Does loosening monetary policy mean lower or higher nominal interest rates?
An article in today's Financial Times (H/T Brad DeLong) is a good illustration of the problems that arise when central banks frame monetary policy as a (conditional) time-path for nominal interest rates.
The Fed is trying to communicate two things. First, it is trying to communicate that it will buy long term bonds and this policy will be effective by pushing down yields on long term bonds, which should increase consumption and investment demand. Second, it is trying to communicate that this policy will be effective in increasing future inflation and real growth, both of which will push up yields on long term bonds. The Fed's "communications strategy" is self-contradictory. No single individual can believe both parts of that communications strategy at once.
“The Fed has been sending the message that its chequebook is ready and it will do what it takes to reflate the economy,” said Jan Loeys, head of global asset allocation at JPMorgan Chase. “What no one knows is whether inflation will start to show in two weeks or two years.”
Mr Loeys added: “We are seeing longer-term-thinking clients becoming increasingly wary of bonds and hedging against inflation. Shorter-term thinkers are still willing to buy bonds, on the presumption that they are nimble enough to get out when inflation comes to push yields up.”
Here's my take. There's one group of people who have ignored the first part of the Fed's message, and who are selling bonds. There's a second group of people who have ignored the second part of the message and are buying bonds. And each individual in the second group thinks he is quick enough to get back out before everyone else in the second group changes his mind and joins the first group. And they can't all get out before the others, of course.
What actually happens in the bond market depends on the relative size of the two groups, and how much wealth they are willing and able to bet on their beliefs. So the bond market cannot tell us whether the Fed's policy is working. We have to listen to people like Mr Loeys instead, who listens to the people actually trading in the bond market.
This is a bad way to manage a communications strategy. The Fed is telling the market it will push a policy lever down, that there is a transmission mechanism from this policy lever to the rest of the economy, and that pushing the policy lever down will pull the economy up. Unfortunately, there is another reverse transmission mechanism from the economy back to the policy lever, and if the economy pulls up, that will pull up the policy lever. So the market can't tell, just by looking at the policy lever, whether the Fed is really pushing it down, and if the transmission is working the way it is supposed to work.
It's as if some bad mechanic had hooked up the power steering the wrong way around. So if you wanted to turn right, you tried to turn the steering wheel left, at which point the power steering would kick in and force the steering wheel right overpowering your hands.
Expectations are more important than anything else in determining interest rates, output, and inflation. Those stupid bits of paper we call "money" would be worth nothing if people didn't expect them to be worth something. The whole purpose of central banks' having a communications strategy is to manage those expectations. You can't manage expectations with a self-contradictory message.
Here's an alternative communications strategy: "The Fed will loosen monetary policy by buying stocks; this will raise stock prices and make households more willing to consume and firms more willing to invest; this will increase aggregate demand and create a recovery. And, by the way, expectations of recovery will raise stock prices." That alternative communications strategy is internally consistent. Both parts of the message tell you that stock prices will rise. If it's credible, the Fed won't actually need to do anything, because stock prices will rise simply because expectations change. (Yes, I know the Fed maybe can't legally do this; but laws were made to be changed.)
And that's how the monetary policy transmission mechanism is supposed to work. The central bank tells people where it wants expectations to go, and expectations go there, and markets follow those expectations. All the central bank needs to actually do is make sure it doesn't subsequently do anything that would contradict those expectations, because that would harm its ability to manage expectations in future. The monetary policy transmission mechanism is not a set of mechanical levers. It's a communications strategy.
Worthwhile Canadian Initiative 
Nick,
The effect of a lower cost of capital on investment is questionable in the current environment. We already have record low long-term real corporate borrowing costs. Assuming indifference between debt and equity, large corporations have every incentive to invest in new projects; and yet the three month average of core durables goods orders has been stagnant in 3q, and the ISM and regional survey new orders sub-components have been downright weak. Small businesses might benefit from a lower cost of debt, but their problem is likely to be more a lack of collateral than a high interest rate on loans.
Similarly, in the housing sector, we have record low nominal mortgage rates, and perhaps real as well. And yet housing starts are in the tank.
The two sectors of the economy most sensitive to capital costs are not reacting to lower rates/credit spreads. Clearly, other factors are at work besides the cost of capital for new projects. Would a lower equity cost of capital succeed where the lower cost of debt did not?
BTW, just to be clear — corporate borrowing costs are low because credit spreads are at record lows, not just because Treasury real yields are low. The Fed has already had a major impact on the corporate cost of capital.
Could the Fed buy State Govt. bonds at negative interest to finance a stimulus?
Yes, if they want to subvert their mandate. Eventually they’ll lose money on the trade, and the treasury will have to make up the shortfall. So it’s just fiscal stimulus.
K:
My contention is that there exists a QE strategy with a coherent communication strategy. I
Could you summarize the implied QE2 strategy other than the naive belief that profound structural economical ills, like industrial base erosion with attendant disappearance of production culture and rampant unemployment, can be cured by providing more measurement units in hopes of prolonging the agony through more asset bubbles ?
don’t know if the Fed is going to follow such a strategy, but I’m not going to a priori assume they’re stupid.
