Archive for August, 2019

Yield-Curve Inversion and the Agony of Central Banking

Suddenly, we have been beset with a minor panic attack about our increasingly inverted yield curve. Since fear of yield-curve inversion became a thing a little over a year ago, a lot of people have taken notice of the fact that yield-curve inversion has often presaged recessions. In June 2018, when the yield curve was on the verge of flatlining, I tried to explain the phenomenon, and I think that I provided a pretty good — though perhaps a tad verbose — explanation, providing the basic theory behind the typical upward slope of the yield curve as well as explaining what seems the most likely, though not the only, reason for inversion, one that explains why inversion so often is a harbinger of recession.

But in a Tweet yesterday responding to Sri Thiruvadanthai I think I framed the issue succinctly within the 280 character Twitter allotment. Here are the two tweets.

 

 

And here’s a longer version getting at the same point from my 2018 post:

For purposes of this discussion, however, I will focus on just two factors that, in an ultra-simplified partial-equilibrium setting, seem most likely to cause a normally upward-sloping yield curve to become relatively flat or even inverted. These two factors affecting the slope of the yield curve are the demand for liquidity and the supply of liquidity.

An increase in the demand for liquidity manifests itself in reduced current spending to conserve liquidity and by an increase in the demands of the public on the banking system for credit. But even as reduced spending improves the liquidity position of those trying to conserve liquidity, it correspondingly worsens the liquidity position of those whose revenues are reduced, the reduced spending of some necessarily reducing the revenues of others. So, ultimately, an increase in the demand for liquidity can be met only by (a) the banking system, which is uniquely positioned to create liquidity by accepting the illiquid IOUs of the private sector in exchange for the highly liquid IOUs (cash or deposits) that the banking system can create, or (b) by the discretionary action of a monetary authority that can issue additional units of fiat currency.

The question that I want to address now is why has the yield curve, after having been only slightly inverted or flat for the past year, suddenly — since about the beginning of August — become sharply inverted.

Last summer, when concerns about inversion was just beginning to be discussed, the Fed, which had been signaling a desire to raise short-term rates to “normal” levels, changed signals, indicating that it would not automatically continue raising rates as it had between 2003 and 2006, but would evaluate each rate increase in light of recent data bearing on the state of the economy. So after a further half-a-percent increase in the Fed’s target rate between June and the end of 2018, the Fed held off on further increases, and in July actually cut its rate by a quarter of a percent and even signaled a likely further quarter of a percent decrease in September.

Now to be sure the Fed might have been well-advised not to have raised its target rate as much as it did, and to have cut its rate more steeply than it did in July. Nevertheless, it would be hard to identify any particular monetary cause for the recent steep further inversion of the yield curve. So, the most likely reason for the sudden inversion is nervousness about the possibility of a trade war, which most people do not think is either good or easy to win.

After yesterday’s announcement by the administration that previously announced tariff increases on Chinese goods scheduled to take effect in September would be postponed until after the Christmas buying season, the stock market took some comfort in an apparent easing of tensions between the US and China over trade policy. But this interpretation was shot down by none other than Commerce Secretary Wilbur Ross who, before the start of trading, told CNBC that the administration’s postponement of the tariffs on China was done solely in the interest of American shoppers and not to ease tensions with China. The remark — so unnecessary and so counterproductive — immediately aroused suspicions that Ross had an ulterior motive, like, say, a short position in the S&P 500 index, in sharing it on national television.

So what’s going on? Monetary policy has probably been marginally too tight for that past year, but only marginally. Unlike other inverted yield curve episodes that Fed has not been attempting to reduce the rate of inflation and has even been giving lip service to the goal of raising the rate of inflation, so if the Fed’s target rate was raised too high, it was based on an expectation that the economy was in the midst of an expansion; it was not an attempt to reduce growth. But the economy has weakened, and all signs suggest that the weakness stems from an uncertain economic environment particularly owing to the risk that new tariffs will be imposed or existing ones raised to even higher levels, triggering retaliatory measures by China and other affected countries.

In my 2018 post I mentioned a similar, but different, kind of uncertainty that held back recovery from the 2001-02 recession.

