In a speech entitled – with breathtaking hubris – “The Worldwide Conquest of Inflationâ€, the neophyte Fed Governor Randall Kroszner quotes Hayek’s proposals for currency ‘denationalization’ as support for his thesis that competition between fiat currencies has somehow encouraged a ‘race to the top’ among them, thus retarding the ongoing debasement of our monies.
Those of us whose lot it is regularly to read financial reports and economic data releases – and who are therefore continually bombarded with tales of the record issuance of credit instruments, the record turnover and growth rates of the associated financial derivatives, as well as record M&A and LBO activity (all of this, in great part, conducted at record low credit spreads or exceedingly high leverage ratios, accompanied by unusually lax loan covenants and amid record low measures of financial asset volatility) – may here allow ourselves a wry smile at Mr. Kroszner’s gross misunderstanding of what constitutes ‘inflation’.
Kroszner also makes an attempt to deal with the phenomenon of the negative yield curve which has been exercising so many stock-watchers and macro-forecasters of late.
Warming to his theme, the Governor puts it all down to “the combination of lower and less volatile inflation around the world†which – under benign central bank guidance, of course – has led to “a reduction in inflation expectations and lower perceived inflation risk, and hence to a lower premium in long rates for inflation uncertainty…. important contributors to the lower long-term yields and the flattening of yield curves.â€
Thus, Kroszner attaches a benign explanation to what the empiricists have been touting as a sign of our impending cyclical doom. Though we can dismiss his over-sanguine explanation almost as readily as his boss’s gibberish about a ‘global savings glut’, we should also note that the pessimistic consensus has taken past correlation blindly to imply causation and has, in typical fashion, failed to conduct any deeper, rational inquiry into why inverted yield curves often signal an imminent end to the boom and why therefore they are never a sufficient condition for the relapse (and may not even be a necessary one).
As I wrote in a recent report to my company’s investors, the bust comes about when the degree of overstretch and disco-ordination in the productive structure – which the boom’s inflationary fuel has progressively induced – at last becomes a widespread and binding constraint upon the further execution of misplaced entrepreneurial activities:
“… it is this combination of a scramble for the necessary co-factors to one’s own output (many of which may lie well downstream) and the associated dwindling of cash flow which tends to push up real short-term interest rates at the same time that the strident disharmonies in the structure discourage or disable longer-term investments and so lessen the pressure on long rates.â€
“This is why an inverted yield often presages a crisis, since the exigent demand for money which twists time rates in this fashion is, in effect, a signal of a generalized scarcity of present goods: to borrow a term from commodity markets, it is akin to a widespread ‘backwardation’ of circulating capital, of a dire lack of the needed complements to all too many misconceived productive plans.â€
“Thus, contrary to the many who rely, not upon a theory as to why this should be so, but only upon a happenstance of the statistical record, it is also why such an occurrence should be disregarded when, as today, it is not accompanied by elevated real short rates, falling profits, rising risk premia, and direct evidence of credit restriction, but, rather, is only an artefact of prodigious, leveraged purchases of longer-dated securities acting in concert with a vast government programme of foreign exchange intervention through the same medium of the bond market.â€
Or, as Hayek put it, the truly ominous aspect of a negative yield curve is that which arises in a situation where ‘investment raises the demand for capital’ and not when inflation itself – properly defined – is boosting the price of riskier financial assets and thus suppressing long bond yields.
{ 13 comments }
This is deep waters for me, so I want to make sure I understand. Are you saying that the current inverted yield curve is, on the long end of the curver, the result of previous increases in the money supply, (which have inflated all asset prices, but in this case, the price of bonds)? And on the short end, higher rates are due to demand for capital to purchase complementary inputs to production? How does the Fed’s raising it’s rate fit in?
No, sir.
I am saying that the Fed’s increases have been relatively ineffective and clearly no impediment to further borrowing and/or financial leverage, one sign of this is the same inflation of asset values that is keeping long bond yields supressed (indeed, we could even argue that given that so many buyers are using lower cost foreign currencies to fund these purchases, the ‘world’ yield curve is not really negative at all!
Conversely, the situation in which the yield curve does forewarn of stress – i.e. that complementary capital is desperately needed – does NOT seem to be the case now.
Yes. Very good. Your additional comments: “(indeed, we could even argue that given that so many buyers are using lower cost foreign currencies to fund these purchases, the ‘world’ yield curve is not really negative at all!”
+
“that complementary capital is desperately needed – does NOT seem to be the case now.”
Add much clarity and resolve a fine insight.
Thanks! That helps. So you’re saying the yield curve isn’t really inverted if you subtract the inflation rate from the short term rate to get the real interest rate? Wouldn’t you do the same for the long rate, or do you assume inflation is factored into the long rate?
An article in the Nov 15 Financial Times makes the author sound nearly Austrian in his analysis of the US economy and money supply. Access require subscription, but here are some relevant passages:
“Compared to nominal gross domestic product, money of zero maturity – a measure of money supply – is still 35 per cent higher than in 1995…But it is no surprise that all this excess liquidity is at last showing up in the prices of goods and services, as well as assets.
“As a senior Federal Reserve official admitted earlier this month, interest rates stayed too low for too long during the current expansion, fuelling speculative activity, notably in housing.”
