Friday, February 8, 2013

If You Think the Fed is Behind the Low Interest Rates

Think again...

Long-term government yields on safe assets across the globe have been declining since the crisis broke out.  Something more than the Fed is at work (hint: think global economy buffeted by series of bad economic shocks). For more, see here and here.


  1. David,

    1) RGDP expectations embedded in bond prices have fallen since 2009;

    2) Inflation expectations embedded in bond prices have risen since 2009.

    3) RGDP expectations embedded in virtually all risk assets have improved since 2009.

    Does the "economic shocks" theses account for all three phenomena? If not, then either markets are segmented for sustained periods; or Fed policy has caused the divergence between 1) and 2),3).

    1. Diego,

      I accept (1), but not (2) and (3). Inflation expectations increased in 2009, but have gravitated around 2.4%. There never was a "catch-up" period of temporarily higher expected inflation to make up for the shortfall in 2008-2009. If anything, inflation expectations have been more volatile. These developments are more consistent with a weak and uncertain economic environment.

      On (3) it is true that spreads are falling on risky assets, but that is relative to other risky assets. Also,the overall level of private debt (household and business)in the U.S. is still below pre-crisis peak and far below trend. ( the reduction in spreads should not be viewed for more than it really is, a sign of improvement and a sign of markets being segmented.

      I have come to believe that at the ZLB the market for safe assets has become segmented from other asset markets. I wrote about that here:

  2. Diego,

    Can you elaborate on #3. Risk premiums suggest the exact opposite

  3. Fullcarry,
    Using risk premia derived from Treasury yields is akin to assuming what you are trying to prove. In other words, assuming Treasury yields are market-determined to prove that Treasury yields are market-determined.

    At best one could say that the strong rally in risk assets is non-probative of improved market optimism over the path of NGDP growth. However, a strong case can be made for it being probative using other measures of optimism: HY bond issuance; the use of covenant-lite provisions in HY bonds; CMBS and CRE credit issuance; sub-prime auto credit issuance, etc. All of these correlate well with market optimism historically.

    1. Diego,

      85% of marketable treasuries are not held by the Fed. Even if we look to the long-end of the yield curve, almost 70% is held outside the Fed (and even this overstates the case since the weighted avg. maturity is just over 5 years). And the Fed's forward guidance on the ffr is determined by the economic outlook. So no, it is not a stretch to say treasury yields reflect for the most part market forces other than the Fed. And then there is the chart I posted above.

      If the low rates of past four years were in the fact the result of the Fed holding interest rates below their market clearing value, then we should have seen a long time ago accelerating inflation expectations. It hasn't happened.

      I already responded above to the risk asset point, but let me note here that spread compression in these assets correlate with market optimism well historically only when the Fed was holding interest rates below the market clearing or natural interest rate. Another way of saying this, is that all of these correlate well with market optimism when the output gap was non-negative and the unemployment rate near its full-employment level.

    2. David,
      On the margin, expectations embedded in bond prices worsened since 2009. On the margin, expectations in other markets improved since 2009. I'm open to any thesis that explains why expectations in these two sets of markets moved in opposite directions.

      Descriptions of factors affecting the current state of expectations (i.e. inflation shortfall, output gap, etc.) do not explain the previous change in expectations. For instance, the 1936 output or inflation gap does not inform the improvement in NGDP expectations from 1933-1936.

      "segmented markets" does explain divergent moves in expectations. However, it requires some change in the mechanism through which arbitrageurs equalize expectations across bonds and risk assets. For instance, the severe curtailment of credit to arbitrageurs; or the elimination of securities for carrying out arbitrage. I don't see evidence of either, but again, I'm open to an explanation for persistent segmentation that cites significant changes in the availability of arbitrage.

      Your point on negative real rates and inflation is well taken. My thesis is the Fed has convinced agents to protect real wealth by buying risk assets. This will work so long as there is a causal link between risk asset prices and the real economy (i.e. Tobin's Q, spending wealth effect). Thus far in the recovery, this link has been quite weak.

  4. Diego,

    Any thoughts on why stocks have been under performing relative to high yield?

  5. Excellent blogging---I have been pointing this out for a long time. The world is headed to ZLB. Japan got there first.

    Meanwhile, central bankers still wrap themselves in the mantle of glorious inflation-fighters.

    Talk about institutional ossification. Making central banks independent public agencies might have worked for the last 25 years---but it ain't working now, Jack.

  6. I shared one of your previous posts on this subject with a PhD professor in a business school who is of the hard-money variety. His response was "But the other countries in the diagram are not a good comparison with the U.S. because their economies are more centrally planned. They can also manipulate interest rates to lower their governments' borrowing costs just as the Fed is doing for the U.S. The diagram proves nothing."
    How does one appropriately respond to such a response? I imagine you must get a lot of emails in your inbox to that effect. I would just click "delete," but I'm wondering how you handle it?

  7. We really enjoyed and benefited from your article. Thanks and more power!

  8. "Long-term government yields on safe assets across the globe have been declining since the crisis broke out. Something more than the Fed is at work (hint: think global economy buffeted by series of bad economic shocks)."

    If something more is at work, then are you saying the Fed is doing *some* work?

    Interest rates have been declining since the early 1980s. Yet savings rates have also been declining since the early 1980s (with a recent uptick). Focusing on the 1980-2008 period, if savings rates are declining, then, ceteris paribus, interest rates should be rising. But since interest rates have in fact been declining, that's sufficient evidence that it is not the market that is decreasing the interest rates.

    Interest rates do not fall over the long term, in a market context, unless savings rates rise.

    It can't be the series of economic setbacks, because interest rates on RISKY private debt have also been on a similar declining trend since the early 1980s, while the returns on various equity indexes have been on a roughly stable long term trend.

    It *must* be the Federal Reserve System that is doing it. There is no other plausible explanation.

    I honestly do not understand the seeming quest on this blog to eliminate the Fed from explanations of why interest rates have been on a secular decline.