth way.
From a monetary disequilibrium perspective, there are two different sources of interest rate fluctuations. Focusing on increases, one possibility is an excess demand for money. By money, I mean the financial instruments used as media of exchange. An excess demand occurs when the existing quantity of money is less than the demand to hold it. Those short on money may sell off short term assets they hold for his very purpose or perhaps borrow--effectively issuing and selling new money market instruments. This will tend to cause money market rates to rise. From a monetary disequilibrium approach, the solution is to increase the quantity of money to accommodate the demand. It is also important to consider the possibility of lowing the interest rate paid on financial instruments used as money to reduced the quantity demanded.
The other reason interest rates might spike is because of an excess demand for credit. This could occur because of an increase in desired borrowing to fund purchases of capital goods or consumer goods. Or it could occur due to a decrease in desired lending. It could be that firms choose to lend less and instead internally fund purchases of capital goods. Or it could be that households are saving less. From a monetary disequilibrium perspective, the interest rate should rise to bring the credit supplies and demands into balance. More fundamentally, the interest rates should rise to coordinate saving and investment. If the monetary regime is such that the quantity of money rises or the demand to hold money falls, creating an excess supply of money, this is a failure. The result is that interest rates fail to adjust enough to keep saving and investment equal, and instead total expenditure fluctuates. A central bank with a policy of interest rate smoothing is purposefully causing monetary disequilibrium to keep the interest rate from adjusting enough to clear the supply and demand for credit. Avoiding an interest rate spike due to an increase in the demand for or decrease in the supply of money is generating an undesirable excessive increase in spending on output.
From the point of view of individual money center banks, it hardly matters whether an increase in interest rates is due to an increase in credit demand--more investment or less saving--or a shortage of money. Their borrowing costs increase either way. But from the point of view of maintaining monetary equilibrium and so, overall macroeconomic equilibrium, it makes a difference.
A policy of interest rate smoothing then, keeps interest rates too stable. This means that financial intermediaries have less risk and can operate with more leverage. This makes financial institutions more likely to fail due to those increases in interest rates that the central bank finally approves to avoid inflation. However, as explained above, slowing any needed interest rate increase can give financial institutions time to adjust.
However, interest rate spikes are hardly the only thing that might go wrong for financial intermediaries. Bad investments, such as investing into a speculative real estate bubble, can also generate losses.
Of course, a monetary regime that allows monetary disequilibrium to generate fluctuations in money market interest rates will create even more risk to financial intermediaries from interest rate spikes. And so, they would tend to have more capital and less leverage than an ideal regime that always adjusts the quantity of money to the demand to hold it. Further, if the monetary regime allows that disequilibrium to fester, so that spending on output, production, and prices all decrease due to a shortage of money, the solvency issues that creates for financial intermediaries will greatly increase their motivation to limit leverage, have ample capital, and even hold higher reserves.
But surely, creating fear for financial intermediaries is hardly a sufficient reason to have a monetary regime that periodically results in recessions and deflation. Still, a monetary regime that seeks to protect financial intermediaries from all short term increases in interest rates to the degree possible, is creating extra financial risk as well as tending to generate booms in output and inflation.
Wednesday, April 16, 2014
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