“…the recent slowdown in productivity growth…hints at some liquidity-driven capital misallocation. That suggests weaker growth and inflationary pressures might linger…”
In short, we’re suffering a hangover from Greenspan’s party.
Also struggling to get my arms around this…all very abstract (but important). I’m going to try a gross generalization to try to render some of this tangible:
The famous purchases by the central bank of China of US government securities (of long term) are what has inverted the yield curve.
There. Please fire away at it – I’m trying to flush out some tangible meaning from this
Following is taken from Mishkin’s book (Economics of Money, Banking and Financial Markets, 8th edit,p144);
“Because the yield curve contains information about future expected interest rates, it should also have the capacity to help forecast inflation and real output fluctuations. To see why recall from Chap 5 that rising interest rates are associated with economic booms and falling interest rates with recessions…
…Indeed, the yield curve is found to be an accurate predictor of the business cycle..
..The ability of the yield curve to forecast business cycles and inflation is one reason why the slope of the yield curve is part of the toolkit of many economic forecasters..”
What do you think about previous section? It seems that mainstream econ uses this much.
I’m still trying to work out the practical implications of this, myself, but it seems that Sean is saying that the yield curve isn’t a perfect indicator of business cycles, and the current yield curve doesn’t indicate a recession because we don’t have the symptoms of malinvestment present, such as “elevated real short rates, falling profits, rising risk premia, and direct evidence of credit restriction.” So I guess we should expect the credit boom to continue until short rates rise higher.
Also, as Joseph writes above, the drop in rates at the long end is due to China, and the Fed, buying those securities. Of course, it seems that the Chinese have the dollars to buy those securities because of the loose living of the Fed. Why the Fed continues to buy US bonds is a mystery, if they’re realling trying to rein in inflation, because that works against their policy of increases short rates.
This is complicated stuff, so don’t take my musings as gospel.
The yield curve’s reliability is being washed out by a global financial system awash in constantly increasing money supply (in spite of tight posture by the Fed), which is different from ordinary, entrepreneurial driven demand on rates. Much of the U.S. curve is driven by recycled deficit dollars and then carry-trades off foreign currencies, and not just from China (petro dollars, etc.). This depresses U.S. rates, and in turn enables the banking system to continue expanding credit at artificially low rates.
This is different from the issue of capital formation (and disintegration) as a determinant of economic health. ATBS demonstrates pretty clearly the eventual dislocations, which eventually lead to the inversion.
The problem IMO is in determining the true health of the finite capital stock that has been dislocated due to inflation.
A core consequence of inflation getting out of control is the washing out of usually reliable indicators, which leads to greater volatility in the markets. Simultaneously, entrepreneurial decisions become more complicated and a less attractive alternative for capital than speculation, especially when entrepreneurs are saddled with excessive bureaucracy — smothering regulatory / tax burdens that protect the enfranchised status quo from new entrants.
I’m with RogerM so far in his conclusion. My problem is with why, at this time, is the yield curve not reliable? I think I understand the idea that Chinese (and others) are supplying their real savings to offset the effects of the Fed’s inflation, but I’m not sure how this is distorting the information provided by the yield curve.
“Why the Fed continues to buy US bonds is a mystery, if they’re realling trying to rein in inflation, because that works against their policy of increases short rates.”
The second clause is where the problem lies. If they really wanted to rein in inflation, they have a very simple tool to do it – stop printing money. What they really want is to monetize government debt and provide positive inflation to sustain the banking and stock brokering industries, while not going too far that it causes popular unrest. Of course, like all government programs, they eventually go too far.
“Simultaneously, entrepreneurial decisions become more complicated and a less attractive alternative for capital than speculation”
Hmm. I personally see speculation as the lowest (and therefore least common in a true free market) form of entrepreneurial activity. I’d be interested to see the definitions where they are in fact separate categories.
hello RogerM, hello Potts,
- Raghuran Rajan himself, IMF’s chief economist, as well as others, wrote about a USA-CHINA agreement: USA lets China enter the WTO and export its goods to USA (while printing far more money tha the FED to keep the Yuan underpriced against the Dollar, I add)and China provides USA with own savings through buying Treasuries and T-Bonds (this helps USA interest rates in being lower than the domestic market alone would); Why? For guiding the economy to a soft landing after Fed’s previous easy-money policy: its pumping money has led to bubbles, and the answer to bubbles bursting has been an even laxer policy and, by a non-keynesian point of view, this equates summing up two wrongs which will not make it right.
General Asia’s purchasing USA Bonds would not be explained otherwise: USA Bonds back a hing and increasing debt (both internal and external) and Asia’s Central Banks profits could be raised by some portfolio diversification, but this option has been only recently discussed; Bank of China’s (and the others’) behaviour is far more politically than financially driven.
hello Quasibill,
- Consider interest rates themselves as a price for capital: such a heavy intrusion in USA capital market as China’s must clearly bias the market signals (interest rates), which in this case would show less or no capital scarcity than they would otherwise (e.g. lower real interest rates, no signs of credit restrictions, in Corrigan words).
Anyway, economic letterature about the yield curve’s forecasting power is actually mixed, hence we must consider it as a tool but absolutely no rule-of-thumb.
I did like what Corrigan exposed: interest rates as moving in response to business dynamics, as the price of capital, all along the yield curve, and not the mere summing up of inflationary expectations which common university courses wanted me to believe.
L.Baggiani,
Very interesting info. Thanks!
ironic?
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