Swiss Deflation

The Wall Street Journal Monday Oct 19 offers a reflection on deflation in Switzerland.

"It’s as close to an economic consensus as you can get: Deflation is bad for an economy, and central bankers should avoid it at all costs."

I differ, as does Milton Friedman's "Optimum quantity of money." And my "who's afraid of a little deflation" in... The Wall Street Journal.

"Then there’s Switzerland, whose steady growth and rock-bottom unemployment is chipping away at that wisdom."

"At a time of lively global debate about low inflation and its ill effects, tiny Switzerland—with an economy 4% the size of the U.S.—offers a fascinating counterpoint, with some even pointing to what they call 'good deflation.' ”

Indeed. The 1970s had stagflation. Now we have the opposite, "good deflation."  The Phillips curve lives on in "consensus."

Switzerland also is a good case for just how powerless central banks are to do much about it.


I don't think there really is such a thing as monetary policy any more. Money and government bonds are perfect substitutes. At that point, central bank interest rate setting is the same thing as if the Treasury simply decreed the rate it will pay on government debt. When (if) the Fed raises interest on reserves, and Treasury interest goes up similarly, it will be just as if the Treasury announced it will pay 1% on short term debt. (p. 77-78 of Monetary Policy with Interest on Reserves or p. 6-7 ungated here makes this point with equations.)

But you have to be careful when you set a price. If you set the wrong price, you are either overwhelmed or starved with demand.

That's how I read recent events: The Fed talks about raising rates, a sea of foreign capital starts to want to buy US debt at that higher rate. The treasury is not offering an elastic supply -- they're setting both price and quantity. So with the interest rate fixed, the dollar goes up. Then the Fed has to back down. The Fed can't raise rates if it wants to.

Switzerland also taught that lesson when its central bank tried to peg to the Euro and was overwhelmed.

The decline in long-term interest rates

Source: Council of Economic Advisers

Long term interest rates are trending down around the world. And it's not just since the great recession and financial crisis. The same trend has been going on for decades.

The Council of Economic Advisers just issued an excellent report surveying our understanding of this question. A blog post summary by Maury Obstfeld and Linda Tesar.

(Many other interesting CEA reports here. Occupational licensing is next on my in box.)

The report is really well done, for explaining the economic issues in clear simple terms, but without hesitating to use a model and an equation when necessary. If you're wondering how to keep your undergraduate or MBA class (heck, your PhD class) busy this week, this report will do the trick.

There is some grumbling in economics circles about the CEA and what role it should play, between Sunday morning talk show cheerleader for the Administration's policies vs. providing dispassionate  economic analysis to the Administration and country. This kind of report is the kind of CEA I cheer for.

I won't summarize the whole thing. Maury and Linda's blog post blog post does a great job of that, and you should just go read it. A few comments however.

1. Surprise surprise, the trend is a surprise. Hence, beware our current forecasts. This is not a criticism, it's just a fact. The best forecasts have been wrong in the past. They may well be wrong in the future.

2. Said: "The long-term interest rate is a central variable in the macroeconomy. A change in the long-term interest rate affects the value of accumulated savings, the cost of borrowing, the valuation of
investment projects, and the sustainability of fiscal deficits."

Unsaid: The surprise decline in long-term interest rates has been a boon to financing deficits. Current deficit forecasts use the current forecast of a return to higher interest rates. If this forecast is wrong once again, and real interest rates on government debt continue at rock-bottom levels, this will be a boon to "fiscal sustainability." Of course, the opposite is also true: If a trend nobody expected and everyone expects to reverse does reverse, then countries with big debts are in trouble.

3. The long term graph makes nicely a point that's been on the back of my mind lately. People typically assume that long term bonds should pay more then short term bonds, because they are riskier. But that's actually a puzzle: most bond investors hold their money for long periods of time, for which long term real bonds are less risky. It's hard, in fact, to get most term structure models to produce an upward-sloping yield curve.

It was not always so. In the 19th century, short term yields were consistently above long term yields.

The difference, of course, is inflation. In the 19th century we were on the gold standard, as noted in the graph. So long term bonds did not have inflation risk.  So, if inflation continues to die, or if our central banks go on a price level target, we might expect the same pattern to hold again. Which would be great for financial stability too. Short term debt causes runs and crises. If long term debt were cheaper, the inducement to finance short would be less.