All the empirical evidence, starting from Greenspan’s tenure, indicates that the said stupidity is an a posteriori conclusion rather than an a priori hypothesis.
Thinking a bit more about the Feds paper power to buy unlimited quantity of various “assets” I must concede that you are right in the technical sense.
Why the speculative rather insignificant, quantitatively, $500 bn initial syringe shot of QE2 won’t have much of an effect has been discussed above.
If, hypothetically, the Feds decides to buy say ten times more, dollar collapse as a reserve currency, due to loss of trust internationally, followed by domestic unrest, due to Zimbabwe-like environment, is a much more likely outcome than lowering 10-30 year interest rate by more than a dozen bps.
Let’s hope they are not that stupid.
One may be surprised though.
Nick: “The main effect of stock prices on AD is not via wealth effects. It’s Tobin’s Q.”
I agree with this. The wealth effects are just a massive side effect of the Fed buying stocks. But it feels like TARP 2. “In order to save this economy of yours we have to give these people a trillion dollars. You may find it distasteful, but it’s what’s best for you.” But it isn’t. How is it preferable to a helicopter drop which is both more direct and more fair. Is it just the political reality that getting stuff done requires vast amounts of pork for special interests?
K: Is that bit about “pork for special interests” right? Any recovery will increase share prices. If the Fed buys shares now, and sells them later, it will mean the Fed and hence the US taxpayer gets some of those profits. If the Fed does something else, the taxpayer will get nothing, and will actually lose money if the Fed buys bonds.
vjk:”Could you summarize the implied QE2 strategy other than the naive belief that profound structural economical ills, like industrial base erosion with attendant disappearance of production culture and rampant unemployment, can be cured by providing more measurement units in hopes of prolonging the agony through more asset bubbles?”
Well, when you put it like that… But seriously. The strategy I was proposing was Oct 26 @ 4:08 PM (see above). I don’t even think it’s necessarily going to be sufficient to pull us out of a death spiral, as discussed in subsequent comments. But I do think it would be stimulative. I.e. apart from feeding pointless asset bubbles, it would have a positive effect on real investments by lowering the threshold for profitability. Real investments bring real jobs.
“All the empirical evidence, starting from Greenspan’s tenure, indicates that the said stupidity is an a posteriori conclusion rather than an a priori hypothesis.”
Waahaha! There is something inherently stupid about committees, I’ll agree.
I don’t agree that unrest follows from devaluation. Unrest could follow from unemployment. Devaluation, if it happens, will reduce unemployment.
Nick:”If the Fed buys shares now, and sells them later, it will mean the Fed and hence the US taxpayer gets some of those profits.”
I think it’s a bit wishful. These are the scenarios I see:
Optimally: The Fed buys $500Bn of stocks. As they are doing that stocks rise, slowly responding to the effect of the Fed purchase. The market gets some of the gains; the Fed gets some of the gains. Fed gets inferior risk adjusted returns on its investment compared to the rest of the market.
Realistically: Market sees the Fed coming from a mile away. Front runs the Fed for the full economic impact of the expected amount of the purchase. Fed still has go through with the purchase in order that the effect is not reversed. Fed gets little or none of the gain.
“But you can’t say that there is no reason.”
Oh yes I can. What you have described is not an arbitrage, it is a kind of statistical hedge: you hope that your losses on the project will be covered by the profits on your futures position. Of course, if your project turns out to be profitable after all, you expect to give up your profits. There are many things that can go wrong with this hedge: your project may fail for idiosyncratic reasons; you may have wrongly estimated your hedge sensitivity. It is therefore an expensive and risky way to earn the risk-free rate of return. That is not a reasonable description of an arbitrage.
Even in markets with traded underlyings, such as wheat, soy, or corn, futures and spot prices sometimes fail to converge; sometimes by large amounts. If a farmer can’t count on a futures position to hedge his crop, how can you expect to hedge your project with a future in an untraded quantity like NGDP?
K,
“the EH as stated in the paper you cite, is is a hypothesis that forward rates are literally expectations of future short rates under the historical measure.”
No, that is the Pure Expectations Hypothesis. EH just says that the term premia are time invariant, whereas PEH says that they are zero. These are defined against the historical measure as you point out, using ratex, as that is the only way to test the hypothesis against historical data, at least AFAICT.
But if you define the term premia to be price of risk then EMH will always be true under the new risk-neutral measure, regardless of what the historical term premia actually are. You are using the definition of the measure as a fudge term to make PEH true by definition.
But by doing this you lose all predictive power about the relationship between short and long rates, which I guess EMH views as a feature. And you also lose all economic content as to what may drive the term premia.
In that case, you have no reason to believe that observed longer term yields “should” be lower if the market could be convinced that ZIRP will last longer. For all you know, the market is assuming ZIRP in perpetuity, and the current yields are the appropriate ones.
But now suppose that your fudge factor does not just measure perceived risk of capital loss in the historical measure, but is also a function of general economic outlook. I.e. suppose that the term premia are of the form
(psychological factors) + expected return on investment
where here ‘expected return on investment’ is using the historical measure.
