Monday, June 30, 2014

The BIS Wants to Put the Cart Before the Horse.

The Bank for International Setttlements (BIS) released its annual report today. It calls for central banks in advanced economies to begin tightening monetary policy to ward off the buildup of financial imbalances. This is great advice if it were 2002. But it is 2014 and advanced economies are still fragile. Raising interest rates now, as Ryan Avent notes, would choke off the feeble recovery and create the very financial instability the BIS fears.

This tension between what the BIS wants monetary authorities to do and the consequences of doing so is evident in the annual report. For example, observe the contraction between these two excerpts from chapter five of the report (my bold):
Over the past 12 months, nominal and real policy rates remained very low globally, and central bank balance sheets continued to expand up to year-end 2013...This extraordinary policy ease has now been in place for about six years...


Effectiveness [of monetary policy] has been limited...the zero lower bound constrains the central banks’ ability to reduce policy rates and boost demand.
The first paragraph says monetary policy has been extraordinarily easy while the second paragraph implies the opposite. In fact, the whole point of the ZLB is that the market-clearing or 'natural' interest rate has become negative while the nominal target interest rate is stuck at zero percent. The Fed, in other words, has been forced to keep interest rates high relative to where market forces would naturally push them. This is not the definition of extraordinarily easy monetary policy. It is the definition of tight monetary policy. The BIS policy prescription is to have the Fed raise interest rates even higher above the natural interest rate. That is a sure recipe for financial instability.

Now some may argue that the natural interest rate has not been negative. However, most output gap measures, including the BIS finance neutral version, indicate there is still an sizable output gap. And a negative output gap is usually associated with a negative natural interest rate. This can be seen in the figure below. It shows the 10-year real risk-free treasury yield alongside the output gap.1

We all want more robust economic growth. But raising interest rates before the economy recovers is putting the cart before the horse.

1This measure is constructed by subtracting the 10-year expected inflation and the 10-year term premium from the 10-year nominal treasury yield. The term premium is an average of the Kim-Wright data and the Adrian, Crump, and Moench data. 

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  1. David
    This year I decided to completely ignore the BIS Annual Report. They keep writing the same nonsense!

  2. Everybody has drawn their lines in the sand for how much output gap there is. I say it is smaller than presented in this post. The CBO continues to re-draw their line toward a smaller gap.
    We'll just wait to see now who came closest with their real-time projections.

  3. David, O/T: Where's the best place to find a chart of the price level (P) vs year which compares a theoretical model of P to empirical data? Here's two examples of what I mean for Canada and for Japan. Those both use the same model, by the way, and the author of the model also created a related pair of curves for the interest rates in those two countries (and others). He's trying to compare his model results with professional examples but he can't find any professional examples (he says when he does a Google image search for "price level model" he only finds his own plots! (again he's looking for model results vs empirical data)). Do you have any idea where he should he be looking?


  4. The US recession is over imo. They are between the fuzzy line of recession-boom. I think revisions and surprising revelations are going to come out the 2nd half of this year. The fact accounting rules are showing monetary policy should be in a modest tightening phase is unsurprising.

  5. Keynes’s “Liquidity Preference Curve” (demand for money), is a false doctrine. The money supply (& commercial bank credit), can never be managed by any attempt to control the cost of credit (i.e., thru pegging the interest rate returns on government securities; or thru "floors", "ceilings", "corridors", "brackets", IOeR, Taylor Rule’s, etc.). The only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be controlled is legal (required), reserves. And contrary to Milton Friedman, legal reserves are not a tax.

    The FOMC’s targeting problems stem from using the wrong criteria (interest rates, rather than member bank reserves) in formulating and executing monetary policy (that’s why the Federal Reserve c. 1965, hasn’t escaped business cycle vagaries). William McChesney Martin Jr., abandoned the FOMC’s net free, or net borrowed, reserve targeting approach in favor of the Federal Funds “bracket racket” beginning in c. 1965 (coinciding with the rise in chronic monetary inflation & in anticipated inflation).

    The effect of these operations on interest rates (now via the remuneration rate), is indirect, varies widely over time, and in magnitude. What the net expansion of money will be, as a consequence of a given injection of additional reserves, nobody knows until long after the fact (after the BEA reports negative real-gDp). The consequence is a delayed, remote, & approximate control over the lending and money-creating capacity of the banking system.

    Monetary policy is currently too tight & money flows are decelerating. Janet Yellen will fail to hit both real-gDp & inflation targets in the last half of 2014.