EDEB8 - Ultimate Online Debating
About Us   Debate    Judge   Forum

A Note on Monetary Policy

< Return to subforum
JohnMaynardKeynes
By JohnMaynardKeynes | Nov 30 2015 7:04 AM
As the most astute amongst you know, the Fed is likely to raise interest rates for the first time in almost a decade at its upcoming December meeting -- at the same time that the ECB and the Swedish Riksbank will likely ease policy further, pushing up even further on the value of the dollar. I've seen -- not necessarily here, but elsewhere -- a whole lot of nonsense about monetary policy, so this is a preemptive "Everything you wanted to know about monetary policy but were too scared to ask" guide.

I'll be updating this periodically as I have time, but if anyone has a specific question, feel free to ask.

I. The Fed is not tightening policy

Anyone who argues that the Fed is "tightening" by raising the federal funds rate is dead wrong and doesn't understand what "tightening" means. A tightening is a relative shift in the STANCE of monetary policy, though to equate a movement in the federal funds rate with changing the policy stance, as opposed to codifying a stance the Committee has long locked in, is to reason from a price change.

Case in point, rates were really low in the 1930s -- the Great Depression -- and no one with an IQ above room temperature and a fourth-grade reading level would accuse the Fed of following an "overly expansionary" policy in the 1930s. Likewise, no one with that level of reading comprehension would accuse the Fed of following an excessively tight policy in the 1970s, with double digit nominal rates to combat double digit inflation.

"Tightening" would constitute a change in nominal income expectations. Look at TIPS spreads (spread between nominal and inflation-protected Treasuries, as a proxy for inflation expectations :( that tightening has been in place for an extremely long time, and is entirely independent of the actual or projected path of the fed funds rate: that path merely codifies and reinforces the stance of monetary policy. Low rates now and into the future signal that policy has been far too tight to generate any upward momentum in time-varying, neutral real interest rates (often termed in academia the "Wicksellian natural rate")

II. Inflation?

There is no inflation. There is no natural rate of unemployment. In theory there might be, but the idea of a tipping point beyond which all hell breaks loose -- i.e., an unemployment rate below which inflation begins to rocket -- within a reduced-form, accelerationist Phillips curve whereby current inflation is a function of lagged inflation and the employment gap is utter nonsense. Not to mention, the relationship between lagged inflation and expected inflation has likewise broken down. In other words, the implementation of inflation targeting has centered inflation expectations around explicit--or, prior to 2012 in the case of the Fed, implicit--inflation targets that central banks (ECB, Fed, BOJ, etc.) have credibly (or in the BOJ's case, not so credibly) committed to. The unemployment gap is utterly meaningless insofar as expectations of future inflation remain well anchored.

III. Bubbles?

An argument often parroted by people who don't know what they're talking about is that low rates cause "bubbles." I'm agnostic on this, though there isn't meaningful evidence that it actually has taken place. There are several issues at play, though:

(i) These people conflate low rates with "easy money." There's evidence of reaching for yield behavior, but that's a function not of "easy money": reaching for yield is associated with low current rates and low expected future short-term rates, culminating in lower long-term rates today. Low rates now and into the future is a byproduct of *tight money.*

(ii) Anyone who points the finger at the Fed for the housing bubble conflates easy money with easy credit. Easy money is conducive to an upward movement in nominal income expectations -- that's, frankly, all it is. It should be consistent, if it's successful, with higher long-term rates as both inflation expectations and expectations of future short rates rotate the yield curve upward. Easy credit, however, is strictly a function of *regulatory* policy. Prior to the 2010 Dodd-Frank Act, that was uniquely the role of Congress. Now, the Fed has a bit more leeway in imposing capital and liquidity requirements, orderly dissolving "SIFI's," forcing financial institutions to comply with stress tests, etc.

(iii) The idea that anyone -- and I mean anyone -- can detect a bubble in the making is a product of nothing else than the Dunning-Krueger effect: thinking you know more and understand more than you actually do. If Ben Bernanke, a scholar of the Depression and a much, much smarter person than the Austrian nitwits who "predicted" the housing bubble couldn't see it, it isn't likely that someone with half his IQ was able to. And that's precisely the point: you would need a crystal ball to detect a bubble in the making. If you define a bubble as "money printing" -- which isn't even technically correct, but whatever -- then you're going to predict a whole lot of bubbles. That's why Peter Schiff predicted 10 of the last... 1... bubble. If you forecast a bubble and one happens, much like a broken clock you're "right," though anyone who dug below the surface would rightly call you out for the charlatan you are.

A "bubble" is a scenario in which asset prices deviate from fundamentals. If you think that's the case, the burden of proof is on you. Don't show me "elevated" equity valuations -- show me, in real time, an asset-pricing model delineating the intrinsic value of the asset in question and the extent and scope that current prices deviate from that trend line. If you can, I'll show you 10 problems with that model. Then I'll show you why equities are a horrid gauge of underlying fundamentals -- i.e., you can probably find me a transient "irrational exuberance" bubble, but you won't be able to find me a more destructive, credit-driven bubble that will come crashing down like the one in 2008.