And in that case, falling term premia in the historical measure correspond to falling perceptions of return on capital. As others have pointed out, corporate borrowing costs are low, but you do not see investment because the return on capital is also perceived to be low.
And in that case, you want to actually improve the return on investment, rather than trying to drive borrowing costs lower. If you try to drive borrowing costs lower, then you are fighting against the liquid capital markets and against EMH. You are in effect trying to convince investors to supply excess returns to firms.
On the other hand, if the government puts in a purchase order for 1,000 planes, then Boeing’s return on investment will increase, and it will be higher than its borrowing costs, and then more investment will be made up until the borrowing costs are equal to the new (higher) return on investment.
Now you are not trying to get capital market investors provide firms with excess returns, but you are supplying excess returns to firms so that they will invest more until those excess returns are driven to zero. Now the process of arbitrage is working with you, to encourage more investment, rather than having the government fight the arbitrage process.
The situation of fiscal policy rather than monetary policy is not symmetric.
And as a final note, in the decomposition
term premia = ‘psychological factors’ + ‘expected return on capital’
there is a form of zero bound, in that if the second term is zero, then still the first term will be non-zero and yields will not fall lower than that, regardless of how many assets the CB purchases.
“If people did expect recovery, then nominal and real interest rates would rise …”
Is this true? I am asking honestly, not rhetorically. How do you know this? Is it a model prediction or have you analyzed historical data? It is plausible but empirically, it seems not to have been true during the last two decades. I mean, this is what the claim of contradictory communication comes down to: the assumption that interest rates, both real and nominal, are leading economic indicators. Personally, I don’t think the market is as confused about this as you say. I think they will interpret the fed’s message as follows: as long as actual economic data – employment, tax receipts, durable goods orders – keeps falling, keep buying bonds. Once this reverses, start selling.
Nick, in terms of the importance of expectations, I would be careful. It could may well be the case that the expectations were wrong prior to this crisis, when everyone was assuming endlessly rising real estate prices.
That could have been the tinkerbell effect.
But if the tinkerbell effect has to eventually revert to fundamentals, then real revenues and balance sheet improvement is needed now, not more tinkerbell.
In other words, we may now be in a rational equilibria, whereas previously we were in the enthusiastic equilibria. The psychological games in which rising optimism drives rising incomes wont work, and now we need rising incomes to drive optimism.
And in terms of how the CB controls the short rate, it is not a “trick”, but the fact that money is not used up when it is invested, but goes from the bank of the buyer to the bank of the seller. The total amount of cash in the system remains unchanged.
From the point of view each individual bank, it is always better to have an interest bearing cash-equivalent than non interest bearing cash. If the banking system as a whole has excess reserves, then one bank tries to replace its reserve excess with a cash-equivalent, but that merely forces another bank to have excess reserves, so it also places a bid for a cash equivalent.
As a result, the yield on cash-equivalents continues to fall until the CB removes the excess cash by selling a security.
In the same way, a bank that is in a reserve shortfall must either sell a cash-equivalent or pay the penalty rate, so there is a flurry to sell by the banks, driving cash equivalents to the policy rate, at which point the CB adds back the cash by buying a security.
The CB does not overpower anyone, but merely tunes the parameters of the system so that the MM participants outbid themselves until the cost of cash equivalents is what the CB wants.
None of that applies in the capital markets.
RSJ: there can be multiple equilibria. That’s what i think is happening right now. Both optimisim and pessimism can be rational, if self-fulfilling.
Phil: I’m mostly coming at this theoretically. The empirical support for procyclical real and nominal interest rates is more mixed. But that’s because some recessions have been driven by deliberate attempts by central banks to raise real and nominal interest rates. like 1982.
Phil Koop: You’re right. I shouldn’t have said arbitrage. But if the residual risks are idiosyncratic and there is a large amount of them in the economy then it is almost surely as good as arbitrage. But I shouldn’t have said it because the argument doesn’t depend on it.
“Of course, if your project turns out to be profitable after all, you expect to give up your profits.”
No. Assuming the hedge allows you remove the systemic risk factor from your project then putting on the hedge will leave you with a profit equal to the profit that you would have had if that risk factor had gone to the forward price you sold it at. If the Fed is willing to buy it from you at 2% above the equilibrium value then your profit will be higher by 2% times the number of contracts in your hedge. Or equivalently – your profit will be what you would have made if the systemic risk factor was 2% higher than equilibrium.
The fact that you don’t know your systemic risk exposure exactly doesn’t change anything. You still have an estimate of it. I.e. there is an amount (not zero) of futures contracts you could trade that will make you indifferent to the systemic risk factor for the combined portfolio of the project and the futures position. This is your risk minimizing futures position. It is your best shot at an idiosyncratic risk only position. Whatever this amount is, multiply it by the difference between the price of the future and your subjective expected value of the future. This is the amount of additional profit over your expected profit the market will pay you to take on your project. Now your expected profit on the project is exactly the same as if you were expecting the system risk factor to be equal to the futures price (but you have also minimized the systemic risk).
