tag:blogger.com,1999:blog-59088308271350608522024-03-18T15:01:15.235-04:00Bond EconomicsBrian Romanchuk's commentary and books on bond market economics.Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.comBlogger1274125tag:blogger.com,1999:blog-5908830827135060852.post-29299585406939338212024-03-18T15:00:00.000-04:002024-03-18T15:00:43.113-04:00Macro N Cheese Podcast - Inflation<div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEiwnocvCqhchqhBMn3pyZHxxriUr1hzvprzXQAW5SKVhYlaXfAvY-SQ657D-ThcnRScpYUCXsChmVO8dBrIvKJoiOh55sW4b3pbtko8uNbtLDfDSan9JHrVD1b-9gifWXaLKZ7Aat8F_l0rXClZ2n3YlDgeY3KSdeQ46i3pFgvgx3wT7RqwgQE39ln4UkY" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img alt="" data-original-height="697" data-original-width="696" height="240" src="https://blogger.googleusercontent.com/img/a/AVvXsEiwnocvCqhchqhBMn3pyZHxxriUr1hzvprzXQAW5SKVhYlaXfAvY-SQ657D-ThcnRScpYUCXsChmVO8dBrIvKJoiOh55sW4b3pbtko8uNbtLDfDSan9JHrVD1b-9gifWXaLKZ7Aat8F_l0rXClZ2n3YlDgeY3KSdeQ46i3pFgvgx3wT7RqwgQE39ln4UkY" width="240" /></a></div><p data-pm-slice="1 1 []">I was recently on a podcast with Steven D. Grumbine to discuss inflation. Link: <a href="https://realprogressives.org/podcast_episode/episode-268-there-is-no-magic-pricing-fairy-with-brian-romanchuk" rel="noopener noreferrer nofollow" target="_blank">https://realprogressives.org/podcast_episode/episode-268-there-is-no-magic-pricing-fairy-with-brian-romanchuk</a></p><p>The podcast description from the webpage is.</p><blockquote><p>“Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”</p><p>Milton Friedman </p></blockquote><p><em>This quote by the grandaddy of neoliberal economics is from 1963. Some in the mainstream have been dining out on it ever since. </em></p><p><em>According to our guest, author and blogger Brian Romanchuk, neoclassical economics relies on mathematical models and fail to capture the complexity of real-world inflation. He highlights the importance of understanding the supply and demand dynamics in setting prices and explains that inflation can be influenced by factors such as supply chain shocks and changes in the labor market. </em></p><p><em>Brian also points out that it’s not enough to blame inflation on corporate greed; after all, corporations are always driven to maximize profits. He mentions the Cantillon effect, which suggests that the first recipients of newly created money benefit from inflation as prices go up, while the poor and working class bear the brunt of higher prices down the road. </em></p><p><em>Brian and Steve discuss inflation constraints on fiscal policy. Brian argues that while extreme fiscal policies could lead to inflation, most of the time, fiscal policy is relatively moderate and does not have a significant impact on inflation. They criticize the government for not trying to set prices and argue that the government often follows the private sector’s lead, making things worse. </em></p><p>This is a discussion of some topics around inflation. Although some of the discussion related to the concerns of my book, a lot of it relates to some of the recent political economy controversies with inflation. It was fun, although I am not sure how well suited I am to the podcast format.</p><p>Otherwise, I have been plugging away at fixing weak points in my inflation manuscript. Rather than waste reader’s time by rushing out some random comment, you are encouraged to get your dose of Romanchuk (and Grumbine) content via the podcast.</p></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2024Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-39486573064847249492024-03-07T15:09:00.001-05:002024-03-07T15:09:31.652-05:00"The Debt Crisis Is Here": The Conference Board Is At It Again<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgXHvWpIiIuYUbqBlWfv_gVXAdf1ylbsPTpviK4EqCwWU8TYXm1H13ZnGDrrg-yxoCHhn-4qt8Lmwy8e7xZWbWUvxn4cN6DI6ARfxUiC3LSbvneN1coZF6hgDhgQ4SgKMAQU8cHvno-sLZeQfsNzHX4lgztK6ttP5tWDMqzxs4Z2H_go6s2ro0a1-YGETU/s600/c20240306_us_debtgdp.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="400" data-original-width="600" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgXHvWpIiIuYUbqBlWfv_gVXAdf1ylbsPTpviK4EqCwWU8TYXm1H13ZnGDrrg-yxoCHhn-4qt8Lmwy8e7xZWbWUvxn4cN6DI6ARfxUiC3LSbvneN1coZF6hgDhgQ4SgKMAQU8cHvno-sLZeQfsNzHX4lgztK6ttP5tWDMqzxs4Z2H_go6s2ro0a1-YGETU/s16000/c20240306_us_debtgdp.png" /></a></div><br /><div><p data-pm-slice="1 1 []"><a href="https://www.conference-board.org/pdfdownload.cfm?masterProductID=50206" rel="noopener noreferrer nofollow" target="_blank">The Committee for Economic Development (CED) of Conference Board recently put out “Explainer: The National Debt”</a> which is pretty much a greatest hits of debt scare mongering. Other than the references to recent events and data, it is timeless: the authors could have put out the same report in any year since the mid-1980s and not much of the contents would have changed. Anyone who thinks that the MMT debate would improve things just needs to read the report to see that progress in conventional economics is largely illusionary. </p><p>The shtick of the “explainer” is that “the fiscal crisis is here.” The evidence is everybody’s favourite time series: the debt/GDP ratio (above). </p><p>I will immediately note that the United States does face a crisis: its ability to govern itself appears to have collapsed. Getting the budget process to work when one party of a two party system wants to burn the system to the ground is obviously difficult. What type of dysfunction the United States will have after November depends upon the electoral results (and whether a certain party would accept those results).</p><h2>The “Analysis”</h2><p>The report runs through the basics of fiscal policy, and the various categories of spending.</p><blockquote><p>Comparing the national debt to GDP (Figure 5) produces a ratio that reveals the United States’ ability to pay down its debt. The debt-to-GDP ratio shows the burden of the national debt relative to the country’s total economic output and can provide greater context than looking at total debt numbers alone. Based on examples from international financial institutions, the recent past, and econometric analysis, CED recommends a public debt-to-GDP ratio of no higher than 70 percent as a stable and sustainable level of debt burden. The European Union requires member states to limit government debt to 60 percent of GDP as a condition for joining the euro, and a World Bank analysis finds 77 percent as the threshold at which debt begins to impede economic growth in developed countries. CED’s recommendation is roughly in the middle of this reference frame.</p></blockquote><p>The CED thus declares the U.S. debt unsustainable based on (a) a number pulled out of the nether regions of Eurocrats and (b) a number from a report that undoubtedly reversed the causality between high debt/GDP ratios and low nominal GDP growth rates.</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhv1xivz9ygmVT_xaWgsNOCqX8bJzhbNZ2tIgPBcwycZ0QpTWCmBrn5G_hr2fyXJrrqyrr_1a-G2kyfvRhMTXdomcVoNT2kIIEneo2Mu_DKvirkrbFfooBKNn7fqve7HkFMgzRAuc58wN5wPZY05hx1VWK75BJA3TLT6INpzf9iQpBVX3HXPTfIFMqSJbc/s600/c20240306_Japan_net_debt.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="400" data-original-width="600" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhv1xivz9ygmVT_xaWgsNOCqX8bJzhbNZ2tIgPBcwycZ0QpTWCmBrn5G_hr2fyXJrrqyrr_1a-G2kyfvRhMTXdomcVoNT2kIIEneo2Mu_DKvirkrbFfooBKNn7fqve7HkFMgzRAuc58wN5wPZY05hx1VWK75BJA3TLT6INpzf9iQpBVX3HXPTfIFMqSJbc/s16000/c20240306_Japan_net_debt.png" /></a></div><br /><p data-pm-slice="1 1 []">When we compare the magic “unsustainable 70% debt/GDP limit” to Japan’s history, we see an immediate problem. Of course, the authors of the report explain this as being due to high personal savings rates, and Japanese growth was slow. Given the rather low levels of JGB yields, it is hard to see how the debt levels impeded growth.</p><h2>Yeah, The 1980s</h2><p>What stands out to me is the following passage.</p><blockquote><p>After the economic turmoil of the 1970s, President Reagan entered office in 1981 promising to tackle inflation and the budget deficit. While inflation did come down, the Federal government also ran high deficits because of tax cuts and significant increases in military spending that were not matched by cuts in other areas of discretionary or mandatory spending. Nevertheless, economic growth was relatively strong, which tempered the rise of the debt-to-GDP ratio in the 1980s to 39 percent of GDP by 1989.</p></blockquote><p>If we look at the chart I provide at the top of the article, we get a somewhat different view of the debt/GDP situation in that era. The debt/GDP ratio hit its lowest level during the peak inflation period around 1980. Rapid nominal GDP growth crushes the debt/GDP ratio courtesy of how division works.</p><p>If we accept the MMT premise that the sustainability risk associated with fiscal policy is inflation, then the debt/GDP ratio is an anti-indicator: it falls when inflation rises.</p><h2>Interest Costs</h2><p>The discussion of interest costs also underlines the incoherence of conventional thinking: interest costs are rising because the central bank is raising rates because it wants lower inflation. Yet those rate hikes represent an inflation risk.</p><h2>Outlook Is Concerning Because the U.S. Federal Government is Adrift</h2><p>Hand-wringing about discretionary versus non-discretionary spending is just political cover for fiscal conservatives to demand cuts to the welfare state. To the extent that there is a fiscal problem, tax hikes are also a solution. The inability of the U.S. Federal Government to run a budgetary process in a sane fashion is always going to be an issue.</p><p>Fiscal policy was forced into extraordinary measures by the unusual nature of the pandemic. There was an inflationary bump — but no lost decade afterward. If fiscal policy is structurally loose, there might be future tightening measures needed. However, it is unlikely that the U.S. can approach that prospect in a sane fashion.</p><h2>Concluding Remarks</h2><p>It is very easy to respond to such reports by fiscal conservatives. They keep publishing the same report, and I keep publishing the same response.</p></div><div><br /></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2024Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-11805311942928313622024-03-01T10:37:00.000-05:002024-03-01T10:37:27.777-05:00Primer: Why Not Used Fixed Consumption Baskets In The CPI?<div><p data-pm-slice="1 3 []"><em></em></p><div class="separator" style="clear: both; text-align: center;"><em><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjrRR1SMj7kbqNjk-7FJxJqQc0xfSADbgV1yinmtYDylfnYgsZyffkOg3IigOwOkxkGo7RrUCLmMNYcDo9yT1E6WUHYpQZ4-BrkWMo9X2hUZhRQQGbGHo5jGe1Y9jRfwkmZvKHQ2NsffUDwQS_H2NDVKL1UQQABSVnwh2E8VLg_dU-JVxsNRvJvc-KB8zU/s80/logo_inflation.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjrRR1SMj7kbqNjk-7FJxJqQc0xfSADbgV1yinmtYDylfnYgsZyffkOg3IigOwOkxkGo7RrUCLmMNYcDo9yT1E6WUHYpQZ4-BrkWMo9X2hUZhRQQGbGHo5jGe1Y9jRfwkmZvKHQ2NsffUDwQS_H2NDVKL1UQQABSVnwh2E8VLg_dU-JVxsNRvJvc-KB8zU/s1600/logo_inflation.png" width="80" /></a></em></div><em>This article is an unedited draft section from my inflation primer manuscript. This section is a re-write of content that I saw as having issues. This re-write has led me to be happier with the first chapter, which I had long seen as having problems. Given the importance of the free preview in online book sales, the first chapter has to be solid.</em><p></p><p>One fundamental problem with the consumer price index is that it is the result of what most people would consider a complex calculation. This should not be surprising, since they are tasked with converting the price change of large number of items (80,000 items in the United States) into a single monthly index percentage change. People who are mad about the price of eggs going up generally just look at the price of eggs, they do not want to hear academic jibber-jabber about 80,000 items or (oh dear) a Laspeyres formula.</p><p>In this section, I am not going to attempt to explain the formulae used by the national statistical agencies. Anyone comfortable with reading those equations either know the answer already or would be sensible enough to go to the source agency rather than rely on me not mangling the equation during the editing process. Instead, I will explain the fundamental issues that we see in the simplest possible price index: one with two types of apples. A reader might immediately ask: why use two types of apples, and not apples and oranges (which I used in the first draft)? The explanation for that choice is given later, but the short answer involves not mixing up apples and oranges.</p><p>I want to warn readers that they should not spend time attempting to find logical flaws with my “index” calculations. I have come up with examples that I believe give a good feel for the underlying economic issues, but I can think of at least one way of “breaking” a suggested calculation by playing around with the numbers. Statistical agencies use more complex formulae than I use, and if you want to nitpick, you need to look at those formulae.</p><p>But before we get to simplified index calculations, we need to address why we need consumption weights in the first place? Why not just look at the price of a fixed basket of goods?</p><h2>Fixed Basket of Goods</h2><p>The most intuitive price index is one that corresponds to a fixed basket of goods. <em>(Price indices also include services. But I will just write goods in this section since I do not want to have to write “fixed basket of goods and services.”)</em> The idea is straightforward: if you buy the same goods at different times, how much does the price change? One whimsical version of this index is “The PNC Christmas Price Index.” This is an index that tabulates the cost of buying the items listed in the song “The Twelve Days of Christmas” (with a certain amount of imagination needed to determine prices for things like “10 lords-a-leaping” in the non-aristocratic United States). One might run into indices of this type in economic history, where researchers are attempting to summarise price trends in earlier eras when the CPI was not calculated.</p><p>To give an example that will be used in the rest of this section, imagine a price index for a subset of fresh fruit that just includes Cortland Apples and Empire apples. <em>(These are two popular varieties of apples that are grown in Quebec, I have no idea whether readers elsewhere are familiar with them.)</em> Although not too many people would be interested in such an index (other than apple lovers), this might be a sub-index of a larger index. We then assume that a household buys 30 apples of each type each month.</p><p>If the price for these applies conveniently start $1 at each, then the starting price for the total fruit basket is $60. We could strip the dollar sign out of the quoted number and say the price level is 60.</p><p>Let us then imagine that the price of Empire apples doubles to $2, but the Cortland ones remain at $1. Then the cost of the basket is $90 ($60 for the 30 Empire, and still $30 for the 30 Cortland). This is a 50% increase, which makes sense. Previously, there was a 50/50 weighting between Empire and Cortland, and so the overall inflation rate is a 50/50 weighting of the two percentage changes (100% and 0%).</p><h2>Mad About Weightings</h2><p>If you wade through complaints about rising prices not being reflected by the CPI, most of what you see are effectively complaints about weightings. People mad about price increases just want to talk about those price increases, and do not want to discuss other goods and services whose prices did not rise. In the previous example where Empire prices doubles but Cortland were unchanged, one would be ensured that there will be hundreds of angry people on the internet discussing Empire apple prices, but not Cortland. Even though the price index rose by 50%, that is not good enough because that does not match the 100% Empire price rise.</p><p>Although one might feel sad for fans of Empire apples, we need to accept that macroeconomics is the study of overall behaviour. Although the fixed basket of Cortland and Empire apples is imperfect (for reasons to be discussed), it at least is supposed to reflect an economic concern of households: how much am I spending on apples?</p><p>As such, we need to have some means of weighting the different percentage price changes into an average price change. When we look at how price indices are used, we need to have the weighting set so that they reflect the overall consumption of households.</p><h2>Why Not a “Fixed Basket?”</h2><p>We can then return to the question of having a “fixed basket”: always have the same number of items purchased each month? If we buy the same things every month, why not just add up their cost (like in my example)?</p><p>The immediate response to that question is that my example “index” is misleading, as it consists of generic fresh fruit that appear somewhat timeless from the point of view of consumers who are not particularly concerned about the histories of apple varieties. If we jumped to things linked to technology, problems with fixed consumption baskets are obvious. For example, renting VHS video cassettes was an extremely common expenditure item in the 1980s. At the time of writing, it is extremely hard to find stores that rent even the successor technology to VHS cassettes – Digital Video Discs (DVDs). Conversely, cellular data plans are a feature of most families’ budgets, and such plans did not exist in the 1980s. Any attempt to create a fixed basket of consumption goods is eventually going to look laughable in modern industrial capitalist societies.</p><p>One might say that this is true for technology goods but is not true for non-processed foods. Why not have a fixed basket for those items? (One crank made exactly that argument on social media just before I wrote this section.) Even if we want to skate over awkward questions like how food with “organic” designations fit in with food when those designations did not exist, consumption weights change (admittedly slowly). North America consumption of quinoa was negligible in the 1970s. Coffee selection is vastly improved in North America since the 1980s, and grocery coffee purchases are increasingly weighted towards coffee pods.</p><p>Although whole foods are a convenient category that seems comparable over time – Statistics Canada has a section breaking out the prices used for selected ones as part of its CPI release – they are an increasingly small weighting in consumer budgets in developed countries. You can find other “generic” goods and services – natural gas, gasoline (sort of, blends change), hair cuts – but they are in scattered categories. To be useful, we need to make periodic surveys of consumption to get weights that reflect what people are actually spending money on.</p><h2>Weightings are Tricky (And Get Some People Mad)</h2><p>If government statisticians tracked every single transaction in the economy, they would know exactly the current consumption spending weighting of consumers. The problem is that they do not have access to that information. It is time consuming (and expensive) to survey consumers to get detailed breakdowns of their consumption<em>. (By contrast, getting price data is relatively easy – just send government employees into stores to see what prices are posted.)</em> Consumption surveys are done at a lower frequency. The U.S. Bureau of Labor Statistics describes the weighting situation as:</p><blockquote><p>The CPI measures the change in the cost of goods and services purchased by consumers from one period to the next. Household spending weights are used to average the changes in component goods and services into the All-items index. In the first 50 years of producing the CPI, the BLS updated the spending weights roughly every 10 to 15 years based on spending information collected in periodic household surveys. In the 1980s the Consumer Expenditure Surveys (CE) became continuous and the BLS began updating the CPI spending weights every two years, starting in 2002, when the CE sample was increased to support more frequent weight updates.</p></blockquote><p>(Taken from the 2022 CPI Weight Update information: <a href="https://www.bls.gov/cpi/tables/relative-importance/weight-update-information-2022.htm" rel="noopener noreferrer nofollow" target="_blank">https://www.bls.gov/cpi/tables/relative-importance/weight-update-information-2022.htm</a>.)</p><p>An update frequency of every two years might not sound too bad, but there is a fundamental problem: consumption patterns will shift based on price changes. For readers who are fans of free market capitalism, one of the selling points of the system is that <em>households and firms change behaviour based on price signals</em>. If the price of Empire apples doubles, you are supposed to say to yourself “Maybe I will replace my intake of relatively expensive Empire apples by Cortland apples.” If we had monthly surveys of consumption weights that updated in line with prices, we would know how much substitution happened. But we do not, and so economists need a methodology to make a guess how much substitution occurred.</p><p>Although most of us accept that we are stuck with making an educated guess for substitution, this is a topic gets some people mad. By an amazing coincidence, the people who are most mad about assuming that consumers substitute away from goods that jumped in price are pretty much the same people who insist that free market capitalism is great because of price signals. (I will be dwelling on this point multiple times in this book, since it is shows up in a variety of complaints.)</p><p>I will now look at possible alternatives to what happens in response to the Empire apple jump.</p><h2>Total Substitution</h2><p>If we wanted to reduce the reported rate of inflation, we could assume that consumers substitute completely away from the relatively expensive apples. Instead of buying 30 Empire and 30 Cortland, they could just buy 60 Cortland apples. Since we assumed that Cortland prices are unchanged at $1, the total consumption is unchanged at $60. This is a 0% inflation rate (matching the inflation rate for the Cortland variety).</p><p>Of course, this outcome does not match the description of the fixed consumption basket – since the number of each item changed. Instead, we have a situation like the commonly used price indices (like the CPI): we are tracking the cost of a category of goods (apples within fresh fruits) over time. Since we no longer are buying a fixed basket of goods, we really should not put a dollar value on the index. Instead, we are looking at the percentage change in the price of buying two varieties of apples over time.</p><p>Since we are not using a fixed menu of purchase amounts, we are always working with relative prices. To calculate the percentage change on the overall basket, add up the percentage changes of each item multiplied by their assumed weight in the monthly purchase basket. In the case of total substitution, we have a 0% weight on the 100% change in Empire prices plus a 100% weight on the 0% change in Cortland prices. In the fixed basket example, there is a 50% weight on the two price changes, giving the 50% overall inflation rate.</p><p>However, assuming consumers always stop purchasing goods whose prices rose the most would be as silly as always putting a 100% weight on the fastest-rising prices. (In fact, there are some logical problems with such a situation. What happens if Empire apples were unchanged the next month, while Cortland apple prices doubled?) We need some magic way to split the difference.</p><h2>Mysterious Model Weight</h2><p>We then let some economists loose to come up with a model that gives us an updated consumption weight that is a function of relative price changes. (If every single item in the sub-index has the same percentage change, the weighting does not matter.) If you want to go through the literature, there will be a lot of jargon discussing the models. My expectation is that the reader is not in charge of developing new price indices, and so I see no need to delve into this jargon.</p><p>Since I am lazy, I will assume that the model output conveniently hits the midway point between the two previously discussed cases. This is purely a literary assumption – actual models used in practice will have different weighting shifts based on the data.</p><p>If we assume that consumers split the difference and buy 45 cheap Cortland apples and 15 expensive Empire ones (instead of 30/30), the total cost of the basket is now $75. This is 25% higher than the previous basket price of $60. This 25% inflation rate is determined by having a 75% weight on the Cortland price change, and a 25% weight on the Empire price change.</p><p>If we want to think in terms of the prices of baskets of goods, the inflation rate that is calculated is not the change in the price of the old basket of goods in the current period. Instead, it is the change in the price of the current basket of goods versus buying that new basket at the old prices.</p><p>This is not how people who get mad at inflation statistics want to think. They invariably present price changes based on buying the old basket of goods at current prices, rather than what being based on what it would have cost to buy the current basket at the old prices.</p><p>To the extent that price spikes represent shortages, we also have the problem that substitution must happen. If Empire apple prices spiked because there was a highly selective crop failure, there are less Empire apples to buy. The volume of Empire apple purchases <em>must</em> fall. That said, this is trickier to apply to globally traded goods. There might be a shortage of oil at the global level, leading to a price spike on oil markets, but a rich country might keep importing the same amount and keep consumption unchanged.</p><p>We only would know how much substitution there was if we had access to monthly consumption data (which we do not).</p><h2>Let Us Mix Up Apples and Oranges!</h2><p>We can then ask ourselves: if apple prices have a high relative price shift, why would consumers not get their fresh fruit fix by buying oranges? That is, we could assume that consumers will substitute spending based on relative price shifts within the wider fresh fruit category.</p><p>This is a possibility that creates a lot of complaints about CPI, based on people not paying attention to the actual calculations. The CPI calculations generally do not allow for substitution across item categories. To quote Greenlees and McClelland in “Addressing misconceptions about the Consumer Price Index”:</p><blockquote><p>To begin, it must be stated unequivocally that the BLS does not assume that consumers substitute hamburger for steak. Neither the CPI-U, nor the CPI-W used for wage and benefit indexation, allows for substitution between steak and hamburger, which are in different CPI item categories. Instead, the BLS uses a formula that implicitly assumes a degree of substitution among the close substitutes within an item-area component of the index. As an example, consumers are assumed to respond to price variations among the different items found within the category “apples in Chicago.” Other examples are “ground beef in Chicago,” “beefsteaks in Chicago,” and “eggs in Boston.”</p></blockquote><p>I used the non-intuitive “Empire versus Cortland apples” instead of “apples versus oranges” because the U.S. CPI calculation does not allow for substitutions across apples and oranges, only within “apples.” However, this is not going to hold for every price index, as they may allow for substitution effects within categories like fresh fruit.</p><p>At the higher level, one might ask whether people substitute across much different categories. If movies get more expensive, will they instead buy a video game? Although people always need to eat, they can do things like eat at home instead of at a restaurant.</p><p>To the extent that price indices do not allow substitution, they are going to overstate the true cost inflation experienced by households who react to price signals. This partly explains the massive disconnect between the mainstream economists that argue that the CPI overstates inflation versus the commentators who insist that CPI inflation rates understate inflation.</p><h2>Non-Existent Goods</h2><p>Another issue that pops up in index calculation is that we might have a price for a good or service in one month, but not in another. This could be the result of data gathering issues, outright shortages, a product coming into existence – or being pulled from the market.</p><p>Since we only have a price for the good or service for one month, we cannot give a percentage change in the price. One would need to dig into the methodology handbook to see how each statistical agency deals with this.</p><p>However, there is an interesting philosophical issue created by new product launches. In an environment of rising wages, it is easy to see how new product offerings might be “luxury” versions of existing ones.</p><p>One example that comes to mind is the evolution of take-away “coffee drinks” in North America from mainstream venues. Back in the Good Old Days (i.e., when I was a kid), North Americans mainly just bought plain coffees from restaurants/doughnut shops. By the 1980s, you had an infiltration of cappuccino and espresso and so forth in mainstream restaurants. Later on, we saw the rise of “iced coffee drinks.” Each of these evolutions had new beverages coming out at higher price points relative to the existing drinks.</p><p>Even though the prices of standard coffees might not have risen by much, switching to the new drinks meant that consumers were paying more money for the same amount of caffeine buzz. This allowed restaurants to grow their nominal sales, even though the stores might have had the same overall volume of customers.</p><p>This leads to one of my personal inflation theories. When we look at the late 1990s, the economy was buoyant, but the bears were mystified: where is the inflation? My reading of the situation was that companies were able to absorb increased nominal demand by pushing out luxury brands. This worked until the pandemic, where product innovations were not enough to absorb the nominal demand.</p><h2>Concluding Remarks</h2><p>It would be very easy to drown in jargon and mathematical notation when looking at conventional descriptions of price indices. Most of the internal debates among economists refer to complex assumed behaviour. But it is possible to see how price index calculations run into rather awkward questions by just looking at what happens with a basic example.</p><h2>References</h2><ul><li><p>Detailed discussion of price index construction is best found at the methodology guides of national statistical agencies. Example references are listed in Section 1.2.