If you don't like low interest rates, you want the Bank of Canada to loosen monetary policy now

Two weeks ago I wrote a post "Monetary stimulus vs financial stability is a false trade-off".

My opening lines in that post were: "There's an idea floating around out there that I fear may be influential. And that idea is horribly wrong. Which makes it dangerous. And I want to try to kill it."

Today, the C.D. Howe Institute publishes a Commentary by Paul Masson "The dangers of an extended period of low interest rates: why the Bank of Canada should start raising them now".

That's the idea I was talking about.

If you are worried about the dangers of an extended period of low interest rates, the worst possible thing the Bank of Canada could do would be to start raising them now. Because if the Bank of Canada tightens monetary policy now, and this causes the economy to slip back into recession and disinflation, that would require an extended period of even lower interest rates in the future.

Now go read my old post. Update: and posts by Mike Konczal and Brad DeLong. Update2: and see how the Bank of Japan's looser monetary policy is raising interest rates on 10 year bonds (finally, now the bond market has woken up to the fact that monetary policy really has loosened).

Update 3: To see pictures of recent Canadian data, which illustrate my point here, see Marcus Nunes' post.

Update4: if you want a mechanical metaphor to help you understand the paradox here: the Bank of Canada is like a man balancing a pole upright in the palm of his hand. If he wants the pole to move north, he must first move his hand south, so the pole begins to lean north, so he can then move his hand north to prevent the pole falling over. Except the pole has expectations.

Comments

[rsj]

Nick, on what basis do you believe that monetary policy is "raising interest rates" on long term bonds? This is just noise. When the y-axis is measured in basis points, you know that you are in a low IR environment. So the yield went up to what it was in Jan '13. In three months, when the yield falls back down to what it was in March 2013, will you credit monetary policy for that, too? I note that Mish -- ugh, I can't believe you are linking to him! -- is predicting a "currency crisis just around the corner."

This is really a loaded question, right? We agree that there are dangers of financial repression, but low rates need not be "too low" just because they are low in absolute terms. Last I checked, CPI in Japan is still falling.

[marcus nunes]

Nick
The illustrated story:
http://thefaintofheart.wordpress.com/2013/05/16/a-canadians-folly/

[Ralph Musgrave]

Nick refers to “the dangers of an extended period of low interest rates..”. I’d put it more strongly: monetary policy is rubbish, and for the following reasons.

1. Interest rate cuts (long and short term) distort investment decisions (if interest rate adjustments influence investment at all). 2. There is no relationship between base rates and credit card rates. 3, as to QE, that just benefits the rich. 4, it makes no sense to channel stimulus into an economy just via investment rather than via increased expenditure on as wide a selection of items as possible. 5, an investment is a long term project: few people with any sense will expand investments just because base rates have been cut for two or three years. 6, in a recession (certainly in the initial stages of a recession) there is a SURPLUS of capital equipment. More investment is exactly what is not needed. 7, the popular idea that interest rates can be cut overnight, whereas fiscal adjustments take longer is nonsense: the important point is the TOTAL LAG involved in each case. 8. The popular idea that fiscal adjustments have to be approved by politicians is also nonsense: it’s easy to build in an element of variability into fiscal items, e.g. VAT has been altered three times in the UK in the last five years without any specific vote on the matter in elected chambers. 9, Radcliffe Report on monetary policy in the U.K. published in 1960 concluded that ‘there can be no reliance on interest rate policy as a major short-term stabiliser of demand’.

[Nick Rowe]

Ralph: in the mid-1990's Canada went from a big fiscal deficit to a big fiscal surplus. This big tightening of fiscal policy was exogenous; it was not done because the government thought AD was growing too fast and it wanted to reduce AD. But despite that massive and exogenous fiscal tightening, there is no sign that AD fell. The Bank of Canada used monetary policy to offset the fiscal tightening, and succeeded in keeping inflation at or close to the 2% target. That is but one example to show that monetary policy works. The Radcliffe Report was wrong.

[Nick Rowe]

Marcus: thanks! Post updated to link to yours.

[Nick Rowe]

rsj: even though they are still below 1%, that upward spike in Japanese bond yields looks like more than just noise to me. Time will tell. I often read Mish, and I linked to him here because I was reading Economics Roundtable soon after posting this, saw Mish's post, saw the graph, and saw how it illustrated my point here. That doesn't mean I agree with Mish. Sometimes I do, sometimes I don't. (I don't agree with him in this case.)