“your project may fail for idiosyncratic reasons”
Equally with or without the hedge. But if the hedge trades above your expectation you have an additional profit buffer.
“you may have wrongly estimated your hedge sensitivity”
Yes. But not knowing it, is not an excuse for estimating it to be zero. You still need to make your best estimate of your exposure. The test of deciding at what quantity you become indifferent to the level is an excellent way to pick the right amount of any asset.
“It is therefore an expensive and risky way to earn the risk-free rate of return.”
It doesn’t earn the risk free rate. You decide what profit margin justifies putting it on.
“That is not a reasonable description of an arbitrage.”
No, it isn’t. It’s a variance minimizing strategy for generating maximum risk adjusted excess returns.
“futures and spot prices sometimes fail to converge; sometimes by large amounts”
At settlement? Because they don’t settle on spot? This contract would settle on spot NGDP.
RSJ,
I disagree with a lot of the points you are making in the above comments (and man, you make a lot). But to the extent that we agree on the only issue of consequence, i.e. that fiscal measures are far more direct, fair and efficient methods of producing the required stimulus, I think the rest is becoming a bun fight (for which I take full responsibility), and I don’t have your stamina. So, with the utmost respect, thank you, and till next time.
K
RSJ,
Since you may not have had the time to consider my truce yet, that gives me a last chance to do two things:
1) Take back the martingale measure argument. That was totally lame. It was really a red herring bun. Of course, any term structure with non-zero forwards is potentially arbitrage free. “Expectations”, here, ought to mean under a measure that is related to the martingale measure by a reasonable risk premium. And this is not the case for the curves that were studied in the literature you point to. The differences were too large. So I was wrong. I’d also like to
2) throw another bun. I know, it’s totally undignified after offering a truce, but then, I’ve had a nights sleep and feel reinvigorated. It’s an audacious one and it’s got jam on it, so I hope it’ll stick:
The whole “EH is false” literature is flawed (Longstaff). It appears to be largely based on government bond yields unadjusted for liquidity premia. And the most significant results were found in the T-Bill end of the curve. So Longstaff repeated the analysis on the term structure of GC and found small and reasonable term premia (though T-Bills revealed the same strong bias over that period as was found in previous papers). The vast majority of the previous results were simply specific to T-Bills, which are notoriously special and idiosyncratic.
Government bonds don’t anticipate the overnight target. They anticipate their own cost of funding. In the case of bonds longer than T-Bills, this is equivalent to their own specific term structure of repo. Repo for on-the-run government bonds is very different from GC. But you can’t observe the forward repo curve. And for T-Bills, you can’t observe the convenience yield at all, except with reference to another risk free rate. For that risk free rate, Longstaff looked at term GC. If I were repeating the analysis today, I would probably look at overnight fed funds vs the term structure of OIS.
You can’t blame all those old papers for using government bond yields; they didn’t have any other kinds of data. But you can blame them for not realizing that the instruments from which they were constructing their curves had additional convenience yield over and above their yield to maturity. The Thornton paper that you pointed to, by the way, carries out their analysis on on an updated version of the same government bond data used in the original Campbell-Shiller paper and apparently completely ignores the Longstaff criticism.
K, the problem is that you can explain away any anomaly you like with convenience yields. The question then becomes are those convenience yields efficient themselves. And they are clearly not.
K asks: “At settlement?”
Yes, in the settlement period. On the same days on the same Illinois river loading facilities. See, for instance, http://econpapers.repec.org/paper/agsaaea07/9951.htm.
As it happens, Jim Bianco has just put up a post on Ritholtz that is germaine to the present discussion: http://www.ritholtz.com/blog/2010/10/pomo-still-matters/. So there is one fund manager’s view. The money quote:
The Federal Reserve believes in the portfolio balance theory. This means it does not matter what they buy with newly printed money (QE2). The market will arbitrage this new money into the market that it thinks it will have the most impact. So do not get hung up on what the Federal Reserve is buying, but rather think about where these new dollars matter the most.
Right now the markets think that newly printed dollars will benfit “risk on” markets like stocks. So, Treasury purchases are a conduit to the “risk on” markets. Treasuries will still respond to the ups and downs of the economy like they always do. Stocks, on the other hand, respond to the perceptions of newly printed dollars from the Federal Reserve and other larger macro themes (like fear or relief of a double dip recession) than the more traditional fundamentals.
@Phil Koop
NGDP futures will be cash settled. You won’t be required to deliver hamburgers and entertainment services for settlement 🙂
TMDB:”the problem is that you can explain away any anomaly you like with convenience yields.”
I don’t agree. Securities may have hidden convenience yields. But in the case of government bonds, they aren’t hidden at all. The difference between on-the-run repo and GC is huge. Often several percent. That is a convenience yield. Repo is the cost of owning the bond; not GC.
Swaps can’t be used for settlement or collateral. They can’t be repoed. They have no economic value other than their explicit payoff. Therefore we wouldn’t assume that swaps have hidden convenience yields. Swap yields also don’t exhibit non-economic returns.
