The “two faced” credit view

According to Bernanke, keeping short term interest rates low for a period “farther than the eye can see” is the way to go to keep long term rates also low in order to get a recovery “on the road”:

In his first public remarks since the Fed launched a fresh measured aimed at keeping down long-term borrowing costs, Bernanke indicated a willingness to push deeper into the realm of unconventional policy if economic growth remains anemic.

But there´s also the “credit view” espoused by McKinnon:

First, the counter-cyclical effect of reducing interest rates in recessions is dampened. When interest rates dipped in the past, at least part of their immediate expansionary impact came from the belief that interest rates would bounce back to normal levels in the future. Firms would rush to avail themselves of cheap credit before it disappeared. However, if interest rates are expected to stay low indefinitely, this short-term expansionary effect is weakened.

Second, financial intermediation within the banking system is disrupted. Since early 2008, bank credit to firms and households has declined despite the Fed’s huge expansion of the monetary base—almost all going into excess bank reserves. The causes are complex, but an important part of this credit constraint is that banks with surplus reserves are unwilling to put them out in the interbank market for a derisory low yield. This bank credit constraint, particularly on small- and medium-size firms, is a prime cause of the continued stagnation in U.S. output and employment.

Third, a prolonged period of very low interest rates will decapitalize defined-benefit pension funds—both private and public—throughout the country. In California, for example, pension actuaries presume a yield on their asset portfolios of about 7.5% just to break even in meeting their annuity obligations, even if they were fully funded.

Perhaps Fed Chairman Ben Bernanke should think more about how the Fed’s near-zero interest rate policy has undermined fiscal discipline while corrupting the operation of the nation’s financial markets.

Both are wrong. They seem to believe that the Fed determines long term interest rates, and while for one low rates are “expansionary”, for the other low rates can be distortive, in effect blocking the credit expansion needed for recovery.

Remember that when QE2 was launched – with the stated reason of reducing long term rates – long term rates went up! That lasted while it was thought that the Fed was adopting an expansionary MP. When agents understood the “ruse” – that it was just a means to avoid deflation, not promote long lasting economic expansion – long term rates dropped fast, reflecting expectations of continued lackluster spending growth.

A likely “cure”, if the Fed can still be believed to really want to get the economy back on solid footing, is to stop calling monetary policy actions “unconventional”, which is widening the circle of people that get “freaked out” by the term, and adopt the “conventional” policy of stating a nominal target – not an inflation target which is, more than anything, constraining spending expectations – and credibly and transparently pursue it! As Josh Hendrickson has cogently written, DO NOT FORGET EXPECTATIONS!:

[I]n fact, monetary policy can be successful if it partners the monetary injection with an explicit account of expectations. If monetary policy was conducted by announcing that the central bank would increase the monetary base until it met its target for a particular variable — say the price level or nominal income — this would help to shape expectations and help policy to be successful as the increase in the monetary base would have distributional effects.

3 thoughts on “The “two faced” credit view

  1. McKinnon writes: “When interest rates dipped in the past, at least part of their immediate expansionary impact came from the belief that interest rates would bounce back to normal levels in the future. Firms would rush to avail themselves of cheap credit before it disappeared. However, if interest rates are expected to stay low indefinitely, this short-term expansionary effect is weakened.”

    McKinnon is incredibly intellectually sloppy (or dishonest) here. When he say “expansionary impact came from the belief that interest rates would bounce back to normal levels” he could be making either of two arguments:

    1) ANTI-RATIONAL EXPECTATIONS, i.e., everyone expects rates to bounce back, but the market clearing rate is irrationally much lower than what everyone expects because lenders are sops who accept irrationally low rates anyway.

    2) STEEP YIELD CURVE, i.e., the “expected” recovery is interest rates is actually embedded in the steepness of the yield curve. In this case, higher NGDP/CPI targeting combined with low rates and QE at the front of the curve is exactly the right policy! (but he criticizes this!)

    So which is it, Mr. McKinnon, are you are “irrational markets” guy, or a hypocrite?

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