Good News! Interest rates rise.

This Bloomberg story reports the Fed saying that rising bond yields are a good sign. They don't precisely say that monetary easing is what caused the rise in interest rates; they are perhaps too modest to claim credit? But I will say it for them: by buying bonds, and easing monetary policy, the Fed has caused the price of bonds to fall, and interest rates to rise. Yep, an increase in demand for bonds causes the price to fall.

How does an increase in demand for something cause the price to fall? This could only happen if the increase in demand by one buyer caused other buyers to reduce their demand.

I can think of examples where this might happen. I remember a recent case where an "Essex girl" appeared on a British reality TV show wearing a Burberry bikini, and thereby ruined the Burberry brand image. This reduced demand for Burberry from everyone else.

Why are central banks buying bonds like an Essex girl buying a Burberry bikini? Isn't their money as good as anyone else's?

Well, no, it isn't. A central bank's money is actually better than anyone else's. That can't be the problem.

This is the problem. When you buy a Burberry bikini, what you are buying is not a tartan bikini but a promise of exclusivity. When you buy a bond, what you are buying is a promise of money in the future, and the value of that future money depends on its exclusivity. When a central bank buys a bond, and thereby increases the stock of money, it is doing something that other buyers of bonds don't do. The money will be worth less in future, and so the bond is worth less too. When Essex girl buys a  Burberry bikini she lowers the fundamental value of Burberry bikinis. When the central bank buys a bond, with new money, it lowers the fundamental value of the bond.

Try telling that story without mentioning the supply of money, you Neo-Wicksellians!

This is the same argument I have been making in the past. It's not so much "I told you this would happen"; it's "I told you this ought to happen". Low nominal interest rates can be seen as a sign of tight money as much as easy money.

Quantitative Easing, like any policy to increase Aggregate Demand, is strongly reinforced if it can create the expectation it will work, both by increasing expected inflation, and by increasing expected output growth. And this makes nominal interest rates a poor choice as a monetary policy control instrument. If the central banks wants to make monetary policy easier, it tries to lower interest rates, by buying bonds. But if it is seen as successful in making monetary policy easier, and increasing AD, it will be raising nominal interest rates. This makes it very hard for the market to interpret changes in interest rates. And this makes it very hard for the central bank to generate that cumulative self-reinforcing confidence that the policy is working. "Look, I'm pushing the lever down, and it must be working, because the lever is moving up!"

That confusion in interpreting the rise in interest rates is reflected in the last part of the Bloomberg story:

The situation poses a “dilemma” for the Fed, because if the rise in yields reflects “erroneous market views” about the economy, it will hold back growth, said former Fed Governor Lyle Gramley.

“The Fed is probably scratching its head at the moment and will wait and not react until the smoke clears,” said Gramley, who is now a senior economic adviser with New York-based Soleil Securities Corp.

There are the Fed's "market views", the bond market's "market views", and firms' and households' "market views" when they make consumption and investment decisions. The danger is if the bond market thinks the policy is working, and expects higher inflation and real output growth, but firms and households don't. The bond market raises nominal interest rates, because it sees the IS curve as having shifted as a function of the nominal interest rate. But if households and firms stay pessimistic, and don't share the bond market's views, consumption and investment will fall.

Comments

[Scott Sumner]

Nick, Once again you have some very good analogies. I think we have similar views about the unreliability of nominal rates as policy indicators. What I can't figure out is why more people don't have those views. Sometimes interest rates are a good indicator of monetary policy, sometimes they are not. But that is also true of flipping a coin. I cannot for the life of me figure out why people think nominal interest rates are a reliable policy indicator. It's one of my biggest frustrations, as it led many to believe the Fed eased monetary policy last year, despite the huge rise in real yields in the second half--not to mention crashing stock and commodity prices.

If you hadn't beaten me to it, I had planned a post mocking the "scratching its head" phrase. One of the few areas that I agree with people like Brad DeLong is that this crisis should drive a stake through new Keynesian economics. But it won't, the "common sense" notion that nominal rates are important is just too strong.

[Nick Rowe]

Scott: I think you should definitely go ahead and do the post on "scratching its head". You will have a different take on it, and explain it in a different way, and different people will read it anyway. My rough analogy, and explanation, is certainly not the final word on the subject. More than one perspective may help people understand it. And it's an important point.

Are you sure Brad DeLong dislikes the same aspects of NK economics that you dislike? (I don't know, I'm just asking.)