4. Uncertainty. A message you read loudly between the lines is, that we have very good theoretical understanding of the various mechanisms that can move the trend in interest rates up or down, we (meaning "economic science") have really very little idea of the quantitative force of various mechanisms. By masterfully explaining each mechanism, and then patiently reviewing the vast literature that comes up with hugely different numbers for each mechanism, the point is made clearly, though between the lines.

They might go further. For example, the section on term premiums (the long rate is the average of expected future short rates plus a term premium) cites the latest studies and plots a line, but no standard error or other uncertainty band around that line. As this is an area I've written papers on, I know where the bodies are buried. Term premium estimates come down to forecasting regressions of future bond returns on current variables. Such regressions have huge bands of uncertainty. All forecasts and decompositions should have error bars. The only problem is artistic, as honest error bars would dwarf the forecasts. Well,  knowing what you don't know is real knowledge.

5. Forecasts. On p. 26, after this implicit devastating critique of the state of knowledge, "To illustrate our analyses, we illustrate different approaches to forecasting the long-term nominal interest rate, as is typically done twice a year in the CEA/OMB/Treasury Budget forecast and midsession review." A process for coming up with a number follows. Clearly, the message of the previous 25 pages is that conditioning decisions on a forecast, cranked out to two decimal places, is a bad idea. Economic policy should embrace uncertainty!

This is really a big deal. Much of the illusion of technocratic competence driving our regulatory state is reflected in absurdly accurate forecasts. The joke goes, we know economists have a sense of humor, because economists use decimal points. I'd love to see a Federal Forecast Accuracy Act: All forecasts made by every administrative agency shall include measures of forecast uncertainty. The CBO will evaluate all forecasts after the fact, and agencies shall be penalized when reality exceeds the stated uncertainty bounds more than half of the time.

6. The CEA ain't buying "secular stagnation," in its perpetual "lack of demand" interpretation.  (As a fact, it's undeniable. The question is the diagnosis and treatment.)  See p. 38.

7. In a report whose summary sections are  Fiscal, Monetary, and Foreign-Exchange Policies, Inflation Risk and the Term Premium, Private-sector Deleveraging, Lower Global Long-run Output and Productivity Growth, Shifting Demographics, The Global “Saving Glut”, Safe Asset Shortage, Secular Stagnation?, and Tail Risks and Fundamental Uncertainty, it is perhaps a bit petulant to complain of left-out factors but I will mention one.

The "supply side" part of the analysis is limited to productivity growth. Higher productivity growth leads to higher real interest rates in equilibrium, and (these days) vice versa. But it takes time and transition dynamics to accumulate capital.

One hypothesis that I learned from Larry Summers is that today's production function needs a lot less physical capital to produce the same productivity. A 1930s steel mill is a lot of accumulated savings. Facebook has nothing but a basketball court sized building full of 20-somethings coding while wearing headphones, and a really cool food court. The company is worth billions but it took comparatively little accumulated savings to start it up. If technology moves so that human, rather than physical capital is the heart of the K in F(K,L), productivity growth may determine interest rates in the long run, but there are lower interest rates on the transition path. Larry:

Ponder that the leading technological companies of this age—I think, for example, of Apple and Google— find themselves swimming in cash and facing the challenge of what to do with a very large cash hoard. Ponder the fact that WhatsApp has a greater market value than Sony, with next to no capital investment required to achieve it. Ponder the fact that it used to require tens of millions of dollars to start a significant new venture, and significant new ventures today are seeded with hundreds of thousands of dollars. All of this means reduced demand for investment, with consequences for equilibrium levels of interest rates.

(This is an update, thanks to email correspondent who found the quote.)

Update: Steve Williamson reminds us all that there is no "the" interest rate, and that the rate of return on capital is both stable and much higher than government bond yields. There is a risk premium, and it's big, and it varies over time. Practically all macro and growth theory forgets this fact. Since I've spent most of my career emphasizing the size and volatility of the risk premium, I should remember this reminder in every blog post. Thanks for pointing it out Steve!