(iv) Even if you somehow found me a bubble in real time, there's just no scope with which a rate increase could properly lean on that bubble: you would only make the problem a whole lot worse, and then have to slash rates EVEN FURTHER to deal with the aftermath.

IV. Ammunition?

I'll conclude with one more. Some have recently argued that a quarter point move -- and we'll ignore the whole "it's just a quarter point!" as I point you to the ECB, which tightened a quarter point, the BOJ, which tightened 50 bps, and the Swedish Riskbank, which tightened a quarter twice (i.e., it's more complex and more to due with perceptions of the underlying reaction function than a mechanical move in interest rates -- which, once again, tell us nothing of the stance of monetary policy) -- would give the Fed "ammunition" to respond to the next recession.

A few comments here:

First, Rudi Dornbusch put it best: "expansions don't die out, the Fed kills them." Tightening in the hope of ammunition is a self-fulfilling prophecy: you're going to produce a need to physically cut rates in the future by raising them now, insofar as raising constitutes tightening (this is complex, but we'll come back to it). Again, low futures short rates -- i.e., a need for that ammunition -- is a function of tight money today.

Second, stop focusing on interest rates. What matters is the real policy rate -- effective federal funds rate, less some utility-weighted price index (we can proxy it with some headline inflation rate, though most people cheat and use core, which removes food and energy) -- relative to the equilibrium real interest rate. That rate is based on three things: financial conditions, marginal propensity to save, and expected productivity growth. In every single case, tightening *reduces* that rate, magnifying the effect of the rate hike. You're not creating ammunition: you're creating a situation in which you wish you had ammunition, and are circuitously holding constant fundamentals in the absence of a rate hike and credibility, both of which are pie-in-the-sky nonsense.


That's enough for now.
~JohnMaynardKeynes
"Those who cannot remember the past are condemned to repeat it." - George Santayana
"We are what we repeatedly do. Excellence, then, is not an act, but a habit." - Aristotle
ColeTrain
By ColeTrain | Nov 30 2015 1:30 PM
JohnMaynardKeynes: Glad you posted this, thanks. I was actually just getting on to post something about the inevitable rate increase, then saw this. :D

To be clear, do you think rates should be increased in Dec.?
"Man is not free unless government is limited" -- Ronald Reagan
Topics: http://tinyurl.com/oh9tm6u
JohnMaynardKeynes
By JohnMaynardKeynes | Nov 30 2015 1:47 PM
ColeTrain: Ah, good question... I could go on for days, but then that would prevent me from typing this silly paper. So I'll try to be terse.

So there are a lot of sensible arguments for raising and some not-so-sensible. There are also some asinine arguments for *not* lifting. I'll summarize those arguments and then tell you where I come down. I acknowledge that the discussion is far more nuanced -- especially now -- than it was several months ago and much more than most people are willing to admit.

So the Fed says, before they lift, that they want to see two things happen: "some" further improvement in the labor market and they want to be "reasonably confident" that inflation will return to 2 percent in the "medium term." They don't tell us what that means, though the presumption is that it's about 2 years, which is consistent with policy lags and such.

So the labor market front looks pretty good. Don't let people scream that the "labor force participation rate is at a 38-year low!" It's a red herring. If these people actually bothered to look at the research on this, they'd see that half of that decline is explained by demographics: aging of the population, drop-of in prime age participation that has spanned decades (50s for males, 90s for females), etc. Some of it is explained by an increase in educational enrollment, which will lower trend participation today and raise it in the future; some is explained by hysteresis: unemployment durations spiked, and that's consistent with the long-term unemployed seeing their skills atrophy, which raises the "normal" rate of unemployment.

The labor market slowed a bit in the past few months, though October -- 271k nfp -- continued the old "trend line" which was exceedingly high. There might be some latent slack in PTER and marginally attached, but it's very, very small, and reentry rates have probably already peaked, if history is our guide. Wage growth is crap, but that's probably a reflection of horrid productivity and a flat "Phillips curve" relationship. The fall in commodities, which has raised real incomes, has likewise probably reduced the *desire* to bargain for higher wages. Jobless claims are near a 42-year low, the LMCI -- an index of 19 indicators -- is where it was in the 90s, vacancies are at a record high (e.g., the "Beveridge Curve" has shifted out), hiring slowed at the same time, which is possibly the best sign of a skills mismatch, etc.

So we've definitely hit that, especially since trend employment growth is around 100-150k in the future due to a shrinking labor force. Trend RGDP is also somewhere around or below 2 percent, so insofar as we continue to grow 'above trend," we should see the unemployment rate fall.

That doesn't mean that inflation would necessarily build in some virtuous cycle, though. To the contrary, inflation is low, inflation expectations are low, the dollar shows no sign of slowing down, China/EME/Europe are going to implode, and diverging policies (easing by the ECB/Riksbank vis-a-vis expectations of a Fed tightening) threaten to bolster the dollar further, all whilst commodity price declines show no sign of tapering off.

