Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Saturday, September 26, 2015

Zero intolerance

In an earlier post, I summarized the main arguments people have used for and against a September lift-off.  There are, of course, other arguments one can make and bond guru Bill Gross isn't shy about offering his view on the matter in his September 23 2015 investment outlook.

According to Gross, the Fed's low interest rate policy constitutes a form of "financial repression." His argument, as far as I can tell, goes as follows. Long-term prosperity depends on the stock of productive capital. The stock of productive capital is augmented by investment (the flow of newly produced capital goods). Investment is financed out of saving. Low interest rates discourage saving. Therefore, low interest rates are ultimately a prescription for secular stagnation.

Gross claims that "no model will lead to this conclusion." I'm not exactly sure what he means by that. I think what he means "forget about theory, let's just look at the facts." Unfortunately, facts do not always speak for themselves.

So what sort of evidence does he select to support his conclusion? He begins by noting that inflation-adjusted interest rates (on high-grade bond instruments, I presume) were on average negative over the period 1930-1979 and on average positive since then (thanks to Volcker) until recently. Here's what the data looks like since the end of the Korean war (FRED only gives me the interest rate series since then).

The blue line plots the nominal yield on a one-year treasury, the red line plots the one-year CPI inflation rate. Blue minus red gives us a measure of the realized inflation-adjusted return on a nominally risk-free security. Returns were relatively high in the 1960s, 1980s, 1990s, and relatively low in the 1970s, 2000s, and 2010s (so far).

In relation to this observation, Gross writes approvingly of Fed policy decisions in the early 1980s:
But then Paul Volcker turned the bond market upside down and ever since (until 2009), financial markets enjoyed positive real yields and a kick in the pants boost to other asset prices, as those yields gradually came down and increased the present value of bonds, stocks and real estate.
This is a bizarre statement in some respects. First, as the data above makes clear, it was nominal yields that gradually came down--real yields remained elevated for two decades after the event. Second, he evidently does have a model of how a policy-induced increase in the nominal interest rate leads to prosperity: as yields march downward from an elevated level, capital gains are realized in a broad range of asset classes. This is a bizarre argument both in its own right and because it ignores the initial capital losses realized on wealth portfolios when the policy rate is suddenly increased.

So, no, I don't think that model makes much sense. But if so, then how do we make sense of the data? The fact is that the U.S. economy generally did prosper after the 1981-82 recession. Most economists attribute this subsequent era of prosperity in part to the fact that Volcker's policies ushered in an era of low and stable inflation. Jacking up the interest rate was just a temporary measure to bring inflation down. And once inflation began to drift down, nominal yields declined because of the Fisher effect. The fact that real yields remained elevated was just the by-product of an accelerated growth in productivity (after the 1970s productivity slowdown) that likely had little to do with monetary policy.

But maybe this conventional interpretation is incorrect. Could Gross be on to something? Maybe there is a model that justifies his conclusion. I've been thinking about this lately, wondering just what such a model would look like. Here is what I came up with.

Consider a textbook macro model. Let S(r,y) denote the supply of saving, assumed to be increasing in real income y (GDP) and the real interest rate r. Let I(r,x) denote the demand for investment, assumed to decreasing in the real interest rate r and increasing in the expected productivity of capital investment, x.

In a closed economy, domestic saving must equal domestic investment, so S(r,y) = I(r,x). This equation gives us the famous IS curve: the locus of (y,r) combinations consistent with S=I. This relation exists, in one form or another, in virtually every macro model I'm aware of.

The neoclassical view is that the market, left to its own devices, will determine a "full employment" level of income, y*. With y* so determined, the equilibrium rate of interest r* is determined by market-clearing in the loanable fund market, S(r*,y*) = I(r*,x).

Business cycles are generated by fluctuations in the x. High x is associated with optimism, low x with pessimism (over the expected return to capital spending). The diagram below demonstrates what happens when the economy switches from an optimistic outlook to a pessimistic outlook. Let point A denote the initial equilibrium position. A decline in x to x' shifts the investment demand schedule downward. Lower investment demand puts downward pressure on the interest rate--the economy moves along the saving schedule from point A to B. If depressed expectations persist, then the lower level of investment leads to a lower stock of productive capital. This has the effect of depressing GDP. As income declines from y* to y', the saving schedule shifts down and the economy moves from point B to C.

Point C is characterized by lower income, lower investment, lower saving and a lower real interest rate. This is the neoclassical explanation for why periods of why real interest rates are procyclical. Low interest rates are not the product of "financial repression." They are symptomatic of a depressed economic outlook. And any attempt to artificially increase the real interest rate is going to make things worse, not better. One cannot legislate prosperity by increasing the interest rate.