</p></li><li><p>The PNC Christmas Price Index has been calculated by the PNC Financial Services group for over 40 years. It has a web page found at: <a href="https://www.pnc.com/en/about-pnc/topics/pnc-christmas-price-index.html" rel="noopener noreferrer nofollow" target="_blank">https://www.pnc.com/en/about-pnc/topics/pnc-christmas-price-index.html</a></p></li><li><p>Greenlees, John S., and Robert B. McClelland. “Addressing misconceptions about the consumer price index.” <em>Monthly Labor Review</em> 131 (2008)</p></li></ul></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2024Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-59665653124914733702024-02-13T09:47:00.001-05:002024-02-13T09:47:34.070-05:00TIPS And Drying Paint<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg8AjiyLVJKlICTiOf1ey6N0tDIbr7vmQj7T6uGyxjbVudfQW3IhY-MPGajRvuvQDldWwFaeHvNBw9WqhtFLd1HqrmGyggN2vUd4lu37d-fQIvtHVZxResiJT1CsKQpPKHGKZRR7t6WN_V9FDCTjyThoqeTH1x-SFh4DARCrNKinUFxACZUxZLisiP_8Ns/s600/c20240213_breakeven_decorated.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="500" data-original-width="600" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg8AjiyLVJKlICTiOf1ey6N0tDIbr7vmQj7T6uGyxjbVudfQW3IhY-MPGajRvuvQDldWwFaeHvNBw9WqhtFLd1HqrmGyggN2vUd4lu37d-fQIvtHVZxResiJT1CsKQpPKHGKZRR7t6WN_V9FDCTjyThoqeTH1x-SFh4DARCrNKinUFxACZUxZLisiP_8Ns/s16000/c20240213_breakeven_decorated.png" /></a></div><br /><div><p data-pm-slice="1 1 []">One of the issues of an interest rate focussed blog is that bond markets can settle into rather uneventful extended range trading dynamics. This has been the case for U.S. inflation-linked bonds, at least from a strategic perspective. That is, given a target fixed income allocation (which depends upon preferences and situation of the investors involved), should we hold inflation-linked or conventional government bonds? </p><p><span></span></p><a name='more'></a>(The general tendency is to overweight bonds that incorporate credit or prepayment risk, making the allocation decision slightly more complicated. This is because there are no large sources of private sector inflation-linked bonds. This means that even if we think inflation-linked bonds (also known as “linkers”) will mildly outperform conventional government bonds, “spread product” might still outperform them. To make life simple, I am just discussing the credit risk free investment space.)<p></p><p><em>(I assume that the reader is familiar with the definition of a breakeven inflation rate. To quickly recap, it is the future average rate of inflation that results in an inflation-linked bond and a conventional bond of the same maturity having the same total return to maturity. If that is not enough information, it is explained in </em><a href="http://www.bondeconomics.com/2014/05/primer-what-is-breakeven-inflation.html" rel="noopener noreferrer nofollow" target="_blank"><em>this primer on my blog</em></a><em>, and at more length in </em><a href="https://www.books2read.com/b/4AYBae" rel="noopener noreferrer nofollow" target="_blank"><em>my rather amazing book on the inflation linked market</em></a><em>.)</em></p><p>If we look at the figure at the top of the article, we see that the 10-year breakeven (top panel) has settled into a trading range after a certain amount of excitement around the pandemic. The 5-year breakeven rate, 5 years forward — which isolates the breakeven from near run expected inflation from energy markets — settled into a similar range even earlier.</p><p>If we are doing leveraged relative value trading, there certainly were opportunities to make or lose money trading linkers. However, from the strategic standpoint, we are interested in chunky out-/under-performance of the overall asset class versus conventional bonds, and we need a lot of carry or breakeven movements for that to happen. From the perspective of a long-term investor, this is not a disaster, as you might want a partial hedge against large movements in expected inflation. (<a href="https://bondeconomics.substack.com/p/inflation-hedging-do-not-ask-for" rel="noopener noreferrer nofollow" target="_blank">Note that this hedge has limitations.</a>) You probably want to allocate your risk budget elsewhere — and you might have gotten better returns.</p><p>One way that this could be interpreted is that central bankers are doing a great job of anchoring inflation. Yay! Another theory is that modern economies have a lot more inflation inertia than they did during the peak of the welfare state and Old Keynesian business cycle management. Yet another theory is that the linker market is broken, and/or fixed income investors are delusional. </p><p>Anyone familiar with modern quantitative research will start to ask questions about the risk premia embedded in the breakeven inflation rate. My bias is that outside a crisis, linkers tend to be slightly expensive to fair value since the ultimate source of inflation protection is only central government linker supply. <em>(Other issuance is invariably swapped by somebody, and the inflation swaps market in turn relies upon government linkers for inflation protection. All the investors with big balance sheets are already short inflation risk, and no counterparty in their right mind is going to accept large amounts of directional inflation risk from fast money accounts with flimsy balance sheets.) </em>The beauty of my theory is that it is largely non-falsifiable in the absence of another century of data, so I will not worry about alternative theories here. </p><p>This theory is telling us that bond investors expect that the next decade will probably resemble the bulk of the post-1990 experience and stick around 2% or so. In other words, the mood swings regarding inflation among the economics commentariat had almost zero pass through into breakeven inflation pricing.</p><p></p></div><div><br /></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2024Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-25730683387466839992024-02-08T09:37:00.000-05:002024-02-08T09:37:44.690-05:00What Is Neoclassical Economics?<div><p data-pm-slice="1 1 []"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhDu4oKEHaoJwcaeRknxJfcLDB71X7pGRIESJTKkKSzjri6HjxBvTJJ9dK-NovkGmAMoNwbM6hs8O0Fq0GENsv7NEgikwjFAX1Y-7UoM-BSEjNVgU1sxhTRzLkAwsmpVQADDEFYVPESQvicNRGCuMWkFb8rb3bJrAd_rbeasUyBCGA-sbfFZ6fdUXNYt88/s80/logo_DSGE.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhDu4oKEHaoJwcaeRknxJfcLDB71X7pGRIESJTKkKSzjri6HjxBvTJJ9dK-NovkGmAMoNwbM6hs8O0Fq0GENsv7NEgikwjFAX1Y-7UoM-BSEjNVgU1sxhTRzLkAwsmpVQADDEFYVPESQvicNRGCuMWkFb8rb3bJrAd_rbeasUyBCGA-sbfFZ6fdUXNYt88/s1600/logo_DSGE.png" width="80" /></a></div>I ran into an interesting question online: what is neoclassical macroeconomics? I use neoclassical economics as a synonym for “modern mainstream academic macroeconomic theory,” which may not coincide with other definitions. That said, I think it captures what people are interested in, as opposed to any other narrower definition. The terms in the above definition are vague, and so I will spell the definition out in more detail below.<p></p><p>What I find interesting about this question is that I think the usual post-Keynesian approach to this question is misleading. The usual charge is that neoclassical economics has real world political connotations. I think that the real connotations are for academic politics. The real world political content of neoclassical economics just reflects that it is being developed by individuals and groups that have a conservative bent. <em>(Note that I deliberately wrote conservative and not free market, as the focus is more on serving the interests of the governing elites, and developed countries are mixed economies.)</em></p><h2><span><a name='more'></a></span>“Formal” Definition</h2><p>The defining characteristic of neoclassical macroeconomics is that it is generally put forth in the form of mathematical models that follow a particular pattern. <em>(Although neoclassical economists might do empirical work, I do not consider econometric work to be “neoclassical economics” — a statistical tool is a statistical tool.) </em>I do not believe that the “pattern” can be formalised as a mathematical statement, as mathematical statements are given in terms of precisely defined sets. What model fits the “pattern” is a question of psychology, and not real analysis. That is, any attempt to create a formal set covering “neoclassical models” will be invalidated by somebody coming up with what is arguably a “neoclassical model” that is not a member of that set.</p><p>I summarise the pattern as follows. The core of the model structures involve inter-temporal optimisation by “household agents,” along with optimisation problems with other actors (firms, the central bank, etc.). Actual economic outcomes are determined by an “equilibrium” resulting from agents setting exchange ratios between goods and money. </p><p>Note that there is an infinite number of <em>classes of models</em> that can fit within this structure, and since these classes typically have free parameter values that are real numbers, there is also an infinite number of models within each class. If we have two different models within the same class, they can still have very different implications due to the behavioural differences. <em>(E.g., if we look at the simplest different equations, models of the same order can be either stable or unstable based on the coefficients in the equations.)</em></p><p>As an example of the slipperiness of the definition, keep in mind that there are no little people in households inhabiting mathematical sets. A “household optimisation problem” is just an optimisation problem that is allegedly embedded in a larger mathematical system. But somebody else can choose a different objective function (“utility function”) that has the result that the model no longer fits the original set that was supposed to contain “neoclassical models,” but psychologically, it is still a “household optimisation problem” and thus would be considered in practice to be a “neoclassical model.”</p><p>The models can either be discrete time or continuous time, and may have sensible time axes (monthly, quarterly) or insane ones (“generations” in overlapping generation (OLG) models). In the sensible time axis category, the so-called Real Business Cycle (RBC) model would be a canonical model.</p><p>One could interpret all the sensible classes of models that fall under this definition as being RBC models plus “refinements.” I am unable to give a precise date when “neoclassical economics” starts (i.e., what qualified as “modern mainstream macroeconomics”), but the release of the RBC model would be the latest cut off date.</p><h2>Real World Political Content</h2><p>Although the models can be used as cheerleading for capitalism (“market outcomes are optimal!”), one is free to add “imperfections” that result in “capitalist outcomes — boo!”</p><p>However, I would argue that the conservative edge of the theory comes from the people producing the theory. Central banks are key to funding and validating the theory. One of the advantages of being a Canadian Prairie Populist is that my thinking is not clouded by tribal right/left politics: the Bank of Canada and the private banks is one of the clubs for Canada’s governing elites, and you are either a member of that club or not. A club that includes private banks and a central bank that enacts policy for the central government does not fit into a simplistic “free market versus socialism” political spectrum. </p><h2>Is Neoclassical Economists Coherent?</h2><p>If we move beyond the dubious Welfare Theorems of Economics, we can then ask: is the neoclassical project theoretically coherent? Well, look at the definition I gave. You have an extremely wide of classes of models that can be looked at, and each class includes an infinite number of models. Why would you not expect to find a model that can fit almost any specified behaviour? Unfortunately, neoclassical economics education is designed to weed out people who would ask nihilistic questions like that. Instead, the attitude is that the objective of an economics education is to train people to pick the “best” model for a question at hand. This is obviously disastrous if the models themselves are internally inconsistent.</p><p>The way real applied sciences deal with this issue is that they have successful models, which can then create a standard to judge other models. Macroeconomics is notable for its complete lack of successful mathematical models, so this is not possible.</p><p>This is why arguing that there is a political bias to neoclassical economics is straining at a gnat but swallowing a camel. In order to believe that neoclassical has a political agenda, you have to believe it is an internally consistent theory in the first place.</p><h2>Brilliant Academic Politics</h2><p>Neoclassical economics is where it is because it is an amazing evolutionary development in response to the “publish or perish” environment.</p><ol><li><p>The infinite number of model classes — with inconsistent lessons to be learned — guarantees that articles can be published forever.</p></li><li><p>Results “proving” that central banks ought to be given free rein to do whatever they want is extremely convenient from the perspective of where funding and recognition comes from. Although one could probably come up with models that suggest that the central bank should be under the control of elected officials, attempting to publish such a model would be career limiting. </p></li><li><p>By eliminating other approaches — particularly literary approaches favoured by post-Keynesians — largely eliminates any challenges the neoclassical paradigm.</p></li><li><p>Any theoretical failing of favoured models just means that researchers need to look at more complicated models.</p></li></ol><p>Taken together, they make the neoclassical paradigm extremely robust to change. Even if researchers have doubts about the current batch of models, they have been trained to believe that a new generation of models that rely on the same underlying assumptions is just around the corner. All we need is just a bit more mathematics, and all the problems with predicting the future will go away.</p><h2>Concluding Remarks</h2><p>The defining characteristic of neoclassical economic education is that it produces people who are clearly unwilling to question core theoretical assumptions of neoclassical economics. The belief that “science advances one funeral at a time” relies on the assumption<em> </em>that there exists young scientists that wants to impose a new paradigm. Instead of reading the philosophy of science, one needs to study anthropology, and in particular how magical practice stuck around in complex societies.</p></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2024Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-4738279861208823992024-01-31T11:36:00.001-05:002024-01-31T11:36:56.742-05:00Inflation Hedging: Do Not Ask For The Impossible<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEheo6tlHCL91rMfD7Gv7QKqYe0BdWvw2pUn4-EIl1CDRqGbaeAAHLpGL42RQyGLZtKbZHB0O6S_UxNgYvBA4V_TPaT9_FdRERmbAjYXzBOWPoab4VAys5DamNl8Oz-5gHQzHNhq7THgOyxbJ5kT0pPHbzlvqBN3eCNXdXZWaUGi5pyJZq-FsADylFZ3Tr8/s80/logo_linkers.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEheo6tlHCL91rMfD7Gv7QKqYe0BdWvw2pUn4-EIl1CDRqGbaeAAHLpGL42RQyGLZtKbZHB0O6S_UxNgYvBA4V_TPaT9_FdRERmbAjYXzBOWPoab4VAys5DamNl8Oz-5gHQzHNhq7THgOyxbJ5kT0pPHbzlvqBN3eCNXdXZWaUGi5pyJZq-FsADylFZ3Tr8/s1600/logo_linkers.png" width="80" /></a></div><p data-pm-slice="1 2 []"><a href="https://www.ft.com/content/f9cf6d1a-0313-4c1f-aeb2-df1f64bd5d3e" rel="noopener noreferrer nofollow" target="_blank">I ran into this article on inflation hedging with inflation-linked bonds from FT Alphaville.</a> I just scanned it quickly, but I think that the the approach used makes the topic unnecessarily complicated. I addressed the issue in my book <a href="https://www.books2read.com/b/4AYBae" rel="noopener noreferrer nofollow" target="_blank"><em>Breakeven Inflation Analysis</em></a>, and the odds are that I also over-complicated the analysis on the basis that I wanted to keep my book longer than five pages. This article is an attempt to reiterate my views in as short a text as possible. </p><p>The way to think about this is to not dive into the weeds of details of inflation-linked bonds, and go back to basics. We need to analyse the following premise:</p><p><em>I want a guaranteed high return over a particular investment horizon if event </em>X<em> happens.</em></p><h2><span><a name='more'></a></span>The Impossible: X is All Possible Future States</h2><p>The starting point is where the event <em>X</em> covers all possible future states, making the statement “I want a guaranteed high return over a particular investment horizon.” </p><p>You certainly can get something resembling a guaranteed investment return over an investment horizon, but the problem is with the word “high.” That “guaranteed” return is known as the risk-free rate in financial jargon.<a class="footnote-anchor" data-component-name="FootnoteAnchorToDOM" href="#footnote-1" id="footnote-anchor-1" target="_self">1</a> <em>(Yes, there are always potential disasters, like a nuclear war.) </em> If the risk-free return is “high” for you, great — you do not have to sweat the details of the financial markets.</p><p>You can try getting enhancements over the risk-free rate, but you are exposing yourself to some kind of tail risk. The usual way to do this is to take credit risk. Financial academics are busy coming up with “innovations” that appear to give these enhancements, with the tail risks being disguised from the people using those strategies (such as selling volatility).</p><p>(If you believe that you have a magic scheme to generate guaranteed returns above the risk-free rate, you might as well stop reading since you should be so rich that you have better things to do with your time.)</p><h2>The Impossible: Event X not Covered by the Instrument “Design”</h2><p>The next effectively impossible thing is to have the event <em>X</em> being unrelated to the payoff of the instruments you are trading. A significant portion of market commentary is discussions of what instruments might do well under different circumstances. Although I think this is a useful approach, we have to accept that we are only going to get “correlations” and not guarantees.</p><h2>Possible: You Buy the Risk at a 1:1 Ratio</h2><p>If the event you are worried about is that the price of something goes up, you can often buy instruments that give you 1:1 exposure to that something. Examples include the following.</p><ul style="text-align: left;"><li>You can buy gold to get a 1:1 exposure to the price of gold.</li><li>You can buy index funds to get 1:1 exposure to the stock market.</li><li>You can buy inflation-linked bonds to get 1:1 exposure to the inflation index <em>over the lifetime of the bond.</em></li></ul><p>Since our interest is in linkers, I would note that there are some caveats: tax treatment, and coupon reinvestment. That said, the major investors in linkers do so in tax-sheltered portfolios, and coupon rates on linkers are currently pitiful.</p><p>But the key point to note in the above description: over the lifetime of the (inflation-linked) bond. People who analyse over shorter horizons expecting an inflation guarantee are unnecessarily killing innocent electrons.</p><p>The problem with this approach is the phrase “high return.” A 1:1 ratio means that your instruments just keep up with the price of <em>X</em>. You would have to invest 100% of your portfolio in linkers to get 100% inflation protection of the portfolio value. Given the expected returns on other assets versus the quoted (indexed/”real”) yield of linkers, that is an ouchie.</p><h2>Possible: Buy <em>X </em>With Leverage</h2><p>One could try to get the “high returns” by using the secret sauce of Scientific Finance: leverage. Although leverage does offer the prospect of high returns, you are exposed to the cost of financing the position as well as forced liquidation risk. </p><p>In the case of linkers, we saw how things could go horribly wrong with leveraged positions in 2008-2009.</p><h2>Possible: Side Bet on <em>X</em></h2><p>The final way to hedge against a risk <em>X </em>is to undertake a bet with another market participant on the event. However, as soon as you do this, you are not getting an absolute protection, rather relative to market pricing. If there is a function CPI swap market, if it is pricing in 5% inflation next year, there is no guaranteed way to make money if the inflation rate does end up at 5%. (E.g., you could sell inflation volatility, but then you are stuffed if inflation ends up far away from 5%.)</p><p>Since there is no particular reason to care about the inflation rate only over the next three months, the only sensible side bet is a longer-term inflation swap — which is economically equivalent to a leveraged breakeven position, and thus has all the mark-to-market/liquidation risk concerns.</p><h2>Concluding Remarks</h2><p>Linkers offer 1:1 inflation guarantees (modulo coupon reinvestment, tax) over the lifetime of the bond. Expecting an “inflation hedge” on any other horizon is a case of not understanding the terms sheet of the investment.</p><div class="footnote" data-component-name="FootnoteToDOM"><a class="footnote-number" contenteditable="false" href="#footnote-anchor-1" id="footnote-1" target="_self">1</a><div class="footnote-content"><p>Those of a pedantic nature will note that what investments can generate the risk-free return are somewhat vague. People loosely talk about the Treasury bill rate as the risk-free rate, but bills can get expensive versus other instruments with no private credit risk. Since we are talking about a couple dozen basis points at most, this is a nothingburger for anyone not employed in the money markets.</p></div></div><div><br /></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2024Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-65387949233312300772024-01-22T08:32:00.000-05:002024-01-22T08:32:17.654-05:00Why The "Friedman Thermostat" Analogy Should Be Uncomfortable For The Mainstream<div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgX6lG6sSleRo7hbu3IWBF0_XbE58vPH8nMMtDalRWHJgDFWzSx37-szsbGIJ4ZeFbxTLmIuCIkMzEszxwXhRg9TjjbMm_mY4COknmfTWEsQc69v6cnYuG2Gx4hRu3qPYs-TlCk1-RS5pB1fv59bNSjV0YM7UCMSD06rbveI1M8aZJHOS8FO3yYp5DOxW0/s80/logo_central_banks.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgX6lG6sSleRo7hbu3IWBF0_XbE58vPH8nMMtDalRWHJgDFWzSx37-szsbGIJ4ZeFbxTLmIuCIkMzEszxwXhRg9TjjbMm_mY4COknmfTWEsQc69v6cnYuG2Gx4hRu3qPYs-TlCk1-RS5pB1fv59bNSjV0YM7UCMSD06rbveI1M8aZJHOS8FO3yYp5DOxW0/s1600/logo_central_banks.png" width="80" /></a></div><p data-pm-slice="1 2 []"><a href="https://worthwhile.typepad.com/worthwhile_canadian_initi/2010/12/milton-friedmans-thermostat.html" rel="noopener noreferrer nofollow" target="_blank">Nick Rowe’s article on Milton Friedman’s Thermostat</a> has popped up in online conversation. For those of you unfamiliar with it, it is about inferring statistical relationships between inflation and interest rates. Although I agree that it is possible to do some silly correlation analyses between those variables<a class="footnote-anchor" data-component-name="FootnoteAnchorToDOM" href="#footnote-1" id="footnote-anchor-1" target="_self">1</a>, if we think about the analogy more carefully, it points to concerns with the mainstream approach.</p><h2><span><a name='more'></a></span>My Restatement of the Analogy</h2><p>Imagine that I was teaching you some version of “introduction to engineering mathematics” and for some insane reason I gave you and your project partners access to a typical Canadian house with an oil furnace in the winter. I want your team to develop empirical formulae for the determination of interior temperature near the thermostat. For simplicity (and to avoid awkwardness to my argument that I discuss in the appendix), let us assume that the furnace works in a straight on/off fashion: it fires up to 100% heat output, runs, then shuts off completely.</p><p>We can then imagine that Nick Rowe submitted this response (from the linked article).</p><blockquote><p>If a house has a good thermostat, we should observe a strong negative correlation between the amount of oil burned in the furnace (M), and the outside temperature (V). But we should observe no correlation between the amount of oil burned in the furnace (M) and the inside temperature (P). And we should observe no correlation between the outside temperature (V) and the inside temperature (P).</p><p>An econometrician, observing the data, concludes that the amount of oil burned had no effect on the inside temperature. Neither did the outside temperature. The only effect of burning oil seemed to be that it reduced the outside temperature. An increase in M will cause a decline in V, and have no effect on P.</p></blockquote><p>This response would not make me happy if I graded it. To be fair to Nick, he is setting this response up as being from a dim econometrician. But even as a straw man, it leaves a massive logical problem, and his statements about the alleged correlations are in fact incorrect/misleading. <em>We Canadians put furnaces inside houses for a reason, and any engineering undergraduate should know what that reason is.</em></p><p>Canadian outdoor winter temperatures range from uncomfortable to lethal. Any house other than a “passive house” will lose heat and eventually the indoor temperature will start to approach the outdoor temperature. (Unless there are gaping holes in the building envelope, there will be some heat trapped, so it would remain somewhat warmer. It also protects from wind chill, which is the real safety issue, not the absolute temperature.)</p><p>For a furnace that swaps between “fully on” and “off” modes, <em>if it is possible for the thermostat to work as expected</em>, we have two regimes. For now, we assume that there are no other major factors driving hear flow — it is night, no woodburning stove, limited electricity consumption, no cattle providing body heat in the basement.</p><ol><li><p>When the furnace is off, temperatures generally decay towards some steady state value that largely depends on the outside temperature and wind velocity/direction (since building envelopes in practice leak).</p></li><li><p>When the furnace is on, the temperature decays towards what is expected to be an uncomfortably warm temperature (depending on the sizing of the furnace, outdoor temperature, insulation, etc.). </p></li></ol><p>Despite Nick Rowe’s assertions to the contrary, if we select the correct time scale, we do see a “correlation” between temperature change and instantaneous fuel usage. (This “correlation” would break down if the sun/wood stove/cattle are providing enough heat to independently raise the temperature, or outdoor temperatures are not constant, etc.)</p><p>The only way Nick Rowe’s statement that “But we should observe no correlation between the amount of oil burned in the furnace (M) and the inside temperature (P)” is true if M is monthly or seasonal oil burning. But even there, if we took a bunch of similar new houses in a neighbourhood with the same North/South facing, total energy consumption (need to factor heating from electricity consumption within the house, not just the furnace) would in fact be correlated with the average thermostat settings. Middle aged dads grumble to family member to turn down the thermostat and wear a sweater for good economic reasons.</p><h2>You Need to Have An Idea How the System Works</h2><p>If one were just handed the raw data from the house without any explanation of what they were, it would likely be difficult to pick out a sensible relationship between the variables. You would need some knowledge of the system dynamics to realise that outdoor temperature, wind speed/direction, and other heating sources would need to be tracked and quantified in order to get a model that goes beyond “when the furnace turns on, room temperature generally goes up.”</p><p>In other words, you cannot just use statistical analysis to do magic, you need some fundamental analysis of the system as well. </p><h2>Back to Interest Rates</h2><p>The true lesson from this analogy is that in order to do statistical tests on the relationships between the variables of a system, you need at least some idea what the dynamics of the system are supposed to be. Realistically, you need a model of system dynamics that you can test against the data. Although there are attempts to use mathematical magic to infer system models solely based on observed data, my bias is that this is not going to replace fundamental analysis.</p><p>The reason why correlating the policy rate with inflation is silly is that we know something about the dynamics of the system. The policy rate is a variable set by a small clique in a boardroom, and the setting is somewhat arbitrary. They certainly believe that there are more than one possible option to take in most meetings. Conversely, the inflation rate is some sort of weighted average of price changes taken by entities across the whole economy. The correlation just tells us about the psychology (reaction function) of central bankers.</p><p>In order to sensible statistical analysis of the effect of interest rates, you need a quantitative theory/model to test. But it has to be an actual quantitative theory. For example, saying that “lags are long and variable” can only be described as pseudo-scientific hand-waving to excuse model failure.</p><p>The problem is that there is an infinite number of potential models in which interest rates appear. We cannot test them all within the finite lifespan of the solar system. All we can do is look at proposed models (or families of models that can be captured as a group).</p><p>I will then run through some basic classes of models, in increasing order of complexity.</p><h2>The Policy Rate Matters</h2><p>These models are probably what a lot of people have in mind when thinking about the central bank, and the earliest ones tested. (I assume the original Friedman analogy referred to these attempts.) The basic concept is that if the nominal policy rate is above some “trigger” value, then inflation and/or GDP growth will fall (with some lag). The policy rate is a single-valued lever which drives the economy up or down.</p><p>(Given that most conventional economists think in terms of a real “trigger value” for the policy rate, we need to make the appropriate inflation adjustment to get the nominal trigger value.) </p><p>You can then test the predictions of this framework against actual policy rate and observed inflation/growth data. Note that the existence an inflation target does not matter: you are testing what actually happens on a sensible frequency for business cycle dynamics (monthly, possibly quarterly).