[SimonC]

As a fellow canoeist is was somehow hoping for this Paul Mason.
http://en.wikipedia.org/wiki/Paul_Mason_(canoeist)

Back to reading your post. :)

[Max]

Regarding Japan: the lack of response by the bond market is consistent with long term yields being determined by the BOJ's interest rate floor, and therefore being insensitive to news, except for news about changes to the floor.

This challenges strictly endogenous theories of interest rates, since a binding interest rate floor hasn't caused the Japan economy to implode. So why not agitate for a higher floor if you prefer higher rates?

[Andy Harless]

As long as we're doing the mechanical metaphors thing, I'm going to make another plug for Chinese finger cuffs.

[James in London]

Looks like Canada is heading for a recession if this article from the Bank of Canada Review today is what informs their thinking.

http://www.bankofcanada.ca/wp-content/uploads/2013/05/boc-review-spring13-santor.pdf

Exceedingly, depressingly conventional. And reinforcing the message of the piece you critique above. Almost Austro-Rothbardian in parts.

[James in London]

Looking like not just a Masson, Bank of Canada thing, but a concerted effort.
From the BIS today:
http://www.bis.org/speeches/sp130516.htm

And the IMF, and maybe even journalists being told to see it as a concerted effort?
http://www.businessweek.com/news/2013-05-16/imf-sees-benefits-of-qe-becoming-ambiguous-if-growth-stays-tepid

[Nick Rowe]

SimonC: Ah yes, like me, he lives in the canoe capital of Canada. I see his sister on Meech Lake sometimes, a tiny woman solo in a big Prospector, paddling it heeled over old-school style.

Max: we have seen economies explode into hyperinflation. But yes, we have never seen an economy implode and disappear into a deflationary black hole. Yet. (Unless light couldn't escape?) And I don't know why. Maybe absolute downward nominal wage rigidity? But a repeat of the Great Depression would be good for financial stability, even if the economy didn't totally implode.

Andy: My first best is the car with the power steering hoses connected the wrong way around.

But what worries me is that these finance guys just really don't get macro/money. They don't seem to understand that interest rates are an unstable control mechanism. But after the 1960's and 70's and 80's, where we saw that low interest rates eventually caused high interest rates, you would think they could figure it out in the reverse direction.

James: Yep. I'm worried. I skimmed the BoC review piece you linked, but I don't see it as being as bad as you fear.

[Ritwik]

"But what worries me is that these finance guys just really don't get macro/money"

Assume Ben Bernnake/FoMC/BoC etc. think that finance guys *get* macro/money. Does your statement still hold?

[Ritwik]

What I mean is - how much is the theory of monetary authority omnipotence dependent upon the presumption/acknowledgement of omnipotence by the monetary authority?

Also, had you seen the 10 yr/ 30 yr yields move in the initial days of Abe/Kuroda? There was a ~1% drop. Further, I presume you have seen teh Japan news from today? By the(NGDP + inflation)/2, it looks like AD has stayed put or even somewhat declined there.

[wilhelmson]

[i]If you are worried about the dangers of an extended period of low interest rates, the worst possible thing the Bank of Canada could do would be to start raising them now. Because if the Bank of Canada tightens monetary policy now, and this causes the economy to slip back into recession and disinflation, that would require an extended period of even lower interest rates in the future.[/i]

Sorry if I'm missing something fundamental here but the greatest example of the deflationary trap that is ever cited continues to be "The Great Depression" and while economists continue to debate what finally pulled the economy out of it, a significant contribution if I recall, was credited towards WW2 [b]not because of the consumption aspect[/b] but as a period where a significant part of the population minimized consumption and saved, saved and saved.

^ Rambling comment above aside, basically, as deflation continues to spiral businesses and individuals continue to save (and unemployment increases) until hard asset prices vis-a-vis aggregate savings levels to a point where it is attractive to spend/invest again, no? One of the key problems in Japan over the past several decades seems to have been 1) deflation (-confidence) but also 2) low to negative return stimulus spending that massively increased public debt (-confidence)?

Perhaps I simply don't get the premise after reading the previous article as well as this one .. but my query is how GoJ is going to afford to refinance its existing public debt when rates finally do rise?

[Determinant]

WW2 not because of the consumption aspect but as a period where a significant part of the population minimized consumption and saved, saved and saved.