I like a lot of things about NK macro, by the way. It's just at at times like these especially, having one interest rate, and leaving out stocks of money, is a bit of a problem.

[Josh Hendrickson]

Scott,

I think that you should be a bit more confident (or perhaps I should be less confident) about the view of nominal interest rates. I don't think that this view is quite as widespread as you believe. For example, Mishkin's text has an excellent graph of the nominal and real interest rate from 1931 - 2005 as well as a great corresponding discussion. Specifically, highlighting the behavior of the real interest rate during the Depression is a particularly useful teaching tool for communicating this point.

Perhaps I am one of the few who accentuate this point, but the fact that it is included in one of the best Money & Banking textbooks available suggests that this point is better appreciated than you might think.

I would also like to emphasize that there are alternatives to NK macro. Mishkin, Bernanke, Gertler, Gilchrist, Carlstrom, Fuerst, and the other credit channel folks are very insightful and under-appreciated.

[Don the libertarian Democrat]

I thought that the plan of QE was to keep short term interest rates low, giving investors an incentive to invest in other higher yielding pursuits now, and have longer term interest rates rise, showing that deflation is being defeated and signaling a recovery in the future when rates will have to go up. In other words, QE attacks the Fear and Aversion to risk with short term incentives and longer term confidence. As far as I can tell, it's working pretty well, if slowly.

[Scott Sumner]

Nick, The parts Brad doesn't like, I do like, and vice versa. He like NK it to the extent it is old Keynesian (if I am not mistaken), whereas I like it to the extent it is new (Ratex, highly effective M-policy, not much use for fiscal stabilization, etc.)

Josh, A good point. But here's what I can't figure out. The Mishkin quotes in my "monetary cranks" post support my view of the 2008 crisis. That view is that the crash was caused by tight money. It is a very reasonable reading of the 4 key points Mishkin made in summarizing the lesson of his book for monetary policy. So why does everyone find my hypothesis so far-fetched? If instead of holding rates at 2% between April and October 2008, suppose the Fed had raised them from 2% to 8% during that time period. And suppose all the other things still happened (stock and commodity price crashes, high real interest rates, falling industrial production, sharply rising value of the dollar against euro, acceleration or real estate failures, etc.) Here is my very serious question: would there be a single prominent mainstream NK macroeconomist that did not blame the Fed for the crash in those circumstances? I say no. And if I am right, then the only logical reason my hypothesis is viewed as far-fetched, and my alternative history case would be viewed as conventional wisdom, is the difference between 2% and 8%. And more specifically, the implicit assumption that 2% is easy money and 8% is tight money. Am I wrong?
Now someone can say "look, even though nominal rates are sometimes misleading, surely 2% is not tight money." Fine, but them why are Friedman and Schwartz revered for their theory that tight money caused the Great Depression, when rates were around 2% for much of 1930-33. Some might say because M1 and M2 fell. Well suppose rates went from 2% to 8% and M didn't fall, but all the other bad things happened in 2008. I still say people would blame the Fed. They'd say people hoarded FDIC-insured deposits in bad times, and that's the difference from the 1930s. They'd say the Ms were misleading.
So I think you raised a very good question. This sort of thing is what I started the blog with last February, and I think its quality has gone down a bit recently as I have drifted away from the original argument.

[Josh Hendrickson]

Scott,

I think that you are correct that many macro folks still focus on the nominal interest rate as a guide.

However, I must ask, when did monetary policy become tight? Take, for example, commodity prices. Was it tight when oil prices went from $70 to $140? Did tight monetary policy cause oil to go from $140 to $35? My answer to each of these questions would be 'no' and 'maybe'.

(Incidentally, the behavior of the price of gold is particularly perplexing in attempting to identify whether or not monetary policy was tight.)

[Josh Hendrickson]

Scott,

Just to clarify, the reason that I ask when is because the period that you discuss is April to November, but commodity prices continued rising considerably until July.

[Dale]

As a household, I expect inflation. However, even though my salary will be adjusted to cover inflation, it won't be until next January, so I have to cut back to cover the higher prices that are coming.

[Scott Sumner]

Josh, I my blog I have been arguing that money became somewhat tight in August and September, and very tight in early October. In the spring and early summer I think policy was neutral. I am in the small group that believes it was foreign demand from developing countries that drove up commodity prices. I look at U.S. NGDP, which grew at a 3.3% rate in the nine months between October 2007 and July 2008. I consider that growth rate reasonable, not a sign money was either way too easy, or way too tight