</p><p>Without any knowledge of that literature, I think it is safe to summarise it as that no stable relationship was discovered. I base that assessment on the existence of the <em>r* </em>literature — as <em>r*</em> is an attempt to measure the trigger level for the policy rate. The<em> r*</em> model outputs tells us that the estimated <em>r*</em> is moving so fast that we do not have a reliable guidepost to policy. By construction, it fits the historical data, but going forward, the estimate tends to move if the real policy rate is moving. (If the economy enters a steady state, the predicted <em>r*</em> converges to actual.) Until there is a model that predicts <em>r*</em> based on other variables available in real time, it cannot be subjected to falsification tests.</p><h2>Expectations</h2><p>Given that treating the policy rate as a single-valued policy lever is a dead end, we need to retreat into more complex model structures. The theoretical assumptions of neoclassical economics pushes towards “expectations” to augment/replace the spot policy rate.</p><p>Within a standard modern neoclassical model with “Real Business Cycle” roots, “expected values” are easy to work with. All entities in the model are aware of an alleged “equilibrium” that determines the probability distribution of forward prices of everything (including interest rates and the price level) out to infinity. You just read off the expected values of the price distributions.</p><p>Back here in the real world, we do not have forward prices of everything (never mind the full probability distribution). And the forward prices that exist are generally believed to have biases. We can use surveys, but then we do not know how representative or biased those surveys are.</p><p>One can be bloody-minded and try to use observed conventional and inflation-linked bond pricing to determine “risk neutral” expectations for interest rates and inflation. The immediate problem is how to feed this information into a statistical test. A continuous yield curve on a single day contains a lot of information.<em> (Theoretically infinite, but really closer to the number of instruments in the fitting.)</em> The simplest way to compress this information is to just use a single bond price, typically the 10-year yield.</p><p>Although most countries have a decent data set of 10-year conventional bonds, inflation-linked data generally only appears after inflation dynamics were generally uninteresting (until 2020, anyway). So either one needs to use surveys, or use models to make expectations up (which creates model selection problems).</p><p>Since there is a lot of ways of compressing market-based expectations series, the jury remains out whether we can find one that works. I am in the camp that we will run into the same problem as <em>r*</em> for any variation of “expected rates.”</p><h2>Reaction Function Changes Matter</h2><p>One of the distinctive features of modern DSGE macro is the argument that changes to the central bank’s reaction function matters for outcomes. That is, the outcome of a single rate meeting does not matter, rather what matters is what this says about the future behaviour of the central bank. This effect is certainly going to be true in DSGE models by construction (although we run into the calendar time versus forward time gap). However, I am uncertain how this is operationalised into the real world. </p><p>The only measurable quantities related to “reaction functions” I can point to is the observed yield curves. One can interpret the yield curve as the implied reaction function output based on the “expected” economic outcomes that is embedded in the yield curve. (This expected economic outcome reflects what market participants forecast, not the central bank’s forecast.) Changes to the reaction function would show up as changes to the shape to the forward curves.</p><p>I have not followed this area enough to comment further (beyond my concerns about the non-measurability of the reaction function).</p><h2>Expectations Fairy</h2><p>The final and hardest to test theories involve the dreaded Expectations Fairy. The central bank allegedly determines outcomes almost instantaneously by changing its target. Although this sounds crazy, it is actually how DSGE models are supposed to work (outcomes are driven by expected values at equilibrium, and the current central bank target drives the equilibrium). </p><p>Most neoclassicals skate over the awkward implication of this, but the “Market Monetarists” pushed this idea to its limit in their writings in the 2010s. I do not want to put any words into Nick Rowe’s mouth, but I think it is safe to say that the arguments in his linked article have Market Monetarist ideas embedded in them. </p><p>In the early 2010s, it was possible to point to the apparent success of inflation targeting — on average, most central banks hit their target since the inception of formal targets until that era. At present, there are a lot of holes in that theory — Japan’s persistent miss, the undershoots of targets in the 2010s, and then the pandemic experience. Although I imagine that the Market Monetarists can find a way to explain this, I remain skeptical.</p><p>In any event, if one believes that inflation will always hit the inflation target because of expectations, Nick Rowe’s claims about the non-existence of correlations makes sense. The problem is that we can easily reject that claim — inflation certainly missed target, and so we can do analysis on the misses. </p><h2>Concluding Remarks</h2><p>The policy rate is not set at random, nor is it the result of “economic forces.” At each meeting, it is set by a small group of human beings who follow a set of beliefs about interest rates. If they set it the “wrong” level, it is very hard to find examples of there being immediate negative consequences, so they do have freedom of action. <em>(If there is a pre-existing crisis, “wrong” levels of interest rates can generate reactions.) </em>Given the content of Economics 101 teaching, we cannot be surprised that the policy rate follows the inflation rate with a lag. Given that inflation is normally thought of as a lagging economic variable, we end up with interest rates often exhibiting the same cyclical behaviour as other variables. (Although this is not universal, the Japanese policy rate was remarkably non-cyclical.) If everything is pro-cyclical, deciphering statistical relationships between them is inherently difficult. You need policymakers rejecting Economics 101 and moving interest rates counter-cyclically to get interesting data for testing.</p><p>The funny thing about this topic is that using interest rates to control inflation<a class="footnote-anchor" data-component-name="FootnoteAnchorToDOM" href="#footnote-2" id="footnote-anchor-2" target="_self">2</a> is the main ideological plank of neoclassical economics from 1975-2010 (at least), yet there is a remarkable inability to give a quantitative demonstration that can convince outsiders about the effectiveness of the policy. Engineers can generate quantitative guidelines for furnace sizing that stand up to outside scrutiny, the same cannot be said for changes to the level of interest rates.</p><h2>Appendix: Non-Saturating Heating</h2><p>It is possible to get closer to Nick Rowe’s ideas about correlation if we look at what happens if have heaters whose heat output was adjusted continuously between zero and some upper limit that is not normally hit. (The furnace I described only operated at either the lower or upper limit.) It would be easy to rig up such a system with baseboard heaters, although I am not sure about the wisdom of the approach.</p><p>If the control law in the thermostat were properly tuned<a class="footnote-anchor" data-component-name="FootnoteAnchorToDOM" href="#footnote-3" id="footnote-anchor-3" target="_self">3</a>, we could end up in a situation where the temperature hits a steady state at the target temperature — the heater output would be calibrated to match the heat loss. Although we would have sensor noise, we might get runs of near-constant interior temperature.</p><p>We can then do the following exercise: identify each period of near constant temperature, and just record the average temperature (which is supposed to equal the thermostat setting) and the heater average power consumption setting. If we look at those pairs of numbers over time, we would see that the power consumption would (most likely) vary.</p><p>Ah ha, we get the claimed data distribution — indoor temperature constant at target, with varying power inputs. </p><p>The problem is that we achieved this result by deliberately obliterating the time axis. If we examine the time series during the “steady state” intervals, they are both constants (within limits of noise), and constants are correlated. Instead, we would do our model estimation based on the rest of data set, when the interior target has moved away from target, and the heater is acting to bring it back. Given that we do not embed time machines in thermostats, we know that there will be deviations from target that allows this model fitting (i.e., there is no “expectations fairy” that always causes temperature to remain on target at all times).</p><p>Meanwhile, the fact that the steady state power consumption changes over time is not surprising given that we know that houses face different heating needs over time. If room temperature depended solely on power consumption, nobody would put on/off switches on furnaces. In other words, we knew in advance that the steady state power consumption would change. We need a model — such as looking at other factors that affect room temperature (differential with outside temperature, wind, other heat sources) if we want a way of predicting the steady state power consumption. Correspondingly, we need a model to predict “steady state” interest rates if we follow conventional beliefs. </p><div class="footnote" data-component-name="FootnoteToDOM"><a class="footnote-number" contenteditable="false" href="#footnote-anchor-1" id="footnote-1" target="_self">1</a><div class="footnote-content"><p>The reason to do a correlation analysis between the policy rate and inflation is that it is guaranteed to indignant replies from mainstream economists.</p></div></div><div class="footnote" data-component-name="FootnoteToDOM"><a class="footnote-number" contenteditable="false" href="#footnote-anchor-2" id="footnote-2" target="_self">2</a><div class="footnote-content"><p>I am lumping using the money supply to control inflation with interest rates given that they were linked in practice, and not everyone entirely bought the Monetarist story.</p></div></div><div class="footnote" data-component-name="FootnoteToDOM"><a class="footnote-number" contenteditable="false" href="#footnote-anchor-3" id="footnote-3" target="_self">3</a><div class="footnote-content"><p>At the minimum, would most likely need a full PID controller to eliminate the steady state offset.</p></div></div></div><div><br /></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2024Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com2tag:blogger.com,1999:blog-5908830827135060852.post-6995066141950281232024-01-19T08:23:00.000-05:002024-01-19T08:23:31.650-05:00Waller Comments<div><p data-pm-slice="1 1 []"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg2lORgWXpQA8Xla2ObWKhfqdO9VbTgljH8uYdCi1j1WlHQYSRh6b-Zbgaw5fvvJ4-5SFk7nfKIhYIkOq_c0P4RRkdEs4yXElB_Nt1QsorMGgunp_kG9XwG4Y6K7xdivDeVRSBfR6Qko8toO-MyKBDj7HahUwDrCdkNgdxOJaYtOyN5jPUizHAZKZpQAFA/s80/logo_inflation.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg2lORgWXpQA8Xla2ObWKhfqdO9VbTgljH8uYdCi1j1WlHQYSRh6b-Zbgaw5fvvJ4-5SFk7nfKIhYIkOq_c0P4RRkdEs4yXElB_Nt1QsorMGgunp_kG9XwG4Y6K7xdivDeVRSBfR6Qko8toO-MyKBDj7HahUwDrCdkNgdxOJaYtOyN5jPUizHAZKZpQAFA/s1600/logo_inflation.png" width="80" /></a></div>Nick Timiroas highlighted an exchange from Fed Governor Waller (<a href="https://www.brookings.edu/wp-content/uploads/2024/01/20240116_Waller_Transcript.pdf" rel="noopener noreferrer nofollow" target="_blank">link to speech/interview transcript</a>) on Twitter. This article consists of two rants based on the transcript, plus a bonus rant in the appendix based on what somebody else said.<p></p><h2><span><a name='more'></a></span>Supply Shocks</h2><blockquote><p><strong>David Wessel</strong> Hmm. Another question was what your view is about, what role did fiscal policy played in causing the inflation that you've been working so hard to restrain? How big an issue was fiscal policy and how big an issue is fiscal policy now, as you try and calibrate the right pace of monetary easing?</p><p><strong>Christopher Waller </strong>Well, just from a, it's just a simple macroeconomics point of view. If you're going to increase the spending in the debt [sic?] by $6 trillion in a matter of two years, and then say that has no effect on demand, that seems just impossible to me. It isn't the only thing that contributed to the inflation, but it certainly has had to have had an impact. The reason I say that is, you know, people have been talking a lot about, oh, all the last six months shows this was all supply, all supply, all supply. Well, if these are temporary supply shocks, when they unwind, the price level should go back down to where it was. It's not.</p><p><strong>Go to Fred. Pull up CPI. Take the log. Look at that thing. The level of inflation [sic?] is permanently higher. That doesn't happen with supply shocks. That comes from demand. </strong>And this was a permanent increase in demand and permanent increase in debt. So I think there clearly was in fact a fairly... </p></blockquote><p>I am just going to go after the part of the text that I highlighted. Firstly, the “level of inflation being permanently higher” is either a mis-statement or not carefully thought through. So I will not sweat his exact wording and try to guess what he meant. (Why is his wording a problem? The inflation rate went up, and has since gone down. Although it might still be higher than previous averages, that would imply that one could claim that “inflation is permanently higher” every single time inflation rose in the 1950-2024 period. If he meant that “the price level is permanently higher,” well, that is how a 2% inflation target is actually supposed to work.)</p><p>My concern is the Economics 101ism of the analysis, which is all over the discussion of this topic. In the world of Economics 101, everything in the economy is the result of two lines intersecting. All discussions revolve around what happens when one — and only one — of those lines are allowed to move.<em> (This can often devolve into a debate whether one of the lines is horizontal or vertical, which is Peak Economics 101.) </em>In this case, there has to be either a supply shock, or a demand shock. It is forbidden that “demand” and “supply” change at the same time.</p><p>Although I am mere blogger with almost no academic training in economics even I was able to notice that the pandemic lockdown period saw the simultaneous impositions on the ability to produce goods (“supply shock”) as well as fiscal transfers designed to avoid Consumer Cash Flow Armageddon (“demand shock”). This was then followed the Russian invasion of Ukraine (supply shock), etc. Deaths, early retirements, and the shutdown of worker migration also created a supply shock in the labour market. Although I saw a lot of commentary putting weight on supply side factors for the inflation, I cannot recall any serious commentator saying that <em>nothing</em> happened on the demand side.</p><p>Meanwhile, the idea that the price level/inflation must go back to its previous level after the shock passes is remarkably static thinking. The supply shock also hit the labour market, and wages broadly rose. Empirically, higher nominal wage incomes implies higher nominal household expenditure — sustaining the higher price level. This is not like <a href="http://www.bondeconomics.com/2016/01/canadian-bonds-currency-and-cauliflower.html" rel="noopener noreferrer nofollow" target="_blank">The Great Canadian Cauliflower Panic Of 2016</a> where there is a shock to a single commodity that has extremely limited effect on other prices; the whole structure saw price increases. The higher wages allows the economy to function with higher prices across the board, which is why we have aggregate wage and price levels in economic models in the first place. </p><p>Inflation is only supposed to head back down after the various markets sorted themselves out. Given the empirically demonstrated persistence of inflation, a model that predicts that inflation exhibits immediate steps up and down in response to “shocks” can easily be rejected.</p><p>Comments like this are why I think that the whole “supply versus demand” debate needs to be put out of its misery.</p><h2>Side Rants</h2><p>This episode also provides an interesting view into inflation psychology. The entire neoclassical enterprise is premised on <em>everybody </em>internalising the central bank target, and doing sophisticated calculations related to it. But back in the real world, I keep having conversations with/reading texts by people who are mad that prices are not going back to where they were in 2019. Given that Canadian inflation had been rising at an average close to the target 2% per year <em>(and more if you believe the inflation truthers!) </em>between 1990-2020, if people were really aware of what was happening to inflation, why would they ever expect prices to return to their previous level?</p><p>As a final aside, the somewhat garbled comment on debt could be turned into a little MMT rant. Deficits are outcomes of economic developments, and the exact monetary amounts are somewhat arbitrary in the sense that what constitutes a “stimulative” deficit depends on a lot of factors. <em>(Some might object to the use of dollar amounts instead of a more sensible scaling versus GDP. I think the use of dollar amounts should be avoided in written communications about aggregate fiscal policy, but using them in verbal remarks is going to be more natural for someone who stares at economic data all day.)</em></p><h2>Reserves Comments</h2><p>Another comment by Waller caught my eye.</p><blockquote><p>Christopher Waller Yeah. I mean, I made an argument for probably ten years. There's no economic theory that tells you how big a Central Bank's balance sheet should be. I know of no theory that tells you. You have Switzerland where, it's basically 100% of GDP or some number like that. So there's no real theory. And from a point of view of the reserves, I love a floor system because, as Milton Friedman once said, you want to put enough liquidity in the system that you satiate the system. So there's no scarcity or shortage.</p></blockquote><p>I am in the process of going after another dubious theory of Milton Friedman <em>(should be published next week)</em>, so I have no choice but to comment. </p><p>To the contrary of Waller’s assertion, there is an economic theory about the size of the central bank balance sheet, or at least part of it. The central bank’s balance sheet is equal to notes and coin holdings plus reserves held at the central bank. Notes and coins is literally a money demand function found in any mainstream monetary textbook (although one might debate how accurate the models are). </p><p>As for reserves, they are arbitrary. A banking system can function perfectly well with exactly zero reserves held overnight at the central bank. Reserve holdings are either a tax on banks (required reserves) or are pushed in by central bankers to replace short-dated Treasury securities (which they are economically equivalent to from the perspective of the private sector). (Admittedly, there are markets where banks hold reserves based on convention. Since conventions are arbitrary, the reserves required to meet them are arbitrary.)</p><p>If I have $100 in my bank account and my idiot bank insists that I hold that $100 “in reserve,” I cannot use that $100 to pay any incoming expenses. I have a stranded, illiquid asset that pays whatever interest rate my bank decides to offer on it. In the case of bank reserves, replace “idiot bank” with “idiot central bank” and you immediately see the issue with reserves that Economics 101 textbooks ignore.</p><p>If banks truly want to hold reserves at the central bank and not lend in wholesale money markets (including the interbank market), this is not a “money demand” issue. It is a signal that the central bank once again failed its core responsibility to properly regulate the banking system. Letting the banks bypass wholesale lending markets by using the central bank as an intermediary is just putting band-aid on a major wound. How many band-aids you apply is a secondary concern relative to dealing with the real problems.</p><h2>Appendix: My Turn to Strawman!</h2><p>Having just objected to a strawman argument about supply shocks, I will then turn around and hit my own strawman. To be clear, this is not based on the Waller interview. Rather than create a new article, I will just throw this little rant (based on some recent comments I saw elsewhere) into this appendix.</p><p>I have seen comments to the effect that the rise in nominal GDP tells us that we would have an inflation problem.</p><p>Any time someone uses nominal GDP in such a context, please return to the following (approximate) identity. <em>(You could use logarithms to be exact.)</em></p><p><em>Nominal GDP growth rate = (deflator inflation rate) + (real GDP growth rate).</em></p><p>Look at that equation. Ask yourself this: under what circumstances will the deflator inflation rate go off in a completely direction than nominal GDP growth (ignoring very short period rates of change, where it does)? How often do we see this medium-term divergence in practice? </p><p>After that exercise, one can then question why someone would suggest using nominal GDP trajectory as a <em>cause </em>of inflation?</p><p></p></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2024Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-76618988719231567332024-01-15T13:17:00.000-05:002024-01-15T13:17:15.324-05:00A Response To A Question About Post-Keynesian Interest Rate Theories (...And A Rant)<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj6kFK5OpS6ii_NBbV0qX-Y-vsqrCheg1cSps47LgUqUvhMo1G5hV3YkzQWTBk_XpDq7bTFd0CR0NyPxzXB2tSUiQ8T2sRrMajtZPjPF_AVWr7qS5VAFZSfdUsMhHI1YHFbdqxt696Q5KveP0SaSWoc75SRtp0GychFqzMgIsK6igKtYC_fJz_0PaPlL34/s900/ereport02_irc_web.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="900" data-original-width="600" height="200" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj6kFK5OpS6ii_NBbV0qX-Y-vsqrCheg1cSps47LgUqUvhMo1G5hV3YkzQWTBk_XpDq7bTFd0CR0NyPxzXB2tSUiQ8T2sRrMajtZPjPF_AVWr7qS5VAFZSfdUsMhHI1YHFbdqxt696Q5KveP0SaSWoc75SRtp0GychFqzMgIsK6igKtYC_fJz_0PaPlL34/w133-h200/ereport02_irc_web.png" width="133" /></a></div><p data-pm-slice="1 2 []">I got a question about references for post-Keynesian theories of interest rates. My answer to this has a lot of levels, and eventually turns into a rant about modern academia. Since I do not want a good rant to go to waste, I will spell it out here. Long-time readers may have seen portions of this rant before, but my excuse is that I have a lot of new readers.</p><p>(I guess I can put a plug in for my book <a href="http://books2read.com/interest-rate-cycles" rel="noopener noreferrer nofollow" target="_blank"><em>Interest Rate Cycles: An Introduction</em></a> which covers a variety of topics around interest rates.) </p><h2><span><a name='more'></a></span>References (Books)</h2><p>For reasons that will become apparent later, I do not have particular favourites among post-Keynesian theories of interest rates. For finding references, I would give the following three textbooks as starting points. Note that as academic books, they are pricey. However, starting with textbooks is more efficient from a time perspective than trawling around on the internet looking for free articles.</p><ol><li><p>Mitchell, William, L. Randall Wray, and Martin Watts. <em>Macroeconomics</em>. Bloomsbury Publishing, 2019. Notes: This is an undergraduate-level textbook, and references are very limited. For the person who originally asked the question, this is perhaps not the best fit. </p></li><li><p>Lavoie, Marc. <em>Post-Keynesian economics: new foundations</em>. Edward Elgar Publishing, 2022. This is an introductory graduate level textbook, and is a survey of PK theory. Chuck full o’ citations.</p></li><li><p>Godley, Wynne, and Marc Lavoie. <em>Monetary economics: an integrated approach to credit, money, income, production and wealth</em>. Springer, 2006. This book is an introduction to stock-flow consistent models, and is probably the best starting point for post-Keynesian economics for someone with mathematical training.</p></li></ol><h2>Why Books?</h2><p>If you have access to a research library <em>and you have at least some knowledge of the field</em> one can do a literature survey by going nuts chasing down citations from other papers. I did my doctorate in the Stone Age, and I had a stack of several hundred photocopied papers related to my thesis sprawled across on my desk<a class="footnote-anchor" data-component-name="FootnoteAnchorToDOM" href="#footnote-1" id="footnote-anchor-1" target="_self">1</a>, and I periodically spent the afternoon camped out in the journal section of the engineering library reading and photocopying the interesting ones.</p><p>If you do not have access to such a library, it is painful getting articles. And if you do not know the field, you are making a grave mistake to rely on articles to get a survey of the field.</p><ol><li><p>In order to get published, authors have no choice but to hype up their own work. Ground-breaking papers have cushion to be modest, but more than 90% of academic papers ought never have to been published, so they have no choice but to self-hype. </p></li><li><p>Academic politics skews what articles are cited. Also, alternative approaches need to be minimised in order handing ammunition to reviewers looking to reject the paper.</p></li><li><p>The adversarial review process makes it safer to avoid anything remotely controversial in areas of the text that are not part of what allegedly makes it novel.</p></li></ol><p>My points here might sound cynical, but they just are what happens if you apply any minimal intellectual standards to modern academic output. Academics have to churn out papers; the implication is that the papers cannot all be winners. </p><p>The advantage of an “introductory post-graduate” textbook is that the author is doing the survey of a field, and it is exceedingly unlikely that they produced all the research being surveyed. This allows them to take a “big picture” view of the field, without worries about originality. Academic textbooks are not cheap, but if you value your time (or have an employer to pick up the tab), they are the best starting point.</p><h2>My Background</h2><p>One of my ongoing jobs back when I was an employee was doing donkey work for economists. To the extent that I had any skills, I was a “model builder.” And so I was told to go off and build models according to various specifications.</p><p>Over the years, I developed hundreds (possibly thousands) of “reduced order” models that related economic variables to interest rates, based on conventional and somewhat heterodox thinking. (“Reduced order” has a technical definition, I am using the term somewhat loosely. “Relatively simple models with a limited number of inputs and outputs” is what I mean.) Of course, I also mucked around with the data and models on my own initiative. </p><p>To summarise my thinking, I am not greatly impressed with the ability of reduced order models to tell us about the effect of interest rates. And it is not hard to prove me wrong — just come up with such a reduced form model. The general lack of agreement on such a model is a rather telling point.</p><h2>“Conventional” Thinking On Interest Rates</h2><p>The conventional thinking on interest rates is that if inflation is too high, the central bank hikes the policy rate to slow it. The logic is that if interest rates go up, growth or inflation (or both) falls. This conventional thinking is widespread, and even many post-Keynesians agree with it. </p><p>Although there is widespread consensus about that story, the problem shows up as soon as you want to put numbers to it. An interest rate is a number. How high does it have to be to slow inflation?</p><p>Back in the 1990s, there were a lot of people who argued that the magic cut off point for the effect of the real interest rate was the “potential trend growth rate” of the economy (working age population growth plus productivity growth). The beauty of that theory is that it gave a testable prediction. The minor oopsie was that it did not in fact work. </p><p>So we were stuck with what used to be called the “neutral interest rate” — now denoted <em>r*</em> — which moves around (a lot). The level of <em>r* </em>is estimated with a suitably complex statistical process. The more complex the estimation the better — since you need something to distract from the issue of non-falsifiability. If you use a model to calibrate <em>r*</em> on historical data, by definition your model will “predict” historical data when you compare the actual real policy rate versus your <em>r*</em> estimate. The problem is that if <em>r*</em> keeps moving around — it does not tell you much about the future. For example, is a real interest rate of 2% too low to cause inflation to drop? Well, just set it at 2% and see whether it drops! The problem is that you only find out later.</p><h2>Post-Keynesian Interest Rate Models</h2><p>If you read the Marc Lavoie “New Foundations” text, you will see that what defines “post-Keynesian” economics is difficult. There are multiple schools of thought (possibly with some “schools” being one individual) — one of which he labels “Post-Keynesian” (capital P) that does not consider anybody else to be “post-Keynesian.” I take what Lavoie labels as the “broad tent” view, and accept that PK economics is a mix of schools of thought that have some similarities — but still have theoretical disagreements.</p><p>Interest rate theories is one of big areas of disagreement. This is especially true after the rise of Modern Monetary Theory (MMT).</p><p>MMT is a relatively recent offshoot of the other PK schools of thought. What distinguished MMT is that the founders wanted to come up with an internally consistent story that could be used to convince outsiders to act more sensibly. The effect of interest rates on the economy was one place where MMTers have a major disagreement with others in the broad PK camp, and even the MMTers have somewhat varied positions.