The American economy had entered a recession in early 2001, partly as a result of the bursting of the dotcom bubble of the late 1990s. The recession was short and mild, and the large tax cut enacted by Congress at the behest of the Bush administration in June 2001 was expected to provide significant economic stimulus to promote recovery. However, it soon became clear that, besides the limited US attack on Afghanistan to unseat the Taliban regime and to kill or capture the Al Qaeda leadership in Afghanistan, the Bush Administration was planning for a much more ambitious military operation to effect regime change in Iraq and perhaps even in other neighboring countries in hopes of radically transforming the political landscape of the Middle East. The grandiose ambitions of the Bush administration and the likelihood that a major war of unknown scope and duration with unpredictable consequences might well begin sometime in early 2003 created a general feeling of apprehension and uncertainty that discouraged businesses from making significant new commitments until the war plans of the Administration were clarified and executed and their consequences assessed.

The Fed responded to the uncertain environment of 2002 with a series of interest rate reductions that prevented a lapse into recession.

Gauging the unusual increase in the demand for liquidity in 2002 and 2003, the Fed reduced short-term rates to accommodate increasing demands for liquidity, even as the economy entered into a weak expansion and recovery. Given the unusual increase in the demand for liquidity, the accommodative stance of the Fed and the reduction in the Fed Funds target to an unusually low level of 1% had no inflationary effect, but merely cushioned the economy against a relapse into recession.

Recently, the uncertainty caused by the imposition of tariffs and the threat of a destructive trade war seems to have discouraged firms to go forward with plans to invest and to expand output as decision-makers prefer to wait and see how events play out before making long-term commitments that would put assets and investments at serious risk if a trade war undermines the conditions necessary for those investment to be profitable. In the interim, decision-makers seeking short-term safety and the flexibility to deploy their assets and resources profitably once future prospects become less uncertain leads them to take highly liquid positions that don’t preclude taking future profitable actions once profitable opportunities present themselves.

However, when everyone resists making commitments, economic activity doesn’t keep going as before, it gradually slows down. And so a state of heightened uncertainty eventually leads to a stagnation or recession or something worse. To prevent or mitigate that outcome, a reduction in interest rates by the central bank can prevent or at least postpone the onset of a recession, as the Fed succeeded in doing in 2002-03 by reducing its interest rate target to 1%. Similar steps by the Fed may now be called for.

But there is another question that ought to be discussed. When the Fed reduced interest rates in 2002-03 because of the uncertainty created by the pending decision of the US government about whether to invade Iraq, the Fed was probably right to take that uncertainty as an exogenous decision in which it had no decision-making role or voice. The decision to invade or not would be made based on considerations over which the Fed rightly had no role to evaluate or opine upon. However, the Fed does have a responsibility for creating a stable economic environment and eliminating avoidable uncertainty about economic conditions caused by bad policy-making. Insofar as the current uncertain economic environment is the result of deliberate economic-policy actions that increase uncertainty, reducing interest rates to cushion the uncertainty-increasing effects of imposing, or raising, tariffs or of promoting a trade war would enable those uncertainty-increasing actions to be continued.

The Fed, therefore, now faces a cruel dilemma. Should it try to mitigate, by reducing interest rates, the effects of policies that increase uncertainty, thereby acting as a perhaps unwitting enabler of those policies, or should it stand firm and refuse to cushion the effects of policies that are themselves the cause of the uncertainty whose destructive effects the Fed is being asked to mitigate? This is the sort of dilemma that Arthur Burns, in a somewhat different context, once referred to as “The Agony of Central Banking.”

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August 15, 1971: Unhappy Anniversary (Update)

[Update 8/15/2019: It seems appropriate to republish this post originally published about 40 days after I started blogging. I have made a few small changes and inserted a few comments to reflect my improved understanding of certain concepts like “sterilization” that I was uncritically accepting. I actually have learned a thing or two in the eight plus years that I’ve been blogging. I am grateful to all my readers — both those who agreed and those who disagreed — for challenging me and inspiring me to keep thinking critically. It wasn’t easy, but we did survive August 15, 1971. Let’s hope we survive August 15, 2019.]