No, the Government spent, spent, spent. On shells, planes, tanks, beans, bacon, bullets, boots, battledress, etc....

In 1939 Canada went from a federal budget just short of $1 billion to $5 billion, passed after our Declaration of War in September 1939.

All of those "savings" were in general not translated into investment (some were), but went to finance the war deficit (current consumption of G). Which was paid off through peacetime prosperity. Saving had little or nothing to do with it, Aggregate Demand did.

[Ralph Musgrave]

Hi Nick, Re your point about Canada in the mid 1990s, I think it requires more than just one episode from one country to prove this one way or the other.

As you’ve probably noticed, MMTers are often keen to show that surpluses tend to be followed by recessions. E.G. this article:

http://my.firedoglake.com/letsgetitdone/tag/government-surplus/

Has anyone done any quality research in this area? If not, it needs doing.

One recent bit of evidence in favour of fiscal policy was this from the NY Fed which showed the payroll tax cut in 2011 had favourable consequences:

http://fictionalbarking.blogspot.co.uk/2013/05/impact-of-us-payroll-tax-cutand-tax-hike.html

[rsj]

that upward spike in Japanese bond yields looks like more than just noise to me. Time will tell.

Fair enough. I predict in 6 months CPI will remain on the slight deflationary trend that it's been on over the last 10 years, and JGB will be back to where they were in March. I could well be wrong on the JGBs as predicting financial markets is a fools errand, but I don't think the new aggressive stance of the BoJ will accomplish anything at all, neither do I believe that CB forward guidance or QE is a reliable tool for economic management. I also predict that after this failure, articles will be written arguing that the BoJ was not aggressive enough in purchasing government bonds, just as such arguments were written about the previous failed adventures in Japanese QE. No currency crisis, either.

But one thing that really bothers me is how models that have no compelling explanation for downturns are supposed to point the way to right the ship. Taking Japan as an example, I am amazed that there is so little emphasis about structural problems in the Japanese economy that are the source of the current malaise there, just as no one seems to be proposing any structural solutions.

Assuming, for the sake of argument, that central banks control aggregate demand, there doesn't seem to be a discussion about why demand is so low throughout the advanced economies now. If it is not a global conspiracy of central banks that created this demand problem, then you must admit that other factors also drive aggregate demand beyond central bank policies, in which case why not address those other factors directly as part of your demand management strategy? The only reason I can think of is that the policy rate is the only exogenous factor in the model, with everything else being optimal, in which case why use such a model for policy analysis?

[Nick Rowe]

Ritwik: "What I mean is - how much is the theory of monetary authority omnipotence dependent upon the presumption/acknowledgement of omnipotence by the monetary authority?"

A lot. Because money is an asset, and expectations matter a lot for any asset's demand. for example, if people expected that an asset would be worthless tomorrow, it would be almost worthless today.

"By the(NGDP + inflation)/2, it looks like AD has stayed put or even somewhat declined there."

That's a very weird metric. Draw an AD curve in {P,RGDP} space. Depending on the slope of that AD curve, a metric for shifts in the AD curve would be something like (w.RDGP+(1-w).P).

wilhelmson: "Perhaps I simply don't get the premise after reading the previous article as well as this one .. but my query is how GoJ is going to afford to refinance its existing public debt when rates finally do rise?"

Possibly with some difficulty. Which is why it is important that the economy recovers and rates rise NOW, rather than later, so they can tighten fiscal policy before the debt/GDP ratio gets any bigger.

Ralph: but of course fiscal policy can affect AD. Unless monetary policy offsets it (or is designed in such a way that it "automatically" offsets it). And of course there's oodles of research testing whether (and how much) monetary and fiscal policy works. But it's easier said than done. Because it's hard to tell whether a change in monetary or fiscal policy is exogenous (so we can assume other things are equal), or it they changed monetary or fiscal policy to offset a change in one of those other things.

[Nick Rowe]

Back much later.

[James in London]

You are right abouit the Bank of Canada piece, it's more just depressingly wishy-washy. Very like the Jaime Caruana (GM of the Bank for International Settlments) warning of the dangers of out-of-the-box thinking. The economic risks from deflation are downplayed, on the altar of central bank inflation-fighting credibility. Deflation-fighting credibility is what they should really be challenged on.

[Ritwik]

Nick

That's a Scott Sumner metric, riffing off on Bernanke's Japan paper.

In the example that you give, when w = 0.25, your metric is exactly the same as mine.