Now, if I understand Gross correctly, he seems to be saying that present circumstances are not the byproduct of depressed expectations. The problem is that the Fed is keeping the real interest rate artificially low. Let's try to interpret this view in terms of the following diagram. The economy naturally wants to be at point A, where the interest rate is higher, along with saving, investment and income. But the Fed is keeping the interest rate artificially low--at zero, in the diagram below.

The effect of the zero interest rate policy is to discourage saving. While the demand for investment is high (point D), there's not enough saving to finance it (point B). As such, the level of investment falls from A to B. The lower investment eventually translates into lower GDP. As income declines, the saving schedule shifts down and the economy eventually settles at point C. This is secular stagnation brought about by the Fed's financial repression.

So is this a sensible argument? There is a problem with it that Gross touches on in his piece when explaining how low interest rates are harmful:
How so? Because zero bound interest rates destroy the savings function of capitalism, which is a necessary and in fact synchronous component of investment. Why that is true is not immediately apparent. If companies can borrow close to zero, why wouldn’t they invest the proceeds in the real economy? The evidence of recent years is that they have not.
Indeed, the logic of the argument is not apparent at all. With interest rates so low, the business sector should be screaming for funds to finance huge new capital expenditures (point D in the diagram above). But they are not. Why not? At this stage, he simply abandons the logic and refers to the evidence. As if the evidence alone somehow supports his illogical argument.

There are, in fact, some logical arguments that one can use to interpret the facts. One is given by the neoclassical interpretation in the first diagram above. Expectations are depressed because the investment climate is poor (feel free to make a list of reasons for why this is the case). The demand for investment is low. Low investment demand is keeping the real interest rate low. The Fed is just delivering what the market "wants" in present circumstances. Raising the interest rate in the present climate would be counterproductive.

There is another argument one could make. Suppose that the investment climate is not depressed. There are loads of positive NPV projects out there just waiting to be financed. Unfortunately, financial conditions are such that many firms find it difficult to find low-cost financing to fund potentially profitable investment projects. In the wake of the financial crisis, creditors still do not fully trust debtors to make good on their promises. As well, regulatory reforms like the Dodd-Frank Act may make it more difficult to supply credit to worthy ventures. In the lingo used by macroeconomists, firms may be debt-constrained. The situation here is depicted in the following diagram.

The debt-constraints that afflict the business sector's investment plans caps the total amount of investment that will be financed by creditors--the investment demand schedule effectively becomes flat at this capped amount. The financial crisis moved the economy from point A to B. As before, lower investment ultimately reduces the productive capacity of the economy, so that income declines. The decline in income shifts the saving schedule down--the economy moves from B to C. The equilibrium interest rate is low--not because of Fed policy, but because investment is constrained. Savers would love to extend more credit if investors could be trusted and if regulatory hurdles were removed. But alas, present circumstances do not permit this saving flow to be released (except, potentially, to finance government expenditures or tax cuts). The effect of a policy-induced increase in the interest rate in this case would be to lower income even further. (The saving schedule would have to shift down even further to ensure that S=I.)

If the analysis above is correct, then the recommendation to increase interest rates in the present climate is off base. Low interest rates are not the cause of our ills--they are symptomatic of deeper problems. The way to get interest rates higher is to adopt policies that would stimulate investment demand (the neoclassical view) and/or adopt measures that would remove financial market frictions (the debt-constraint view). A deficit-financed tax cut (or subsidy) on investment spending would constitute one such measure.

There are, of course, other models that one could use to justify a policy-induced increase in the interest rate in present circumstances. Some members of the FOMC, for example, view the economy as having largely recovered and are now worried about the effect of very low interest rates on the prospect of future inflation. These types of arguments, however, are quite a bit different from the Gross hypothesis. But if he wants higher interest rates, maybe he should use them! A bit of a warning though: I don't think his bond portfolio is going to like the consequences.

Thursday, September 3, 2015

The costs of interest rate liftoff for homeowners

The results of some interesting experiments to report here from the work of my colleague Carlos Garriga and his coauthors, Roman Sustek and Finn Kydland. DA

The statement from the July meeting of the Federal Open Market Committee reveals a support for starting to increase interest rates this Fall, provided some further improvement in the labor market. Such monetary policy stance is currently held also by policy makers in the U.K., as hinted by some members of the Monetary Policy Committee, the rate-setting body of the Bank of England.

An important channel through which interest rates affect the typical household is the cost of servicing mortgage debt. Standard mortgage loans require homeowners to make nominal installments—regular interest and amortization payments—calculated so that the loan is fully repaid by the end of its term. Changes in the interest rate set by the central bank affect the size of these payments, but differently for different types of mortgage loans. In addition, the real value of these payments depends on inflation.