“are those convenience yields efficient themselves. And they are clearly not.”
Why not? Repo is below GC. But that’s not inefficient. Because all you can do with a repo loan is buy a particular government bond that yields correspondingly less than the equilibrium risk free rate.
K:
Repo is below GC
What do you mean ?
Repo is a contract to buy-back a security, and GC is a security(generic collateral) — you cannot say “repo is below GC” — it does not make sense.
What you are probably talking about is “on the run” repo rate vs. GC repo rate, i.e. repo spread.
But it’s not clear.
K:
Re: EH and Longstaff.
As I remember, Longstaff conclusion was that EH is not rejected for extremely short-terms (neither is it confirmed). EH was strongly rejected for tenors > couple of months.
K, I’m not denying that convenience yields exist, as they obviously do. But EH + convenience yields doesn’t really work. For dramatic purposes, let me take an example from equities. In November 2008, Volkswagen was by far the best performing stock in DAX. Yet EH was true, as any deterioration in earnings outlook was offset by much more dramatic increase in convenience yield. EH becomes a useless truism if you introduce convenience yields.
BTW, what is your opinion about TIPS anomaly in late 2008, there was a heated debate about it here one month ago.
GC is indeed a category of securities. It is also a type of repo loan in which the borrower gets to decide which government bond to deliver as collateral. GC is also the name for the rate of a general collateral repo loan. If you call for GC you don’t know what government bond you are going to get as collateral – but you can be sure it wont be on-the-run; it’ll be whatever’s most available/cheapest to deliver. If I call for a (reverse) repo on a particular bond, I’m going to get that bond, and receive the repo rate (typically less than GC) associated with that bond. That’s the cost of demanding a particular bond. If you want, you can call any repo desk and ask them “where’s GC?” The answer is going to be a rate. But if you ask “where’s the repo rate?” they’ll ask you “for what bond?”
TMDB:
The debate over the EH began with my assertion that because the Fed controls the path of the short rate, it has enormous power over the near end of the curve. This led to the response that EH is false.
But as far as I can tell, EH is false only with respect to the headline yield. But who cares about the headline yield. It has nothing to do with the total return of holding the asset. All that should matter in any economic debate is whether or not the dynamics of the path of the short rate determines the return of risk free instruments to within a reasonable term risk premium. And I believe this to be true for government bonds. And people will evaluate alternative investment opportunities, not with respect to the headline yield, but with respect to the expected total return of government bonds.
I didn’t look at the TIPS anomaly. But will try to have a look at it tonight.
vjk: “EH was strongly rejected for tenors > couple of months.”
They only tested up to the end of term GC, i.e. 3 months. They could not reject the expectations hypothesis, not even its pure form:
“In fact, except for the one week term repo rate, we cannot reject the hypothesis that the term premia in repo rates are zero.”
K:
It is also a type of repo loan
Did not know they call it just GC nowadays.
We used to say “GC repo” vs. “special repo”
But that was > 10 years ago.
Times change.
Re. Longstaff:
“1. The EH is strongly rejected by the data. The slope coefficient of both individual bonds and
aggregate bonds regressions is significantly lower than one. In one of the two specifications,
the deviations are so large that, in three cases out of four, the current slope of the term
structure of special repo spreads is negatively correlated with future changes in long term
special repo spreads. High relative levels of long term repo rates overestimate the extent to
which a bond will remain special and/or the extent of the specialness.”
Etc.
The whole foundation of EH (all four or is it more ? varieties) is based on insane assumptions.
Perhaps, the whole edifice of financial “engineering” is (Brownian motion, normality assumption, gaussian copula, Ito lemma, etc), but one would not go there — too distracting. Ask Scholes about LTCM. He should know.
Funny people still believe in this stuff.
K:
And to kick the dead horse one last time:
Using Longstaff’s (2000) primary method on in-sample data (but from an alternative
source) from May 1991 to July 1997 that covers most of Longstaff’s sample period, we reject the
expectations hypothesis for one- and two-week only. When using pre-sample repo rates from
February 1984 through May 1991, we reject the expectations hypothesis for each term.
No EH evidence in the short end either, not surprisingly.
Vjk:
As I said: “All that should matter in any economic debate is whether or not the dynamics of the path of the short rate determines the return of risk free instruments to within a reasonable term risk premium. ” The substantive arguments I’ve been making here depend on this alone. Someone else equated this to the EH in order to discredit it. Then I went back to the literature to see if the “EH is false” papers found evidence of excessive risk premia. They don’t (they are however fraught with flaws), and neither does the paper you quote (which is not Longstaff – It’s Buraschi and Menini (2002)). As far as the second quote, you haven’t given me a reference for that either, so tough to comment.
As far as the foundations of “financial engineering” by which I assume you are referring to arbitrage pricing, it doesn’t include any of the versions the EH I’ve come across. But then nor is there anything foundational about normality assumptions, or the Gaussian copula. Ito, I’ll take, though.
K,
It’s a fun discussion! I have many opinions, but I’m not wedded to them. Often times I’ve found myself vehemently arguing the exact opposite belief I espoused previously.
