Using interest rates to “get in all the cracks”

Gavyn Davis has tears in his eyes saying good-bye:

The FOMC meeting this week is not likely to see any policy fireworks, but it will mark the departure of Governor Jeremy Stein, who returns to academic life at Harvard at the end of May. He has only been on the Board for two years, but he has made an intellectual mark in a critical area where leading members of the FOMC have been largely silent – how to set monetary policy when the need to maintain financial stability is conflicting with the near term outlook for inflation and employment.

The issue can be simply stated: should the Fed tighten policy solely because they are worried about the emergence of bubbles in asset prices?

Macro-prudential measures may not be sufficient to handle all circumstances, mainly because parts of the financial system are unregulated. There is a long history of direct controls being avoided by aggressive financial institutions, working “off balance sheet”. Therefore higher interest rates may be needed to supplement these macro-prudential measures, because they “get in all the cracks” of the financial system.

This raises the paradoxical possibility that an early tightening in monetary policy might actually reduce not only the variability of unemployment in the future, but its average level as well. This is not so crazy. If the Fed had raised interest rates more aggressively in 2002-06, the financial crash, and the current level of unemployment, might have been less severe. We may not be there yet in the current cycle, but we soon could be.

When your argument appeals to the interest rates stayed “too low for too long” in 2002-06 it is a sure sign you have a losing argument.

There´s at least one argument for the contrary, to which Gavyn Davies gives short shrift:

Paul Krugman rightly points to an opposite example. In Sweden, a tightening in monetary policy in recent years seems to have worsened the deflationary pressures in the economy. But that will not always be the case.

I have also commented on the Swedish case here.

Update: Don´t miss Mark Sadowski ‘guest post’ in the comments below!

 

 

3 thoughts on “Using interest rates to “get in all the cracks”

  1. In my latest post I criticized A. Gary Schilling for making the claim that central bankers are troubled by deflation, which may have been the wrong thing to do because he at least is on the right track regarding why they should be concerned about it: i.e., the increased incidence of bankruptcies due to the appreciation in value of the medium of exchange from lack of nominal stability. His argument regarding interest rates is wrong, but I have no problem taking what I want and leaving the rest.

    With that said, using Mr. Schilling’s explanation regarding deflation and applying it to the argument presented by Mr. Stein, I see a logical discrepancy regarding the notion of raising interest rates in order to ensure financial stability, because under certain conditions it would increase the likelihood of nominal instability in the deflationary direction, thereby contributing overall financial instability where there might otherwise be none. But because my self-directed training in macro has been almost entirely from the point of view of market monetarism, I tend to find discussions about interest rates unnecessarily complex as they relate to monetary policy and bewildering, and I highly favor the decoupling of interest rates from policy in general. There is a time, a place, and a right set of circumstances for higher or lower Fed Funds rates, and without the proper context it is impossible to say wither higher or lower is good or bad.

  2. Gavyn Davies:
    “…This raises the paradoxical possibility that an early tightening in monetary policy might actually reduce not only the variability of unemployment in the future, but its average level as well. This is not so crazy. If the Fed had raised interest rates more aggressively in 2002-06, the financial crash, and the current level of unemployment, might have been less severe. We may not be there yet in the current cycle, but we soon could be.

    Paul Krugman rightly points to an opposite example. In Sweden, a tightening in monetary policy in recent years seems to have worsened the deflationary pressures in the economy. But that will not always be the case.

    These are genuinely difficult dilemmas, perhaps the most difficult in monetary policy today. Jeremy Stein may now be gone from the Fed, but his work should not be forgotten.”

    Davies’ presumption is that it was loose and not tight monetary policy which caused the US financial crisis. Let’s take a closer look.

    Since we’re considering the effect of interest rate policy on monetary policy stance let’s look at the fed funds rate and the yield spread from 2004 through 2008:

    https://research.stlouisfed.org/fred2/graph/?graph_id=75581&category_id=

    Note that the fed funds rate was was raised from 1.0% to 5.5% from May 2004 to June 2006 in quarter point increments. It was held at that rate through August 2006. The slope of the yield curve flattened (blue line) until it inverted in August 2006 and remained so through May 2007.