Feldstein on inflation

Martin Feldstein has an interesting Op-Ed in the Wall Street Journal, "Why the U.S. Underestimates Growth."

The basic idea is that inflation may be overstated, because it doesn't do a good job of handling new products. As a result, real output growth may be a bit stronger than measured.  Marty runs through a lot of sensible conclusions.

He doesn't talk about monetary policy, but that's interesting too. So what if inflation really is (say) 3% lower than we think it is, and therefore real output growth is 3% larger than it really is?


That would mean we are a lot closer to "normal" of course.

It would mean that we really have 0% nominal interest rates, 1.5% deflation rather than 1.5% inflation; +1.5% real rates rather than -1.5% real rates. That is about the ideal monetary policy. Flat nominal wages, so we don't have wage stickiness problems, slight deflation matching productivity increases and a positive but low real rate of interest. We live the Friedman optimal quantity of money. In addition, it means no inflationary distortions and fewer intertemporal distortions in the tax code -- no taxing interest.

The labor market is pretty much back to normal except for the labor force participation rate. The main sign of weakness is real output growth, and Marty suggests that might not even be there.

How should the Fed react? News that real output growth is stronger than the Fed thinks would be an argument to raise rates. News that inflation is weaker than the Fed thinks is an argument to lower rates. At conventional Taylor-rule parameters of 1.5 times inflation plus 0.5 times output gap, news that inflation is 1% lower and output is 1% higher means the lowering effect wins. So, in fact this is an argument to keep rates where they are and to continue basking in the Friedman optimal quantity of money for a while.

In fact, this strikes me as the main conclusion. As Marty points out, if real growth is stronger than we think, that doesn't mean it couldn't be stronger still. If real wages are really rising, that doesn't mean they couldn't be rising more. Weak labor force participation and total factor productivity are not much influenced by inflation measures.

McAndrews on negative nominal rates

Jamie McAndrews of the New York Fed has a thoughtful and clear speech on negative nominal rates and the benefits of currency. (Some previous posts on the subject here  here and here.)

A few high points:

1. Needed: anonymous electronic transactions.

Many (not all) negative interest rate proposals call for the elimination of currency. Currency is dying anyway due to the great advantages of electronic transactions. I bemoaned the loss of privacy and political freedom when the NSA, the IRS, and pretty soon Twitter and the Chinese Department of Hacking have a record of everything you've ever bought or sold. Jamie brings up another important point:

The anonymity afforded by currency transactions prevents a buyer from suffering from any actions taken after the transactions that could exploit the knowledge gained by the seller of the buyer’s identity. For example, identity theft, or theft of credit or debit card information, is avoided through the use of currency. This is an economic benefit that is distinct from valuing privacy from a civil liberties point of view. If currency cannot be used in transactions, buyers are at a disadvantage, and many otherwise beneficial transactions (not related to buyers seeking to engage in tax evasion or otherwise illicit activity) would not take place.

Anonymity has value in many transactions. Anonymity equals finality.

It's not hard to have anonymous electronic transactions. Stored value cards could work well as electronic cash. If regulators allowed it, it would be simple enough to set up a money market fund that allows anonymous investing. Regulators don't allow it.

2. Hysterisis of institutions and the lesson of the 70s


There are fixed costs in setting up many institutions that adapt to negative nominal rates. For example, the option to hold currency:

.. Often, the costs of holding currency securely, by having a safety deposit box or a vault, are fixed costs. Once one has a vault, or has rented a safety deposit box, the costs of storing additional currency in it, up to its capacity, is nil. This suggests that there is a dynamic element to the economics of avoiding negative interest rates: the longer the negative rates are expected to persist, and the lower they are, the more favorable are the returns to investing in a vault. Once the vault investment has been made, maintaining negative rates would likely become more difficult.

An even more far-reaching change that many have suggested would be the creation of a new institution to handle and store currency on behalf of others; this could dramatically reduce the costs of holding currency...

Jamie adds to the clever ways to synthesize zero rate investments, and a cost I hadn't thought of

For example, suppose that one holds a credit card under existing U.S. rules: one can withdraw funds from an account that is earning a negative rate, and pay one’s debt to the credit card company in advance of when it is due, earning a zero return during the prepayment period....