I’m behind in reading the comments. The paper you cite, which I only looked at briefly, has a term structure that goes out 6 months, so you are basically talking about the money markets. Leaving aside for the moment that the original topic of discussion was longer term maturities, I don’t think you would see data for EH at the very short end, even if EH were true.
The CB is following some Taylor rule that is well known. And the economic data that the CB uses is also known. That means that for very short time scales, the market has a pretty good chance of guessing whether there will be a cut or a hike at an FOMC meeting, whose dates are also known. Even if you don’t believe in ratex, the CB is fairly predictable. Suppose that everyone knows that rates will be cut from 3% to 2% next week, and that rates would remain at this level for at least a month.
You would expect 1 month bills to be lower than 1 week bills — an inverted yield curve. But if that actually occurred, then banks would be able to sell 1 month paper, which would be discounted against the lower bill, even today. And selling 1 month paper is about as good as selling 1 week paper in terms of obtaining funds to meet reserve requirements.
That means that their marginal cost of reserves is less than 3% today. So either you are going to charge a serious credit risk delta for the 1 week paper over the 1 month paper, which is not plausible, or the CB cannot control the marginal cost of reserves — which is also not plausible — or the 1 month bill is not lower than the 1 week bill.
And if you want to argue that the 1 month bill wont be lower because of a positive time invariant term, then either increase the rate cut or change the above argument to 2 week paper, etc.
I am not saying that the 1 month bill can’t move, but it’s not going to move in a way that confirms EH. I would be surprised if the data showed that it did.
The notion that a CB can have a predictable known path for interest rates is inconsistent with forward looking arbitrage-free asset pricing. The fact that CBs set short term rates means that someone in the economy is earning an arbitrage-free profit.
Money Market participants can be forced to take any rate, even during a period of high inflation. The CB is the monopoly supplier of cash. It sets the price, and they borrow as much as they find economic to borrow at that price. And if they don’t want to lend at that price, well the alternative is a bank account. If they had funds that they didn’t need to store in the form of cash equivalents, then they would be investing those funds in the capital markets. I don’t like this system, and it’s not necessary that the CB manipulate short term yields this way, but that is how it works.
But that monopolist power diminishes as you go out the term structure, at which point you are subject to capital arbitrage. I’m not required to pay “the market rate” for capital in the capital markets since I can make my own capital. Alternately I can refrain from re-investing and lend out my funds. And the effect of that freedom is that the market price of capital is equal to the expected return of deploying an additional unit of capital — i.e. it is set by profit expectations based on the overall economic outlook. The capital markets are connected to the underlying performance of the economy via this arbitrage.
There are channels by which low short term rates can affect the long term rates, but these channels rely on supplying rents or imposing fees on the financial sector.
That shouldn’t be surprising — it’s pretty obvious that finance is earning rents, particularly since the triumph of monetarism. But even there the amount of rents earned are finite, again because real economic forces will step in and either the risk premium of the firms are increased, or inflation forces the CB policy rate to be increased, or so many rents are extracted from productive investment that overall outlook declines up until no arbitrage is possible. The problem is that you don’t know what the adjustment mechanism will be. Whatever the adjustment mechanism is, any influence on the long term rates will be via the changing expectations of economic performance as that adjustment occurs, not by EH.
OK, re: the larger point of whether short end dynamics control the long end, where we relax EH to just be the short end plus some function, then I think that its straightforward to argue that if the CB decided to hike the short end to 5% and keep it there indefinitely, then the long end would also rise to at least 5%. You would see a massive contraction in borrowing, a financial crisis, rapid deflation — meaning real rates would rise even more, etc.
But the situation is not symmetric. For example, if the short rates are low, and believed to remain low, and this supplies more NII to banks, who pass low mortgage rates onto households, who invest more and this increases agg. demand and output and expected profit opportunities, then the long end would go up. You could say — ex post — that the long end went up because of anticipated rate hikes to stem inflation expectations that were the result of low rates.
And it would be observationally equivalent.
If, on the other hand, we have a Japan scenario, and the banks receive more NII but investment does not increase, the economy stagnates, outlook worsens, and long term yields continue to fall, then you could also say, ex post, that the market anticipated the policy would fail and it anticipated future low short term rates, and that this was why long rates fell. Also equivalent.
Both of the above outcomes have been historically observed, even if you disagree with the causality.
To resolve a debate about observationally equivalent outcomes, we have to discuss the plausibility of mechanisms.
For what reason would the long rate respond to a CB communications policy? What is the “CB communications channel”?
If you are relying on a NK model — and I’m only superficially familiar with those — then it seems that they just assume that the interest rate is the short rate, and so implicit in the assumption of that model is PEH, not EH, because they want this rate to go into the euler equation. The marginal cost of reserves does not go into anyone’s euler equation.
As far as the non-financial sector is concerned — do the NK models have a financial sector? — the call money rate is invisible; the long term rates should go into the euler equation.
