I recently criticized the view that the Fed might want to consider raising interest rates because a long period of low rates could lead to financial imbalances, such as “reaching for yield.” I actually have several problems with this view, but focused mostly on the implicit assumption that tighter money would lead to higher interest rates. That’s not true over the sort of time frame that people are worried about.
Tyler Cowen linked to the post and offered a few comments:
Scott Sumner dissents on reach for yield. I don’t think easier money will boost the American economy right now. So I think you just get a loanable funds effect and then possibly a reach for yield.
A few reactions:
1. I have a rather unconventional view on the question of policy lags, which Tyler is probably referring to in his “right now” remark. I believe that monetary policy affects RGDP almost immediately, or at least within a few weeks. This is based on three interrelated claims, which may or may not be true:
a. Monetary policy immediately affects expected future NGDP growth. That can be defended either as a definition (I define the stance of policy as expected NGDP growth) or if you prefer it can be defended on EMH/Ratex grounds. If it affected growth expectations with a lag, then there would be lots of $100 bills on the sidewalk. I don’t see many.
b. Changes in expected future NGDP have an almost immediate impact on current NGDP growth. I can’t prove this, and it’s the weakest link in the chain. But I strongly believe it to be true. Someone should do a study correlating changes in expected future NGDP (perhaps 4 quarters forward, consensus forecast) with changes in current NGDP. I expect a strong correlation. Thus during periods where the expected future NGDP falls sharply, such as the second half of 2008, current NGDP also falls sharply.
c. Changes in current NGDP are highly correlated with changes in current RGDP. This is one of those “duh” observations, at least for anyone who pays attention to the data.
Most people believe in long and variable lags, because they associate “monetary policy” with changes in interest rates. If the Fed created and subsidized trading in a NGDP prediction market, I believe we would quickly discover that my view of policy lags is correct, and the consensus view is wrong. But even if I were wrong, wouldn’t it be useful to pin down this sort of stylized fact? You’d think so, but my profession seems surprisingly uninterested in these sorts of things.
2. The loanable funds effect is exactly why I think I’m right. Faster growth would lead to more demand for loanable funds, and thus higher interest rates. I wonder if Tyler is referring to the “liquidity effect”, the tendency for monetary injections to lower interest rates in the short run. If so, I don’t think this effect lasts long enough to justify distorting Fed policy with tight money in order to stop people from “reaching for yield.”
3. I don’t like the term “reach for yield.” When the interest rate falls, it’s rational for people to value any given future cash flow at a higher level. So if rates fall for reasons unrelated to corporate profits or returns on apartments, then stock and real estate prices should rise. That’s markets working the way they are supposed to. I believe low interest rates are the new normal of the 21st century (partly but not entirely for Cowenesque “Great Stagnation” reasons), so I’m not at all concerned by higher asset prices.
4. Tyler is on record predicting a very bad recession in China, and also for being open to arguments that the Fed might want to consider raising interest rates this year. Each is an eminently reasonable and defensible view. But surely they can’t both be true? If China is going into a very bad recession, I can’t even imagine a scenario where the Fed raises rates and then a year later looks back and says, “Yup, we’re sure glad we raised rates.” Stocks plunged earlier today on just a tiny, tiny piece of bad manufacturing news out of China. How tiny? Notice that the same low PMI occurred three other times in the past 4 years, without RGDP growth ever falling below 7%.
What would that index look like if Chinese RGDP growth was actually about to turn negative? What would US stocks look like?
5. I strongly agree with Lars Christensen’s post, which suggests that the Chinese are making a mistake by trying to prevent the yuan from falling. I also agree with those who claim that recent events show the Chinese leadership to be less competent in economic affairs than many had imagined. This is a consequence of development; the problems become trickier than when you are just cleaning up after the Maoist disaster. They don’t seem to be any better at monetary policy than we are.
6. Off topic, I probably erred in saying Trump has no chance. That’s my personal view, but maybe I’m just an old timer who is out of touch with changes in America. After all, Berlusconi was elected three times in Italy. I saw Trump as just another example of a rabble-rouser like George Wallace or Patrick Buchanan, who rose up and then faded. That’s still my gut level view, but commenter “John” points out that Trump does have a non-zero chance in prediction markets, and I do claim to be an EMH guy. More importantly, even though Trump and Sanders are unlikely to even be nominated, I see their rise as bad news for American politics. I could even see their limited success hurting the stock market slightly, as the prospect for sensible economic and immigration reforms seems ever more distant. Historically, markets do worse in times when the political situation is adrift. And at the moment China, the US and Europe all seem to be a long way from the almost effortless competence of the Reagan/Clinton era.
PS. Japan 2014, Canada 2015. Another fake “recession” call. Read about it at Econlog.