Tuesday, August 9, 2016

You can lower interest rates but can you raise inflation?

Last week the Bank of England lowered their interest rates. This combined with previous moves by the ECB and the Bank of Japan and the reduced probability that the US Federal Reserve will increase rates soon is a reminder that any normalization of interest rates towards positive territory among advanced economies will have to wait a few more months, or years (or decades?).

The message from the Bank of England, which is not far from recent messages by the Bank of Japan or the ECB is that they could cut interest rates again if needed (or be more aggressive with QE purchases).

Long-term interest rates across the world decreased even further. The current levels of long-term interest rates have made the yield curve extremely flat.

And in several countries (e.g. Switzerland) interest rates at all horizons are falling into negative territory.

The fact that long term interest rates is typically seen as the outcome of large purchases of assets by central banks around the world. In fact, many see it as a success of monetary policy actions.

But if monetary policy is being successful we expect inflation expectations and growth expectations to increase. Both of these forces should push long-term interest rates higher not lower!  Something is fundamentally not working when it comes to monetary policy and it is either the outcome of some forces that the central banks are unable to counteract or the fact that central banks are not getting their actions and communications right.

On the communications I will repeat the argument I made earlier: When central banks repeat over and over again that they can lower interest rates even more they are misleading some to believe that lower interest rates (long-term and short-term, real and nominal) are a measure of success of monetary policy. This is not right. Lower nominal interest rates across all maturities cannot be an objective when inflation and growth are seen as too low. Success must mean higher nominal interest rates. And success must mean at some point a steeper yield curve not a flatter one.

Why are central banks failing in their communications? I see two reasons:

1. They want to send a message that they are both powerful and not out of ammunition. Repeat with me: "Interest rates are low and they can get even lower."

2. These are interesting times. With short terms rates stuck around zero, all the action of the yield curve has to come from long-term rates and, in addition, QE and the massive purchase of assets is also a new phenomenon that is not always well understood by market participants.

My guess is that it is this combination of circumstances that are unusual by historical standards and the difficulty of communicating a complex monetary policy strategy by central banks that are sending long-term interest rates to even lower levels. These levels are not consistent with any reasonable scenario for growth or interest rates over the next decades. When 30 or even 50 year interest rates are negative or close to zero something is not right. Either this is the end of growth as we know it or the start of a 30-year period of extremely low inflation combined with deflation or our expectations are seriously off and we are up for an interesting surprise.

Antonio Fatás

Wednesday, August 3, 2016

Experts, facts and media

Jean Pisani-Ferry has written a very interesting post about the need for trusted experts in a democracy. The post addresses the criticisms that economic experts have received as a result of the Brexit vote. Quoting from his post:
"Representative democracy is based not only on universal suffrage, but also on reason. Ideally, deliberations and votes result in rational decisions that use the current state of knowledge to deliver policies that advance citizens’ wellbeing."
Very well said. He also brings up the point that the lack of influence of economic experts is not that different from that of other experts (as illustrated by the debates on climate science, GMOs,...). I share that view and my guess is that the mistrust of economic experts is simply more visible because of their influence (or lack of) in the political debates that tend to be a lot more present in the media than the debates on scientific issues.

How to enhance the trust on experts? Not obvious, according to Pisani-Ferry. What is needed is a combination of of discipline among the community of experts, an education system that equips citizens with the tools to distinguish between facts and fiction and the development of better venues for dialogue and informed debate.

Good luck! Unfortunately we are very far from this ideal scenario. Education has reached more citizens than ever, more so in advanced economies, but we see little difference. It might be that the complexity of the issues that are being debated is at a level which still does not allow us to have an informed discussion based on facts and not ideology. Opinions that are expressed using either the wrong facts or no facts at all somehow are able to reach the public and have an influence that is as large as that of those who present the facts. And the media does not serve at all as a filter, maybe because controversy sells or maybe because there is a need to present a 'balanced' view of the debate or simply because of self-interest.

Here is my example of the day that illustrates this point: the Financial Times published two articles yesterday on the merits of quantitative easing. One argued for more QE under the logic that is working and we just need to increase the dosage. The second one presented the view that quantitative easing (as well as expansionary fiscal policy) are the wrong tools to use to generate a recovery and that they are likely to lead to a very unhappy ending.

If you read the second article you will notice the use of dubious facts and an economic logic that anyone who has ever taken any economics course should realize that is badly flawed.

Let me pick one example. The article starts with the figure of 300% of GDP for global debt and then it argues that
"If the average interest rate is 2 per cent, then a 300 per cent debt-to-GDP ratio means that the economy needs to grow at a nominal rate of 6 per cent to cover interest."
This is just wrong on so many counts:

  • The increase in debt in the world is matched by an increase in assets. 
  • The interest rate paid by borrowers goes to lenders. So the world (or a given country) does not need to find income to pay for this interest, this is a transfer from borrowers to lenders.
  • Borrowers need to pay for the interest but if debt is coming from a mortgage to buy a house, I do not need to pay rent anymore. Looking at interest payments alone (or at liabilities without taking into account assets) is just wrong.
  • The 300% number cannot be associated to a country or a government, most debt is internal. No country has an external debt that is anywhere close to that level. Same is true for governments (with the exception of Japan which is not far, but, once again, most of this debt is internal - so the interest that the government of Japan has to pay goes to the Japanese citizens who happen to be the taxpayers).
  • Even if you had a government that had 300% of debt, the calculation above is simply wrong. If interest rates are 2%, you need to grow at 2% (not 6%) to ensure that the debt-to-GDP ratio stays constant (as long as your additional borrowing or saving is zero, of course). This is something that is taught in a principle of economics course. The authors are confusing the value of interest payments and the required growth to make that level of debt sustainable.
The rest of the article contains many other mistakes. It is embarrassing that the Financial Times is willing to publish such a low quality article.

Will this article influence anyone's view on the debate on monetary policy? I do not know but what I know is that the pessimistic view presented in the article on the role that monetary and fiscal policy is popular enough that is still influencing both the debate around and also the outcome of current economic policies.

So we are very far from having informed and factual debates about the economic (and scientific) issues that shape economic and social outcomes. As an economist I continue to do my best by sharing my views and analysis with a wide audience through blog posts like this one but it is depressing to see how those that rely on flawed analysis often manage to reach the public through the validation of the most respected media.

Antonio Fatás