Wednesday, April 6, 2016

The Safe Asset Problem is Back: Negative Interest Rate Edition


The safe asset shortage problem is back. Actually, it never went away but drifted into the background as the symptoms of this problem--sluggish growth and low interest rates--became the norm. As the figure above shows, yields on government bonds considered safe assets have been steadily declining since the crisis broke out. 

This problem is now manifesting itself in a new form: central banks tinkering with negative interest rates. Many view this development as the latest manifestation of central banks running amok. A more nuance read is that central banks are continuing to imperfectly respond to the safe asset shortage problem. The above figure indicates the downward march of global safe yields since 2008 is a global phenomenon. This decline has occurred outside of QE and prior to negative rates. It is a far bigger development than central banks playing with negative rates. 

But many observers miss this point. They confuse the symptom--central bankers tinkering with negative interest rates--for the cause--the safe asset shortage. So I want to revisit the safe asset shortage problem in this post by reviewing what exactly it is, why it has persisted for so long, and what can be done to remedy it. 

So what exactly is the safe asset shortage? It is the shortage of  those assets that are highly liquid, expected to be stable in value, and used to facilitate exchange for institutional investors in the shadow banking system. They effectively function as money for institutional investors and include treasuries, agencies, commercial paper, and repos. During the crisis many of the privately issued safe assets disappeared erasing a large chunk of the shadow banking's money supply. This happened just as the demand for safe assets was increasing because of the panic. As recently shown by Caballero, Farhi, and Gourinchas (2016), if this excess demand for safe assets is big enough it will push down the natural interest rate below zero. Since the central bank cannot push its policy rate very far past 0%, an interest rate gap will emerge and cause output to fall below its potential. That seems to fit post-2008 fairly well. (HT Josh Hendrickson)  

This problem can be illustrated by using a standard supply and demand graph for safe assets, as seen in the two figures below. These graphs are fairly standard except for the second vertical axis which allows me to show that interest rates move inversely with bond prices. The first figure shows the supply and demand of safe asset pre-2008. Note that interest rates are near 5% which is roughly where treasury yields were during that time. 


Now comes the crisis in 2008 and two changes occur, as seen in the next figure. First, the demand for safe assets rises given the fear and uncertainty during the panic. This shifts the demand curve to the right. Second, the the supply of safe assets is reduced as many of the private-label safe assets disappear. This pushes the supply curve to the left.

Given these developments, two rather striking results emerge. First, because of the zero lower bound (ZLB), interest rates remain too high. The ZLB, therefore, acts as price floor that prevents the market from clearing along the interest rate dimension. Second, the ZLB also means safe asset prices are too low. It creates a price ceiling that prevents the market from clearing along the bond price dimension.
This implies treasury prices have been too low since the crisis!


Sometimes I am asked how can there be a safe asset shortage? Shouldn't safe asset prices simply adjust upward to meet the increase demand for them? The above analysis shows why this cannot happen with the ZLB. The safe asset market has been constrained by the ZLB and prevented from working its market-clearing magic.

Why has this problem persisted for so long? Why are safe assets yields still so low? I am not entirely sure. I suspect the demand for safe assets has remained elevated given the ongoing spate of bad news shocks since the crisis: Eurozone crisis, China concerns, fiscal cliff talks, 2016 recessions fears, etc. Also, some of the new banking and finance regulations is probably suppressing the growth of private-label safe assets. That is has taken this long, though, is a bit puzzling.



 So what are the solutions to safe asset shortage problem? One solution is for the government to issue more safe assets. That the 10-year U.S. treasury is now 1.73% seven years after the crisis suggest there is still strong appetite for treasury securities. This is the solution proposed by folks like Stephen Williamson and Paul Krugman. Another solution is for policymakers to 'shock and awe' the public into believing a robust recovery is coming and thereby decrease their demand for safe assets. QE was supposed to do this but was not that effective. Scott Sumner and Michael Woodford's call for NGDP level targeting would also fall under this option. The final option is that policy makers could try to work past the ZLB via negative interest rates. Under this option policymakers would help the safe asset market clear by pushing interest rates and prices to their market-clearing levels.

As  noted by Narayana Kocherlakota, the difficulty of doing the first two options seems to be making negative interest rates the default option.  I am not convinced it will be very effective given how it is being implemented (very different than Miles Kimball's suggested approach). But it is a response--a groping in the dark by central bankers--to the deeper safe asset shortage problem. And that is something we all need to better understand. 

20 comments:

  1. as tony the tiger would say, that was GREEAAAT!

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  2. The low yields on assets not traditionally considered safe are just as noteworthy - Italy, Spain and Portugal borrowing for 10 years at 1.3%, 1.5% and 3.2% respectively. It seems like it's part of the same broad phenomenon, but does it make harder for the term "safe asset" to have any meaning?

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    1. Another puzzle. Maybe it reflects an understanding that the Eurozone--including Germany--implicitly backs these countries debt.

