Fairly Recently: Must- and Should-Reads, and Writings... (December 26, 2018)

No. The Fed Was Wrong to Raise Interest Rates

Measuring the Natural Rate of Interest FEDERAL RESERVE BANK of NEW YORK

I see this argument a bunch of places. Here it is from the sharp Felix Salmon. But I think it is wrong: Felix Salmon: Why the Fed Was Right to Hike: "When interest rates stay very low for an extended period of time, that has the effect of creating asset bubbles like the credit and housing boom of the mid-2000s.... If your stocks, bonds and real estate holdings were worth the same today, relative to GDP, that they were worth in 1995, they would have to crash in value by 33%, or $43 trillion. That's more than enough to trigger another financial crisis...

..."Asset bubbles have been a far greater source of economic disruption over the past 25 years than any increase in inflation," says David Kelly of JPMorgan Funds. "While the Fed has kept policy tight enough to restrain general inflation, this has not been enough to slow a too-fast increase in asset prices." The only way to prevent another catastrophic asset bubble is to allow interest rates to revert to something much more normal. That's what the Fed is doing today. The rate hike also gives the Fed some much-needed ammunition for when the next recession arrives. Cutting rates to zero is easy; then you run into difficulties. By hiking rates, the Fed also does what it said it was going to do. Making sure that the Fed delivers on its promises is the best way for Powell to preserve the Fed's credibility in the face of onslaughts from the president...

First, the 2%/year inflation target is simply inappropriate. It runs much too great a risk of cxrashing again into the ZLB when the next recession comes.

Second, with respect to ”preserving the Fed’s credibility”: When the Fed said that it was going to keep raising interest rates, that was back when it thought the stock market would now be significantly higher than it is. You can preserve a reputation for mulish stubbornness by being a stubborn mule that fails to process and react to new information. But why would you want a reputation for mulish stubbornness that fails to process and react to new information? Is there some reason that you should be an idiot in order to gain a reputation for acting like an idiot that I am not seeing?

Third, the idea that you should raise interest rates now so you can cut more in the future—there is more than a superficial similarity to the argument that you should let the others run a lap before you start running at all, because then you will be fresher and so can run faster and so win the race. People should be prohibited from making this argument unless they can posit some mechanism for it. Yet Felix does not posit a mechanism. And I have never seen a plausible mechanism set out and defended. I ask: show me the model; I am met with what I can only interpret as declarations of intellectual bankruptcy.

Thus, at least as I see it, the only argument that has any possibility of plausibility is that:

  • asset price crashes are dangerous
  • low interest rates push asset prices up to unsustainable levels
  • from which they are then likely they will crash when interest rates return to normal.

But this is not an argument against low interest rates. This is an argument against interest rates that are unsustainably low—lower than the economy’s neutral interest rate.

In order to make this argument coherent, you would need to argue not just that Bernanke and Yellen allowed interest rates to be low, but that they pushed interest rates below the neutral rate. Yet the lack of current inflation is as close as we can get in this fallen sublunary sphere to prove positive that such is not the case: Bernanke and Yellen followed a declining neutral rate down, rather than pushed interest rates below neutral.

More important, perhaps: What is dangerous to the real economy Is not an asset price bubble but an overleverage-fueled asset price bubble. Reserve and capital requirements rather than interest rates are the effective tools to nip potential overleverage in the bud.

Maybe the—common—arguments that Felix is making here can be made coherent. But I do not think it has been. As I said above, I keep asking: show me the model. And all I am met with are what seem to me to be a declarations of intellectual bankruptcy.

The stronger argument appears to be that of Jeremy Stein: that Bernanke and Yellen's low interest rates did what they were supposed to do, and that "elevated" asset prices helped and would still help put people to work and created a stronger economy and a happier society:

Jeremy Stein: Have Low Interest Rates Led To Excessive Risk Taking?: It seems pretty clear that the low interest rates (plus QE) of the last several years have led to significant downward pressure on a variety of risk premiums.... Stock prices do seem quite high relative to fundamentals.... At least part of the stock-price impetus can be traced to the same low-rate forces that have compressed credit spreads.... All of this is to be expected, and was explicitly intended to be part of the transmission mechanism for low rates—the so-called "portfolio balance" channel, which is a nicer and more politically=correct euphemism than the "risk-taking" or "reaching for yield" channel.  But they are all the same thing, and indeed, we have been fortunate that monetary policy has these risk-taking effects, because this gives it more potency per unit of funds-rate-cut, which is a crucial benefit near the zero lower bound...

To which I commented: "Portfolio balance" connotes organizations that understand the risks responding to changing spreads by... rebalancing their portfolios... in a sensible way... "Reaching for yield" connotes organizations that find their old business models unsustainable taking on risks they do not really understand and cannot evaluate well... "Risk-taking" is in the middle...

(Parenthetically: Why, Olivier, haven't you put the arm on 60 or so of us to write once a month to make EconSpark a central place? This is a coordination problem—and I would be willing to take on the task if I knew that there were 59 others with me as well.)

Burt, once again: You can say that "overleverage" and "reaching for yield" are bad effects of low interest rates, but given that "portfolio balance" is a good (and desired!) effect of low interest rates you should then go on to demonstrate why the cure is not capital and reserve regulation. The fact that nobody has done so makes me think the argument is weak.


#shouldread #monetarypolicy #finance #behavioral #highlighted