</p><p>The best way to summarise the consensus MMT position is that the effect of interest rates on the economy are ambiguous, and weaker than conventional beliefs. A key point is that interest payments to the private sector are a form of income, and thus a weak stimulus. (The mainstream awkwardly tries to incorporate this by bringing up “fiscal dominance” — but fiscal dominance is just decried as a bad thing, and is not integrated into other models.) Since this stimulus runs counter to the conventional belief that interest rates slow the economy, one can argue that conventional thinking is backwards. (Warren Mosler emphases this, other MMT proponents lean more towards “ambiguous.”) </p><p>For what it is worth, “ambiguous” fits my experience of churning out interest rate models, so that is good enough for me. I think that if we want to dig, we need to look at the interest rate sensitivity of sectors, like housing. The key is that we are not looking at an aggregated model of the economy — once you have multiple sectors, we can get ambiguous effects.</p><h2>What about the Non-MMT Post-Keynesians?</h2><p>The fratricidal fights between MMT economists and selected other post-Keynesians (not all, but some influential ones) was mainly fought over the role of floating exchange rates and fiscal policy, but interest rates showed up. Roughly speaking, they all agreed that neoclassicals are wrong about interest rates. Nevertheless, there are divergences on how effective interest rates are.</p><p>I would divide the post-Keynesian interest rate literature into a few segments.</p><ul><li><p>Empirical analysis of the effects of interest rates, mainly on fixed investment.</p></li><li><p>Fairly basic toy models that supposedly tell us about the effect of interest rates. (“Liquidity preference” models that allegedly tell us about bond yields is one example. I think that such models are a waste of time — rate expectations factor into real world fixed income trading.)</p></li><li><p>Analysis of why conventional thinking about interest rates is incorrect because it does not take into account some factors.</p></li><li><p>Analysis of who said what about interest rates (particularly Keynes).</p></li></ul><p>From an outsiders standpoint, the problem is that even if the above topics are interesting, the standard mode of exposition is to jumble these areas of interest into a long literary piece. My experience is that unless I am already somewhat familiar with the topics discussed, I could not follow the logical structure of arguments. </p><p>The conclusions drawn varied by economist. Some older ones seem indistinguishable from 1960s era Keynesian economists in their reliance on toy models with a couple of supply/demand curves.</p><p>I found the strongest part of this literature was the essentially empirical question: do interest rates affect behaviour in the ways suggested by classical/neoclassical models? The rest of the literature is not structured in a way that I am used to, and so I have a harder time discussing it.</p><h2>Appendix: Academic Dysfunction</h2><p>I will close with a rant about the state of modern academia, which also explains why I am not particularly happy with wading through relatively recent (post-1970!) journal articles trying to do a literature search. I am repeating old rant contents here, but I am tacking on new material at the end (which is exactly the behaviour I complain about!).</p><p>The structural problem with academia was the rise of the “publish or perish” culture. Using quantitative performance metrics — publications, citation counts — was an antidote to the dangers of mediocrity created by “old boy networks” handing out academic posts. The problem is that the quantitative metric changes behaviour (Goodhart’s Law). Everybody wants their faculty to be above average — and sets their target publication counts accordingly.</p><p>This turns academic publishing into a game. It was possible to produce good research, but the trick was to get as many articles out of it as possible. Some researchers are able to produce a deluge of good papers — partly because they have done a good job of developing students and colleagues to act as co-authors. Most are only able to get a few ideas out. Rather than forcing people to produce and referee papers that nobody actually wants to read, everybody should just lower expected publication count standards. However, that sounds bad, so here we are. I left academia because spending the rest of my life churning out articles that I know nobody should read was not attractive.</p><p>These problems affect all of academia. (One of the advantages of the college system of my grad school is that it drove you to socialise with grad students in other fields, and not just your own group.) The effects are least bad in fields where there are very high publication standards, or the field is vibrant and new, and there is a lot of space for new useful research.</p><p>Pure mathematics is (was?) an example of a field with high publication standards. By definition, there are limited applications of the work, so it attracts less funding. There are less positions, and so the members of the field could be very selective. They policed their journals with their wacky notions of “mathematical elegance,” and this was enough to keep people like me out. </p><p>In applied fields (engineering, applied mathematics), publications cannot be policed based on “elegance.” Instead, they are supposed to be “useful.” The way the field decided to measure usefulness was to see whether it could attract industrial partners funding the research. Although one might decry the “corporate influence” on academia, it helps keep applied research on track.</p><p>The problem is in areas with no recent theoretical successes. There is no longer an objective way to measure a “good” paper. What happens instead is that papers are published on the basis that they continue the framework of what is seen as a “good” paper in the past. </p><p>My academic field of expertise was in such an area. I realised that I had to either get into a new research area that had useful applications — or get out (which I did). I have no interest in the rest of economics, but it is safe to say that macroeconomics (across all fields of thought) has had very few theoretical successes for a very long time. Hence, there is little to stop the degeneration of the academic literature.</p><p>Neoclassical macroeconomics has the most people publishing in it, and gets the lion share of funding. Their strange attachment to 1960s era optimal control theory means that the publication standards are closest to what I was used to. The beauty of the mathematical approach to publications is that originality is theoretically easy to assess: has anyone proved this theorem before? You can ignore the textual blah-blah-blah and jump straight to the mathematical meat.</p><p>Unfortunately, if the models are useless in practice, this methodology just leaves you open to the problem that there is an infinite number of theorems about different models to be proven. Add in a large accepted gap between the textual representations of what a theorem suggests and what the mathematics does, you end up with a field that has an infinite capacity to produce useless models with irrelevant differences between them. And unlike engineering firms that either go bankrupt or dump failed technology research, researchers at central banks tend to fail upwards. Ask yourself this: if the entire corpus of post-1970 macroeconomic research had been ritually burned, would it have really mattered to how the Fed reacted to the COVID pandemic?<em> (“Oh no, crisis! Cut rates! Oops, inflation! Hike rates!”)</em></p><p>More specifically, neoclassicals have an array of “good” simple macro models that they teach and use as “acceptable” models for future papers. However, those “good” models can easily contradict each other. E.g., use an OLG model to “prove” that debt is burden on future generations, use other models to “prove” that “MMT says nothing new.” Until a model is developed that is actually useful, they are doomed to keep adding epicycles to failed models.</p><p>Well, if the neoclassical research agenda is borked, that means that the post-Keynesians aren’t, right? Not so fast. The post-Keynesians traded one set of dysfunctions for other ones — they are also trapped in the same publish-or-perish environment. Without mathematical models offering good quantitative predictions about the macroeconomy, it is hard to distinguish “good” literary analysis from “bad” analysis. They are not caught in the trap of generating epicycle papers, but the writing has evolved to be aimed at other post-Keynesians in order to get through the refereeing process. The texts are filled with so many digressions regarding who said what that trying to find a logical flow is difficult.</p><p>The MMT literature (that I am familiar with) was cleaner — because it took a '“back to first principles” approach, and focussed on some practical problems. The target audience was fairly explicitly non-MMTers. They were either responding to critiques (mainly post-Keynesians, since neoclassicals have a marked inability to deal with articles not published in their own journals), or outsiders interested in macro issues. It is very easy to predict when things go downhill — as soon as papers are published solely aimed at other MMT proponents.</p><p>Is there a way forward? My view is that there is — but nobody wants it to happen. Impossibility theorems could tell us what macroeconomic analysis cannot do. For example, when is it impossible to stabilise an economy with something like a Taylor Rule? In other words, my ideal graduate level macroeconomics theory textbook is a textbook explaining why you cannot do macroeconomic theory (as it is currently conceived).</p><div class="footnote" data-component-name="FootnoteToDOM"><a class="footnote-number" contenteditable="false" href="#footnote-anchor-1" id="footnote-1" target="_self">1</a><div class="footnote-content"><p>Driving my German office mate crazy.</p></div></div><div><br /></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2024Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-57043069216828554772024-01-10T10:39:00.002-05:002024-01-10T10:39:37.317-05:00A Non-Forecast 2024 Outlook<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjpZJvfL_zwPRKPJjCTFIQBnZXCjl1CDagP_h9KQm8VQoELP3WN_Npvs1DZ89pL5kYqUkP2G1mg8eGGqghg0A9ei60B7h-yy9tqg9VUOHW8owPKjxdVDChtwuWFXWfcmeFdpBsWAUcfSdQnkl5lbYguLdgWE5iCmF7K3PsbVQWvsmLDbrwqnXJEhDRpyNE/s600/c20240110_fed_tsy_slope.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="500" data-original-width="600" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjpZJvfL_zwPRKPJjCTFIQBnZXCjl1CDagP_h9KQm8VQoELP3WN_Npvs1DZ89pL5kYqUkP2G1mg8eGGqghg0A9ei60B7h-yy9tqg9VUOHW8owPKjxdVDChtwuWFXWfcmeFdpBsWAUcfSdQnkl5lbYguLdgWE5iCmF7K3PsbVQWvsmLDbrwqnXJEhDRpyNE/s16000/c20240110_fed_tsy_slope.png" /></a></div><p data-pm-slice="1 1 []">Since I am not in the forecasting game, I not on top of what the consensus views are. I also no longer pay attention to others’ Year Ahead Forecasts (which tend to be produced in December and long forgotten by February — people seem to produce them solely because it’s traditional). However, I wrapped up my “central banks as banks” article sequence, and I am now going to catch up on some charts to see where we stand. For brevity, I am just looking at a handful of American charts; I could possibly do some comments on other markets later. As a spoiler, I am repeating what I have been saying for at least a year.</p><p data-pm-slice="1 1 []"><span></span></p><a name='more'></a>The chart above for me is the most important summary of the state of the U.S. dollar fixed income market. The 5-year Treasury is trading massively through the overnight rate. As I have noted before, this only makes sense if one thinks there is a good near-run recession risk. (Please note that I am agnostic on that possibility.) In the absence of a recession, I can accept a story that the Fed might be satisfied with where things stand, and might do a few tactical rate cuts to balance out potential risks. But the pricing is beyond that.<p></p><p>One could try selling some theory about risk premia. For some reason, within a few quarters of the worst bond market carnage since 1994, bond market investors suddenly decided that the duration risk premium should be negative. I am somewhat unconvinced, nor does it make any difference to how one should view the market.</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg7X8dmVKOuFBazJXvc90jP7nsCr93J7jIKKb87ejJgotQZOT_F22c81lWyAt_E_CCJ3xvg90_gjlZiTTChpveROdc8smVA0vj9a2H5gQQqeOHeGXjaiDkp7fRhV40trmNyYE1jJ8NCnevEbH7lW0UnpVtUzalCBGTsEF16dGOn5FtHddiPbFXiJG_7A0I/s600/c20240110_us_emratio.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="400" data-original-width="600" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg7X8dmVKOuFBazJXvc90jP7nsCr93J7jIKKb87ejJgotQZOT_F22c81lWyAt_E_CCJ3xvg90_gjlZiTTChpveROdc8smVA0vj9a2H5gQQqeOHeGXjaiDkp7fRhV40trmNyYE1jJ8NCnevEbH7lW0UnpVtUzalCBGTsEF16dGOn5FtHddiPbFXiJG_7A0I/s16000/c20240110_us_emratio.png" /></a></div><p data-pm-slice="1 1 []">Although it has stopped trending higher, the prime age (25-54 year old) employment-to-population ratio is still at respectable levels when compared to recent history. The employment-to-population ratio moved a lot due to structural changes in the work force, but those lost steam by the 1990 start date of the chart. By cutting out the low and high age cohorts out of the working age population, this measure is less affected by the aging population. (The working age employment ratio has been depressed by the increasing weight of retired oldsters in the 55-65 year old bracket.) It is hard to look at the above chart and say that tight labour markets are a thing of the past — the usual tendency is for tightening until derailed by a recession.</p><p>I remain of the view that if one wants to be long duration at these levels, you need to find a story about faltering investment cashiering the business cycle. </p><h2>Transitory Debate, Again</h2><p>The demise of Twitter as a useful source of information has been personally annoying. To the extent that any economic debates made it onto my timeline, it was mainstream economists dunking on MMT/heterodox economists for allegedly being wrong about inflation being transitory. Since I am not greatly interested in bad faith attacks on MMT, I largely skipped over those discussions to look at the cat videos. </p><p>There were two articles on this (and related) topics.</p><ul><li><p><a href="https://www.employamerica.org/blog/ten-thoughts-on-the-tribal-transitory-debate-as-we-enter-2024/" rel="noopener noreferrer nofollow" target="_blank">Skanda Amarnath at Employ America.</a></p></li><li><p><a href="https://substack.com/home/post/p-140126605" rel="noopener noreferrer nofollow" target="_blank">This Substack by Claudia Sahm on inflation performance.</a></p></li></ul><p>At this point, I have little idea what points are attempted to be scored on this debate. I think the only interesting bits are about the alleged mechanisms that stopped inflation — since those mechanisms are still in play.</p><ul><li><p>One argument was that the U.S. needed a recession/rise in unemployment (that was somehow not a recession) to tame inflation. (This was not the case.) This was the Larry Summers view, until he flip-flopped to whatever he is droning on about now.</p></li><li><p>Another argument was that inflation would only turn around once the real Fed Funds rate was heavily positive. I have forgotten who was pushing that story, and since it was not a long form article, not easy to discuss. (Interestingly, it did appear to be a minority opinion — which raises questions about how seriously mainstream economists take their own models.)</p></li></ul><p>The lack of a recession to tame unemployment pops up in the two pieces above. Skanda also discusses the effect of interest rates. However, my main observation is the Calvinball-esque nature of neoclassicals claiming victory for the alleged effect of interest rates. </p><p>Neoclassicals are very quick to condescend to anyone who doesn’t use mathematical models in macro. But what do neoclassical models say about interest rates? They say that <em>real </em>interest rates matter (nominal rates less inflation).</p><p>Well, let’s look at that.</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgqtjMpF0vmMjQHjB1aWeWowzt_nu6bTmiYLvqxAhNBxFHLZQRKnJiyEGgZBTfej7MDmzw0v4mxV69_nkBlhz40RFRNjV7UFIq9NJQ843wGrzSnu_UOZrYNdox-wRuOXg5MM_2hzaVoCTcrDnSc2eKre6JBZSIZ-9X0vpdZMjlI7JHif3gwp8Q1bCkjBck/s693/c20240110_real_fed_funds_historic.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="693" data-original-width="600" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgqtjMpF0vmMjQHjB1aWeWowzt_nu6bTmiYLvqxAhNBxFHLZQRKnJiyEGgZBTfej7MDmzw0v4mxV69_nkBlhz40RFRNjV7UFIq9NJQ843wGrzSnu_UOZrYNdox-wRuOXg5MM_2hzaVoCTcrDnSc2eKre6JBZSIZ-9X0vpdZMjlI7JHif3gwp8Q1bCkjBck/s16000/c20240110_real_fed_funds_historic.png" /></a></div><p data-pm-slice="1 1 []">The top panel shows the evolution of the real Fed Funds rate, where I deflate by core CPI to get the “real” rate. Below that, we see the core CPI rate itself. Core CPI did a double peak in Q1 and Q3 of 2022. When we look at the real Fed Funds rate, it was still quite negative. Unless <em>r* </em>was zooming around like a toddler overdosed on chocolate cake, the real policy rate was still in accommodative territory. However, rather than dwell on this inconvenient fact, the standard tactic seems to be quoting the change in the nominal rate and then claiming that this means that interest rates “worked.” <em>(I am in the camp that rapid increases in the nominal policy rate will whack the economy — but I am basing that on heterodox arguments.)</em></p><p>The bottom panel perhaps offers a way of wiggling out of this problem. One could argue that we should not look at the real policy rate, rather we need to look at the discounted path of real interest rates (and to be fair, that is how the models work, although this is typically ignored in discussing central bank policy). The quoted yield (“real yield” or “indexed yield”) on inflation-linked bonds is precisely that (assuming risk neutrality). The quoted yields did rise. The argument whether this was enough to “cause” inflation to drop remains unclear. It also raises the issue whether this implies that if the discounted real interest rates in early-/mid-2022 were enough to cause inflation to reverse, why will inflation not rapidly rocket to deflation since we are at similar levels? <em>(We can then get into non-falsifiable theories about inflation expectations and/or the inflation risk premium that allows movements in these non-measurable values to explain any possible outcome.)</em></p><p>Going forward, this is probably the most important angle for Fed watching — if they are not sure what the “neutral rate” is, how exactly are they supposed to set the policy rate (beyond vibes)? I do not spend a whole lot of time parsing Fed statements, but I believe that Powell is somewhat frustrated with the answers he is getting to that question. But we need to look beyond his opinions and ask how the Fed personnel more broadly are looking at this (and whether it makes any sense).</p>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2024Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-5487870052599052642024-01-03T11:16:00.000-05:002024-01-03T11:16:51.898-05:00Central Banks And Crises<div><p data-pm-slice="1 2 []"><em></em></p><div class="separator" style="clear: both; text-align: center;"><em><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhgu9SJRhGsaV-_9M_oXdoBt5eY5F8unyD2rYxluBpmtwV4nKefMqyg09SZB7wi4lQfZKf3qNzeMca0IBQWE1YDtPy7PWW1UloOozCuVlx_imbCSbE3xT91LDTV0zENxnehyphenhyphenxQBI-OL_VcQsbsLMy6hn7LjcQksDiALFWrxR3JT94Pwiz-cCY-gSumPrM4/s80/logo_central_banks.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhgu9SJRhGsaV-_9M_oXdoBt5eY5F8unyD2rYxluBpmtwV4nKefMqyg09SZB7wi4lQfZKf3qNzeMca0IBQWE1YDtPy7PWW1UloOozCuVlx_imbCSbE3xT91LDTV0zENxnehyphenhyphenxQBI-OL_VcQsbsLMy6hn7LjcQksDiALFWrxR3JT94Pwiz-cCY-gSumPrM4/s1600/logo_central_banks.png" width="80" /></a></em></div><em>This article is a wrapping up of a sequence of articles on the topic of “central banks as banks,” which is expected to form a chapter in my book on banking. This version of the text is a brainstorming exercise — I expect that it would require a massive re-write to get into a book. I am presenting it in this format since it was a topic that came up in comments on earlier articles, and I also want to finish the train of thought starting in my online articles. It is breezy, and it relies on discussions that appeared in my earlier book </em>Recessions: Volume I<em>. I am going to suggest that readers spend their bookstore gift cards buying that book rather than repeating too much from it; my banking manuscript is going to have to be more stand alone. I also am relying on stream-of-consciousness assertions, and would need to backfill references once the text is closer to finalised.</em><p></p><p data-pm-slice="1 2 []"><em>Happy New Year!</em></p><p>If things are going well, the role of the central bank within the banking system of a developed country is largely invisible. The wholesale payments system just works, and there are no serious worries about the private banks that are the core of the financial system. Instead, most commentators just worry about central bankers’ abilities to centrally plan the capitalist economy by nudging a policy rate up and down and making cryptic statements about the economic future. <em>(Of course, those of a hard money bent are continuously predicting calamities since nobody is adopting their demand that the currency be pegged to whatever collectible they favour.)</em></p><p><span></span></p><a name='more'></a>During a crisis, the role of the central bank in the banking system comes back into focus. Given the trauma of the Financial Crisis of 2008, we might have a generation of central bankers and central bank watchers who are more attuned to crisis management. However, stability breeds complacency, and we should expect the importance of crisis management to fade as youngsters move up and push their agendas.<p></p><h2>The Inevitability of Financial Crises</h2><p>Crises driven by finance are part and parcel of industrial capitalism. My thinking largely follows the story of Hyman Minsky, who in turn followed Keynes. I will just outline the structure of the argument without offering references. From my own writings, this would be covered in <a href="https://books2read.com/b/recessionsvol1" rel="noopener noreferrer nofollow" target="_blank"><em>Recessions: Volume I</em></a><em>, </em>while Hyman Minsky has a lot of readable material on this topic.</p><p>If we look at the <a href="http://www.bondeconomics.com/2018/06/primer-kalecki-profit-equation-part-i.html" rel="noopener noreferrer nofollow" target="_blank">Kalecki Profit Equation (link to primer)</a>, we see that (net) investment is a source of aggregate profit to the business sector. We need to keep in mind that cash flows tend to be circular — wages are paid out as an expense, but unless those wages are saved, the cash flows return to another business as revenue. For investment, they are a cash flow out of firms (or households if they invest in housing) that is not an expense (depreciation will eventually occur) but they create revenue for the firms providing the investment goods.</p><p>The justification for fixed investments is the expectation of profit, while the act of investing itself generates aggregate profits. This creates a self-reinforcing feedback loop (“positive feedback loop” if you are an audio engineer). Although profits can be used to finance investment, in the real world, a lot of investment is done by companies speculating about future profits. This implies that the investment needs to be financed by debt (since equity financing is too expensive for any but the most risk averse).</p><p>This creates the tendency for capitalist economies to “melt up” — an investment-driven profit boom. We can capture this effect in classical (1950s era) investment accelerator models. The problem is that this feedback loop works until it doesn’t. Sooner or later, businesses and households pile on too many dubious investments, and lenders develop cold feet. At which point, the process goes into reverse.</p><p>Everything I have written so far is just a consequence of how industrial capitalism works. We then need to ask what the financial system is doing while all this is going on.</p><h2>Financial Instability</h2><p>If one reads financial commentary, it would appear that the entire purpose of the financial system is to gamble on literally everything. In fact, that is just the world view of most financial market participants. This outlook is self-reinforcing, but believe it or not, the credit markets do finance activity in the real economy. The credit markets are split between the formal banking sector and non-bank finance — or the “shadow banking sector” if you want it to sound cool.</p><p>The fundamental problem with capitalist finance is that there is an overwhelming bias to hold short-dated instruments with a low perceived credit risk, while fixed investment cannot naturally be financed by such instruments. <em>(The closest we get is trade receivable financing.)</em> The financial sector needs to do some magic to bridge this mismatch. The traditional banking model notoriously does this with deposits being used to finance loans. The shadow banking sector achieves this by issuing short-dated instruments that are allegedly safe and used to finance positions in long-dated credit assets. To the extent that the shadow banking sector is safe, it relies on lines of credit backstops from the formal banks — and they have the implicit backstop of the central bank.</p><h2>Minsky-Ism</h2><p>Although Hyman Minsky thought of himself as following Keynes, his writings are certainly easier for a lot of us to follow. Although parts of his Financial Instability Hypothesis are catchy and get a lot of attention (Ponzi Units!), I think you also need to pay attention to his description of institutional changes in finance. (For example, see “Central Banking and Money Market Changes” in the collection <em>Can “It” Happen Again: Essays on Instability and Finance.) </em>The key is that the financial system is not static: its structure changes over time in response to regulatory action, and market forces that pushes for “innovations” (that coincidentally wiggle out of said regulations). The views here are mine, and may at this point be only tangentially related to what Minsky meant, but he would be a source to turn to if you want a reference.</p><p>The short version of the idea is as follows. Given the maturity mismatch between the overall mix of lenders and borrowers, in order to generate growth, we need financial intermediaries to bridge the gap. However, such a mismatch can lead to a financial crisis, which will result in the classic behaviour of putting in reforms that will prevent a repeat of the exact same crisis <em>(horse, barn door, etc.)</em>. A crisis tends to cull some of the more imprudent credit market participants, and so we would probably avoid a repeat of the same crisis even if nothing is changed. However, industrial capitalism (generally) needs credit growth for incomes to grow, and so there is pressure to find “innovative” “safe” ways to bridge the maturity gap. (<em>The innovation invariably is finding structures that are economically equivalent to debt, and they are “safe” because they are so “innovative” that the people dealing in them are unaware of the credit risks.)</em></p><p>The real kicker is that “stability is destabilising.” New financial practices are often put into place with good safety margins — the novelty of the instrument allows greater credit spreads to be charged, covering potential losses. Meanwhile, credit standards are tight in the aftermath of a previous financial crisis, so there is no need for the new instruments to offer too much embedded leverage. These safety margins validate the new financial practice as safe. (And in the sense of realised losses being less than what was priced into the instrument, they are safe.) </p><p>And if one has ever run into finance professors in the wild, one discovers that the answer they almost invariably prescribe to a situation where there is a “safe” profit to be made: put more leverage on that sucker. Firms loosen lending standards, allowing more leverage against assets. At the macro level, this increases leverage allows a greater price for the asset being levered. Once again this validates the decision to loosen lending standards.</p><p>I do not recall Minsky using these words exactly, but there is a Darwinian selection at work: stodgy financial firms that do not loosen lending standards will lose market share to those that do. This is ensures that the funding mix will move towards aggressive intermediaries — even if other lenders hold the line on standards. (That is, this shift does even not require participants’ attitudes to change, their weighting will shift anyway. Entities loosening standards turbo-charges this.)</p><p>Of course, the loosening of standards dooms itself. Since the core problem is lending short-term against long-term assets, the formal banks are likely have been drawn in somehow. In the Financial Crisis of 2008, the formal banks in many developed countries mainly kept the garbage off their regulated balance sheets — they just ended up involved with “bankruptcy remote” (lol) off balance sheet vehicles.<a class="footnote-anchor" data-component-name="FootnoteAnchorToDOM" href="#footnote-1" id="footnote-anchor-1" target="_self">1</a> <em>(If the formal banks have not been drawn in, the central bank is free to let the speculative bubble to melt down — not matter what the market capitalisation of the bubble is. One of the problems that the financial press has is that people conflate “market capitalisation” with actual cash flows. Every major sporting event sees the collapse of the market value of losing bets — yet this has no effect on the macroeconomy. Although the equity market might be useful as an indicator, very little money is raised by equity issuance, so the equity market could be shut down for a considerable time and firms could continue to function. This is unlike the credit markets, where debt needs to be rolled almost continuously.) </em>The formal banks can only survive if they can draw on financing from the central bank — which is exactly why people are willing to lend to them in the first place.</p><h2>Can This Be Stopped?</h2><p>A standard reaction to the previous argument is outrage — typically at bankers, financial capitalism, or “socialist” central bankers (depending upon ideological sympathies). I view financial crises to be one of the inevitable side effects of industrial capitalism, like pollution and idiotic advertising. It is easy to prevent the last crisis — the problem is that the best and brightest in finance will just end up with a new way of generating a crisis.