Friday, January 9, 2015

Don't Worry, Be Happy: Falling Treasury Yields Edition

Long-term treasury interest rates are falling again with the 10-year treasury briefly dipping below 2% this week. Some observers see this decline in yields as an omen for the U.S. economy:
The United States economy is accelerating... Yet a huge bond market with a strong track record for predicting economic problems is flashing a warning sign right now.The prices of Treasury bonds are rallying fiercely. The slide in oil prices has elevated concerns about growth in the global economy, and investors, as they do in times of stress and uncertainty, are seeking out the safety of government bonds. 
The rally in global government debt is pushing their yields, which move in the opposite direction from their price, to astonishing lows... “Make no mistake, these low levels of rates are challenging the notion that we are going to see robust and constant growth,” said George Goncalves, a bond market analyst with Nomura. In other words, the bond market is raising the specter that a period of economic growth that may have already felt lackluster to many Americans could be on the verge of losing steam. 
So is this dire view of the falling interest warranted? I am not convinced that it is, but before I explain why it is worth noting that even monetary authorities are bewildered by it. According to the Wall Street Journal's Jon Hilsenrath (AKA the "Fed Wire"), Fed officials are not sure how to interpret what is going on with yields: 
Falling long-term interest rates pose a quandary for Federal Reserve officials... If falling yields are a reflection of diminishing inflation prospects, as is typically the case, it ought to prompt the Fed to hold off on raising short-term interest rates in the months ahead. If, on the other hand, lower long-term rates are a reflection of investors pouring money into U.S. dollar assets, flows that could spark a U.S. asset price boom, it might prompt the Fed to push rates higher sooner or more aggressively than planned. 
[...] 
The Fed’s next policy meeting is three weeks away. It is clear officials will spend a considerable time debating the correct response to a perplexing lurch down in long-term rates.
The worried market observers and the perplexed Fed officials should take a deep breath. The Adrian, Crump, and Moench (2013) method of decomposing treasury yields paints a far more benign story, one that signals the U.S. recovery is on a solid footing.

To see why, we first need to recall that long-term interest rates can be broken down as follows:
(1) long-term interest rate = average short-term interest rate expected over same horizon + term premium
The term premium is the added compensation investors require for the risk of holding long-term treasuries over short-term ones. For example, if investors are worried that the Eurozone crisis is about to flare up again and desire to hold more U.S. treasuries, they will demand less compensation to hold the long-term securities. This will drive down the term premium. The term premium is also the component of the long-term interest rate the Fed was trying to manipulate with its large-scale asset purchases. 

The other component, the average short-term interest rate, is a nominal interest rate and via the Fisher relationship can be further decomposed into a real interest rate and an expected inflation:
(2) long-term interest rate = (average expected real short-term interest rate over same horizon + average expected inflation over same horizon) +  term premium
This average expected real short-term interest rate is often called the real risk-free interest rate since it is free of investor's risk considerations, the Fed's tinkering with risk premiums, and the expected path of inflation. This interest rate measure, consequently, tracks the fundamentals of the economy and is equivalent to the average expected path of the 'natural interest rate'. 

By looking at these components we can make sense of what is driving the fall in yields. We can also look to the real risk-free interest to see what it implies about the health of the U.S. economy. The Adrian, Crump, and Moench (2013) decomposition of the 10-year treasury yield into these components is below:




What we see is that changes in inflation expectations and the term premium are both behind the decline in the 10-year treasury interest rate. This suggest that there may be concerns about future inflation--though this might also be reflect the temporary drop in inflation from declining oil prices--and that there has been a rush into treasuries because of the worries about the Eurozone and China.

But there is more. After being negative for several years, the real risk-free interest rate has been steadily climbing and is now positive. This only happens when the economic outlook improves as seen in the figure below. It shows a close relationship between the real risk-free interest rate and the business cycle:




So the upward trend of the real risk-free rate implies we are in the midst of a solid recovery in the United States. This interpretation is supported by the spate of positive economic news shows. Yes, the economic problems in Europe and China could eventually harm the U. S. economy.  But for now the U.S. economy seems to be in the clear. 

So be careful when interpreting long-term treasury yields. They might be signalling a robust recovery even if they are falling.

Sunday, January 4, 2015

Solving the ZLB Problem without Eliminating Cash

Should the Federal Reserve should eliminate cash as a way to avoid the zero lower bound (ZLB) problem? Ken Rogoff says yes in a recent paper. John Cochrane, on the other hand, is not ready to give up cash and is convinced that even if we did it would not solve the ZLB problem. Who is right?

Before answering these questions, let us recall the nature of the ZLB problem. It occurs when the market-clearing level of nominal short-term interest rates turn negative while actual short-term interest rates get stuck at 0%. This happens because individuals would rather hold paper currency at 0% than invest their money at a negative interest rate. The ZLB, in short, is a price floor that prevents interest rates from clearing the output market. And like any price floor, the ZLB creates a glut. In this case, it is an economy wide-glut better known as a recession.