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  3. Great post, but I can't help but wonder if you're starting with the assumption that a negative interest rate policy (or some other monetary response, "shock and awe" included) is the only cure for the economic malaise. Why couldn't the safe asset shortage be solved via central banks selling down their holdings (ie reducing their balance sheets), increasing the supply of safe assets and balance demand. Yes, this MAY result in higher yields. But why is that necessarily a problem? Perhaps more credit would be created (which is the problem afterall) if investors ended their capital strike (ie reducing their demand for safe assets in favor or risky ones), which can only happen if they become comfortable with the valuations offered in the market place for the amount of risk they think they are taking. Unfortunately no amount of monetary "nudging" can structurally change the demand curve; that requires investor's longer term outlook to change (and become more favorable). These increasingly bold central bank interventions are only increasing fear among investors that the true price of risk is becoming more and more distorted, and that the prices they are paying are wrong and could result in future losses; not a good outcome.

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    1. Anonymous, the main point of the post is to simply show the push for negative rates is consequence of the safe asset shortage problem. I am not advocating it here, especially the way it is being done. (If they would follow Miles Kimball's approach then maybe...)

      Regarding the central bank's 'bold intervention' that is more true for some central banks than others. The Fed, for example, only holds about 19% of marketable US treasuries, which is about the same share it held before the crisis. Most studies show at best a modest effect on yields from its LSAPs. Again, the long decline in yields in the figure above started well before (sometimes after) the various QE programs.

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    2. I am anonymous 2. I am confused. The ultimate safe asset is the currency, the dollar, so the problem is not shortage of safe assets, it is shortage of THE safe asset (incredibly, the easiest to issue!!). Do more QE (including privately issue debt), if one prints enough money than the supply of safe assets will grow and yields go up at some points, for the safe assets that are not money. One knows she has printed enough when long yields go up...

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    3. Anonymous 2, you are correct but it requires a permanent increase in the monetary base and that is something the Fed does not want to do. QE has only done temporary increases in the monetary base. See here for more on this point: http://macromarketmusings.blogspot.com/2014/12/the-federal-reserves-dirty-little-secret.html

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    4. Anonymous 2 here. Yes, I am familiar with that text. My point is that it is not clear, from your current post, that you believe doing more QE will achieve its stated goal, that is, raise inflation, inflation expectations and yields. You don't count this as an option in your three way story. I would expect a vigorous defense of QE, no matter how large it seems to be. After all, it seems to me that monetarists believe that QE will eventually work. Expectations are not the only channel here ....

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  4. apparently, NIRP is not working in Japan so far

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    1. Japan's problem is not NIRP so much as it that it has to contend with Fed policy. The Fed signaled it wouldn't be raising rates so fast after all and the dollar starts declining. Brexit fears putting downward pressure on the pound. Collectively, this are outgunning NIRP in Japan. Also, as I note in the post, I am not convinced NIRP is being properly implemented.

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  5. Excellent blogging.

    Well, I am just little ol' me, but I have been calling for shock and awe since 2008.

    BTW, Michael Woodford is open to QE-financed fiscal stimulus, which is the fancy way of saying "print money and finance government spending that way."

    http://www.voxeu.org/article/helicopter-money-policy-option

    I say go for it. If QE-financed federal outlays don't work, then fine we monetize the national debt and give ordinary people a tax break.

    Try this please: A FICA tax holiday, and finance FICA contributions by having the Fed buy T-bonds and placing them into the Social Security and Medicare trust funds.

    The only people to get a tax break would be those working for a living and those hiring people to work for less than $100,000 a year.

    In other words, productive people who will probably spend the money.

    Is this a win-win-win or what? It's Win-a-rama for America.

    Or would you prefer secular stagnation?

    And please, no sanctimonious sermonettes from little boys in short pants about the Perils of Inflation.

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  6. There is no safe assets problem, just a target problem. I can't believe serious chaps like you are spending time on such an issue when the leader of the world's most important central bank spreads such confusion about what she wants.

    From the Fed chairs' pow wow yesterday, according to bloomberg:
    http://www.bloomberg.com/news/articles/2016-04-07/yellen-says-u-s-close-to-full-employment-some-slack-remains

    She added that the committee is not aiming for a level that will drive inflation above the Fed’s 2 percent target. “But it’s also the case that 2 percent is our goal, and it’s not a ceiling," she added.

    What????

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    1. James, I agree that a credible NGDP level target would go a long ways in addressing this problem. I am, however, becoming less convinced the Fed could politically do something like NGDP level targeting. So for now I think it is important we highlight the linkages among what many see to be very different phenomenon.

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    2. David:
      The Fed can't do NGDPLT for political reasons?

      What minut percentage of the u.s. population even knows what is the Fed or who is Janet Yellen or whether they have a 2% inflation target or an NGDPL Target?

      What is the point of having an independent fed, and even such a invisible change in policy is impossible?

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    3. Ben, Christopher Phelan said that the Fed can't raise rates for political reasons and that is why the Fed keeps growth low and inflation from escaping too the high side. .

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  7. Tim Duy does a far better job than I on the Yellen's confusing guidance on the "ceiling". Market suggests Duy's conclusion is way too charitable.
    http://www.bloomberg.com/news/articles/2016-04-07/so-just-how-much-of-an-overshoot-on-inflation-will-the-fed-tolerate

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  8. Sumner was a great choice as your first guest, and it was a great podcast. Scott is always so reasonable and clear that one wonders what's a matter with everyone that they haven't gotten on board with MM.

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  10. There is a fourth (and simpler?) option. You say, "safe asset prices are too low". Have the central bank raise them by purchasing bonds at a higher price (helicopter money, effectively).

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