Interest rates and the face/vase problem
The relationship between interest rates and money is pretty confusing. So I’m not surprised most people are confused. I’m somewhat confused. But I’m nowhere near as confused as some of my somewhat confused commenters (Bob Murphy) assume I am. In some respects it’s pretty simple. We’ve always known the following:
1. Moves toward easier money usually lower short term rates. The effect on long term rates is unpredictable.
2. Moves toward tighter money usually raise short term rates. The effect on long term rates is unpredictable.
3. Extremely easy money policies (hyperinflation) almost always raise interest rates.
4. Vice versa.
And those are still true.
When I talk about money and interest rates I am sometimes talking about cases 1 and 2 “Interest rates are an unreliable indicator of the stance of monetary policy.” And sometimes I’m talking about cases 3 and 4 “Ultra low interest rates are a sign that money has been tight.” I should make that distinction clearer.
Nothing that has happened recently has changed my basic views on these 4 points. We have a long data set to look at, and recent events simply add a few points, consistent with what we already knew. So why does it look like it conflicts with market monetarism? Several reasons:
1. We emphasize the contrarian cases, where tight money lowers rates, in order to differentiate our brand. People begin to think we believe that always occurs. If we are going to do that, we better be ready to take a hit when things go the other way. I plead guilty.
2. We don’t have a good theoretical model explaining why the liquidity effect sometimes dominates at the longer maturities. We observe that fact, but can’t really explain it.
But remember that I’m 58 years old and have been observing monetary policy my whole adult life. I certainly knew that tighter money can raise long term bond yields.
Now here’s where commenters seem to get confused. Even when the liquidity effect is important, other effects are important two. Yesterday monetary policy returned to the status quo ante. Last September the Fed told us that QE would be data-driven. Bond yields were very low, around 1.7%. (But 10 year bond yields actually ROSE on the news!) In the middle of this year there were hints that the Fed was switching policy, and that they’d taper despite the fact that the data did not call for tapering. Bond yields rose to a peak of roughly 2.9%. Then they returned to the earlier policy of a data-driven QE. Bond yields are now about 2.7%.
Many people assume that tapering rumors caused bond yields to rise from about 1.7% to 2.9%, and then the return to the earlier policy caused rates to fall back to 2.7%. But that is almost certainly false. Yes, the decision not to taper did cause rates to fall, but not very much. That means the hints that they would taper caused rates to rise, but not very much. Most likely we had a 100 basis point rise in yields over the past year due to macroeconomic forces, and another 20 basis points due to fear of tapering. Now that 20 points has been unwound.
Note that my hypothesis is not just pulled out of thin air, it’s confirmed by other markets. Consider equities. We know for a fact that equities were hurt by taper talk and helped by yesterday’s decision not to taper. Suppose it really were true that taper talk had explained the huge run-up in bond yields over the past year. What should have happened to equity prices? What did happen? Obviously the same economic forces that were pushing bond yields 100 basis point higher were also pushing the S&P sharply higher.
And we know what some of those forces were. I recall one strong jobs report (early July?) where bond yields rose sharply, and so did stock prices.
Why did so many people miss this? Because:
1. The liquidity effect is real.
2. Once you start thinking in terms of the liquidity effect, it’s hard to think of anything else (the face/vase problem–cognitive illusion.)
For instance, people will cite the fact that the path of short term rates fell yesterday, i.e. the Fed is now expected to raise short term rates later than before, and assume that means money is getting easier. As far as yesterday is concerned that’s true. But only because we know what caused the change yesterday—monetary policy. Over the long term however, the expected path of shorter term rates is mostly endogenous. You might think the Fed has “complete control” over short term rates. But that would only be true if they didn’t care about the macroeconomy. But they do care. If there are forces expected to raise NGDP growth to excessive levels, the Fed would respond by raising rates. In that case the “cause” of the future expected higher rates is not an “expected liquidity effect” it’s an “expected income and inflation effect.”
So don’t fall into the trap of thinking that all rate changes reflect Fed policy, just because you clearly observe that some of them do, and also because the Fed has near total control of short term rates in a technical sense.
PS. Here’s what I said minutes after QE3 was announced last year:
These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.
Nope. Long term yields increased on the news, just as market monetarist’s would have expected. And thank God they did! The higher yields are an indication that markets have (slightly) raised their NGDP forecasts going forward. The jump in equity markets suggests that RGDP growth will also rise (albeit modestly.) The bad news is that 100 points on the Dow is indicative of a really small change in the RGDP growth rate, basically within the margin or error. So we’ll never know any more than we know right now about whether the policy will “work.” Of course that won’t prevent hundreds of economists from making silly pronouncements a few months from now, based on actual changes in RGDP. I beg you to ignore them all.
I should not have said “just as expected”, when what I meant was “just as MMs suggest often occurs with easy money policies.” So the confusion is partly my fault. I gloat when things go my way.
Note that the instant reaction of stocks is a more reliable indicator of monetary policy that long term bond yields. Long term rates rose on the announcement of QE3, and rose again on taper talk. Why is the long term bond market so schizophrenic? I have no idea.