Mortgage contracts and debt servicing costs

Fixed-rate mortgages (FRM), characteristic for the U.S., have a fixed nominal interest rate and thus constant nominal installments for the entire term of the loan, typically 15 or 30 years. The FRM interest rate is determined at origination on the basis of the mortgage lenders’ expectations of the future path of the central bank interest rate. In contrast, the interest rate of adjustable-rate mortgages (ARM), a standard contract in the U.K., changes every time the central bank interest rate changes. The nominal installments of ARM loans are thus recalculated on every such occasion, to ensure the full repayment of the loan by the end of its term.[2]

While mortgage contracts specify nominal installments, either fixed of adjustable, the real cost of servicing mortgage debt depends on inflation. The effects of the liftoff on homeowners will therefore depend not only on the mortgage type and the future path of interest rates but also on what happens to inflation during the liftoff.

It is instructive to illustrate the effects of the liftoff on homeowners in terms of changes in mortgage debt servicing costs (DSC)—nominal mortgage payments deflated by inflation as a fraction of household real income. This variable provides a metric of the burden of mortgage debt to homeowners as it measures the fraction of real income homeowners have to give up to meet the mortgage payment obligations of their contract. The numerical examples below illustrate these points.[3]

Liftoff scenarios

Figure 1 considers two alternative paths of the central bank interest rate, a slow liftoff and a fast liftoff from the current nearly zero lower bound (ZLB). In both cases, the interest rate is assumed to revert to 4 percent, the pre-2007 crisis average. In the fast liftoff case, it reaches the half-way mark of 2 percent in two years’ time, whereas in the slow liftoff case this mark is not reached until about eight years from the start of the liftoff. 

Figure 2 plots DSC in the case of liftoff that is not accompanied by an increase in inflation. In this case the path of the nominal interest rate in Figure 1 coincides with the path of the real interest rate. Figure 3 contrasts this case with a situation where the increase in the central bank interest rate is accompanied by a one-for-one increase in the inflation rate. In this case, the real rate is left unchanged at zero percent and the path of the nominal interest rate in Figure 1 is equivalent to a path of the inflation rate. While both assumptions are extreme, they demonstrate how the effects of the liftoff depend on the inflation rate.

In both figures, the DSC under the various liftoff scenarios are compared with a baseline case, in which both the central bank interest rate and the inflation rate stay unchanged at zero percent (blue dotted line), approximately the current situation. In this case, DSC are about 20 percent due to the assumed lenders’ markup of three percentage points.

A liftoff without inflation

When inflation stays at zero percent during the liftoff (Figure 2) the real mortgage payments of existing homeowners with FRM loans are unaffected. This is because the FRM interest rate has been fixed at origination before the liftoff and inflation stays at zero percent. However, new FRM loans will be priced according to the expected path of the central bank interest rate in Figure 1 and will therefore carry a higher interest rate. The new FRM interest rate is higher the faster is the liftoff. In the case of the fast liftoff, the higher interest rate implies DSC of almost 30 percent; under the slow liftoff, DSC will be 25 percent (the solid red lines in Figure 2).

When mortgages are ARM, the liftoff affects both, existing and new homeowners. The dashed green lines plot DSC for new ARM homeowners and essentially track the paths of the central bank interest rate—DSC gradually increase from 20 percent to 32 percent under the fast liftoff and to 27.5 percent under the slow liftoff. For existing homeowners with ARM the effects depend on when the loan was originated. The more recently originated was the loan the more will the path of DSC resemble that for new loans. DSC of loans that are almost repaid will be almost immune to the liftoff. This is not only because the debt outstanding gets smaller over the life of the loan, but also because mortgage payments in later periods of the life of the loan are mostly amortization payments, rather than interest payments.

A liftoff accompanied by inflation

When the liftoff is accompanied by equivalent increase in inflation, and no change in the real rate, the impact of the liftoff on DSC is greatly attenuated (Figure 3). First, existing FRM homeowners gain from the higher inflation and these gains grow over time as persistent inflation deflates the real value of the nominal payments, which under FRM are constant. Those with the more recently originated mortgages gain the most over their homeownership tenure (the dash-dotted red lines in the figure show the case of a mortgage with 119 quarters remaining; that is 29 years and 3 quarters). New FRM borrowers, however, will face a higher mortgage rate and, as a result, initial DSC of almost 30 percent in the fast liftoff case (solid red line). But the real value of those payments will also gradually decline over time.  