To be fair, I think the risk of China is overblown: a lot is structural in nature, and a function of rebalancing, as opposed to a cyclical downturn, which will probably proceed for a long time to come. Most of the oil decline is due to a supply glut (the IMF has a good study on this if you're interested), which should in theory be expansionary. But the real kicker is inflation expectations: they're perhaps *the* focal determinant of inflation over any meaningful period of time, and they're in the toilet.

So, no, I wouldn't raise rates. It might cost the Fed credibility because they're been (stupidly) yelling that they were going to hike, and markets have already priced it in (see, for instance, yield curve, fed funds futures, eurodollar futures, etc.), but the relative costs of tightening too early -- even though the comparisons to the BOJ/ECB/Riksbank/Depression/(insert dozen other central banks that have tightened since 2009) are overblown and inherently non sequiturs -- far outweigh any minor cost to credibility.
~JohnMaynardKeynes
"Those who cannot remember the past are condemned to repeat it." - George Santayana
"We are what we repeatedly do. Excellence, then, is not an act, but a habit." - Aristotle
JohnMaynardKeynes
By JohnMaynardKeynes | Nov 30 2015 1:52 PM
JohnMaynardKeynes: *shrinking labor force GROWTH
~JohnMaynardKeynes
"Those who cannot remember the past are condemned to repeat it." - George Santayana
"We are what we repeatedly do. Excellence, then, is not an act, but a habit." - Aristotle
ColeTrain
By ColeTrain | Nov 30 2015 1:56 PM
JohnMaynardKeynes: Interesting... I think, though I haven't done near as much research about the topic as have you, they should. But, you bring up great points and reasoning. Thanks! :) Also, I'm interested in that IMF study, could you link me? :)
"Man is not free unless government is limited" -- Ronald Reagan
Topics: http://tinyurl.com/oh9tm6u
ColeTrain
By ColeTrain | Nov 30 2015 1:57 PM
JohnMaynardKeynes: Btw, we could sure use you in the economics forum on DDO :P
Economics is DEAD over there. Me and TheProphett are trying, we've nowhere near the economic prowess that you have. xD
"Man is not free unless government is limited" -- Ronald Reagan
Topics: http://tinyurl.com/oh9tm6u
JohnMaynardKeynes
By JohnMaynardKeynes | Nov 30 2015 2:02 PM
ColeTrain: No problem.

Here it is: https://www.imf.org/external/pubs/ft/sdn/2015/sdn1515.pdf


Lol, honestly... there are a whole lot of reasons why I don't foresee myself returning to DDO anytime soon. In particular, I can't stand how the website is currently developing. The "leadership" is more like a dictatorship, I have virtually no respect -- nor should anyone -- for the "prominent" members, and the seniority-based system is really a sack of crap.
~JohnMaynardKeynes
"Those who cannot remember the past are condemned to repeat it." - George Santayana
"We are what we repeatedly do. Excellence, then, is not an act, but a habit." - Aristotle
ColeTrain
By ColeTrain | Nov 30 2015 2:06 PM
JohnMaynardKeynes: Thanks!

Oh, I know you don't... Though it's unfortunate. :P As long as you stay here where you at least occasionally post economic stuff. :D
Bsh1? I've not had any problems with him so far. I don't like the tournament restrictions, though... but that's about it. :)
Lol. For the record, Annie wishes ya'lls friendship could be restored.

But, I won't fill this good economic thread with other stuff. :D
"Man is not free unless government is limited" -- Ronald Reagan
Topics: http://tinyurl.com/oh9tm6u
JohnMaynardKeynes
By JohnMaynardKeynes | Nov 30 2015 2:10 PM
ColeTrain: Yeah, I'll post some stuff here every so often.

He's certainly one, yeah, and the amount of "influence" he has -- or thinks he has -- is nauseating, even more so than the "respect" he for some God-forsaken reason commands. I won't say much more on him because, frankly, he isn't worth the time it would take me to *really* give you my opinion on him (hint: it isn't positive). It was interesting to see several other people (I think Mirza was one) call him out for being pretentious and sanctimonious. He couldn't have been more spot-on.

Annie and I are fine.
~JohnMaynardKeynes
"Those who cannot remember the past are condemned to repeat it." - George Santayana
"We are what we repeatedly do. Excellence, then, is not an act, but a habit." - Aristotle
ColeTrain
By ColeTrain | Nov 30 2015 2:11 PM
JohnMaynardKeynes: Thanks!

Oh, I know you don't... Though it's unfortunate. :P As long as you stay here where you at least occasionally post economic stuff. :D
Bsh1? I've not had any problems with him so far. I don't like the tournament restrictions, though... but that's about it. :)
Lol. For the record, Annie wishes ya'lls friendship could be restored.

But, I won't fill this good economic thread with other stuff. :D
"Man is not free unless government is limited" -- Ronald Reagan
Topics: http://tinyurl.com/oh9tm6u
ColeTrain
By ColeTrain | Nov 30 2015 2:13 PM
JohnMaynardKeynes: Good!

Lol... don't get banned -- not worth it. :) Well, I'm just glad I haven't had any negative interactions so far. Mirza, lol :P

That's refreshing! :)
"Man is not free unless government is limited" -- Ronald Reagan
Topics: http://tinyurl.com/oh9tm6u