August 15, 1971 may not exactly be a day that will live in infamy, but it is hardly a day to celebrate 40 years later.  It was the day on which one of the most cynical Presidents in American history committed one of his most cynical acts:  violating solemn promises undertaken many times previously, both before and after his election as President, Richard Nixon declared a 90-day freeze on wages and prices.  Nixon also announced the closing of the gold window at the US Treasury, severing the last shred of a link between gold and the dollar.  Interestingly, the current (August 13th, 2011) Economist (Buttonwood column) and Forbes  (Charles Kadlec op-ed) and today’s Wall Street Journal (Lewis Lehrman op-ed) mark the anniversary with critical commentaries on Nixon’s action ruefully focusing on the baleful consequences of breaking the link to gold, while barely mentioning the 90-day freeze that became the prelude to  the comprehensive wage and price controls imposed after the freeze expired.

Of the two events, the wage and price freeze and subsequent controls had by far the more adverse consequences, the closing of the gold window merely ratifying the demise of a gold standard that long since had ceased to function as it had for much of the 19th and early 20th centuries.  In contrast to the final break with gold, no economic necessity or even a coherent economic argument on the merits lay behind the decision to impose a wage and price freeze, notwithstanding the ex-post rationalizations offered by Nixon’s economic advisers, including such estimable figures as Herbert Stein, Paul McKracken, and George Schultz, who surely knew better,  but somehow were persuaded to fall into line behind a policy of massive, breathtaking, intervention into private market transactions.

The argument for closing the gold window was that the official gold peg of $35 an ounce was probably at least 10-20% below any realistic estimate of the true market value of gold at the time, making it impossible to reestablish the old parity as an economically meaningful price without imposing an intolerable deflation on the world economy.  An alternative response might have been to officially devalue the dollar to something like the market value of gold $40-42 an ounce.  But to have done so would merely have demonstrated that the official price of gold was a policy instrument subject to the whims of the US monetary authorities, undermining faith in the viability of a gold standard.  In the event, an attempt to patch together the Bretton Woods System (the Smithsonian Agreement of December 1971) based on an official $38 an ounce peg was made, but it quickly became obvious that a new monetary system based on any form of gold convertibility could no longer survive.

How did the $35 an ounce price became unsustainable barely 25 years after the Bretton Woods System was created?  The problem that emerged within a few years of its inception was that the main trading partners of the US systematically kept their own currencies undervalued in terms of the dollar, promoting their exports while sterilizing the consequent dollar inflow, allowing neither sufficient domestic inflation nor sufficient exchange-rate appreciation to eliminate the overvaluation of their currencies against the dollar. [DG 8/15/19: “sterilization” is a misleading term because it implies that persistent gold or dollar inflows just happen randomly; the persistent inflow occur only because they are induced by a persistent increased demand for reserves or insufficient creation of cash.] After a burst of inflation in the Korean War, the Fed’s tight monetary policy and a persistently overvalued exchange rate kept US inflation low at the cost of sluggish growth and three recessions between 1953 and 1960.  It was not until the Kennedy administration came into office on a pledge to get the country moving again that the Fed was pressured to loosen monetary policy, initiating the long boom of the 1960s some three years before the Kennedy tax cuts were posthumously enacted in 1964.

Monetary expansion by the Fed reduced the relative overvaluation of the dollar in terms of other currencies, but the increasing export of dollars left the $35 an ounce peg increasingly dependent on the willingness of foreign government to hold dollars.  However, President Charles de Gaulle of France, having overcome domestic opposition to his rule, felt secure enough to assert [his conception of] French interests against the US, resuming the traditional French policy of accumulating physical gold reserves rather than mere claims on gold physically held elsewhere.  By 1967 the London gold pool, a central bank cartel acting to control the price of gold in the London gold market, was collapsing, as France withdrew from the cartel, demanding that gold be shipped to Paris from New York.  In 1968, unable to hold down the market price of gold any longer, the US and other central banks let the gold price rise above the official price, but agreed to conduct official transactions among themselves at the official price of $35 an ounce.  As market prices for gold, driven by US monetary expansion, inched steadily higher, the incentives for central banks to demand gold from the US at the official price became too strong to contain, so that the system was on the verge of collapse when Nixon acknowledged the inevitable and closed the gold window rather than allow depletion of US gold holdings.