For ARM homeowners, both the existing and new homeowners, there are two opposing forces in place. On one hand, higher nominal interest rates increase nominal mortgage payments. On the other hand, higher inflation reduces their real value. The first effect is stronger initially but the second effect dominates over time. Furthermore, the point where the second effect starts to bite depends on the speed of the liftoff. While in the fast liftoff case the first effect dominates for the first eight years (32 quarters), in the slow liftoff case it hardly bites at all (dashed green lines).

Policy implications

To sum up, the effects of the liftoff on homeowners depend on three factors: (i) the prevalent mortgage type in an economy (FRM vs ARM), (ii) the speed of the liftoff, and (iii) what happens to inflation during the course of the liftoff.

If inflation stays constant at near zero then in the U.S., where FRM loans dominate, the liftoff will affect only new homeowners. In the U.K., where ARM loans dominate, the negative effects will in contrast be felt strongly by both new and existing homeowners.

However, if the liftoff is accompanied by sufficiently high inflation as in our examples, the negative effects will be much weaker in both countries. In the U.S., the initial negative effect on new homeowners will be compensated by positive effects on existing homeowners. And in the U.K., provided the liftoff is sufficiently gradual, neither existing nor new homeowners may face significantly higher real costs of servicing their mortgage debt.

Therefore, if the purpose of the liftoff is to “normalize” nominal interest rates without derailing the recovery, central bankers in both countries should wait until the economies convincingly show signs of inflation taking off. Furthermore, the liftoff should be gradual and in line with inflation.

Buzz words:If the purpose of the liftoff is to “normalize” nominal interest rates without derailing the recovery, the Federal Reserve Bank and the Bank of England should wait until the economies show convincingly signs of inflation taking off.”

Carlos Garriga
Research Officer
Federal Reserve Bank of St. Louis
(314) 444-7412

[2] In the U.K., the typical mortgage is the so-called standard-variable rate mortgage, which has an interest rate fixed for the first year or two. After this initial period, the interest rate can vary at the discretion of the lender, but usually the resets coincide with changes in the Bank Rate, the Bank of England policy interest rate. A “tracker” mortgage is explicitly linked to the Bank Rate. Here we abstract from these details.
[3] The examples assume that a homeowner’s real income does not change throughout the life of the loan, the loan at origination is four times the homeowner’s income, and mortgage lenders’ mark-up over market interest rates is three percentage points.r market interest rates is three percentage points.

Tuesday, September 1, 2015

On the Chinese fiscal stimulus memory hole

As evidence of China's growth slowdown mounts, Tyler Cowen asks why people no longer seem to be talking about that country's much-heralded fiscal stimulus of 2008-2009. I put the question to China expert Yi Wen, my colleague here in the research division of the St. Louis Fed. I thought it would be of some interest to share what he had to say. DA

There are several issues involved here regarding China’s economic performance and the effects of its stimulus packages.
1) As the following graph shows, 5 years after the financial crisis, U.S. industrial production remained 1.3 percent below its peak level; Industrial output in the EU remains at 12.2 percent below its level five years ago; Japan’s industrial production remains at 19.2 percent, below its level; China’s industrial output is 76.1 percent above the level five years previously. Recall that these regions were and are still china’s largest trading partners and China’s total exports have declined permanently by more than 40% since the crisis and still not recovered.

China’s industrial production therefore increased by over three quarters during a period when U.S. industrial production stagnated and EU and Japanese industrial production significantly declined. That is a conclusive success for China in this competitive struggle.
2) China’s stimulus package was designed to spend mainly on infrastructure buildup during a period when the costs of investment financing (borrowing) were the lowest. Since the operation of China’s first high-speed railroad merely six years ago, 28 Chinese provinces are now already covered by the world largest and longest high-speed rail network (more than ten thousand miles, greater than 50% of existing world capacity). If China had waited instead for 10 more years to do this, the costs would be many, many times higher.
3) Those being said, China today indeed faces the problem of excess industrial capacity, similar to US and European nations and Japan before WWI. China’s strategy to solve this excess capacity problem is to build a global infrastructure system (through so called “one belt, one road” program) that integrates the entire Eurasia continent and the Indian and Atlantic oceans transports, e.g., a full-fledged speed-train network stretching all the way south to Singapore and north to Russia and east to Europe is already under construction. This program is now backed by the newly established Asian Infrastructure Investment Bank (AIIB). This may look foolish to economists (remember China build the Great Wall for nothing J, not even shown up in GDP) but at least it will benefit global trade with significance no smaller than the Great Voyage. The age of maritime global trade (kick started by the Great Voyage) is perhaps going to be replaced or enhanced by cross continent land trade (a revision to the ancient Eurasian trade through the Silk Road).

To sum up, the Chinese appear to be more optimistic than the westerners, especially the well-trained economists, after 300 years of rejecting Capitalism (see my Working paper and forthcoming book:  History will tell if they are right or not.