Typically, a steep yield curve is a sign of a strong recovery, but there is nothing typical about current monetary policy.

From Antonio Fatas and Ilian Mihov on the Global Economy:

The yield curve and the credibility of central banks

An increase in the yield for 10 year bonds put the yield curve in the US at one of its steepest since the mid-70s raising concerns about the evolution of long-term interest rates and the effect that they might have on the economic recovery. From Bloomberg, you can see that there are two ways to interpret the increase in the yield: Timothy Geithner thinks this is a good sign

Geithner also said that the rise in yields on Treasury securities this year “is a sign that things are improving” and that “there is a little less acute concern about the depth of the recession.”

Others see this as a sign of concern

Gross said in an interview today on Bloomberg Television that

while a U.S. sovereign rating cut is “certainly nothing that’s going to happen overnight,” financial markets are “beginning to anticipate the possibility.”

Typically, a steep yield curve is a sign of a strong recovery, but there is nothing typical about current monetary policy. Here and here are two blog entries that discuss the recent steepness of the yield curve in the US.

One thing that I find interesting is that despite the uncertainty surrounding the current economic situation, the yield curve is almost identical in the Euro area (Germany), the UK and the US (see chart below). This means that not only the perception of a default risk for these three government is similar, which is probably a reasonable guess, but also that inflation expectations are almost identical for the ECB, the Bank of England and the Federal Reserve.

While it is difficult to imagine circumstances where the inflation rates in these three areas deviates by a large amount, it is not that unlikely to build scenarios where inflation differentials are larger than the ones implied by those yield curves. Given the uncertainty and the difficulty predicting which ones of these scenarios will prevail, the yield curve seems to be anchored by the assumption that the three central banks will adopt very similar policies and will deliver an almost identical inflation rate. That's a strong sign of confidence on these three central banks.

Antonio Fatás"

Me:

Don said...

From my point of view, this is how you want QE to work against Debt-Deflation, which is a panic phenomenon.
1) Low Short Term Interest Rates, as a disincentive to buy guaranteed assets, and an incentive to buy stocks and corporate bonds. This attacks the Fear and Aversion to Risk.
2) Rising Longer Term Interest Rates, which signal an end to Deflationary Fears, and are an incentive for Longer Term Investing.As well, as you say, the Spread often ( which is as exact as this gets ) signals a recovery.

Now, what's interesting, is that I take it that this is what Bernanke and Geithner have been arguing, although not necessarily saying it the way I do. And, in fact, it seems to be working, which , again, is about as good as it gets, since none of us know the future.

Yet, as obvious as this is to me, others have been puzzled by this line of reasoning. I, on the other hand, do not understand the point of having interest rates move in tandem, insofar as incentives are concerned.

I understand the idea of rising interest rates being a problem, but the Fed has other means of addressing mortgages, in coordination with other parts of the government. However, I am not for keeping interest rates of mortgages artificially low at all, but certainly feel that this policy should now end. We need to see a plausible bottom on housing prices, without the perception of government still keeping housing prices artificially high.

Don the libertarian Democrat

Of course, Inflation will be the issue going forward, but I prefer that to a Debt-Deflationary Spiral. Call me silly, I guess.

June 1, 2009 2:14 PM

John Taylor thinks that the Federal Reserve is to blame for the crisis because of the low interest rates

TO BE NOTED: Antonio Fatas and Ilian Mihov on the Global Economy:


"Three different views on the role of monetary policy leading to the current crisis

John Taylor thinks that the Federal Reserve is to blame for the crisis because of the low interest rates in the year 2003-2005 period.

"Monetary excesses were the main cause of the boom. The Fed held its target interest rate, especially in 2003-2005, well below known monetary guidelines that say what good policy should be based on historical experience. Keeping interest rates on the track that worked well in the past two decades, rather than keeping rates so low, would have prevented the boom and the bust."

You can see the full article at the Wall Street Journal (Feb 9, 2009).

Alan Greenspan, as you would expect, disagrees with John Taylor and claims that the central bank was doing the right thing but the problem was the disconnect between short-term interest rates and mortgage rates (which were being kept too low partly because of the increase in saving rates coming from Asia).

"Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have "prevented" the housing bubble. All things considered, I personally prefer Milton Friedman's performance appraisal of the Federal Reserve. In evaluating the period of 1987 to 2005, he wrote on this page in early 2006: "There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind.""

You can see the full article at the Wall Street Journal (March 11, 2009).

Lucas Papademus, Vice President of the ECB looks forward in a recent speech (May 15, 2009) and asks what monetary policy should do in a similar future situation. He advocates for a symmetric reaction of monetary policy: not only it makes sense to lower rates when the crisis starts but central banks should also act when financial imbalances are accumulating.

"In order to reduce such potentially dangerous side-effects of non-standard measures of liquidity provision and of the very low policy rates during a crisis, monetary policy would have to be sufficiently tightened during the financial boom phase. Such a policy would dampen financial market excesses through two channels. It would tend to reduce asset prices by increasing the rate at which an asset’s future income stream is discounted. Most importantly, the anticipation of such a policy response would reduce the likelihood of a speculative bubble emerging in the first place, by affecting investment behaviour and reducing the level of risk incurred by financial intermediaries in their lending."