</p><p>Many free marketeers who are unhappy with banks are angry at the “welfare state for bankers.” Although it is unwelcome seeing bankers being bailed at by the government, pretending that non-bank finance can survive a major crisis without a central bank bailout is wishful thinking. The non-bank financial sector has a straightforward selective pressure: credit risk ends up in the hands of the participants least able to understand the magnitude of the risks they are running. Sooner or later, that is an unstable edifice — and will take out the real economy if intervention does not occur. Politicians are not going to let their economies be wiped out to defend some abstract notion of “free market capitalism” when they are being inundated with calls by panicky “free market capitalists.”</p><p>On the other hand, hoping that regulators will save the day also requires a hefty dose of wishful thinking. Although behaviour might be more discreet in the aftermath of a crisis, sooner or later the free market dogmatism embedded in neoclassical models will result in regulatory capture of the regulators. In the Financial Crisis, central bankers were too busy patting themselves on the back about achieving “the Great Moderation” to even be aware of what was happening in the shadow banking sector. However, even if they had paid attention, there is no reason to believe they would have been anything other than cheerleaders, arguing that the gaussian copula models scientifically proved that a financial crisis was impossible. </p><p>The elites in a capitalist society are not going to favour crippling growth by refusing to allow financial practices that <em>appear to be safe</em>. Although one can point to periods of stodgy, conservative financial behaviour, the last one — the 1950s — required The Great Depression, World War II, and Communists Under The Bed — as backstory. Even then, behaviour loosened up by the mid-1960s. </p><h2>Concluding Remarks</h2><p>We have been through some major financial upheavals, and warning about financial crises is possibly still somewhat “edgy.” <em>(The underlying reason why it will always appear to be novel is that the neoclassical framework has no satisfactory way to model a financial crisis.)</em> The problem is — if everyone is prepared for a financial crisis, one will not happen. You need somebody taking really stupid risks with a whole lot of money to derail mature capitalist economies. At the end of the day, all the central bank needs to do is lend against any instrument that can fog a mirror to get the core of the banking system functioning again.</p><p>An entirely plausible scenario is that we could stumble along for a couple decades with only mid-level scandals and financial stupidities, while financial crisis bugs repeatedly proclaim the onset of the next crisis (invariably in the second half of the next year). That is, they will end up looking like aged cranks who proclaimed the next wave of inflation every year from 1984-2020. (For those who might think that is not so bad, ask yourself: how old were you — or your parents — in 1984?) At which point, things might be relaxed enough for everybody to break out their Minsky quotes once again.</p><p>In my view, the best that you can hope for is that the central bank has some cynical senior people who are somewhat aware of what monkey business the financial sector is up to, and do not assume that markets tend to stable equilibria if regulators remove pesky “imperfections.” They might spot problems early enough that the damage from over-exuberance can be contained. Having this market expertise probably requires the central bank to be continuously involved in lending against private securities as a means of creating the monetary base — as opposed to just plopping its balance sheet into central government securities that allow it to ignore private credit (the problem with neoclassical thinking from 1945-2008).</p><div class="footnote" data-component-name="FootnoteToDOM"><a class="footnote-number" contenteditable="false" href="#footnote-anchor-1" id="footnote-1" target="_self">1</a><div class="footnote-content"><p>Some formal banking systems blew themselves up, e.g., Ireland. Northern Rock failed in a somewhat traditional fashion by relying too much on wholesale finance, the Icelandic system allowed itself to be captured by somewhat unreliable characters, etc.</p></div></div></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2024Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-29485685655553749522023-12-19T10:11:00.000-05:002023-12-19T10:11:59.845-05:00Should Everybody Have An Account At The Central Bank?<div><p data-pm-slice="1 1 []"><em></em></p><div class="separator" style="clear: both; text-align: center;"><em><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEigSb287jPcZ8AUIsZ39wQNNZCsx2CK-EDQOTjOwdXWpuL9dO_vOx8YrMay0Vhbl0TRTw-X8ZmgC_T9rwGMfgFHk7EWGsYUDX9fk89L792hlXZk9gsrszNGdNwh5FNBFUPpRnrcq5DaEPiEt8jJO2X2HGhzU-pDfiB3VjEoL9j6ZKJ-zA_NIeBT_-hOng0/s80/logo_central_banks.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEigSb287jPcZ8AUIsZ39wQNNZCsx2CK-EDQOTjOwdXWpuL9dO_vOx8YrMay0Vhbl0TRTw-X8ZmgC_T9rwGMfgFHk7EWGsYUDX9fk89L792hlXZk9gsrszNGdNwh5FNBFUPpRnrcq5DaEPiEt8jJO2X2HGhzU-pDfiB3VjEoL9j6ZKJ-zA_NIeBT_-hOng0/s1600/logo_central_banks.png" width="80" /></a></em></div><em>This will be my last posting before Christmas, and depending on what I get up to, possibly the last of 2023. This article is somewhat of a placeholder for my manuscript chapter. It is a group of related topics that I think belongs in there, but not ones that I spent much time looking at. I will revisit this text when I put the manuscript together. </em><p></p><p><em>Happy Holidays (and probably) Happy New Year!</em></p><p>In this article, I will breezily run through a few topics that are <em>related</em> to the idea of “everybody getting accounts at the central bank.” Many (but not all) of these proposals are being put forward as a means to fixing the problems with the private banking system that were exposed during recent financial crises, and/or proposals to del with the somewhat backward retail banking infrastructure of the United States of America (and perhaps a few other countries).</p><p><span></span></p><a name='more'></a>One possible variant of these ideas is that the central bank (or the central government via a “postal bank” system) operates in direct competition to private banks — they offer loans and accounts. Alternatively, the central bank could just move into offering retail payment and deposit services, without offering loans itself.<p></p><h2>Postal Banking</h2><p> I am going to use “central bank” herein as a shorthand for the central government offering banking services more widely. In practice, this might not be done by the existing central bank, under the argument that central bank generally has zero expertise in offering such services. <em>(I believe that the Bank of England used to offer accounts to a limited number of people, but dropped those facilities. I need to get a reference for this alleged history.) </em>In order to match private banking services, one would need widespread retail outlets. Post offices already provide that retail footprint.</p><p>Rather than duplicate the post office infrastructure build out, it makes sense to offer banking/payments services at post offices — postal banking. This a system that exists to a certain extent in various countries. A reinvigoration or expansion of postal banking might result in greater availability of banking services to all citizens, but how this would be done would depend upon the conditions in the legal jurisdiction. Although it might improve conditions for some people, such a move is not going to have a major macroeconomic impact since firms and most individuals will not use postal banking services.</p><p>From a Canadian perspective, it is not clear that postal banking would amount to much. At present, many “post offices” are franchises run out of retail businesses (often pharmacies). (Go to <a href="https://www.canadapost-postescanada.ca/cpc/en/our-company/business-opportunities/become-an-authorized-retailer.page?" rel="noopener noreferrer nofollow" target="_blank">https://www.canadapost-postescanada.ca/cpc/en/our-company/business-opportunities/become-an-authorized-retailer.page?</a> to check out franchising opportunities.) As such, the central government has only limited control over the branches, and although they are going to have access to payments systems, they cannot take financial risks. Beyond adding some payments options, it seems much easier to slap a mandate on the handful of private Canadian banks that they serve all Canadians (within reasonable limits). This might not work in fragmented banking system (like the American one), but it is much more efficient to browbeat a few private senior bankers than try to replicate their branch system.</p><h2>Lending?</h2><p>Another set of proposals involves the central bank getting involved in direct lending decisions to non-banks. As discussed earlier, I am opposed to this. Central governments are involved in lending programmes — for example, student loans — but they quite often offload credit analysis and servicing to the private sector. The government just takes on the credit risk, although they can charge a fee for that. (For example, the Canada Mortgage and Housing Corporation (CMHC) — a Crown Corporation — insures most mortgages that are originated with a loan-to-value ratio above 80% (the rest are insured privately). </p><p>Although one can readily argue that such programmes should be expanded, doing so is a political decision. There is no economic magic created by having the central government directly “create the money” for loans versus taking on the credit risk of a private bank loan. In either case, somebody in the private sector is transferred cash under programme specifications — with the hope that the money is paid back — and this transfer is matched by the issuance of liabilities that are either direct liabilities of the central government, or private sector liabilities wrapped with a central government guarantee. Although those two types of liabilities might appear different, they are economically equivalent.</p><p>The key point to note is that if the government wants to go hog wild underwriting private sector credit risk, it does not need to involve the economics doctorates at the central bank who have zero expertise in credit analysis.</p><h2>Central Bank Offering Safe Bank Accounts</h2><p>We can now move to what some view as a major concern — people should have bank accounts with the central bank so that they do not have to worry about the credit risk behind their “money.”</p><p>The idea is that if the central bank allowed everybody to bank with them, everybody would rejoice and financial crises would allegedly be impossible. This theory runs into two serious problems.</p><ol><li><p>Choice of bank for holding deposits generally depends upon the other services offered by the bank. For example, we ended up banking with the bank that offered the best mortgage rate on our first house — which I assume is a fairly typical situation. The credit risk to deposits is pretty much at the bottom of the list of criteria I would use, courtesy of the existence of deposit insurance (a topic that is discussed further below).</p></li><li><p>Unless all lending activity is nationalised, credit risk has to go somewhere. Removing it from the banking system will just push it to non-bank finance — where most of the real financial crises have arisen in recent decades. <em>(The Silicon Valley debacle appears to be an exception, however that crisis just tells us that nobody in San Francisco should be allowed to work for a private or central bank.)</em></p></li></ol><p>There is nothing stopping the private sector to have credit risk free payments/”deposit” system — just tie Treasury bill funds into the payments system. The problem is that it is not in anyone’s economic interest to offer that service for free — the need to be paid for running the payments system. The reality that deposits are loans to banks gives them an incentive to provide the payments services at a “reasonable” price — as well as the reality that deposit services are a “loss leader” that allows the sale of more profitable services (e.g., mortgages). Even if the government mandated the provision of 100% safe deposit facilities, it is unclear that anyone other than the most risk-averse would use them.</p><h2>Unlimited Deposit Insurance</h2><p>If the objective is to provide deposits with no credit risk whatsoever, we can just remove the limit on deposit insurance. <em>(At the time of writing in Canada, the limit is $100,000, in the United States, $250,000.)</em> This creates the economic equivalent of a deposit with the central government without requiring the central government to put a bank branch in every small town in the country. In a financial crisis, it is clear that the limit is somewhat of a fiction — the central government is probably going to cover all deposits to prevent a panic. </p><p>One could easily argue that we should not have ambiguities that allows a crisis to happen — if the government is going to bail out all deposits, then it should say that up front. Although I am not a huge fan of fictions, I think the legal ambiguity is useful. Unlimited deposit insurance takes away the discretion of regulators to allow a fraudulent bank to get wiped out. Although one might attempt to shed a tear for the poor widows and orphans caught up in the calamity (who are somehow able to muster deposits above the insurance limit), it is entirely possible that the major “depositors” who would get bailed out are in on the scam in some fashion.</p><p>In a country with a few large banks, such fraud concerns are perhaps not an issue. But in a country like the United States where the barriers to setting up a bank are low, we cannot expect regulators to pre-emptively catch all problem banks. Unlimited deposit insurance implies a need to regulate on the basis that no bank is expected to fail — which is not the American situation. </p><h2>“Backup” Risk-Free Deposits Would Make Crises Worse</h2><p>Creating risk-free deposit options that are not used in normal times (because they are uneconomic) would just make financial crises worse. The premise of conventional banking is that they have sticky deposit bases, and the core banks of the system are presumed to be the safest, so they do not face a flight-to-quality risk. Creating risk free accounts at the central bank that are only used in crises just creates an incentive for a run on the core of the banking system — which is exactly the nightmare financial crisis scenario you want to avoid.</p><h2>Wholesale Payments System — Nationalise It</h2><p>One of the campfire horror stories that experts love to discuss is the potential failure of the wholesale payments system in a country. The response to that is straightforward: nationalise it if things look ugly. Until then, you let the private banks worry about containing credit risk so that you do not have to.</p><h2>Central Bank Digital Currencies</h2><p>The final angle is the possibility of central banks hopping on to the crypto-currency hype train and creating their own “digital currency” that is not the national currency. (“Digital currency” is a bit of a silly name in that electronic transactions on digital computers represent the vast majority of daily transaction volume.) </p><p>From what I have seen of the discussions of these currency proposals, they seem aimed more at micro issues (privacy, accessibility) and not macro.</p><h2>Concluding Remarks</h2><p>The willingness of politicians to have the central government stick its nose into lending decisions is going to rise and fall with political trends. Having the government outsource the implementation of lending to private lenders and instead just providing lending guidelines uses much less resources than setting up a parallel lending infrastructure that might be redundant one election later.</p><p>Having the government get involved in retail payments is a question that might have different answers in different countries. That said, postal banking has been in decline, and it is not clear that it is the most efficient way to deal with actual problems.</p><p>Finally, we are left with question of financial system instability. The expected final instalment of this series will look at financial instability — would 100% credit risk free deposits make a difference?</p></div><div><br /></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2023Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-10497352888902363552023-12-12T13:18:00.000-05:002023-12-12T13:18:43.724-05:00Should Central Banks Lend Unsecured To The Private Sector?<div><p data-pm-slice="1 1 []"><em></em></p><div class="separator" style="clear: both; text-align: center;"><em><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh9eNai_qtMtAbX4lCJEtH_fwuEoUnlxoEdZKPK7pK19XTj2ME7cs1v4F9Vb4OnwVMfYPdRlaG-FmmCf_mUeU7Dxao4gMdwnQrXthRWme8BWNl0vJ6XF270WQmrV1yFBmLLMxAO7LKxJSsCSZIJctzTmRzGH51zzny-N5HjlrpVDq_f0RAj7qJNcMRLYQk/s80/logo_central_banks.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh9eNai_qtMtAbX4lCJEtH_fwuEoUnlxoEdZKPK7pK19XTj2ME7cs1v4F9Vb4OnwVMfYPdRlaG-FmmCf_mUeU7Dxao4gMdwnQrXthRWme8BWNl0vJ6XF270WQmrV1yFBmLLMxAO7LKxJSsCSZIJctzTmRzGH51zzny-N5HjlrpVDq_f0RAj7qJNcMRLYQk/s1600/logo_central_banks.png" width="80" /></a></em></div><em>This article continues my sequence of articles on central banks as banks, which is projected to be a chapter in my banking manuscript. This article is relatively lightweight, but I wanted to break this issue out of another planned article. </em><p></p><p>What assets central banks should have on their balance sheet is controversial for some people, but for the post-World War II to 2008 Financial Crisis period, developed countries without currency pegs just held government bonds without raising questions from the bulk of economists. The Financial Crisis forced central banks to buy private sector assets, which re-opened this debate. This article looks at one type of private sector assets to be held — uncollateralised loans to the private sector.</p><p><em><span></span></em></p><a name='more'></a><em>I am assuming here that the currency is not pegged, which necessitates holding the peg instrument (typically gold or a “hard currency”). Even if the currency is pegged, the central bank may hold assets that are not the peg instrument, and they face the questions of what those other assets will be.</em><p></p><h2>Non-Credit Assets?</h2><p>As noted earlier, the central bank is in the same boat as other liability-matching investors. Their liabilities are almost entirely short-dated “deposits” and currency notes — which are bearer claims on central bank deposits that can be redeemed at any time. Nevertheless, it seems unlikely that the private sector would attempt to redeem the entire monetary base within a few months, so the central bank (like other banks) can assume that a certain amount of its liabilities are “sticky” and so it does need 100% of assets to be short duration. This allows for silliness like buying foreign currencies (which do not match local currency liabilities), equities, and gold. Central banks have done such purchases, but they tend to be a small weighting of the balance sheet. My concern here is the rest of the balance sheet, which needs to match liabilities.</p><p><em>The question might arise: why cannot the central bank just “print money” when facing outflows? The entire point of the central bank’s liabilities shrinking is that the private sector no longer wants to hold “government money.” It could attempt to force “money” onto the private sector by buying something to counter the attempted shrinkage, but that is going to break the “rules of the game” for the monetary system, and is going to get push back. If it buys more illiquid assets, this compounds the liability-matching problem.</em></p><h2>Private Credit</h2><p>Lending to the private sector (in whatever format) will create a credit portfolio that has a maturity structure that can be matched against potential outflows. That is, if there is a good weighting of short-dated maturities, the portfolio will self-liquidate — or at least be able to be liquidated near par — in response to a balance sheet shrinkage. </p><p>Historically, this lending to the private sector is generally done in a collateralised form: lending at the discount window, or against collateral in a repurchase transaction. <em>(I am only concerned with the economic effects of lending, and not the financial accounting or credit risk dimensions of different “lending” types.) </em>This greatly limits the need for credit risk analysis at the central bank. Their counter-parties are banks that the central bank is allegedly regulating, and the collateral is supposed to be high quality and provides backup credit protection. If there is a default on the collateral, that is the counter-party bank’s problem. The central bank only takes a loss if the bank goes bust and the collateral defaults. Although events like that can happen, it is probably a systemic blow up that the central bank was supposed to be stopping. I will discuss collateralised lending later.</p><p>Why not unsecured?</p><h2>Unsecured Lending to Banks</h2><p>Although many populist bank critics are unhappy with the central bank lending to private banks via collateralised lending, doing so is just a way to keep financing flows circular. Under the assumption that the collateral is good quality, then it is not exactly “free money” for the banks — they need to have unencumbered good quality assets on their balance sheets in order to access this funding. If they run out of those good quality assets, they are going to be getting a visit from regulators in short order to put their enterprise out of its misery.</p><p>Things are different if no collateral (or dodgy collateral) is posted. In which case, it is a gift to the banks, and it raises a lot of questions. The central bank could easily do a terrible job regulating banks, and then lend money to said banks to cover up their lack of care. Although there is no real resource cost associated with this, the cash flows are effectively an income flow. Doing so creates the worst possible economic system: crony capitalism at the banks underwritten by the central government. Although fans of central planning might not be bothered by this situation, it is going to run into obvious political problems at the ballot box in most developed countries sooner or later.</p><h2>Private Sector Bonds</h2><p>The central bank could easily set up a bond fund and even if it is paying market wages, the cost would not be that large when compared to the cost of keeping hundreds of economics doctorates on the payroll. The problem with having a corporate bond portfolio is that it would end up being managed in exactly the same way as private sector bond funds (“best practices”).</p><p>This means that when the corporate bond market blows itself up, we would have highly paid bond managers <em>working for the central bank</em> running down the halls demanding a bailout <em>from their central bank coworkers</em>. The role of the central bank around any large bankruptcy is going to be a political issue. For example, if one of Quebec’s “national champions” goes belly up ahead of an election, there would be a lot of politicians screaming for the heads of the central bankers in Ottawa that did not bail the firm out.</p><h2>Direct Lending Programmes</h2><p>Finally, the central bank could lend to non-financial entities. The problem is that unless the programme is restricted to large firms, this would greatly increase the need for credit risk management and assessment personnel. That is, the central bank would be acting even more like a private bank, instead of be a bank for a few selected clients (private banks, the central government).</p><p>The reality is that a loan is effectively an income transfer until the loan is paid back. Spending government money is the prerogative of the legislature, and I am in the camp that does not believe that this power should be handed over to unelected bureaucrats. To the extent that the central government is in the lending business (and they generally are), the rules and losses are the responsibility of the fiscal arm of the government.</p><p>Not everyone agrees with that stance, some people are attracted to the “financial engineering” of using the central bank. This might be necessary in the horror show of the Euro system, but it is unnecessary elsewhere. If a programme cannot attract the support of elected politicians, why fund it? Meanwhile, this would just turn central bankers into punching bags when the programme blows up.</p><h2>Concluding Remarks</h2><p>Unsecured lending by the central bank to the private sector is just a means of handing control of the public purse to unelected bureaucrats. Views on the advisability of this are largely a personal political stance.</p></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2023Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-33151737713055580082023-12-06T12:18:00.000-05:002023-12-06T12:18:14.151-05:00Using Fed Projections To Infer The Term Premium?<div><p data-pm-slice="1 1 []"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjtnWgaKG4epdOjsSjEroNPTXPfg02BYYehUhyphenhyphenwuf8HiuRLMda06K1YTinY6MG3twJOidjHjwRJ8hSNrF4wTnVSDiin4K2R2g14JbuGe6YucqhDI7tpkdHimMgKRgQpl7nUSSCHWCdoNSDHWm757CK5YQUsOla4VwgHoaUQpFPhbjBy47Kn9Mlr6GgGHdg/s80/logo_bond_market.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjtnWgaKG4epdOjsSjEroNPTXPfg02BYYehUhyphenhyphenwuf8HiuRLMda06K1YTinY6MG3twJOidjHjwRJ8hSNrF4wTnVSDiin4K2R2g14JbuGe6YucqhDI7tpkdHimMgKRgQpl7nUSSCHWCdoNSDHWm757CK5YQUsOla4VwgHoaUQpFPhbjBy47Kn9Mlr6GgGHdg/s1600/logo_bond_market.png" width="80" /></a></div>I was passed along the article <a href="https://www.man.com/maninstitute/views-from-the-floor-2023-November-07" rel="noopener noreferrer nofollow" target="_blank">“Views from the Floor — Tighter and Tighter” by the Man Institute</a> published last month. It discusses using the FOMC long-term projections to infer the term premium in the 10-year Treasury yield.<p></p><p>The methodology is straightforward (I have a busy week, so I have not gathered the data to replicate it myself). They describe it as follows:</p><blockquote><p> A better approach is to incorporate the FOMC’s projections of the Fed Funds Rate into the expected path of short rates. This will make term premia estimates more consistent with sub-2% growth. Figure 1 shows that model applied, with an expectation that the short rate matches the Fed Funds Rate over the next year, then it linearly converges to the long-run projection over the next three years, and then remains constant.</p></blockquote><p><span></span></p><a name='more'></a>This matches my preferred structure for valuation models, which are based on the fair value for the 10-year being generated by calculating a projected path of short rates over the next 10 years. The fair value path needs to start near the current level, then move towards some steady state value over the “medium term” (2-5 years). This is needed to avoid the silliness of old school “bond value” models that economists used to generate where the current level of short rates has no effect on the fair value. <p></p><p>(Note that if you forecast a wildly different short rate path than what is embedded in such a model, you do not need a model to know how to position for duration. For example, if the model implies a gentle path of rate hikes while you expect a recession to prompt rate cuts, you do not need no stinkin’ model to know to go long duration.)</p><p>The issue is determining the steady state level; in the article, they use the FOMC long-term projections. The “term premium” is the deviation of observed market yields from fair value.</p><p>The general methodology is sound, my concern is whether it is a good idea to throw out market information and just assume that the FOMC is correct about the long-term path of interest rates. That is, if you have a long-term path for the policy rate that you have confidence in, deviations from that path do correspond to a risk (term) premium. However, no sensible market participant is willing to make public what they view as their forecast path for the policy rate, so we cannot determine what the “market forecast” is. We can get <em>economist</em> forecasts, but those economists as a group have zero input to market participants’ positioning. The FOMC forecast looks reasonable to use if one takes DSGE models’ use of expectations seriously, but doing so requires us to believe that market participants believe the FOMC’s forecasts (and I see no evidence that they do). Rate formation does not work as suggested by expectations in DSGE models.</p><h2>Term Premium — What is It?</h2><p>In Chapter 3 of my book <a href="https://www.books2read.com/b/4AYBae" rel="noopener noreferrer nofollow" target="_blank"><em>Breakeven Inflation Analysis</em></a><em>, </em>I discuss the distinction between “forecasts” and “expectations” and how “risk premia” fit into the topic. (I had a brief discussion of the topic in Chapter 4 of <a href="http://books2read.com/interest-rate-cycles" rel="noopener noreferrer nofollow" target="_blank"><em>Interest Rate Cycles: An Introduction</em></a><em>, </em>but it misses some of the concepts discussed in the other book.)</p><p>If we look at academia, they went the idea that risk premia are the output of affine term structure models, which you need to know stochastic calculus to understand. Since these models imply a lot of complicated mathematics and can be varied any number of ways, there is an infinite number of papers to publish on the topic. As such, this is the “sophisticated” approach to the term premium, as my preferred way of looking at the term premium implies that there is not much room to publish new academic papers. </p><p>If you are trading bonds, your breakeven on positions is versus the raw forward rates — that is, your pay offs embed no risk premium (“risk neutral expectations”). As such, you cannot ignore the raw forwards, no matter how unsophisticated Ivy League-educated economists think you are for doing so. That said, you need to know that there is a risk premium: bonds have historically outperformed cash (although you need to use sufficiently long histories to throw out the recent debacle).</p><p>I do not want to repeat what I already wrote, but I will just throw out how to start thinking about the problem. Rather than dealing with the thorny problem of the 10-year, why not ask: what is the term premium of the 6-month Treasury Bill versus the 3-month? (You don’t want to compare to the overnight since Fed Funds or repo are not the same instruments, the “instrument spread” can be larger than plausible term premia estimates.) </p><p>If you can get good data, you should see that the 6-month seems to embed a yield (term) premium that leads to it generally outperforming over time — except when it does not. <em>The big deviations in relative performance occur when the market was wrong about the path of the policy rate. </em></p><p>To the extent that there is a “steady state” risk premium, we probably need to throw out those episodes of the market being severely wrong, and then looking at relative performance when rates evolved <em>roughly</em> as expected. For a six-month instrument, our databases allow us a large number of non-overlapping periods to judge performance during those “non-miss” periods.