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Hmm. I wonder how this story connects with the puzzle of the 15-year asset price bubble?.

Must think on this.

This is much to assimilate.

"If by "money" in the above paragraph we mean money in the narrowest sense - "currency", then central banks must own all the real assets in a zero interest rate economy, since people always prefer money to real assets"

Is this an argument against ZIRP? Would it be better to raise actually raise interest rates to something non-zero, admit the monetary policy ain't going to work, and go full throttle with fiscal policy?

Even I understand spending gov't money on sewers, schools, hospitals etc to stimulate the economy, but ZIRP is sounding like a crazy and scary place I don't want to visited.

Patrick: It is certainly an argument against deliberately pushing inflation so low (i.e. negative) that you end up in a ZIRP (in other words, it's an argument against Milton Friedman's 'Optimum Quantity of Money', though whether Friedman intended it as a practical policy recommendation is another question, since it contradicted his other practical policy advice). But if you find yourself in a ZIRP by accident, where a short-run ZIRP is the only cure for a long-run ZIRP, then no.

Here's the strange thing about interest rates: starting in equilibrium, with steady inflation, if the central bank cuts the rate of interest, inflation will begin to rise, and keep on rising, and the central bank will have to raise interest rates, not just to where they were before, but above where they were before, to keep inflation steady at a new higher level. Low interest rates cause high interest rates; high interest rates cause low interest rates.


Recap: Central banks face the zero bound for policy interest rates, which are a type of wholesale deposit rate (i.e. interbank deposit rate). Commercial banks face the zero bound for rates on retail deposits of a particular type – those that are a near substitute for currency. These are sometimes called core deposits. Because core deposit rates are typically lower than the central bank policy rate, they hit the zero bound before the policy rate does. So with disinflation and declining interest rates, each of policy rates, retail rates, and retail spreads head toward the zero bound.

There is no comparable zero bound compression risk for the spread between wholesale rates and higher lending rates. Zero bound deposit spread compression may end up being subsidized by unbounded lending spread expansion (e.g. prime rate not following the bank rate down 1:1).

Krugman just wrote an interesting post on the zero bound, the yield curve, and interest rate optionality:

“But here’s the thing: the Fed can’t cut rates from here, because they’re already zero. It can, however, raise rates. So the long-term rate has to be above the short-term rate, because under current conditions it’s like an option price: short rates might move up, but they can’t go down.”


Core deposit pricing at the zero bound includes a similar optionality. Core deposits are usually the focus of “maturity transformation” discussions, where bank liquidity risk and deposit runs are the issues. But the zero bound for core deposit interest rates means there’s a different type of problem in interpreting their interest rate risk. So long as the deposit base is stable, and the zero bound is binding, they behave like long term fixed rate funding. But there is still the (option) risk that their interest rates might go up in the future. So the history of declining interest rates means that bank liabilities have tended to become longer in their effective duration (based on pricing rather than the risk of bank runs). Insurance companies have faced a similar problem, but more serious, in hedging their long term actuarial liabilities.

I’m not so familiar with the monetary theory you refer to, but it seems to me that asset bubble deflations have driven much of the risk aversion that is leading people to desire money rather than risk assets. Risk free interest rates have collapsed while risk premiums and the cost of capital have exploded. We have zero interest treasury bills, record corporate bond spreads, and Canadian banks doing equity issues at very depressed stock price levels. Does Friedman’s theory take into account this sort of boom and bust dynamic?

As bank interest margins came under general pressure as described, banks diversified their business model into things like wealth management and investment banking and became less reliant in a relative sense on the core businesses of deposits and lending. At the same time, capital requirements and capital management came under much more scrutiny, including the Basel capital guidelines. Ironically, it was the focus on capital requirements that allowed banks to crank up the securitization machine and move at least some of their funding for mortgages and credit cards off balance sheet.

I find the strange thing about interest rates is that conventional monetary policy success by definition will drive nominal and real rates toward zero, where the balance between inflation and deflation is most precarious, and therefore where the risks for monetary policy stability become the greatest – sort of like an expiring option, where the swings in option “gamma” can be very wild and difficult to control.

Sorry if it's somewhat OT for this thread ....

Excellent post by Brad Setser today:


From his post:

"Central banks were the main source of financing for the US deficit all along.*** Setting Japan aside, the big current account surplus countries were all building up their official reserves and sovereign funds — and they were the key vector providing financing to the deficit countries"

With China experiencing a 'hard landing', and the Gulf states reeling from low oil prices it looks to me like those who financed the deficit countries (esp. the US) are going to be less able and/or willing to do so in the future? China, Korea, etc. will have to spend their reserves to boost domestic demand. Similarly, the Gulf states will have to spend their war chests at home to finance program spending and stimulus at home. It seems unlikely that private money will fill the resulting hole. If this is the case, then how long will the Fed be able to maintain ZIRP? Or do they just print the difference?

JKH: Sorry for the delay; Christmas and all. I think we are on the same page. Friedman's Optimum Quantity of Money paper is silent on the question od short-run fluctuations (as far as I can remember); it's more about the long-run. It has been very influential in monetary theory, but I'm not sure how influential it has been for actual monetary policy, other than one argument among many for getting the average rate of inflation low. So far, the Bank of Canada has only been targeting 2% inflation, which is certainly lower than inflation in the 1970's and 1980's, but still higher than the minus 2% that Friedman's paper would argue for.

Successful monetary policy has been defined as bring down inflation, which will bring nominal interest rates down, but should not have a first-order effect on real interest rates.

Patrick: off topic, but interesting nevertheless. I think the Fed is quite willing to support ZIRP by printing as much money as is needed, until the ZIRP is no longer needed.

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