Papademus falls short of making a statement on whether interest rates were too low during the years that preceded the crisis (as Taylor argues). But his argument supports the view that standard monetary policy (i.e. via interest rates) also has a role to play in dealing with speculative bubbles in financial markets, it is not just a matter of proper regulation and supervision.

Antonio Fatás"

standard national accounts' measure of the saving rate did not take into account the increases in wealth associated to rising asset prices

From Antonio Fatas and Ilian Mihov on the Global Economy:

"No wonder why we see bubbles in financial markets.

Here is an article written about 18 months ago that was justifying the low personal saving rate in the US using the argument that the standard national accounts' measure of the saving rate did not take into account the increases in wealth associated to rising asset prices. The article was written in September 2007 right before the crisis started. It was written by David Malpass, who was at that point chief global economist for Bear Sterns. That increase in wealth is gone (and so is Bear Stearns).

Antonio Fatás"

Me:

Don said...

I don't think that you're being fair. It's as if people saved money by buying longer term bonds at low interest and inflation kicked in for a long time. The problem was the allocation of savings, and the writer seems to agree with that.

The main problem with his post is that he fails to note that we're in a housing bubble, but he was hardly alone in that.

Don the libertarian Democrat

May 19, 2009 11:04 AM

the U.S. benefits from lending at very low rates while it earns substantially higher rates on the capital it sends abroad

TO BE NOTED: From Antonio Fatas and Ilian Mihov on the Global Economy:

"Changes in the funding of the U.S. current account deficit

Since the mid 80's (and with the exception of a small pause in the early 90's) the U.S. has run a current account deficit, which means that domestic spending has been larger than domestic income/production. This deficit was growing in the period leading to the current crisis and it led to concerns about global imbalances and how countries would adjust to them. Here are a couple of charts that show some of this evolution as well as some recent changes that point to adjustments in the way the current account deficit is being financed.

The first chart shows the evolution of the U.S. current account balance. We clearly see the downward trend during the 1995-2007 period and then a reversal during the last year, 2008. This reversal is very much driven by a large drop in imports. Exports have also decreased (as world trade has collapsed), but imports have fallen by a much larger amount. Some of this fall is related to the decrease in the price of oil during 2008 relative to 2007.

U.S. Current Account Balance (Billion USD)

A second interesting fact in the chart above is the behavior of net investment income. Net investment income remains positive during all the years. This means that the US receives more investment income from investments abroad than what it pays to foreigners for the capital that it has borrowed from them. If you take into account the fact that the US has become a large debtor to the world (i.e. that the foreign liabilities are substantially higher than the foreign assets) this is a surprise. One would expect a debtor to be paying interest on the debt. What we see below is that in net terms the U.S. is receiving interest payments on a negative net asset position. In other words, the U.S. benefits from lending at very low rates while it earns substantially higher rates on the capital it sends abroad. Financing a current account deficit under this conditions is much easier!

This investment income has more than compensated the income sent abroad in the form of "Net Transfers". This income include worker's remittances to their countries of origin. The fact that these two variables have been very close to each other means that the current accounts is very close to net exports (the balance on goods and services) [A reminder on balance of payments accounting: Current Account = Net exports on goods and Services + Net Investment Income + Net Transfers].

How was the current account financed during these years? The U.S. was borrowing from other countries (those with current account surpluses looking for investment opportunities). Of course, we observe capital flows in both directions and what matters is the difference between the two. Interestingly, during these years, capital flows in both directions grew. The chart below shows these flows. The current account deficit needs to be financed by foreign lending to the US (labelled below as "changes in foreign assets in U.S." which by convention are positive if there is a flow) in excess of US lending to other countries (labelled below as "changes in US assets abroad" which by convention are negative if there is a flow).

Funding of U.S. Current Account (Billion USD)

Up to 2007 we see both flows increasing but the size of foreign lending to the US is always larger than the flow in the opposite direction, and this difference funds the current account deficit.

In 2008 we see a collapse of both flows. The flow of lending to the U.S. goes from around 2 trillion to 600 billion. This collapse is matched by a decrease of capital flows from the U.S. to foreign countries from 1.3 trillion to almost zero. What is even more interesting is that if we split this flow into private and official (government and central bank related) flows, we see that private flows from the U.S. to other countries changed from an outflow of about 1.3 billion in 2007 to an inflow of 480 billion - this represents a change of close to 1.8 trillion. In other words, a large part of the current account deficit in 2008 was financed by U.S. nationals selling their assets abroad and repatriating the funds to the U.S. The change in these private flows more than compensate the drop in capital flows from other countries. [At the same time, official flows from the U.S. to other countries increased to reach almost 500 billion. Most of this lending is likely to be associated to the lending facilities that the Federal Reserve has made available to European central banks]

A final comment on the chart: the "statistical discrepancy" also helped funding the U.S. current account deficit in 2008. The swing from negative to positive from 2007 to 2008 indicates that while in 2007 there were some "missing" capital outflows, in 2008 we are missing some of the capital that flew into the U.S. by an amount that is large (about 130 billion).