    Now let’ look at nominal GDP (NGDP) growth and financial sector leverage from 2003 through 2010:

    https://research.stlouisfed.org/fred2/graph/?graph_id=174785

    In response to the tightening of monetary policy, year on year NGDP growth slowed significantly and steadily from 6.5% in 2006Q1 to 5.3% in 2006Q3 to 4.3% in 2007Q1 to 3.1% in 2008Q1 to 2.7% in 2008Q2 to 1.9% in 2008Q3, the quarter Lehman Brothers filed for bankruptcy.

    In turn, financial sector leverage, which had been rising at a slow pace, accelerated significantly and steadily. Whereas it had only increased from 92.4% to 93.7% of GDP between 2003 and 2004, an increase of 1.3 points, it increased to 95.6% in 2005 (up 1.9 points) to 99.4% in 2006 (up 3.8 points) to 107.0% in 2007 (up 7.6 points) and then soared to a peak of 118.9% of GDP in 2009Q1.

    So, tighter monetary policy led to slower NGDP growth and rising financial sector leverage. High and rising financial sector leverage was of course an important causal factor in the US financial crisis.

    Since then of course, with the Fed’s zero interest rate policy and QE, financial sector leverage has declined to 82.4% of GDP, a plunge of 30.7%, and the first significant decline in financial sector leverage since 1933-49.

    Now, let’s look at Sweden.

    Here’s the 3-month interbank rate and the yield spread since 2009:

    https://research.stlouisfed.org/fred2/graph/?graph_id=174787

    The Riksbank lowered the repo rate to 0.25% in August 2009 and kept it at this rate through June 2010 (the 3-month interbank rate is close to the repo rate). It also maintained a (-0.25%) deposit rate, the first central bank to institute a negative interest rate. And the monetary base was maintained in the range of 270% to 350% larger than it had been in August 2008.

    Starting in July 2010 the repo rate was raised in quarter point increments until it reached 2.00% in July 2011, where it remained until December 2011. And by January 2011 the Riksbank’s monetary base was reduced to only 2% more than it had been in August 2011.

    The yield curve (blue line) was extremely steep during the period of the near zero repo rate policy, negative deposit rate and QE. But with the sharp increase in the policy rate and unwinding of QE, the yield curve severely flattened (although it did not invert) from September 2011 through September 2012.

    Here’s NGDP growth over the same period:

    https://research.stlouisfed.org/fred2/graph/?graph_id=174786

    Year on year NGDP growth soared from (-4.0%) in 2009Q3 to a staggering 9.5% by 2010Q4. With the tightening of monetary policy it plunged back down to 1.0% by 2011Q4.

    How did financial sector leverage perform during this period?

    Here’s loans and securities other than shares as a percent of GDP in the financial sector sector. All debt data comes from the ECB Statistical Warehouse.

    Quarter-Debt
    2009Q1–118.0
    2009Q2–118.7
    2009Q3–127.6
    2009Q4–126.2
    2010Q1–128.0
    2010Q2–124.2
    2010Q3–117.3
    2010Q4–113.1
    2011Q1–114.4
    2011Q2–115.3
    2011Q3–120.9
    2011Q4–122.8
    2012Q1–121.8
    2012Q2–120.4
    2012Q3–121.7
    2012Q4–119.6
    2013Q1–122.4
    2013Q2–125.8
    2013Q3–125.9

    Note that financial sector leverage fell from its peak of 128.0%, following the Great Recession, to 113.1% by 2010Q4, during the period of low interest rates, QE and high rates of NGDP growth, a decline of 11.6%. But during the period of interest rate increases, the unwinding of QE and slow NGDP growth, this has crept back up to 125.9% of GDP, just a hair’s breadth under its previous peak.

    In short, looser policy leads to falling financial sector leverage, and tighter policy leads to rising financial sector leverage. And this seems to be consistently true across both episodes.

    Since higher financial sector leverage is an important risk factor for financial crises, where is this dilemma of which Gavyn Davies speaks?

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