So critical to the centrality of cb communications policies in these models is the assumption of “strong” CB control of long term discount rates, in the sense that such control bounds the maximum possible credibility of the strategy. If, in your premium function, you have a term equal to something that the CB does not control, and cannot minimize, then you are putting an upper bound on the effectiveness of the communications strategy channel. I argued previously that economic outlook is in that adjustment term.
You can still argue that, forgetting about the short rate, the CB can overwhelm the market in the longer rates, and I think we all made our points there.
p.s.
What’s wrong with Ito’s Lemma?
p.p.s
I have a hard time taking “cb communications strategy” seriously as a policy response to mass unemployment. Come on, don’t you feel a little embarrassed? Is it just me?
TMDB:”EH becomes a useless truism if you introduce convenience yields.”
I’ve been thinking about that point ever since my comment on Scott’s blog a few days back, and his response.
The simple fact that currency is (normally) rate of return dominated by bonds says we are willing to pay for liquidity. So we have to incorporate “convenience yield”. We can’t avoid it. But it’s unobservable of course, so there is a real danger of EH (or EMH) becoming a useless truism. But even if we can’t observe convenience yield directly, if we can have some sort of theory about convenience yield, then the joint hypothesis of EH (or EMH) plus that theory of convenience yield now becomes testable. No?
TMDB says: “NGDP futures will be cash settled.”
No kidding. But that fact does not improve prospects of convergence. Remember, the premise was that the traded asset is going to be artificially fixed to some arbitrary value, and the non-traded asset is the “price” you would like to move.
If you believe in K’s “arbitrage”, you can put it on today, because it is the same plan as hedging an individual stock with the index. Even better: both sides are traded assets. And if you are attributing magical powers to financial futures settlement, you can execute your arb that way too. Feel free to look down and laugh at me from the window of your private jet once you are wealthy beyond the dreams of avarice.
K:
Re. the second quote:
Further analysis of the expectations hypothesis using very short-term rates
Craig R. Brown et al, Journal of Banking and Finance, 2008
”
Using Longstaff’s methods on a sample of repo rates that pre-dates Longstaff’s sample, we reject the expectations hypothesis for every
maturity.
“
RSJ:
I have a hard time taking “cb communications strategy” seriously as a policy response to mass unemployment.
Don’t we all ? A gesture of desperation, perhaps
Come on, don’t you feel a little embarrassed? Is it just me?
I am puzzled by your being embarrassed. Are you one of the twelve ?
P.S. I still cannot figure out the source of profits in the message you’ve posted elsewhere.
RSJ:
Nice to have you back. Re longer maturities: I think it would be statistically difficult to reject EH out beyond 6-12 months. You don’t have enough independent observations. As far as the term structure of tbills goes, I wasn’t able to follow your argument. But I’ll say this: I think it’s almost impossible to say anything useful. There are too many idiosyncrasies, and you can’t even bring a mispricing into line via arbitrage since you can’t short a tbill. And they have huge hidden convenience yields. If you want a summary, read the Longstaff paper. Thats why you need another instrument. I would recommend OIS vs fed funds if someone wants to publish a good paper (maybe it’s already out there).
Money markets are indeed a shell game. The musical chairs version in this instance. They should be used for liquidity only, not credit, but that’s not how it’s set up. If you die if you can’t roll your paper you shouldn’t be there.
On finance extracting rents: now you are onto something deep and profoundly important. It deserves a whole blog (not to mention revolution) of its own, and I’d like to do that some day (the blog that is).
I’ll get to some of your other points later today hopefully.
What’s wrong with Ito? I have no idea. That was my point too.
Nick: that’s exactly how I see it. And, as you said, it’s about the EMH which really at the core of what I’ve been saying above.
Phil Koop: “No kidding.” Laugh of the day. Thanks.
vjk: A version of the EH was wrong 25 years ago.
K,
“As far as the term structure of tbills goes, I wasn’t able to follow your argument.”
I’ll try again 🙂
Assume the marginal cost of reserves is set by policy at 3%, but in 1 week it is known to fall to 2% and stay there for more than a month.
Let z_1 be the yield of 1 week financial paper and let z_2 be the yield of 1 month financial paper.
Selling 1 month paper is just as good, from the point of view of the bank, as selling 1 week paper. Both allow the bank to make up for a reserve shortfall, and both will be rolled over for 2%. It will sell whichever paper is cheaper. Therefore the marginal cost of meeting a reserve shortfall is the minimum of (z1,z2).
But that marginal cost is set at 3% today. 3% <= min (z1,z2)
Therefore the short yields can’t be forward looking. z_2 is not going to fall — it will be stuck at the policy rate until the rate is changed. Unless you ascribe radically changing risk premia, then the bill term structure wont change, either.
Arguing that yields anticipate the future Cb movements effectively says that the CB cannot directly control yields, and on the short end it can. You can’t apply EH on the short end. You can only try to apply EH farther on out the curve.
Only in the special case where the CB rate is X, and markets expect future CB rates to remain at X, can you (vacuously) argue that short rates are set by both current policy and expectations of future policy. So Brown concludes “Our results imply that expectations hold when rates are less volatile and/or that we may be entering a period of lower volatility.”