It will be very interesting to see how these numbers change during 2009 and 2010. The selling of U.S. assets is not a sustainable source of funding. It is likely that the current account deficit will become smaller but not by much (given the limited growth that we are seeing in other countries) so there will be a need for capital inflows to the U.S. to be larger than what we have seen during 2008.

By the way, if you are interested in this topic, I recommend the excellent blog of Brad Setser.

Antonio Fatás"

since the summer of 2008, a very large increase in the amount of commercial bank reserves at the central bank and very little lending

TO BE NOTED: From Antonio Fatas and Ilian Mihov on the Global Economy:

"The money mutiplier has stabilized

One of the most dramatic indicators of the financial crisis has been the collapse of the "money multiplier". The money multiplier is measured as the ratio of the money supply to the monetary base. The money supply is the sum of currency in circulation and bank deposits. The monetary base is the sum of currency in circulation and the reserves held by commercial banks (at the central bank). The money multiplier tends to be above 1 (and that's why it is called a "multiplier") and it is a measure of how much the money supply increases when the central bank raises the monetary base (think about the central bank printing money or increasing the amount of reserves available for commercial banks and what we are after is the final impact it will have on liquidity).

The money multiplier can collapse for two reasons. First, it can be that individuals mistrust banks and they decide to take their deposits away from their bank and keep their liquidity as cash ("under the mattress"). Second, it can be that commercial banks are worried about the future and they accumulate an unusually large amount of liquidity in the form of reserves without lending them to individuals or businesses. This is what we have observed since the summer of 2008, a very large increase in the amount of commercial bank reserves at the central bank and very little lending. The chart below (for the US economy) shows the collapse of the money multiplier at that time. We also see that in recent months the money multiplier has stopped declining although it remains at a very low level (below 1).

While the money multiplier was falling, the Federal Reserve increased dramatically the monetary base. This increase translated into a much smaller increase in the money supply because of the falling multiplier. As the multiplier stabilize and very likely starts growing towards its natural level (when banks stop holding large amount of reserves), the money supply will start growing. It will then be the signal to the central bank that it is time to reduce the monetary base in order to keep inflation under control.

Antonio Fatás"

In other words, we are only willing to lower our forecasts when we see bad news and the news keep being worse than what we expected

TO BE NOTED: From Antonio Fatas and Ilian Mihov on the Global Economy:

"The difficulty of forecasting around turning points

If forecasting in normal times can already be difficult, doing so during times when the phase of the cycle is changing becomes a real challenge. The amount of uncertainty increases as one can consider scenarios that are very far apart. When in 2007 we saw growth rates decreasing we needed to make a call on whether a recession was coming and if it was, how deep and large the recession was going to be.

This uncertainty has been reflected in the forecasts that we have seen about the state of the economy in the last 18 months.

What is interesting about these forecasts is not only that they are hard to make (and that they might turn to be completely wrong) but, in addition, they keep getting more and more pessimistic. In other words, we are only willing to lower our forecasts when we see bad news and the news keep being worse than what we expected so the forecasts are being revised downwards. So it is not just a matter of uncertainty, which could show up as alternating large positive and negative errors. We can think of this process of revising forecasts downwards as a bias in the way we produce our forecasts as the errors are always in the same direction: we are anchored by the past and always too optimistic about the sate of the economy [Strictly speaking, this might not be bias, it could truly be that we receive a string of bad news about the state of the economy that cannot be forecasted, but it is also likely that the consistency of the errors is a sign of our inability to accept that the news are as bad as they look].

Below is a chart with the forecasts for GDP growth rates for 2009 for the World and the US economy as produced by different vintages of the World Economic Outlook (by IMF). Starting with the forecast produced in the fourth quarter of 2007 and until the most recent forecast, we see that the forecast has gone down every single quarter (except for the first).

It is also interesting that forecast errors tend to be highly correlated across different forecasters. The picture below is from an early study about the accuracy of IMF World Economic Outlook (WEO) forecasts (same source as the chart above). The picture shows that there is a strong and positive correlation between the forecast errors of the WEO and the Consensus Forecasts errors - another common source of macroeconomic forecasts.

And here is a third similar picture with the forecasts of the unemployment rate for the US. Starting in the fourth quarter of 2007 I have plotted the forecast done by the Survey of Professional Forecasters of the unemployment rate 6 quarters ahead. We can see the line shifting upwards signaling a continuous update of expectations, always in the direction of increased pessimism. [The data come from the Federal Reserve Bank of Philadelphia]

In summary, our forecasts keep getting worse before they get better! And whenever we find the new turning point –the bottom of this recession- it is likely that we see a similar pattern but in the opposite direction. Forecasts might remain too pessimistic for a while and are only revised upwards as a continuous set of good news improves our views on the economy.

Antonio Fatás"