Wednesday, May 13, 2009

When you buy a Burberry bikini, what you are buying is not a tartan bikini but a promise of exclusivity

From Worthwhile Canadian Inititiative:

"Good News! Interest rates rise.

This Bloomberg story reports the Fed saying that rising bond yields are a good sign. They don't precisely say that monetary easing is what caused the rise in interest rates; they are perhaps too modest to claim credit? But I will say it for them: by buying bonds, and easing monetary policy, the Fed has caused the price of bonds to fall, and interest rates to rise. Yep, an increase in demand for bonds causes the price to fall.

How does an increase in demand for something cause the price to fall? This could only happen if the increase in demand by one buyer caused other buyers to reduce their demand.

I can think of examples where this might happen. I remember a recent case where an "Essex girl" appeared on a British reality TV show wearing a Burberry bikini, and thereby ruined the Burberry brand image. This reduced demand for Burberry from everyone else.

Why are central banks buying bonds like an Essex girl buying a Burberry bikini? Isn't their money as good as anyone else's?

Well, no, it isn't. A central bank's money is actually better than anyone else's. That can't be the problem.

This is the problem. When you buy a Burberry bikini, what you are buying is not a tartan bikini but a promise of exclusivity. When you buy a bond, what you are buying is a promise of money in the future, and the value of that future money depends on its exclusivity. When a central bank buys a bond, and thereby increases the stock of money, it is doing something that other buyers of bonds don't do. The money will be worth less in future, and so the bond is worth less too. When Essex girl buys a Burberry bikini she lowers the fundamental value of Burberry bikinis. When the central bank buys a bond, with new money, it lowers the fundamental value of the bond.

Try telling that story without mentioning the supply of money, you Neo-Wicksellians!

This is the same argument I have been making in the past. It's not so much "I told you this would happen"; it's "I told you this ought to happen". Low nominal interest rates can be seen as a sign of tight money as much as easy money.

Quantitative Easing, like any policy to increase Aggregate Demand, is strongly reinforced if it can create the expectation it will work, both by increasing expected inflation, and by increasing expected output growth. And this makes nominal interest rates a poor choice as a monetary policy control instrument. If the central banks wants to make monetary policy easier, it tries to lower interest rates, by buying bonds. But if it is seen as successful in making monetary policy easier, and increasing AD, it will be raising nominal interest rates. This makes it very hard for the market to interpret changes in interest rates. And this makes it very hard for the central bank to generate that cumulative self-reinforcing confidence that the policy is working. "Look, I'm pushing the lever down, and it must be working, because the lever is moving up!"

That confusion in interpreting the rise in interest rates is reflected in the last part of the Bloomberg story:

The situation poses a “dilemma” for the Fed, because if the rise in yields reflects “erroneous market views” about the economy, it will hold back growth, said former Fed Governor Lyle Gramley.

“The Fed is probably scratching its head at the moment and will wait and not react until the smoke clears,” said Gramley, who is now a senior economic adviser with New York-based Soleil Securities Corp.

There are the Fed's "market views", the bond market's "market views", and firms' and households' "market views" when they make consumption and investment decisions. The danger is if the bond market thinks the policy is working, and expects higher inflation and real output growth, but firms and households don't. The bond market raises nominal interest rates, because it sees the IS curve as having shifted as a function of the nominal interest rate. But if households and firms stay pessimistic, and don't share the bond market's views, consumption and investment will fall.



Me:

I thought that the plan of QE was to keep short term interest rates low, giving investors an incentive to invest in other higher yielding pursuits now, and have longer term interest rates rise, showing that deflation is being defeated and signaling a recovery in the future when rates will have to go up. In other words, QE attacks the Fear and Aversion to risk with short term incentives and longer term confidence. As far as I can tell, it's working pretty well, if slowly. Posted by: Don the libertarian Democrat

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