</p><p>What about the 10-year? Those big forecast misses are typically 10 or less years apart, and we do not have a long history of non-overlapping 10-year periods when bond yields were not regulated along with having a free-floating currency. Although we could test theories about a six-month term premium, we do not have data to confirm or deny any theory about the 10-year yield. <em>(This might change around 2150 or so.)</em></p></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2023Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-67470180415409601842023-11-30T09:18:00.001-05:002023-11-30T09:18:20.185-05:00The Central Bank And Government Finance<div><p data-pm-slice="1 2 []"><em></em></p><div class="separator" style="clear: both; text-align: center;"><em><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEixo8zqu2ZWqCtu2-BhqaA2Zy-jCTVGQz9mdLGMix0hj6k1w3E0ifntMLMARPflvohSfb52Bnu4xpBsdCQYAc06-8GXbPmhlhhFN5YRegLHji_WBzEvxSx5KiWJFDLKz8dois_k0ehmU3fjaa9ajWpfHQ388vJyh8ZE_ToNaivfwLAqmUhrXdORdDnoeDM/s80/logo_central_banks.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEixo8zqu2ZWqCtu2-BhqaA2Zy-jCTVGQz9mdLGMix0hj6k1w3E0ifntMLMARPflvohSfb52Bnu4xpBsdCQYAc06-8GXbPmhlhhFN5YRegLHji_WBzEvxSx5KiWJFDLKz8dois_k0ehmU3fjaa9ajWpfHQ388vJyh8ZE_ToNaivfwLAqmUhrXdORdDnoeDM/s1600/logo_central_banks.png" width="80" /></a></em></div><em>This article continues the sequence of articles on central banks as banks. This article was as brief as possible since it overlapped my book Understanding Government Finance (</em><a href="http://books2read.com/understanding-government-finance" rel="noopener noreferrer nofollow" target="_blank"><em>available for sale cheaply at online bookstores</em></a><em>, and I emphasise that it would be an amazing Christmas present for friends and/or enemies (depending on what you think of my writing)). I might need to expand upon the less obvious points herein if this text does get into my book manuscript.</em><p></p><p>Central banking largely evolved the way it did due to the exigencies of wartime finance. The central government needs control over its financial operations in wartime, and any attempts to interfere by the private sector would be viewed as akin to sabotage. For a free-floating sovereign (and currency pegs are typically broken during major wars), the system guarantees that the financial flows will continue to flow. </p><p><span></span></p><a name='more'></a>As I discussed in <em>Understanding Government Finance</em>, the system is relatively straightforward, but it is unintuitive if you start with the misconception that the objective of government finance is for the government to “raise money” from the private sector. Instead, the system just allows the government to follow archaic accounting norms while ensuring that payment flows remain circular.<p></p><h2>Wholesale Payments System Recap</h2><p>I will assume for simplicity that we have a wholesale payments system that has counterparties that are only private banks, and the central government, which we divide into the finance arm (“Treasury”) and the central bank.<em> (Since the central bank acts as the agent for the Treasury, it is really on the central bank that is the counter-party, but we need to break out the Treasury for this discussion to make sense.) </em>If the government opened the wholesale payments system to non-bank entities for some reason, we just assume that the non-banks have to follow the same conventions as the private banks. We also assume that payments system balances for private banks will correspond to balances held at the central bank.</p><p>We will also assume for simplicity that the private banks are expected to keep their end of day balance with the payments system at $0 (the pre-2020 Canadian system). If the system featured positive reserve balances, then the target ends up being that positive balance, which does not really change the discussion herein — there is just a level shift of the target.</p><p>Under the reasonable assumption that the number of private banks is finite<a class="footnote-anchor" data-component-name="FootnoteAnchorToDOM" href="#footnote-1" id="footnote-anchor-1" target="_self">1</a>, then the previous assumption implies that the total private sector net balance with the payments system at the end of the day is $0. Since the payments system is zero sum, by implication that implies that the consolidated central government balance is also zero (since it is the remaining counter-party to the entirety of the private banking system).</p><p>This then implies that the net money in-/out-flow of the consolidated central government is $0 every single business day. (It might be unbalanced during the day, but it has to be brought back to balance by the end of the day.)</p><h2>Central Government <em>has</em> to Cancel Out the Treasury</h2><p>The implication is that if the Treasury has a net financial flow during the day, the central bank has to undertake transactions that generate the opposite flow.<em> (If the target for reserve balances is non-zero, the central bank has to make sure the change in the consolidated government balance matches the change in target level, if any.)</em></p><p>Let us imagine that the government had spend and tax transactions that net out to zero one day, but the Treasury issued $10 billion in bonds. This means that the Treasury has a $10 billion monetary inflow from the private sector — the bonds have to be paid for by the private banks, possibly under the instruction of clients who were the ultimate purchasers of bonds. By implication, the central bank <em>has</em> to have a $10 billion cash outflow for the balance target to be met. If the only assets the central bank holds are central government bonds/bills, it has to sell $10 billion in old securities (or do repo transactions) to match the $10 billion in new issuance. </p><p>That is, the central government did not draw in “new money” from the private sector, it just pushed out new securities in exchange for old.</p><p>This sounds weird, but it is just how the mathematics works.</p><h2>No, the Private Sector Did Not “Create” the Money</h2><p>One of the crackpot anti-MMT lines is that the private sector “creates the money” that pays for the bond issuance. Yes, bank lending creates banks, and those deposits might allow a non-bank client to put in an order at the bond auction. However, you could imagine a strange intermediary firm that allowed their clients to exchange wiener schnitzel for bonds at auction. This does not imply that government bonds are “paid for by wiener schnitzel,” rather, there is an intermediary deciding it likes wiener schnitzel. The intermediary itself has to wire “government money” on the wholesale payments network to the Treasury (technically, the central bank, since they typically run auctions) to pay for the bonds, and the intermediary then deducts the deposit (wiener schnitzel) from their client by agreement. </p><p>The private sector always starts the day with a $0 balance of government money — there is no pool of “money” to be drained to pay for the bonds; the central bank has to supply the “money.”</p><h2>Well, Where Do Bonds Come From?</h2><p>An alert reader will have noted that the bond auction created exactly zero net government bond holdings during the day — the old bonds that are sold to pay for the new one cancel out the issuance. So, where do bond holdings (which are non-zero) come from?</p><p>The answer is not along the lines of “When a mommy bond and a daddy bond love each other…,” rather, we need to drop the assumption of tax and spending cancelling out. If the Treasury runs a payments deficit during the day, it is sending money into hands of the private sector. The central bank needs to cancel that out — by selling bonds that it owns. This creates the net bond flow to the private sector.</p><p>As expected, the size of the fiscal deficit will determine the increase of government liabilities in the hands of the private sector (some of which might be banknotes, which need to be paid for by wiring money to the central bank).</p><h2>Conventional Accounting</h2><p>The analysis so far has just looked at the private sector, which is the counter-party to the consolidated central government. If we split the Treasury and central bank, we also need to track the balance of the Treasury at the central bank. A sensible society would argue that this balance is purely an accounting construct and can be ignored, but we do not live in that society. Instead, we see that bond issuance increases the balance of Treasury at the central bank. Subsequent deficit spending will tend to run that balance down, and so new issuance is needed to keep the balance positive.</p><p>As long as the central bank ensures that interest rate markets are orderly — literally its job — the Treasury will always be able to squeeze out new bonds to keep its balance positive <em>at some price</em>. (I.e., if bond yields go up, interest rate expenses go up.) <em>Default is pretty much only possible if the central bank decides to force the default. (Why “pretty much” — we can imagine non-financial reasons for a default.)</em></p><h2>Why Issue Bonds in the First Place?</h2><p>Anyone writing on this topic on the internet is going to face comments from MMT fans arguing that government bonds do not need to be issued, allowing society to skip the elaborate financial game-playing described earlier. I will now just run through the conventional justifications for bond issuance without endorsing them.</p><ol><li><p>It is needed to meet the arbitrary accounting rules (a positive balance at the central bank). This is not an economic necessity — changing the rules makes it disappear. I note this as some people refuse to accept that governments can unilaterally change regulations.</p></li><li><p>It creates a yield curve to allow the private sector benchmarks for its borrowing. Although this is useful, it is a niche concern.</p></li><li><p>The yield curve allows interest rate policy to control the economy. The usefulness of interest rate policy is an ongoing controversy between MMT proponents and pretty much every body else.</p></li><li><p>It provides credit risk free assets that are extremely useful for private pension and insurance provision. Given that governments have pushed a significant proportion of voters into private pensions (both defined benefit and defined contribution), this is not an easily reversed policy at this point.</p></li><li><p>Having credit risk assets stabilises the financial system. Private sector bond prices melt during a financial crisis; only central government bonds have a hope of retaining their value.</p></li><li><p>Ending issuance would put “bond vigilantes” and people who write about government bonds out of work. <em>(Since I am semi-retired, not a major concern for me.)</em></p></li></ol><h2>Concluding Remarks</h2><p>Central banks were not set up as a charity to employ economists with delusions of grandeur, they are there to ensure the smooth functioning government finance. The system is set up to allow extremely chunky transactions to take place. Ensuring that everybody can pay for cheesy poofs at the corner shop is an afterthought. </p><p>With this article out of the way, I can turn away from the structure of central banking and start discussing some of the many controversies about them.</p><div class="footnote" data-component-name="FootnoteToDOM"><a class="footnote-number" contenteditable="false" href="#footnote-anchor-1" id="footnote-1" target="_self">1</a><div class="footnote-content"><p>If we have <em>N</em> banks, each with a balance of $1/<em>N</em>, the aggregate balance is $1 as <em>N</em> goes to infinity. </p></div></div></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2023Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-50592981829899479462023-11-28T08:07:00.000-05:002023-11-28T08:07:35.626-05:00Central Bank Balance Sheets<div><p data-pm-slice="1 1 []"><em></em></p><div class="separator" style="clear: both; text-align: center;"><em><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhhx2TsMKyI9Cz-WNAL8hrPz7uLx-sUTBWC7H-Q102_ckjGOMCqFTd2dSPXwA54NEgBI77J0e9fpCglhKgPtBs5hnI45V6GvFNZHzbgnLhtbSqPix0Si91-lB3tGDREp_rIWQYjBzJqjknyZUZk3LqHhSqDn4B05vg646Tsq_SDWYE2s_J1XOQ8LCqGVfk/s80/logo_banking.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhhx2TsMKyI9Cz-WNAL8hrPz7uLx-sUTBWC7H-Q102_ckjGOMCqFTd2dSPXwA54NEgBI77J0e9fpCglhKgPtBs5hnI45V6GvFNZHzbgnLhtbSqPix0Si91-lB3tGDREp_rIWQYjBzJqjknyZUZk3LqHhSqDn4B05vg646Tsq_SDWYE2s_J1XOQ8LCqGVfk/s1600/logo_banking.png" width="80" /></a></em></div><em>This article continues my series of articles on central banks as banks.</em><p></p><p> Central bank balance sheets (in the modern era, at least) are relatively simple. There is a split between banks with a currency peg and those without. After that, the key point to keep in mind that the minimum size of the central bank balance sheet is not under the control of the central bank — other actors create a minimal demand for their liabilities. The only freedom of action for central bankers is growing beyond the minimum, which they did not do before the days of Quantitative Easing (QE). The article finishes off with a discussion of consolidation.</p><p>This text overlaps material found in my book <em>Understanding Government Finance. </em></p><h2><span><a name='more'></a></span>Central Bank Liabilities</h2><p>The key driver of a central bank’s balance sheet size is its liabilities. The central bank will have a small sliver of common equity, which in the modern era is owned by the central government. Since some central banks were historically private banks, there are a few cases where some common shares of the central bank are still traded on the stock market — but the central government typically owns the vast majority of the equity, and has control of the institution. <em>There is a lot of silliness about the Federal Reserve being owned by private banks — they own preferred equity, which does not confer “ownership rights” (e.g.. a claim on central bank profits). </em></p><p>The main typical classes of liabilities for the central bank include (not including any trade credit they incur as part of their operations).</p><ul><li><p>The central government, possibly other governmental entities keep deposits at the central bank. These balances are not part of the “monetary base” and are typically ignored in discussions. Since the central government owns the central bank, the deposit is just one arm of the government owing to an other, so its economic significance to outsiders is effectively nil. (This will be returned to when consolidation is discussed.)</p></li><li><p>Government-issued currency (banknotes) are typically liabilities of the central bank. (Private banknotes still exist, such as those issued by some banks in Scotland.) These banknotes can be returned to the central bank in exchange for a deposit liability (by banks). The amount of banknotes in circulation is driven by the needs of households and consumer-facing businesses (as well as the underground economy). Although the level of interest rates might influence the amount of money held as banknotes (they are <em>assumed</em> to do so in neoclassical models), nobody who has not been brainwashed by neoclassical theory believes that the central bank can directly determine the amount of banknotes demanded (and supplied by the government).</p></li><li><p>Private banks might need to hold deposits at the central bank as a result of reserve requirements (which are based on the amount of demand deposits). The amount of required reserves is fixed within a accounting period, and the amount of reserves required is driven by the balance sheet decisions of the private bank and its customers. Once again, even if interest rate policy influences the size of private bank balance sheets, it does so indirectly and with a lag — the amount of required reserves in an accounting period is not under the direct control of the central bank. The central bank has no choice but to supply those deposits, as otherwise one or more private banks must fail their required reserve test. That is, the central bank will have caused a bank failure(s) as a result of peculiar policy decision — which is not politically tenable.</p></li><li><p>Private banks might not trust each other, and decide to hold excess liquidity in the form of claims on the central bank (excess deposits, a positive balance with the payments system). Private banks doing this is a sign of a financial crisis — a sign that the central bank messed up regulating behaviour. These balances are quite obviously not under the control of the central bank.</p></li><li><p>Finally, the central bank can force excess deposits onto private banks (beyond what they need for required reserves and any crisis demand) via purchasing assets. (When the central bank purchases something via an electronic transfer, it creates a deposit balance to the bank of the recipient. That bank can send that balance to another bank, but it remains a deposit at the central bank. The only way to “delete” that balance is to exchange it for banknotes.) These are the only liabilities whose magnitude is under the direct control of the central bank. This means that when a central bank engages in “QE” it can inflate its balance sheet — but can only reverse back to whatever the minimum liability demand is.</p></li><li><p>Central banks might “borrow” money in open market operations to reduce reserve balances. This is typically structured as a paired sell-buy transaction on a bond, generically known as a repurchase (“repo”) transaction. This is a change of the mix of liabilities, but does not change the amount outstanding.</p></li><li><p>Central banks could issue bonds — but they generally do not. One way of ending the silliness of governments pretending that they have to listen to “bond vigilantes” is to have the central bank issue bonds. This is seen as unacceptable as it would put a lot of fiscal conservatives out of work.</p></li><li><p>Central banks owe each other money when they enter into swap line agreements. <em>(Which I ignore for the rest of this article.)</em></p></li></ul><p>If we look at the Bank of Canada for (most of) the 1994-2020 period, almost the only liability held by the private sector was banknotes — there were no “reserves.” This corresponds to the “simplified system of government finance” I described in <em>Understanding Government Finance</em>.</p><p>In summary, most of the liabilities are the result of the decisions of other actors, and the central bank has to supply them. They can crank up the size of their balance sheet beyond the minimum, but it is not clear why that is a good idea.</p><h2>Assets — Depends on the Peg Status</h2><p>What assets a central bank holds has an important dependence upon whether the currency is pegged. If the currency is pegged, it is possible for selected counter-parties to redeem the local currency for the peg asset. Since the central bank probably does not want the riff-raff showing up at the front door, this is going to generally be private banks or foreign central banks. In the Bretton Woods system, it was only foreign central banks that had the right to redeem U.S. dollars for gold, but older versions of the gold standard would extend the right to the private sector.</p><p>If your currency is redeemable for an external instrument — gold, hard currency — the central bank has little choice but to hold that instrument as an asset on its balance sheet for the redemption promise to be credible. Some academic monetarists argue that the central bank can pin the price of anything via “expectations,” but nobody in their right mind takes those people seriously. How much of its balance sheet needs to be held in the form of the peg asset is an exercise in psychology. If the peg is credible, nobody redeems their currency, and the currency needs little backing. But as soon as the peg credibility is questioned, the central bank needs a lot of the peg asset.</p><p>My expertise and interest is with developed countries with non-pegged currencies. <em>(The euro is not really an exception — the member countries are pegged to a non-pegged currency. The member national banks face challenges that are both similar and different to a country with an external peg.)</em> For these central banks, there is no need to hold a “peg asset,” although most have legacy holdings of gold, as well as foreign currency reserves (that are typically with a small weight relative to countries with currency pegs). I will now discuss their asset allocation decision.</p><h2>Central Bank Assets For Non-Pegged Currencies</h2><p>The main liabilities of central banks are as liquid as they can get — demand deposits, and bearer banknotes that are redeemable on demand. As a result, the central bank needs liquid assets if there was demand to reduce its balance sheet.</p><p>The natural match for the liability structure is a fixed income portfolio. And like a private bank, a central bank can have a good idea how many of its liabilities could plausibly be redeemed, so it can get away with extending the duration of its assets somewhat. That is, it has a portfolio of short-dated fixed income assets that it can sell at close to their balance sheet carrying value to meet redemptions, and another portfolio with more duration that could be liquidated slowly if necessary. </p><p>We then run into the question: should the assets be debts issued by the central government or the private sector? What type of fixed income instruments?</p><p>This used to be a controversy, leading to ideas like the “real bills doctrine” (which I am going to let the reader look up on the internet if they are not familiar with it). However, World War II and mainstream economic thinking led to central banks holding balance sheets that were 100% central government bonds and bills, as well as repurchase agreements on those bonds. Then, the Financial Crisis of 2008 hit, and central banks ended up buying a variety of private sector assets (of varying dubiousness) as part of a programme of “de-risking” key parts of the financial system.</p><p>I might return to the debate about the purchasing private sector assets by the central bank later. I will just finish off this line of thought with the concept of <em>seigneurage</em> (which has alternate spellings “seigniorage” and “seignorage”). The rate of interest on currency notes is 0%, as also was the case for required reserves at the Federal Reserve. The central bank is holding a portfolio of fixed income assets that people hope earn a positive rate of interest. This implied that the bank should run a steady profit — at least as long as the New Keynesians with their negative interest rates are kept away from the rate decision committee. This profit was called seigneurage, harking back to the cut the sovereign took when precious metals (including foreign coins) were minted into coins at the royal mint. However, this is not a profit created by the minting of new money, rather it is the carry generated by the central bank portfolio versus its 0%-costing liabilities. (The advent of QE has meant that central banks were forced to pay interest at close to the policy rate on deposits at the central bank, turning them into de facto overnight bills issued by the central bank.)</p><h2>Consolidation</h2><p><em>Consolidation</em> is an accounting term referring to merging the balance sheet of a wholly-owned subsidiary onto its parent company. (Wholly owned means that the parent company owns 100% of the common equity of the subsidiary.) Instead of presenting two balance sheets, the two balance sheets are added together — but with intra-company entries netted out. This netting needs to be done to avoid double-counting entries, and to ignore “ghost debt” that is purely an intra-company affair.</p><ul><li><p>If the subsidiary has $100 in equity, that would show up as a $100 asset on the parent’s non-consolidated balance sheet, which would imply a corresponding $100 in equity in order for the balance sheet to in fact balance. If we just merged all the balance sheet entries, that $100 equity would show up twice, as it appears on both non-consolidated balance sheets.</p></li><li><p>If the parent lends money to the subsidiary (or vice-versa), it might matter for tax purposes or in a bankruptcy, but otherwise, it is the parent company lending money to itself. If the subsidiary defaults on the debt, so what? The parent owns it already.</p></li></ul><p>Any time you pick up the balance sheet of a multinational corporation, you are looking at a consolidated balance sheet. Even bush-league multinationals will end up with thousands of corporate entities across multiple jurisdiction due to the magic of international tax accounting and financial engineers run amok.</p><p>We then get to central banks. Modern developed central banks are wholly-owned subsidiaries of the central government (or almost wholly owned in oddball cases like the Bank of Japan). Under generally accepted financial accounting standards, the central should be consolidated with the central government. This means that intra-governmental debts — like deposits — should be netted out to zero. And for the purposes of economic modelling, we should consolidate since the intra-governmental transactions have no effect on the rest of the economy.</p><p>We can interpret seigneurage in two ways.</p><ol><li><p>If we do not consolidate, the central government issues debt, the central bank buys some in order to supply money, then the central bank returns the carry profits to the central government. This carry offsets some of the total debt issuance.</p></li><li><p>If we consolidate, we just look at the amount of government debt and money held by the private sector, since the central bank’s holdings of government bonds nets out with the associated liabilities of the central bank. The interest expense is reduced relative to the gross issuance of debt, some of which was bought back by the central bank. There is no need to add in “seigneurage income” into projections of government revenue — we just calculate interest expense based on the mix of money/debt held by the private sector.</p></li></ol><p>There is no doubt that consolidation is cleaner and eliminates problems in economic models. One of the issues with mathematical modelling of the economy is that there is a large number of variables to track, and non-consolidated balance sheets add yet more variables. Furthermore, we need to add behavioural relationships that determine the intra-governmental transactions. The problem with that is that those transactions have no effect on the rest of the economy, and so there is no means to pin down those behavioural relationships. </p><p>Please note that the previous statements are less true if the central bank is managing a currency peg. In that situation, the central bank can default (on its redemption pledge), and so we need to model the default process. Similarly, the only reason to care about the non-consolidated balance sheet for a non-pegged currency is if you can come up with a plausible default scenario (which I generally cannot).</p><p>Nevertheless, whether or not one can consolidate the central bank with the central government is a stupid economic debate. The objections generally come from critics of Modern Monetary Theory (even though other people like central bankers will consolidate for convenience) based on crackpot theories or bad faith attacks. As stated, it is a stupid debate — I certainly <em>can</em> consolidate the central bank, because I know how accounting works. Consolidation is not necessary for any conclusions, since a well-defined model will give exactly the same results for the non-governmental variables regardless of whether you consolidate or not. You consolidate because it is easier, and you do not do it if you are worried about the central bank/government defaulting.</p><h2>Up Next?</h2><p>I have run through most of the basics, but I have at least one more background primer before I get to more exciting central bank debates.</p></div><div><br /></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2023Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-62652510579275527002023-11-23T15:03:00.000-05:002023-11-23T15:03:23.466-05:00Central Bank Banking Basics<div><p data-pm-slice="1 1 []"><em></em></p><div class="separator" style="clear: both; text-align: center;"><em><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhf8fUy8oBK3JYWedSth87aBHOigTCleAFKNcntb8xvPDv4u8q5hL3V6Rxi11REyEg5uu8OkkBtEc7-22K6-ZPFibhCyBS3rDLKwsVR5WRbo_0NJyEbt66NcNrzHiMkGiqs9JSxll-qibJozk0cE8tlyav8r_sgBA5QoaO08hJw1ZZigoLj-jlkhgHrQ0c/s80/logo_central_banks.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhf8fUy8oBK3JYWedSth87aBHOigTCleAFKNcntb8xvPDv4u8q5hL3V6Rxi11REyEg5uu8OkkBtEc7-22K6-ZPFibhCyBS3rDLKwsVR5WRbo_0NJyEbt66NcNrzHiMkGiqs9JSxll-qibJozk0cE8tlyav8r_sgBA5QoaO08hJw1ZZigoLj-jlkhgHrQ0c/s1600/logo_central_banks.png" width="80" /></a></em></div><em>This article continues the plan outlined in the previous article “</em><a href="https://bondeconomics.substack.com/p/central-banks-as-banks" rel="noopener noreferrer nofollow" target="_blank"><em>Central Banks as Banks</em></a><em>.” As I described therein, this is projected to become a chapter within my banking primer. I am not going to describe private banking — as that is the job of other chapters — but I will cover the issues of inter-bank transactions. This article is about fundamentals that we normally do not think about.</em><p></p><p>As the name suggests, central banks are at the centre of the banking system. The objective of a well-run banking system is that you do not have to worry about how it works. So long as everything under the hood is operating, you do not need to enquire how the money gets from one account to another. By not worrying about those details, we tend to only focus on the flashy bits of central banking (e.g., trying to hit an inflation target) instead of the banking system regulation part.</p><h2><span><a name='more'></a></span>“Peer-to-Peer” Monetary Exchange</h2><p>We need to step back and ask: why banks? If we assume that we have a monetary economy, why not have a system where individuals and firms directly transfer “money” to each other without intermediaries?</p><p>For some people, this sounds ideal — we have an economy where people pay for everything by handing each other lumps of gold, or directly transferring crypto currencies. However, for law-abiding citizens, this is unattractive — precious metals (and paper claims on safeguarded gold) present theft risk, and making large transactions would be unattractive. (Popular media like the movie Spartacus had the Romans making large commercial transactions with sacks of gold coins; they had the economic equivalent of banks — as discussed in “The Monetary Systems of the Greeks and Romans,” by W.V. Harris.) The inability to sue to recover crypto-currencies makes them also useless for large commercial transactions, as well as poses risks around losing passwords (or heirs not having access to a password).