So why not get rid of cash, as suggested by Ken Rogoff? John Cochrane gives several reasons why getting rid of cash may not be such a good idea. First, doing so would hurt the people who depend the most on cash: the poor who do not have access to or do not trust the formal banking system, the foreigners who need hard currency (e.g. Zimbabwe), and those wanting anonymity in their transactions. I share these concerns. Are harming these groups really worth beating the infrequent ZLB?

You might take an utilitarian approach and say yes, but even then it would be wrong. For one does not need to eliminate cash to solve the ZLB problem. As Miles Kimball has argued for the past few years, all that is needed is to make electronic (deposit) money the sole unit of account and turn the current fixed exchange rate between cash and deposits into a crawling peg based on the state of the economy. When the economy falls into a slump and the central bank needs to set a negative interest rate target to restore full employment, the peg would adjust so that paper currency would lose value relative to electronic money such that folks would not rush to it as interest rates go negative. This would effectively impose the same penalty on cash and deposits and kick start the monetary hot potato. Once the economy started improving, the crawling peg would start adjusting toward parity.

Now this is where John Cochrane's second objection comes into play. He worries that even if the Federal Reserve did lower short-term interest rates to a significantly negative value (say -5%) it still would probably not work because individuals would cleverly find other assets that would earn a 0% nominal return. Here is Cochrane:
[Q]uiz question for your economic classes: Suppose we have substantially negative interest rates -- -5% or -10%, say, and lasting a while. But there is no currency. How else can you ensure yourself a zero riskless nominal return?    
Here are the ones I can think of:    
(1) Prepay taxes. The IRS allows you to pay as much as you want now, against future taxes.  
(2) Gift cards. At a negative 10% rate, I can invest in about $10,000 of Peets' coffee cards alone. There is now apparently a hot secondary market in gift cards, so large values and resale could take off.  
(3) Likewise, stored value cards, subway cards, stamps. Subway cards are anonymous so you could resell them.  
(4) Prepay bills. Send $10,000 to the gas company, electric company, phone company.  
(5) Prepay rent or mortgage payments.  
(6) Businesses: prepay suppliers and leases. Prepay wages, or at least pre-fund benefits that workers must stay employed to earn.  
Cochrane should be more optimistic here. For all of these options only move the negative interest rate problem from one party to another. Here, the issuers of the 0% yielding assets have inherited the negative interest rate problem. They have effectively borrowed money at 0% and must decide if they want to deposit the funds at -5% in their banks or invest in something with a higher yield like riskier financial assets or capital expenditures. Obviously, the former option is not sustainable so they will opt for the latter one. But the latter option implies more risk taking and spending--the old monetary "hot potato" at work! So even in these cases the negative interest rate is still doing its intended job. Bill Woolsey makes this point in his response to Cochrane:
I am going to start with Cochrane's second example.  People could supposedly get a riskless zero nominal rate of return by purchasing gift cards... Under usual circumstances, when a retailer sells a card it is getting a loan... a zero interest loan. And so, now the retailer has the money. What do they do with it? If the interest rate on money is sufficiently negative, then the retailer will find borrowing money at a zero interest rate and then paying to hold it  unattractive. Of course, perhaps the retailer can invest by purchasing assets that have a positive yield. Or maybe they will accumulate inventory to be prepared for the greater sales when the cards are spent. It doesn't matter. As long as the retailer doesn't hold the money, the lower (below zero) nominal interest rate has done its job. 
[...] 
And what does Walmart do with the money it receives?  If it holds it, that is a problem. But that is what the below zero interest rate on money aims to deter. If Walmart purchases other assets or purchases inventories of goods, constructs new buildings, or whatever, the problem is solved. 
Consider Cochrane's fourth example--pre-paying utilities... [I]f the utility companies allowed people to [prepay and] have credit balances on their accounts and didn't charge any fee, the question remains, what does the utility do with the money? All the negative yield on money is supposed to do is reduce the amount people want to hold. If the utility spends the money on other financial assets or spends it to construct a new plant, the negative yield on money has done its job. 
Cochrane also says that people could prepay their mortgages or their rent... what are the monetary consequences?   Paying down bank mortgages tends to contract the quantity of money.  However, any single bank receiving such repayments will accumulate reserves.   And the interest rate on that form of money is negative as well... Banks are motivated to purchase other assets due to these negative yields on reserves.
Scott Sumner and JP  Koning make similar arguments. The good news here is the John Cochrane can take solace in knowing the ZLB can be tackled without eliminating cash via Miles Kimball's approach and it can be effective in restoring full employment. Negative nominal interest rates will still get the monetary hot potato going.   

Along these lines, it is worth noting that another way of looking at the ZLB problem is that it creates excess money demand. That is, the ZLB prevents the desired money holdings of individuals from lining up with the supply of money. This is a big deal because, as Nick Rowe likes to reminds us, money is the only asset on every market. Disrupt the supply of or demand for this one asset and you will disrupt every market. In the case of excess money demand you get a recession. This 'monetary disequilibrium' view of the ZLB implies, therefore, that the real reason we may sometimes need negative nominal interest rates is to restore monetary equilibrium.

Related:
Miles and Scott's Excellent Adventure