Assertions that the Bretton Woods system could somehow have been saved simply ignore the economic reality that by 1971 the Bretton Woods System was broken beyond repair, or at least beyond any repair that could have been effected at a tolerable cost.

But Nixon clearly had another motivation in his August 15 announcement, less than 15 months before the next Presidential election.  It was in effect the opening shot of his reelection campaign.  Remembering all too well that he lost the 1960 election to John Kennedy because the Fed had not provided enough monetary stimulus to cut short the 1960-61 recession, Nixon had appointed his long-time economic adviser, Arthur Burns to replace William McChesney Martin as chairman of the Fed in 1970.  A mild tightening of monetary policy in 1969 as inflation was rising above a 5% annual rate, had produced a recession in late 1969 and early 1970, without providing much relief from inflation.  Burns eased policy enough to allow a mild recovery, but the economy seemed to be suffering the worst of both worlds — inflation still near 4 percent and unemployment at what then seemed an unacceptably high level of almost 6 percent. [For more on Burns and his deplorable role in all of this see this post.]

With an election looming ever closer on the horizon, Nixon in the summer of 1971 became consumed by the political imperative of speeding up the recovery.  Meanwhile a Democratic Congress, assuming that Nixon really did mean his promises never to impose wage and price controls to stop inflation, began clamoring for controls as the way to stop inflation without the pain of a recession, even authorizing the President to impose controls, a dare they never dreamed he would accept.  Arthur Burns, himself, perhaps unwittingly [I was being too kind], provided support for such a step by voicing frustration that inflation persisted in the face of a recession and high unemployment, suggesting that the old rules of economics were no longer operating as they once had.  He even offered vague support for what was then called an incomes policy, generally understood as an informal attempt to bring down inflation by announcing a target  for wage increases corresponding to productivity gains, thereby eliminating the need for businesses to raise prices to compensate for increased labor costs.  What such proposals usually ignored was the necessity for a monetary policy that would limit the growth of total spending sufficiently to limit the growth of wage incomes to the desired target. [On incomes policies and how they might work if they were properly understood see this post.]

Having been persuaded that there was no acceptable alternative to closing the gold window — from Nixon’s perspective and from that of most conventional politicians, a painfully unpleasant admission of US weakness in the face of its enemies (all this was occurring at the height of the Vietnam War and the antiwar protests) – Nixon decided that he could now combine that decision, sugar-coated with an aggressive attack on international currency speculators and a protectionist 10% duty on imports into the United States, with the even more radical measure of a wage-price freeze to be followed by a longer-lasting program to control price increases, thereby snatching the most powerful and popular economic proposal of the Democrats right from under their noses.  Meanwhile, with the inflation threat neutralized, Arthur Burns could be pressured mercilessly to increase the rate of monetary expansion, ensuring that Nixon could stand for reelection in the middle of an economic boom.

But just as Nixon’s electoral triumph fell apart because of his Watergate fiasco, his economic success fell apart when an inflationary monetary policy combined with wage-and-price controls to produce increasing dislocations, shortages and inefficiencies, gradually sapping the strength of an economic recovery fueled by excess demand rather than increasing productivity.  Because broad based, as opposed to narrowly targeted, price controls tend to be more popular before they are imposed than after (as too many expectations about favorable regulatory treatment are disappointed), the vast majority of controls were allowed to lapse when the original grant of Congressional authority to control prices expired in April 1974.

Already by the summer of 1973, shortages of gasoline and other petroleum products were becoming commonplace, and shortages of heating oil and natural gas had been widely predicted for the winter of 1973-74.  But in October 1973 in the wake of the Yom Kippur War and the imposition of an Arab Oil Embargo against the United States and other Western countries sympathetic to Israel, the shortages turned into the first “Energy Crisis.”  A Democratic Congress and the Nixon Administration sprang into action, enacting special legislation to allow controls to be kept on petroleum products of all sorts together with emergency authority to authorize the government to allocate products in short supply.

It still amazes me that almost all the dislocations manifested after the embargo and the associated energy crisis were attributed to excessive consumption of oil and petroleum products in general or to excessive dependence on imports, as if any of the shortages and dislocations would have occurred in the absence of price controls.  And hardly anyone realizes that price controls tend to drive the prices of whatever portion of the supply is exempt from control even higher than they would have risen in the absence of any controls.