</p><p>Although economic theory suggests that everyone “wants to hold money,” in a sophisticated economy where there is trust among economic actors, people want intermediaries of some sort to hold most of the “money.” This means that most “money” ends up being a credit relationship.</p><h2>One Intermediary</h2><p>The simplest possible system for intermediation is to have a single intermediary. Everyone would hold accounts with that one intermediary, as well as holding bearer certificates (e.g., banknotes) that are convertible to claims on that intermediary.</p><p>This intermediary is almost certainly going to resemble a bank, and the only question is who owns it.</p><ol><li><p>Foreigners: you have adopted a foreign currency. Although this might be acceptable in some countries with poor inflation performance, it is not going to be popular in countries used to economic sovereignty.</p></li><li><p>The private sector. Although some free marketeers might like this, this is not a stable long-term arrangement. This private monopoly intermediary would stand in the way of war finance, and as soon as an existential war risk is faced, that entity would be nationalised.</p></li><li><p>It could be a public central bank — in a system where there are no private banks. This is popular with some people, many of whom comment on my website. I am not in that camp, as I believe that a well-regulated banking system (integrated with non-bank finance) provides the least instability in capitalist finance. (Finance is inherently destabilising, so all we can hope to do is keep the instability somewhat contained.)</p></li></ol><p>Once we exclude these possibilities, we end up with a situation with multiple intermediaries.</p><h2>Multiple Intermediaries Leading To Central Banks</h2><p>If we have multiple intermediaries, we run into an immediate problem. What happens if the two sides to a commercial transaction use different intermediaries? <em>(If they use the same intermediary, then the intermediary just adjusts the two balances without requiring any external transactions.)</em></p><p>We end up with the intermediaries facing the same problem that law-abiding citizens faced: they need to transfer the underlying “monetary asset” between themselves to allow transactions to go across them. If “money” is a precious metal, this means that there will be regular shipments of highly valuable metal, which poses theft risk.</p><p>The way to clear these problems up are to have “senior” intermediaries that clear transactions for smaller ones. Client transactions are cleared through a system of connected intermediaries. There is no requirement that there is a single “most senior” intermediary, but we will now get to reason why developed countries moved in that direction.</p><h2>What is Money?</h2><p> We now need to face the question: what exactly do our monetary units correspond to. There are two cases.</p><ol><li><p>Pegged currency. The monetary unit is pegged to some external unit, either gold, or a hard currency. (Or possibly a gold-linked hard currency.) The value of the local currency is driven by the credibility of the peg, which typically requires holding backing assets (or generating a considerable trade surplus that allows it to credibly draw in backing as needed). Although there is a convenience factor to there being a central intermediary, it is not required.</p></li><li><p>Unpegged currency. The monetary unit is the unit of account on a senior intermediary. Since that senior intermediary can create the unit of account at will, it is going to end up as the “central bank.”</p></li></ol><p>In the second case, there is no requirement that the central issuer of the currency be a government, but it seems unlikely it would be anything else. Historically, we had somewhat out-of-control corporations like The Hudson’s Bay Company that could get away with issuing tokens and maintaining the value of those tokens, but that was really only possible because the Company was acting as a <em>de facto</em> government. Otherwise, only the more gullible members of the public would take too seriously an unbacked private currency. <em>(Although the crypto-currency craze has shown that such people exist.) </em>Meanwhile, the spectre of war finance means that the government will sooner or later be the monopoly issuer of the (base) unit of account (leading into standard MMT primer topics).</p><p>My interest and focus is on developed economies that have non-pegged currencies (with the Franken-currency of the euro being a sort-of exception). Although the mechanics of a pegged and non-pegged currency might be superficially similar (e.g., there was no major domestic shock to operating procedures when Nixon closed the Gold Window), how the systems behave in a crisis is radically different.</p><h2>Wholesale Payments Systems</h2><p>I will now finish off with some general comments about <em>wholesale</em> payments systems. <em>(Retail payments systems — how consumers pay for stuff — is not in my area of interest.) </em>A payments system allows members (typically banks, but lobbyists are pushing for opening up to non-banks) to transmit large blocs of money to each other. </p><p>Each currency bloc has its own system, and there is also the issue of transmitting money to other currency blocs. The systems are complex, and most discussions are aimed at the handful of entities that interact with those systems. Given the variance across jurisdictions and my views on their economic impact, I will not attempt to delve into the subject.</p><p>The key observation is that the payments system is supposed to be a means of transmitting cash from Entity A to Entity B by the end of the day. <em>Assuming everything goes well</em>, all the payments into and out of the payments system net out to zero. As such, the balance sheet of the payments system is supposed to be effectively zero (beyond whatever infrastructure is on its balance sheet). </p><p>The risk that everyone worries about is that a big member fails, and then the payments might not net out to zero. Somebody owes a member money? Who? How is the debt resolved? Given that it is unclear what the bankruptcy judges will say, it is extremely likely that everyone involved would try to freeze transactions — causing a near-instant collapse of the system.</p><p>Since it is clear that a non-deranged central bank would view that as a very bad outcome, the payments system would end being bailed out. That is, the wholesale payments system is too big to fail — and properly should be seen as a contingent part of the central bank’s balance sheet.</p><p>This leads us to the simple (and standard) way of looking at inter-bank transactions: we assume that they are intermediated directly on the central bank’s balance sheet. If Bank A directly wires money to Bank B, we think of it as Bank A running down their settlement balance at the central bank, and Bank B raising theirs.</p><p>There is no need for the balances to be positive during the day. If we take the pre-2020 Canadian system as an example, the target for end-of-day balances was $0. (This is the “simplified system of government finance” that I described in <em>Understanding Government Finance</em>.) That is, the bank starts with a balance of $0, sends and receives money based on client orders (and its own transactions) during the day, and then the bank treasury desk needs to get the balance back to $0 at the end of the day (by undertaking some wholesale transactions). Unlike fairy tales spread by unreliable sources (mainly economic academics), banks do not wait for a positive balance before sending money out — if everyone did that, the system would be frozen at the beginning of the day. </p><p>This system is extremely useful for clarifying thinking: banks are sending “central bank balances” back and forth all day, even though their net holdings at the end of the day are expected to be zero. That is, we cannot look at the balance sheet entry (which are end-of-day) to infer anything about “transaction capacity.”</p><h2>Reserves — Largely an Anachronism</h2><p>One of the unfortunate side effects of American cultural imperialism is that the most popular undergraduate economics textbooks were in fact written by Americans. Balances at the central bank were called “reserves” for the very good reason that there were almost entirely required reserves. Banking regulations insisted that banks end the day with a target settlement balance, with that target based on the size of their deposit balances (based on arcane distinctions between types of deposits). This balance was a “reserve” allegedly against liquidity drains (not to be confused with loan loss reserves). However, since the funds were immobilised, all they really did was act as a tax on the bank back when reserve balances did not pay interest.</p><p>Eventually, the Americans followed the path of other developed countries and effectively abolished reserve requirements. Whether or not people will stop calling settlement balances “reserves” remains to be seen.</p><h2>Up Next?</h2><p>Although I might jump to a completely different topic, I think the next article will be about central bank operations and/or its balance sheet structure.</p></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2023Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-74507378928794528962023-11-21T12:02:00.000-05:002023-11-21T12:02:04.603-05:00Central Banks As Banks<div><p data-pm-slice="1 1 []"><em></em></p><div class="separator" style="clear: both; text-align: center;"><em><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjN_iH1M9Sd9LPNSeO_JgbrOh6JQrikSYp9Eqk2bPEbN5x10-pGEPDh_LzfJpdyfWFwtksoEujSJ3KHiW3Rb-7wyzeHvKlrI6Jmcnr1qCtbA-pXuxtQVLAJj4uNzp5RGij07zSWLA7BvMLUaLb8pPg_i7gDvdhEGW8ULli-sqEN3qrJ5CO6Q99mxlVqREQ/s80/logo_banking.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjN_iH1M9Sd9LPNSeO_JgbrOh6JQrikSYp9Eqk2bPEbN5x10-pGEPDh_LzfJpdyfWFwtksoEujSJ3KHiW3Rb-7wyzeHvKlrI6Jmcnr1qCtbA-pXuxtQVLAJj4uNzp5RGij07zSWLA7BvMLUaLb8pPg_i7gDvdhEGW8ULli-sqEN3qrJ5CO6Q99mxlVqREQ/s1600/logo_banking.png" width="80" /></a></em></div><em>My plan is to write a draft what should become a chapter for my banking book. The inflation manuscript is in good shape (but way behind schedule), but there’s nothing I can publish from it (other than reposting the edited version of articles posted earlier). This article is somewhat lightweight — it might turn into the introductory section, which I normally just keep as a summary of the chapter contents. The advantage of putting this summary out is that it sort-of explains why I might cover some digressions in the first articles.</em><p></p><p>Central banks, as the name suggests, are in fact banks. This rather straightforward perspective was lost in the decades after World War II, when central bankers bought into mainstream thinking and they thought of themselves as “benevolent central planners.” Instead of worrying about mundane distractions like credit risks within the system, the researchers were running around pretending they were 1960s control systems engineers optimally determining the trade off between growth and inflation. Of course, this neglect of banking led to the rather awkward Financial Crisis in 2008, where central bankers suddenly had to get a handle on banking risks once again. Since then, central bankers have been quite vigilant about banking risks — at least the ones that are similar to the last crisis.</p><p><span></span></p><a name='more'></a>I see two major sources of confusion about the relationship between banks and the central bank, that come out of two generic schools of thought.<p></p><ol><li><p>As alluded to earlier, central bank operating procedures changed after World War II. The Anglo Allied central banks were stuffed with government paper (bonds and bills) as part of their role in wartime finance. (Everyone who didn’t default on their debt in the war was stuffed with government paper — debt/GDP ratios were typically 150+%.) The pre-war debates about the role of central banks — e.g., the “real bills doctrine” — were now archaic. Plus, the rise of the neoclassical Old Keynesians means that central banks conceived of their policy space as consisting of setting a policy rate and the number of government bonds/bills it buys — the banking system was literally written out of the models. Instead, the focus was on “money growth” which could allegedly be controlled via the control over the monetary base.</p></li><li><p>People who draw their experience from currencies with pegs — either to gold or a hard currency. Although the gold and crypto enthusiasts remain the largest source of economic misinformation on the planet, relying on pegged currency thinking is widespread. This is not a heterodox/orthodox divide, as some post-Keynesians push pegged currency orthodoxy.</p></li></ol><h2>So What?</h2><p>Although my analysis on the central bank and banking is mainly the result of reflecting upon Modern Monetary Theory (MMT), it is not particularly unorthodox. My view is that quite a few people with different views think there is some magical economic special sauce available from rethinking central banking. My view is that we have a much better chance of understanding what is going on by not falling into the previously listed misleading views, but the economic policy space opened in the real world is not that large. Banking is the art of accounting for where money is, but the economy is driven by money flows — mainly income. Central bankers do not have that much influence on income flows, other than the debated interest rate channel. Meanwhile, fiscal policy is all about income flows, hence the focus on fiscal policy in most MMT primers.</p><h2>Central Banks and Banking</h2><p>The topics of interest I see follow from these points.</p><ul><li><p>The central bank is a bank that the fiscal arm of the government (Treasury, Ministry of Finance), private banks, and foreign central banks do their banking at. Although the Bank of England used to have accounts for non-banks, modern central banks do not compete for retail or business customers. The problem with understanding these operations is the generic problem of understanding how banks operate in general — popular discussion seems to veer between the perspective of a bank’s customers and the bank itself. For example, balance sheet entries often end up on the wrong side of the balance sheet in discussions, since people are thinking about their balance sheet, and not the bank’s.</p></li><li><p>The payments system allows the cash flows between banks to happen. There are a number of problems with discussing payments system. They vary between currency blocs, and they are complex, with only the banks involved with an interest in them. As such, discussion is dominated by experts who want to underline the importance of their expertise. This complexity is offset by the observation that the payments system nets out to zero if it is functioning properly. The only reason to care about the payments system is if it is about to blow up. However, the payments systems experts do not like being ignored, so they blow every single potential hiccup out of proportion. </p></li><li><p>It is extremely unusual for banks to issue their own currency (“bank notes”) in the modern era. They instead exchange their deposits for governmental bank notes. This creates an asymmetry between the central bank and private banks. That said, banknotes are not a major part of modern economies (outside the underground economy), and their importance is overstated in online discussions.</p></li><li><p>The major area of debates revolve around whether the currency is pegged or not. If the currency has a peg, then the central bank ends up in a position that is not radically different than a private bank. However, if the currency is not pegged, the central bank is freed from <em>real</em> obligations, and it is in the position of being able to do whatever it can get away with. This means that any “constraints” it faces can usually be worked around via some form of regulatory/financial engineering — which gets everyone attached to currency peg thinking mad.</p></li></ul><p>The last topic should represent the bulk of the chapter, but I think I need to touch on the earlier ones before I get there.</p><h2>Concluding Remarks</h2><p>If we put aside the debateable effect of interest rate policy, central banking is mainly about ensuring cash flows flow where they are supposed to. So long as central bankers do not completely drop the ball on banking system regulation — which they did going into 2008 — the system should work as expected, and the economic forces that matter are elsewhere. In a country without a pegged currency, financial constraints on the central bank — like its equity level — are only of symbolic importance, and can be worked around. If the country has a peg, then does matter if there is any chance of the peg being broken. These fragmentary remarks should be explained in more detail in following articles.</p></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2023Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-5943704783000956712023-11-15T16:21:00.000-05:002023-11-15T16:21:18.495-05:00"So How Did You Lose Money Buying Risk-Free Bonds?"<div><p data-pm-slice="1 1 []"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgCiyopH_W-WRz_DSw9sYZTIYNtDQ1GjSm436YXD0SI4t4Elyyza2cjt0GmI_c_KHIcAskm35OBuZul5PU050a8s5Klf8DtB4q8dvKVEVgBfpVdtdfxXJ3IUwe1qkak_0tNoFWDic6DbkFDqsQnoQUh71EMKhKIlT20yGDfHdG9_Dt_aV-O6vJahL6fkeY/s80/logo_bond_market.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgCiyopH_W-WRz_DSw9sYZTIYNtDQ1GjSm436YXD0SI4t4Elyyza2cjt0GmI_c_KHIcAskm35OBuZul5PU050a8s5Klf8DtB4q8dvKVEVgBfpVdtdfxXJ3IUwe1qkak_0tNoFWDic6DbkFDqsQnoQUh71EMKhKIlT20yGDfHdG9_Dt_aV-O6vJahL6fkeY/s1600/logo_bond_market.png" width="80" /></a></div>The title of this article is deliberately silly, but there are times where I just need to be deliberately silly. I am not going to discuss why people (like myself, sigh) decided to not cut their bond allocations to zero ahead of the recent Bond Catastrophe, but rather how to judge or even calculate returns based on the most common bond market data — constant maturity yield series.<p></p><p><em>(This article is a bit rushed, since I yet again have family visiting from out of town…)</em></p><h2><span><a name='more'></a></span>Constant Maturity Yield Series</h2><p>The U.S. Federal Reserve (as well as most other developed central banks) publishes a table of constant maturity yield series daily — <a href="https://www.federalreserve.gov/releases/h15/" rel="noopener noreferrer nofollow" target="_blank">the H.15 report</a>. That is, for differing types of fixed income instruments (like nonfinancial commercial paper), there are rates posted by maturity (1-month, 2-month, etc.). These maturities are clean time frames, not things like “9 years, 7 months, and 3 days” if you had to use issued securities. (Swaps are naturally clean maturities since the benchmark tenors are the ones usually quoted.)</p><p></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/a/AVvXsEiv0I-xU-FjyoYmIljbg_N3ud1DYFNdUk9YoY01BuiUHmAshqoZRDnNU6fYXmfqwhAci2cCWwEB0VX7CtXp505seKvusfsnoaz8Vq7c3wEUoYE8txV9X6TD4dvyiW6FsqqTfyAF24rgQDGCVl-FfOWlVQJE-SrvLn4m9AuYRAWb7bwP7kJqu2QrmSTyGQU" style="margin-left: 1em; margin-right: 1em;"><img alt="" data-original-height="712" data-original-width="1210" height="376" src="https://blogger.googleusercontent.com/img/a/AVvXsEiv0I-xU-FjyoYmIljbg_N3ud1DYFNdUk9YoY01BuiUHmAshqoZRDnNU6fYXmfqwhAci2cCWwEB0VX7CtXp505seKvusfsnoaz8Vq7c3wEUoYE8txV9X6TD4dvyiW6FsqqTfyAF24rgQDGCVl-FfOWlVQJE-SrvLn4m9AuYRAWb7bwP7kJqu2QrmSTyGQU=w640-h376" width="640" /></a></div><br /><p></p><p data-pm-slice="1 1 []">Depending on the source, there are different ways of calculating a constant maturity series.</p><ul><li><p>Just use the yield of the benchmark bond at that maturity. The problem with this is that the yield jumps when we switch to a new benchmark.</p></li><li><p>Fit a yield curve through all bonds, then read off the fitted curve at that maturity. (My preference, but you can get benchmark effects, and the fitted curve can be quite different than the benchmark yield, which gets some people mad.)</p></li><li><p>Fit based on bonds in that maturity bucket (which the Fed H.15 uses), which keeps the fit closer to the benchmark yield.</p></li></ul><p>The yield quotes can be thought of as corresponding to the yield on a par coupon bond (<a href="http://www.bondeconomics.com/2015/05/primer-par-and-zero-coupon-yield-curves.html" rel="noopener noreferrer nofollow" target="_blank">link to primer on par coupon bonds</a>). As quick summary, a par coupon bond is bond whose yield matches the coupon rate — which has the effect that the bond price is at par. E.g., if the par coupon rate for the 10-year yield is 4%, then a 10-year bond with a coupon of 4% will have a price of $100 (and a yield of 4%).</p><h2>So How Do You Lose Money?</h2><p>Although government bonds are often described as “risk free,” that really refers to <em>credit risk free</em> — floating currency sovereigns are effectively immune to involuntary default for financial reasons. <em>(Some people disagree with that assessment, but they are incorrect.)</em> Although payments are guaranteed, you still face potential capital losses on the bond ahead of maturity.</p><p>As a reminder, yield up → price down, and vice-versa. When you buy a bond, you can calculate the internal rate of return from the payments based on the initial payment price, and modulo some fixed income yield conventions, that is the quoted yield that corresponds to that price. Easiest way to see how it works is to play with the bond price function that is typically built in to spreadsheet software.</p><p>If bond yields rise after you bought the bond, this implies a higher discount rate, and thus the corresponding price for the bond drops. </p><p>The proper way to calculate returns is with some bond pricing routines. However, we can approximate the return on holding a bond by:</p><p><em>Return = (interest earned over the period — “carry”) + (change in yield)×(modified duration).</em></p><p>The first component is relatively straightforward — just multiply the starting yield by the fraction of a year that the holding period represents. This is a bit annoying for daily calculations (since the holding period changes between weekends, weekdays, and around holidays). There is an issue regarding the reality that bond yield quotes follow funny conventions, but just dividing the yield by 12 for a monthly holding period is going to be a “good enough” approximation in most cases.</p><p>The second term is trickier. There are a few variants of “duration” used in fixed income (and show up in bond fund published statistics), but modified duration<em> (or effective duration, which is the same thing as modified duration for option-free government bonds)</em> is the first order sensitivity of bond returns to changes in yield (that is, the first term to the Taylor series of capital gains as a function of yield). Note that this is an approximation since the modified duration changes as yield changes — so we need higher order terms to calculate the returns properly for large yield changes.</p><p>As noted, the modified duration depends upon the bond yield and its characteristics (maturity, coupon), but is generally below the maturity in years (decreasing as yields increase). At the time of writing, the benchmark 10-year Treasury has an effective duration of 7.91. (the <a href="https://www.spglobal.com/spdji/en/indices/fixed-income/sp-us-treasury-bond-current-10-year-index/#overview" rel="noopener noreferrer nofollow" target="_blank">S&P U.S. Treasury Bond Current 10-Year Index</a> is an index that tracks the 10-year benchmark). The approximation suggests that we would lose 7.91% if the 10-year yield rose by 1% (100 basis points). However, the losses would be less for such a large move — the second order term of the Taylor series (“convexity”) would reduce the loss. Nevertheless, it would still be enough to wipe out more than a year of income.</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhGLcjJ0Nu2wnPwp-DJ9GU-vrmPiY3W5QiBcE9IBpB3QzyhWeb6H-v7HZB4cKiVCMMoqAf4QMfwdkhs1QwUtRKET86HNCYDY17IpGTGUCZ9BTgtOCllY9SHsS6YH_8YdlBD28aNZmlydyvdCuE9lv9T_q-KqyTb5l4NSg31k6wECzfW0XSvzh5gLWJcfHk/s600/c20231115_tsy10.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="400" data-original-width="600" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhGLcjJ0Nu2wnPwp-DJ9GU-vrmPiY3W5QiBcE9IBpB3QzyhWeb6H-v7HZB4cKiVCMMoqAf4QMfwdkhs1QwUtRKET86HNCYDY17IpGTGUCZ9BTgtOCllY9SHsS6YH_8YdlBD28aNZmlydyvdCuE9lv9T_q-KqyTb5l4NSg31k6wECzfW0XSvzh5gLWJcfHk/s16000/c20231115_tsy10.png" /></a></div><br /><p data-pm-slice="1 1 []">I will then just leave the exercise of eyeballing the yield changes on the H.15 10-year Treasury yield chart above to get an idea how much money hapless longs lost since 2020. (The S&P index previously linked gives a more precise view.)</p><h2>Calculating Returns With the H.15 Data</h2><p>It is a fairly standard exercise to calculate total returns for bonds based on central bank constant maturity yield data using the formula above. (One reason to do this is that bond index data is normally quite expensive — only a handful of deep-pocketed investors are really interested in the data.) If one properly accounts for the change in duration as yields change (simplest version is to take the average of start and end duration for each period), the results are going to be close to an index return (which abstracts away from transaction costs). However, there will be some unavoidable gaps due to missing security-level data.</p><ul><li><p>As a new benchmark bond is issued, it typically trades expensive relative to bonds issued earlier. If the “constant maturity” series just uses the benchmark yield, then there will be a change in yields due to the benchmark change that does not correspond to yield changes for other bonds. If the constant maturity uses a fitting procedure, this effect is smaller but still present. Since this effect is happening every benchmark change and the error is the same direction, the error will accumulate over time, with the return proxy being lower than index returns.</p></li><li><p>There is normally a slope to the curve. For example, one might have a period where the 9-year yield is consistently 20 basis points lower than the 10-year. This means that bond yields “roll down” the curve, and there will be roughly 20 basis points per year of capital gains missed if one just looks at the 10-year point.</p></li><li><p>Benchmarks often have advantageous funding rates in the repo market. Although this matters to investors with access to the repo market, index calculations will ignore this effect.</p></li></ul><p></p><p></p><p></p><p>We cannot infer the size of these effects from just the constant maturity yield data, but they generally result in the approximate returns being below index returns. However, if one is comparing returns to other asset classes (equities, cash), these calculation defects are not that significant versus the wide returns spreads between asset classes. They would matter more if one is doing a long-term returns comparison.</p></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2023Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-91541675671490076902023-11-08T07:36:00.001-05:002023-11-08T07:36:58.733-05:00Employment-Population Ratio Revisited<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiEn_1uXmpQK5we0aWTBAXM9BcM5qlxRaYvMPMquu1-Gn2Cc-lwdKbO77QCvDyCJk6AT0-tSHwFrVDiZCLItP6FYItL9EUI_sVluX9uDRBfe3mlkSHVkLzxa_hN6NTt9_SD5L0n9C5EbEbm6qSC22C192jSEed7_QhlReUWZY-K1UdDlSfQHZtl969S-3I/s600/c20231107_us_emratio_all_cohorts.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="500" data-original-width="600" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiEn_1uXmpQK5we0aWTBAXM9BcM5qlxRaYvMPMquu1-Gn2Cc-lwdKbO77QCvDyCJk6AT0-tSHwFrVDiZCLItP6FYItL9EUI_sVluX9uDRBfe3mlkSHVkLzxa_hN6NTt9_SD5L0n9C5EbEbm6qSC22C192jSEed7_QhlReUWZY-K1UdDlSfQHZtl969S-3I/s16000/c20231107_us_emratio_all_cohorts.png" /></a></div><br /><div>I have been writing some manuscript comments about labour market capacity constraints and inflation, which I hinted at in my previous article. One tangent that came up that will not fit the manuscript is the behaviour of the employment-to-population ratio. Although the argument that the “labour market overheating is a major component of sustainable domestic inflation” is quite plausible, the problem is defining “overheating.” If we want to tell stories about the back history, we can pick and choose data as we wish. But it we want to make quantitative forecasts — which is what you need for a falsifiable theory of inflation — you need some variables to feed into your model.</div><div><p><span></span></p><a name='more'></a>The most popular model input variable historically was the unemployment rate, and it was part of the original “Phillips Curve” of Bill Phillips (although “Phillips Curve” has transmogrified into meaning almost any linkage between labour markets and inflation). The employment-to-population ratio (which I am mainly focussing on herein) was not popular historically because it moved a lot as women entered the workforce. As seen in the top panel of the chart above, we see the pronounced upwards trend from the 1960s to the 1990s. And in the post-2000 period, the ageing population means that there the older cohorts with early retirees drags down the workforce as a percentage of the total 18-65 year old population (which is what the chart above is based on). <p></p><p>The unemployment rate appears to correct for these structural changes — it is the percentage of the population that is looking for work. People who are not looking for work — stay-at-home spouses, people on disability payments, students, retirees, rich people — are not counted as part of the workforce. This explains why the unemployment rate is much smaller than 100% minus the employment-to-population ratio.</p><p>The problem with the unemployment rate is that is also affected by structural changes to the economy. (The count of claimants for unemployment insurance was affected by tightening of unemployment insurance policies, but that theoretically should not affect the unemployment rate determined by the BLS survey.) The argument made in the 2010s (which I agreed with) was that the labour market was stagnant, and people drifted out of the official “looking for work” status. They either stopped looking (because they knew there was no chance of being hired), or they entered into educational schemes (of varying quality), or else ended up taking jobs that offered less hours than they desired. Thus, there was increased interest in alternative labour slack measures — other than the people who were convinced that the economy was going to overheat “any minute now” throughout the entire 2012-2020 period. As jobs were created, people drifted into the workforce at roughly the same pace, and so the number of unemployed did not go to zero.