Under pure EH z1 is 3% and z2 is (1×3% + 3×2%)/4=2.25%. (4 weeks in a month day count basis). Assume z1 is 3%. If z2 is less than 2.25%, they should sell the 1 month bill (it’s earning 3% for a week, but less than 2% for the following 3 weeks). In the following three weeks they will roll the 1 week bill at 2%. If z1>2.25% they should sell the 1week bill instead. Does this not make sense? What were you assuming for the value of z2?
Oops: “if z1>2.25%” should have been “if z2>2.25%”
K,
Any value of z_2 < 3% is a violation of the assumption that the CB can control bank’s marginal cost of reserves, so I just made it a 1 month bill and didn’t average 🙂
If EH were true, then a bank $1 short of reserves can borrow that dollar for $1.025, in which case why would it put a bid in the interbank market for $1.03? Why would the interbank market trade at $1.03 if banks could tap the MM and obtain funds more cheaply, and with longer maturities? So the IB market is a floor underneath the positive term rates.
If you are interested in the mechanism, then one bank sells a z_2 for $1.025, but that places another bank into a reserve shortfall, so it sells a z_2, which places another bank into a shortfall, so it sells a z_2, etc. Non-bank investors, even if they believe that the z_2 is worth more, are facing an infinite supply of z_2 whenever the yield on z_2 < the yield on z_1. But of course they do not have infinite borrowing power to arbitrage the deviation between EH and supply/demand because they are not going to be able to borrow to buy z_2. The money markets is where you borrow.
The very short end of the curve is where you can’t arbitrage and these supply/demand constraints reflect the supply of cash by the CB, not expected return.
And this is not to say that you can’t construct futures markets that effectively bet on future policy rates, and that EH would not hold in those markets — it would!
But no one is going to be able to borrow cash at those rates, because the CB is the one that supplies cash and the marginal cost of borrowing cash is only going to fall when the CB says it will fall, not when the CB futures markets anticipate it falling.
The mechanism by which futures prices can force spot prices to move consists of investors taking a stock of inventory off the market — e.g. stockpiling — or releasing a stock of inventory from the stockpile.
But in the cash markets, all the cash is in the banking system. You cannot “stockpile” it out of the system — not in any practical way. Private sector arbitrageurs can’t take any inventory out of the market, or add to the stock of cash available to be lent. The CB is the only one that can do that.
Again, that is true for cash, not capital. For longer maturities, the CB does not have this power.
K,
…(last part!)
For rate hikes, assume that z_1 = 2% and that the EH value of z_2 should be 2.75%, since there will be a rate hike in one week, that will last at least a month.
Now, banks can borrow (from each other) in the interbank market at 2%, but lend (to each other) at 2.75%. That doesn’t make sense! They will bid down the yield so that they can’t arbitrage between z_1 and z_2, taking a term premia into account.
And note that as long z_2 > z_1 + term premia, banks never “run out” of money to borrow from each other or lend to each other. They have infinite firepower.
So PEH says that z_1 = 2% and z_2 = Expected (z_1) + 0
But the market equilibrium price will be: z_2 = current_(z_1) + term premium
(with no assumptions about what the premia are)
The difference between these two hypothesis will be small when 3/4*(rate hike) is small in comparison to the term premia.
I think this is why Brown argues that he can reject zero premia in periods of high IR volatility but cannot reject zero premia in periods of low IR volatility. If there are other studies that show term premia of 30bp or so, then it’s certainly plausible that EH will not be rejected given rate hikes or rate cuts in the 50bp range.
What’s wrong with Ito’s Lemma?
The Wiener process assumption.
VJK,
Oh, now my head hurts! I vaguely remember that the jumps don’t have to be normally distributed, but that things can get ugly if the semi-martingale is discontinuous — maybe that’s the assumption? Does just everything collapse without normality? Still you at least can make various simple arguments about arbitrage, even if only to point out that arbitrage occurs 🙂
p.s. — I made a comment over at Bilbo’s re: profits.
RSJ:
I do not remember very well Ito-Tanaka extension re. jumps so I cannot comment.
Another thing that bothers me deeply is continuous time assumption associated underlying fin math and empirical evidence that BSM never worked quite well requiring a lot fiddling to “fit” actual market pricing. Taleb goes as far as to say that no trader ever used BSM in real life to price options.
Phil Koop:”But that fact does not improve prospects of convergence.”
I dont know what you mean. If you sell the future at 5% and it cash settles at 2% then you will earn 3% of profit. Doesn’t matter if it gradually converges to 2% or never even trades anywhere near there.
RSJ:”Now, banks can borrow (from each other) in the interbank market at 2%, but lend (to each other) at 2.75%. That doesn’t make sense! ”
Are you suggesting that interbank lending has to have the same yield for all terms?
“Are you suggesting that interbank lending has to have the same yield for all terms?”
No.. by IB lending I mean the overnight markets.
But what is the difference between an overnight loan that you know you can roll over as often as you want (since the rate is set by policy, and the policy is known) with a non-zero term loan?