About ten years after the first energy crisis, I published a book in which I tried to explain how all the dislocations that emerged from the Arab oil embargo and the 1978-79 crisis following the Iranian Revolution were attributable to the price controls first imposed by Richard Nixon on August 15, 1971.  But the connection between the energy crisis in all its ramifications and the Nixonian price controls unfortunately remains largely overlooked and ignored to this day.  If there is reason to reflect on what happened forty years ago on this date, it surely is for that reason and not because Nixon pulled the plug on a gold standard that had not been functioning for years.

Irving Fisher Demolishes the Loanable-Funds Theory of Interest

In some recent posts (here, here and here) I have discussed the inappropriate application of partial-equilibrium analysis (aka supply-demand analysis) when the conditions under which the ceteris paribus assumption underlying partial-equilibrium analysis are not satisfied. The two examples of inappropriate application of partial equilibrium analysis I have mentioned were: 1) drawing a supply curve of labor and demand curve for labor to explain aggregate unemployment in the economy, and 2) drawing a supply curve of loanable funds and a demand curve for loanable funds to explain the rate of interest. In neither case can one assume that a change in the wage of labor or in the rate of interest can occur without at the same time causing the demand curve and the supply curve to shift from their original position to a new one. Because of the feedback effects from a change in the wage or a change in the rate of interest inevitably cause the demand and supply curves to shift, the standard supply-and-demand analysis breaks down in the face of such feedback effects.

I pointed out that while Keynes correctly observed that demand-and-supply analysis of the labor market was inappropriate, it is puzzling that it did not occur to him that demand-and-supply analysis could not be used to explain the rate of interest.

Keynes explained the rate of interest as a measure of the liquidity premium commanded by holders of money for parting with liquidity when lending money to a borrower. That view is sometimes contrasted with Fisher’s explanation of the rate interest as a measure of the productivity of capital in shifting output from the present to the future and the time preference of individuals for consuming in the present rather waiting to consume in the future. Sometimes the Fisherian theory of the rate of interest is juxtaposed with the Keynesian theory by contrasting the liquidity preference theory with a loanable-funds theory. But that contrast between liquidity preference and loanable funds misrepresents Fisher’s view, because a loanable funds theory is also an inappropriate misapplication of partial-equilibrium analysis when general-equilibrium anlaysis is required.

I recently came upon a passage from Fisher’s classic 1907 treatise, The Rate of Interest: Its Nature, Determination and Relation to Economic Phenomena, which explicitly rejects supply-demand analysis of the market for loanable funds as a useful way of explaining the rate of interest. Here is how Fisher made that fundamental point.

If a modern business man is asked what determines the rate of interest, he may usually be expected to answer, “the supply and demand of loanable money.” But “supply and demand” is a phrase which has been too often into service to cover up difficult problems. Even economists have been prone to employ it to describe economic causation which they could not unravel. It was once wittily remarked of the early writers on economic problems, “Catch a parrot and teach him to say ‘supply and demand,’ and you have an excellent economist.” Prices, wages, rent, interest, and profits were thought to be fully “explained” by this glib phrase. It is true that every ratio of exchange is due to the resultant of causes operating on the buyer and seller, and we may classify these as “demand” and supply.” But this fact does not relieve us of the necessity of examining specifically the two sets of causes, including utility in its effect on demand, and cost in its effect on supply. Consequently, when we say that the rate of interest is due to the supply and demand of “capital” or of “money” or of “loans,” we are very far from having an adequate explanation. It is true that when merchants seek to discount bills at a bank in large numbers and for large amounts, the rate of interest will tend to be low. But we must inquire for what purposes and from what causes merchants thus apply to a bank for the discount of loans and others supply the bank with the funds to be loaned. The real problem is: What causes make the demand for loans and what causes make the supply? This question is not answered by the summary “supply and demand” theory. The explanation is not simply that those who have little capital demand them. In fact, the contrary is often the case. The depositors in savings banks are the lenders, and they are usually poor, whereas those to whom the savings bank in turn lends the funds are relatively rich. (pp. 6-7)


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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