</p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgLg0Q0mIaQpXl8prtm5k-oqUAGMuta-4gNDArhyphenhyphenIqPJgtyxhTsT7uCjVGaoplf_QwdGSYnD3GkXaIcYRN1TXdv3sDQRwoddwpFM7CxalUo3jqBfqw8BAzz5x2lwWAMiqJODkTsthL9uM8s8xOPrV6J5o7GMZ8ufElTVrStH5ULDIMEcm3yUzxgu6HdOZs/s600/c20231107_us_emratio.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="400" data-original-width="600" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgLg0Q0mIaQpXl8prtm5k-oqUAGMuta-4gNDArhyphenhyphenIqPJgtyxhTsT7uCjVGaoplf_QwdGSYnD3GkXaIcYRN1TXdv3sDQRwoddwpFM7CxalUo3jqBfqw8BAzz5x2lwWAMiqJODkTsthL9uM8s8xOPrV6J5o7GMZ8ufElTVrStH5ULDIMEcm3yUzxgu6HdOZs/s16000/c20231107_us_emratio.png" /></a></div><br /><div class="separator" style="clear: both; text-align: left;"><p data-pm-slice="1 1 []">If we just look at the “prime age” (25-54 years old) cohort — which lops off the university and early retirement ages — we got a better picture of the state of the labour market. We just need to compare to post-1990 levels, since the effects of “Women’s Liberation” had largely made there way through the prime age cohort by then. Using this measure, ratio is near the pre-pandemic level, but below the 2000 boom level. </p><p>Since I am not offering a forecast for inflation, I will not comment further on the implications for what is happening next (are we truly running out of available workers?). Instead, I just want to point out that this measure made a lot more sense explaining the post-2000 dynamics than the unemployment rate, which misled a lot of people in the previous cycle. From an inflation theory point of view, the break down of various capacity metrics in response to structural changes in the economy makes it difficult to test quantitative models. An indicator might work in one cycle, but it might break down 1-2 cycles later, which is not that surprising given that recent business cycles are about a decade long.</p></div></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2023Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-51972885609580721272023-11-01T10:47:00.000-04:002023-11-01T10:47:35.654-04:00No, QE Is Not Costless<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiieirHTtmIuSy-yHww_kaiulG_cEf_7RdDH52BHS4fs_OR_s062dmFMQFX-fqnZTnIpT9UUYfQXwymCXnOX94YZ-f8Av11Bii1gxJBy01JecxJ1cdDf7nF4XngUU6x5uO3g6HU9g1Rdnu1YV106HNFXP8vXD5Js8ftl3hO28hgM23Ug_lNGev830T5dEM/s600/c20231101_fed_balance_sheet.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="400" data-original-width="600" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiieirHTtmIuSy-yHww_kaiulG_cEf_7RdDH52BHS4fs_OR_s062dmFMQFX-fqnZTnIpT9UUYfQXwymCXnOX94YZ-f8Av11Bii1gxJBy01JecxJ1cdDf7nF4XngUU6x5uO3g6HU9g1Rdnu1YV106HNFXP8vXD5Js8ftl3hO28hgM23Ug_lNGev830T5dEM/s16000/c20231101_fed_balance_sheet.png" /></a></div><br /><div><p data-pm-slice="1 2 []">I ran across a couple lame attempts at blaming the U.S. Treasury for not extending the duration of issuance during the pandemic low in yields. This is entirely typical for market commentary — going after fiscal policymakers and ignoring the major culprit, which is the central bank. To the extent that the United States has put itself into an awkward macro stabilisation situation with respect to interest rate expenditures, it is the result of the brain trust at the Federal Reserve.</p><p><span></span></p><a name='more'></a>One could try arguing that if the Treasury lengthened issuance maturities and the Fed buys those bonds back, the Treasury has locked in their funding cost and that is all that matters. The problem is that approach ignores that the Fed is a wholly-owned subsidiary of the Treasury<a class="footnote-anchor" data-component-name="FootnoteAnchorToDOM" href="#footnote-1" id="footnote-anchor-1" target="_self">1</a>, and so when the Fed blows itself up on hare-brained levered rates positions, the Fed losses will work its way into the fiscal accounts via reduced dividends. Financial accounting consolidates wholly-owned entities for a reason.<p></p><p>I will accept that there might have been a “market functioning” argument behind the initial wave of purchases. However, once the initial shutdown panic subsided, there was no need for the Fed to keep gorging its balance sheet with assets. At best, these purchases lowered long-term yields by 50 basis points or so — magnifying everyone’s capital losses (private sector as well as the Fed) on the way up. Yay.</p><p>Meanwhile, the Fed managed to inflict “fiscal dominance” upon itself, where “fiscal dominance” was the big bugbear of neoliberals. By shortening the duration of the liabilities of the consolidated Federal government, interest payments now have a much greater sensitivity to the policy rate. Unless you want to pretend that the multiplier on interest spending is zero, that is going to counteract the alleged braking effectiveness of rate hikes.</p><p>It is completely typical for the Fed to take credit for things that they probably did not do, while studiously avoiding blame for their own policy blunders. They are aided and abetted in this stance by prominent economists who do not want to lose their Jackson Hole invite. About the only people who questioned the balance sheet expansion are the hard money cranks who have been continuously wrong about the inflationary impact of the policy.</p><div class="footnote" data-component-name="FootnoteToDOM"><a class="footnote-number" contenteditable="false" href="#footnote-anchor-1" id="footnote-1" target="_self">1</a><div class="footnote-content"><p>Cranks make a big deal about bank ownership of “shares” in the regional Fed banks; however, those are preferred shares.</p></div></div></div><div><br /></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2023Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-35768203363586697162023-10-27T09:55:00.001-04:002023-10-27T09:55:08.733-04:00Inflation Theories<div><p data-pm-slice="1 1 []"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiuxNKncyT7xZEyCqI4fyx2TGNRKoHkwIP1_DcYn3_mN4gh7HC67PmJ6m2LwDPZkTZBed_KdOWQdQrsF5OjuWxoq8dXxeM-MLtVSC0T3VYyX9pqwd1VHW48dtW4gyP_rwuhyphenhyphenbQGOavLLPQuS0OaLqsTCdcQ38h4Lwhqd91BFlo8o0tgwIjvTaKBt5DKrdU/s80/logo_inflation.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiuxNKncyT7xZEyCqI4fyx2TGNRKoHkwIP1_DcYn3_mN4gh7HC67PmJ6m2LwDPZkTZBed_KdOWQdQrsF5OjuWxoq8dXxeM-MLtVSC0T3VYyX9pqwd1VHW48dtW4gyP_rwuhyphenhyphenbQGOavLLPQuS0OaLqsTCdcQ38h4Lwhqd91BFlo8o0tgwIjvTaKBt5DKrdU/s1600/logo_inflation.png" width="80" /></a></div>I have been editing sections of my manuscript, and nothing out of that writing output is publishable here (since it is just a rehash of an earlier article). However, I am adding a new section on inflation theories that I will need to think about. This article summarises what I think I will cover.<p></p><p>My manuscript is somewhat unusual in that I am mainly discussing the “known properties” of inflation, without offering a theory of inflation. The more usual situation is that people have extremely strong views on what explains inflation (and more often than not, these views contradict “known properties” of inflation). I decided to not cover inflation theories on the basis that it somewhat difficult to get good introductory information due to the huge mass of disinformation. By avoiding theory, the manuscript statements are relatively safe to make, and so my manuscript itself hopefully stays out of the “disinformation” category.</p><p><span></span></p><a name='more'></a>Note that I when I refer to “inflation theory” I mean “a means to predict future inflation rates” and not things like “how to calculate inflation?” or “what are the side effects of inflation?” Furthermore, when I refer to “inflation” I have the annual rate of change of CPI (or equivalent) in mind.<p></p><p>I split “inflation theories” into two categories:</p><ol><li><p>attempting to explain the inflation aggregates with aggregated economic time series (unemployment, money supply, etc.); and</p></li><li><p>attempting to model the components of the CPI index on a component-by-component basis.</p></li></ol><p>(The two categories blur somewhat if the analyst throws out part of the CPI basket, and does something like just try to predict core CPI.)</p><h2>Aggregated Models</h2><p>There is a great variety of aggregated models, but they tend to be based on a few common themes. The ones that I see most often are in the following categories.</p><ul><li><p>Labour market variables being the main input (typically) the unemployment rate. Often lumped under the “Phillips Curve,” but that is slightly confusing since “the” Phillips Curve is just one particular relationship.</p></li><li><p>“Output gap” models that are based on the rate of growth of (typically real) GDP versus some sort of “speed limit.”</p></li><li><p>Indicator-based approaches (i.e., throwing a number of variables into a statistical blender and ending up with a model output that is supposed to track inflation). To the extent that growth indicators are the inputs, this is an attempt to proxy the output gap. If the inputs are prices, it is an attempt to get a lead on the CPI release, but since you are using some rising prices to explain others. it is not really an “explanation” of rising prices.</p></li><li><p>Money growth.</p></li><li><p>Fiscal theories. The most common is the (almost) mainstream Fiscal Theory of the Price Level (FTPL), but there is also the “price level determination” model of Modern Monetary Theory (MMT). I do not see many attempts to treat the MMT model as anything other than proving an abstract theoretical point, and so it would mainly be FTPL adherents trying to predict inflation based on their theory.</p></li><li><p>Models based on “inflation expectations.” which poses other issues (discussed below).</p></li><li><p>Post-Keynesian conflict inflation theories which are aggregated, but tend to be less quantitative in presentation.</p></li></ul><p>If we were to approach economics like the physical sciences, we would simply evaluate the quantitative outputs of the models on a quantitative basis. Of course, that is not what ends up happening. In practice, the quantitative models stink or else are “proprietary” and outsiders have no idea where the alleged model output comes from. But, many of the models are part of rigid world views (most notably, anyone who looks at money growth), and so there is a continuous effort to add epicycles or redefine reality to get the preferred model to “work.”</p><p>The closest to somewhat successful quantitative predictions of inflation come from central bank staffs. However, despite pretty much every one involved being highly invested in quantitative economic modelling, their forecasts are not normally generated by a single model — it is a large effort with a lot of different models. And in the cases where they use a “single model” there tends to be a lot of fudging around with the model parameters to steer it in the desired direction.</p><h2>Anything Involving Inflation Expectations</h2><p>A lot of theories/models involve “inflation expectations,” but I cannot recall the economist fraternity being concerned with some rather obvious problems with using them to predict inflation. Since most of us are not the representative household in a neoclassical model, we do not know the level of “inflation expectations” in the economy. Rather, we are stuck with inflation surveys. There are two main types.</p><ol><li><p>Surveys of households. These surveys tend to pick up gasoline spikes and whether inflation has made more coverage in the financial press.</p></li><li><p>Surveys of forecasters/economists. The problem with using this measure is: where exactly are the forecasters getting their forecasts from? Why not use whatever that source is to forecast inflation? It also raises the thorny problem: why wouldn’t forecasters at least occasionally be able to forecast inflation (normally classified as a lagging economic indicator) reasonably well? If inflation forecasts have no predictive value whatsoever, why are these forecasters still employed?</p></li></ol><p>Meanwhile, we run into another conundrum: even if inflation expectations is a major driver of inflation, we have just changed the forecasting exercise from predicting inflation to predicting inflation expectations. Is that really an advance?</p><h2>Non-Aggregated Theories</h2><p>My preference is for non-aggregated inflation modelling, but the general approach has drawbacks. It is not academically respected for a number of reasons — and I would agree with the negative assessment if I somehow found myself as an economics academic. (Luckily, I am ex-control systems academic.) There are too many ways of knitting models together, and so it is very hard to test them. There is also the question of components not being internally consistent. However, one major complaint would be that they are not tied to a favoured modelling strategy, like neoclassical DSGE models.</p><p>These models are not going to favoured by many producers of economic/financial commentary because they cannot fit their hobby horses (“money printing!”) into them. At most, you can have people who are mad about some part of the economy — like house prices — can just talk about that component, and they do not care about the rest of the CPI.</p><h2>Concluding Remarks</h2><p>We can often guess what is going to happen to the inflation rate based on events. For example, it was not hard to see that there would be a rise in prices as a result of the pandemic restrictions matched with fiscal income support measures. The issue is being able to confidently make quantitative predictions. The confidence of forecasters generally outstrips the quality of models.</p></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2023Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com4tag:blogger.com,1999:blog-5908830827135060852.post-28612885668095640602023-10-19T11:22:00.000-04:002023-10-19T11:22:26.103-04:00"Paying For Two Wars"<div><p data-pm-slice="1 1 []"></p><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhGOpbnMk1gm2i-_eAiI_aZNmRkuz_-UxSFX92BWglE9mkjh0ESLW5y-n3FkFCoIsqqUDw0Fel6WF7P0ALkL20w8qigG8XVEB5HvQHZIoDYjPEzUVsI0YbAx3m9Wnbjnp-3LDM8QEciA-OBuaBPQkX-uiWzRoOAwkFbc_WauluZoaB-5tD8hscFYtlg50I/s80/logo_MMT.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhGOpbnMk1gm2i-_eAiI_aZNmRkuz_-UxSFX92BWglE9mkjh0ESLW5y-n3FkFCoIsqqUDw0Fel6WF7P0ALkL20w8qigG8XVEB5HvQHZIoDYjPEzUVsI0YbAx3m9Wnbjnp-3LDM8QEciA-OBuaBPQkX-uiWzRoOAwkFbc_WauluZoaB-5tD8hscFYtlg50I/s1600/logo_MMT.png" width="80" /></a></div>Comments by Treasury Secretary Yellen and President Biden about “paying for two wars” has attracted some chatter. <a href="https://adamtooze.substack.com/p/chartbook-246-how-america-can-pay">For example, Adam Tooze just wrote an article on it.</a><p></p><p>As Tooze notes, saying that America is paying for two wars is a particularly bad framing for support for Ukraine and Israel. A good portion of United States aid is shipping “obsolete” weaponry (admittedly not as obsolete as Russian 1950s era equipment that is showing up on the front line), the offloading of which saves the United States the expenditures associated with decommissioning it. The United States is not going to have combat personnel on the ground under most plausible scenarios, and so the usual disruptive effects of a war are not present for the United States. </p><p><span></span></p><a name='more'></a>What is more interesting how Yellen — who loves talking about budget constraints on fiscal policy — suddenly sounds more like a Functional Finance fan when discussing warfare. Tooze puts the political implications this way:<p></p><blockquote><p>The insights of left Keynesianism, MMT et al are generally taken to be liberatory, freeing democratic politics from the shackles of fiscal rules, cases in point being America’s debt ceiling or Germany’s “debt brake” (Schuldenbremse). What actually constrains our choices, are the scarcity of economic resources, available technologies and our ability to reach political agreement. Questions of finance and “affordability” are secondary, organizational and technical matters. They reduce to matters of law and accounting. These are not trivial. They have their own institutional ramifications. But they are malleable.</p><p>This may be liberatory, but it also raises the political stakes. If we espouse the Keynesian vision we can no longer appeal to budgetary constraints to rule out options of which we disapprove. If one side favors war, or even two wars, or three, fiscal arithmetic does not stand in the way. What does are ethics, or politics or raison d’état.</p></blockquote><p>I would argue that political situation for the left is more awkward. The centre-right will always bash the left for being irresponsible if they do not toe the line that fiscal budget constraints must be respected at all times. Meanwhile, “hard budget constraints” turn into “squishy aspirations” if the right wants either to spend on the military or cut taxes. This leaves the left with two options: either accept fiscal orthodoxy and try to win elections on the argument that the other side is being hypocritical, or hop into the Modern Monetary Theory camp and argue that the only real constraint is the tolerance of inflation. Of course, the establishment centre-left is generally going with the first option, and is discovering that electorates do not really care that much about hypocrisy.</p><p>People who approach politics with a strong economic theory bias are doomed to disappointment. Various strands of leftism have been toiling in political failure for decades. On the right, fiscal conservatives are invariably disappointed by their centre-right compatriots when they get in power and axe tax rates. The science of democratic politics is coalition building, and the purity of economic thought is trumped by the need to win elections.</p><p></p></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2023Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-7956706031724552952023-10-17T09:20:00.001-04:002023-10-17T09:20:36.948-04:00Slopes And Recession Probabilities<div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiC2M21soo7XDQ2_tSK8bMyk8I4PPecn8G2xFQg5vA3Wp9Qjz5PBO9PKjVc4LbKFfxysIHMWzm7_gODV5EnzGerqT9qur8UKLzsAtJECjF-FWxq5IyzAu7zadF8q-hrTrkVM9Q0Xvmsd92FGsopGwAapOmyZ7cJAgyzEUE7TTCTVgmxfHx_TcNBwKLi0CQ/s600/c20230926_fed_tsy_slope.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" data-original-height="500" data-original-width="600" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiC2M21soo7XDQ2_tSK8bMyk8I4PPecn8G2xFQg5vA3Wp9Qjz5PBO9PKjVc4LbKFfxysIHMWzm7_gODV5EnzGerqT9qur8UKLzsAtJECjF-FWxq5IyzAu7zadF8q-hrTrkVM9Q0Xvmsd92FGsopGwAapOmyZ7cJAgyzEUE7TTCTVgmxfHx_TcNBwKLi0CQ/s16000/c20230926_fed_tsy_slope.png" /></a></div><br /><p data-pm-slice="1 1 []"><br /></p><p data-pm-slice="1 1 []">Menzie Chinn just published a short note “<a href="https://econbrowser.com/archives/2023/10/inversions-bear-steepening-inversions-and-recessions" rel="noopener noreferrer nofollow" target="_blank">Inversions, Bear Steepening Dis-Inversions, and Recessions</a>.” He was responding to an article that argued that a bull steepening is a good sign for the economy, as it indicates less need for the Fed to cut in response to a recession. Chinn updated some recession probability indicators based on the yield curve.</p><p><span></span></p><a name='more'></a>I have written about using yield curves as recession indicator in the past, and I just wanted to chime in the implications of a bull steepening. <p></p><p>I recently published the above chart, which is not a typical slope chart for fixed income commentary. The 2-/10-year slope is more popular for one important reason: it is a tradeable “instrument,” unlike the Fed Funds/5-year slope (above), as the Fed Funds leg has no duration. However, moving the short maturity leg to a tradeable instrument like the 2-year misses the important information embedded in the Fed Funds to 2-year slope. Although some people did use the 2-/10-year for recession forecasting, the tendency has been to shift to the 3-month Treasury Bill as the short maturity instrument. (The advantage of the 3-month bill is that it is a “market rate” and it exists as a time series in databases typically over the same horizon as bond yields, whereas other money market rates are based on instruments of more recent vintage or did not exist as a concept — for example, the Fed did not announce a target for the Fed Funds rate until the 1990s).</p><p>Chinn looked at variety of probit models that are meant to back out a probability of recession events based on the slope (and calibrated against historical recession dates). As I do not have a source for a model output handy (readers can click the link to see Chinn’s chart), I will just note that the level of inversion we see in recent data is similar to that around past recession events, and so the estimated recession probabilities are quite high. (Chinn lists model outputs that range from a 66.4% to 90.8%.) </p><h2>Bull Versus Bear Steepening</h2><p>One of the pieces of bond market jargon that showed up in the piece was “bear steepening” versus “bull steepening.” For people who read economic commentary and just look at the slope, the terms are somewhat mystifying. The reason is we need to look at the level of yields, and not just the slope (like in the above chart.) There are two axes to discuss.</p><ul><li><p>Bull/bear: whether bonds are in a bull/bond movement. Since bond prices move in the opposite direction of yields, a bear market is yields going up, while bull market is yields going down. <em>Note that bond yields beyond the 2-year point tend to all move in the same direction, but it is technically possible that the short and long maturities move in the opposite direction. The direction of the yield change of the long maturity instrument presumably determines whether it is a “bull” or “bear” move. Since it does not happen very often, not sure how others would classify that.</em></p></li><li><p>Steepening/Flattening: is the slope (long maturity yield minus the short maturity yield) going up or down.</p></li></ul><p>So the slope is increasing recently (as seen in the bottom panel) while the long maturity is rising: hence, a bear steepener. Since this means that the 5-year is discounting less cuts (putting aside term premia quibbles), that is directionally bullish for the economy. However, this easy interpretation does not work for the 2-/10-year slope: if the 2-year yield is falling, that indicates a rising expectation of near-run rate cuts (or less hikes). </p><p>The bond/bear steepener/flattener distinction is also important for fixed income commentary in that it is possible to structure conditional curve trades. By using a pair of payer/receiver swaptions, one can enter a flattening/steepening trade that is only active in a bull or bear market. This is a good way to express conditional forecasts: you think that markets will behave a certain way if an event happens, but you do not have a strong view if it does not. Since the front end typically moves faster than the long end, one would be biased to enter bear flatteners or bull steepeners — but implied volatility normally prices in that behavioural bias, and so it is not enough to be correct on the direction of the change of the slope, you need to beat a hurdle level that is determined by the forwards and the implied volatility differential.</p><h2>Probit Models are Great for Economists, Not So Much For Bond Investors</h2><p>I have never built one these probit models on the view that I am not in the target market for the models. They are designed for economists (like those at central banks) who want to have a way of reading “what does the bond market price in for the economy?” beyond just slapping the slope chart up and pointing out that inversions tend to happen before recessions. Being able to say that the market is discounting a 90.8% or 66.4% chance of a recession makes it look like your doctorate is paying dividends.</p><p>From the perspective of a bond investor, one can attempt to invert the usual logic: do I think there is an x% chance of recession over the next year? If I think the odds of a recession are much lower than that, then I want to be bearish on bonds. Unfortunately, this is probably only useful when the probability is quite high (like now) — where you do not need a fancy model to offer the insight that bonds are expensive in the absence of a recession. If the implied probability is 20%, there is probably not a lot of useful valuation information if I think the probability only 5%. You need to look at other valuation metrics.</p><p>A larger issue is that bond market pay-offs are not given from whether the NBER committee decides there was recession, rather they are based on where yields end up relative to forwards (driven by the cost of funding). What ultimately matters is the realised path of the short rate, not the economy. The bond market correctly priced in the mini-cut cycle ahead of the pandemic, but whether the pandemic recession was truly “priced in by the bond market” is a tiresome debate.</p><p>Another thing to keep in mind with these models is that the probability estimation is not going to cope with a changing term premium. One of the common habits of finance professionals is that they want to grab as many mathematical models as possible, and are happy to quote them without worrying about their internal consistency. For example, one should not rely on probit model recession probabilities and at the same time argue slope changes are the result of changing term premia unless you adjusted the slope for your term premium estimate. </p><h2>Concluding Remarks</h2><p>From the perspective of someone not deeply interested in bond market pricing, probit recession odds models are neat way of summarising market pricing. However, one needs to keep in mind that this is just the weighted average of investor positions, and not some time series that pops magically out of nowhere. Investors can be wrong, and/or there can be other technical factors “distorting” yields.</p></div><div><br /></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2023Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0tag:blogger.com,1999:blog-5908830827135060852.post-11829023579249647972023-10-10T12:21:00.003-04:002023-10-10T12:21:32.489-04:00Comments On Logan Speech<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjKaIdWQg_rHlpnc7-xyNgq3E8eKp2mKh8Sjwj72vJQIib9voGfG-LxvlX0UaASBnOuSYIrF1fVsSfaZ1q_ylq68fywmpOvnj2e0n11ANVaRwZIU_QaIzuhfdOkRtyg9m13PdesyU5fqCJf_6oxhXsx0QXeyqpgV4nvxOFlHalBPM4U03XPuMkvBFGPvWo/s80/logo_bond_market.png" imageanchor="1" style="clear: left; float: left; margin-bottom: 1em; margin-right: 1em;"><img border="0" data-original-height="70" data-original-width="80" height="70" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjKaIdWQg_rHlpnc7-xyNgq3E8eKp2mKh8Sjwj72vJQIib9voGfG-LxvlX0UaASBnOuSYIrF1fVsSfaZ1q_ylq68fywmpOvnj2e0n11ANVaRwZIU_QaIzuhfdOkRtyg9m13PdesyU5fqCJf_6oxhXsx0QXeyqpgV4nvxOFlHalBPM4U03XPuMkvBFGPvWo/s1600/logo_bond_market.png" width="80" /></a></div><p data-pm-slice="1 1 []">Lorie Logan of the Dallas Fed gave a recent speech in which the term premium figured. Although I think Logan’s remarks are fairly innocuous, I saw some chatter that extended to a “oh no, fiscal!” story.</p><p><a href="https://www.dallasfed.org/news/speeches/logan/2023/lkl231009" rel="noopener noreferrer nofollow" target="_blank"><span></span></a></p><a name='more'></a><a href="https://www.dallasfed.org/news/speeches/logan/2023/lkl231009" rel="noopener noreferrer nofollow" target="_blank">In the speech</a>, Logan ran through the difficulties with measuring the term premium, and various approaches to the topic. She concluded with:<p></p><blockquote><p>So, what does this mean for monetary policy? As I said earlier, inflation remains too high, the labor market is still very strong, and output, spending and job growth are beating expectations. I anticipate that we will need continued restrictive financial conditions to return inflation to 2 percent in a timely way and sustainably achieve our goals of maximum employment and price stability.</p><p>Financial conditions have tightened notably in recent months. But the reasons for the tightening matter.<strong> If long-term interest rates remain elevated because of higher term premiums, there may be less need to raise the fed funds rate. However, to the extent that strength in the economy is behind the increase in long-term interest rates, the FOMC may need to do more. [Emphasis mine] </strong>So, I will be carefully evaluating both economic and financial developments to assess the extent of additional policy firming that may be appropriate to deliver on the FOMC’s mandate.</p></blockquote><p>I noted in a recent post that one of the joys of term premium models is that by decomposing yield changes into two components, it is a lot easier for commentators to spin yarns about what they mean. This speech provides yet an other example of this. For a boring person like myself who believes that the term premium is small and stable, the recent rise in yields is just the market partly throwing in the towel on a recession call. However, with term premia, we get more ways to interpret what happened. Having more ways to interpret the past does nothing useful for anyone attempting to forecast markets, but it is useful for commentators who want to push narratives.</p><p>One of the interesting parts of the speech is that Logan only referred to the rise in Treasury yields, and threw the inversion of the curve under the bus. Apparently, market forecasts indicating that the Fed has already made a policy mistake are not popular in Dallas.</p><p>Trying to turn an alleged recent rise in the term premium — which other commentators have tried — is an example of fiscal conservatives being desperate for material. It is extremely hard to see why anyone in their right mind should be concerned about long-term yields that are trading below the overnight rate. Furthermore, saying that there are long-term implications from the change in the term premium over the past few months is a stretch. If it is that erratic, why not just wait a few months to see whether the model changes its mind?</p><p><em>I have not been publishing much recently as I was first visiting family and then had relatives from overseas visiting. I should be back to a more normal schedule after this week.</em></p><div><br /></div>Email subscription: Go to <a href="https://bondeconomics.substack.com/">https://bondeconomics.substack.com/</a> <div><br /></div>
(c) Brian Romanchuk 2023Brian Romanchukhttp://www.blogger.com/profile/02699198289421951151noreply@blogger.com0