... if one were to receive a check from the U.S. government for a tax refund, one could simply put it in a safe place and earn zero interest on it during the time the check remained undeposited...

...leaving the check undeposited, much like the hoarding of currency, is a negative outcome for society. ... This may impose unexpected costs on the check writer, triggering unplanned overdrafts and associated charges...

...having talented individuals looking for these opportunities is a dead-weight loss to society. We would rather have them use their talents for more socially productive purposes.

We went through this once before. In the 1970s, pricing and financial institutions were set up with small positive interest rates in mind. It took a period of prolonged inflation to induce people to spend all the fixed costs to adapt to high interest rates, including widespread indexation, money market funds, interest-paying checking accounts, and so forth. In turn, the easing of these "frictions," quickly removed the hoped-for benefits of inflation. For example, prices and wages were sticky when there was less inflation. Turn on inflation, and once people put the effort in to index contracts, price and wage stickiness fade, and inflation has much less output and employment effect.

So, the same sorts of legal and financial investments that allowed an economy to adapt to high nominal interest rates can also allow it to adapt to negative interest rates -- at large cost, in time and effort, in rewriting contracts, and in foregoing many advantages of currency. But are we sure the benefits will not disappear at the same time?

3. Financial institutions and negative rates

The health of banks and many other financial institutions depends on earning a spread between what the institutions earn on their assets and what they pay on their liabilities. Negative rates can squeeze bank profits.

and a lot of non-banks too. There is a plausible channel here that negative nominal rates hurt a large swath of financial institutions -- at least until they rewrite all their contracts and persuade all their clients to accept negative rates. This is a channel by which lowering rates could hurt economic activity.

By the way, I learned that those negative rates aren't so negative,

..the central banks that have negative policy rates offer zero rates on many of their deposits from banks, imposing negative rates on the “marginal” deposits. In this way, commercial banks can, in general, charge their retail depositors deposit rates of zero and earn zero at the central bank on at least a large portion of their reserve holdings.

4. Speaking of cause and effect signs...

..people could infer [from a negative interest rate] that the central bank itself has low expectations for inflation and is lowering nominal rates into negative territory as a way to “ratify” the low expected inflation environment. Such an inference would complicate the central bank’s effort to achieve its objective because it could encourage and entrench the public’s expectations for deflation. That could complicate the potential exit from the negative rate regime

Maybe with abundant excess reserves, the Fisher equation is stable -- and that lowering nominal rates will cause inflation to decline. Jamie isn't quite ready to burn at the heretic's stake on this issue, but you can see him edging closer to the fire.

Banking at the IRS

A while ago in two blog posts here and here I suggested many ways other than currency to get a zero interest rate if the government tries to lower rates below zero. Buy gift cards, subway cards, stamps;  prepay bills, rent, mortgage and especially taxes -- the IRS will happily take your money now and you can credit it against future tax payments; have your bank make out a big certified check in your name, and sit on it, don't cash incoming checks. Start a company that takes money and invests in all these things (as well as currency).

Chris and Miles Kimball have an interesting essay exploring these ideas "However low interest rates might go, the IRS will never act like a bank." Their central point: sure that's how things work now. But with substantial negative interest rates, all of these contracts can change. It's technically possible in each case for people and businesses to charge pre-payment penalties amounting to a negative nominal rate.

Reply: Sure, in principle. Nominal claims can all be dated, and positive or negative interest charged between all dates.

But this did not happen in the US and does not happen in other countries for positive inflation and high nominal rates,  despite symmetric incentives, and at rates much higher than the contemplated 3-5% or so negative rates.  Yes,  with large nominal rates there is pressure to pay faster,  inventory cash-management to reduce people's holdings of depreciating nominal claims, but this pervasive indexation of nominal payments did not break out. The IRS did not offer interest for early payment.

More deeply, what they're describing is a tiny step away from perfect price indexing. If all nominal payments are perfectly indexed to the nominal interest rate, accrued daily, then it's a tiny change to index all prices themselves to the CPI, accrued daily. If "how much you owe me," say to rent a house, is legally, contractually, and mechanically determined as a value times e^rt, and changes day by day, then e^(pi t) is just as easy.

So, price stickiness itself would (should!) disappear under this scenario.

Price stickiness has always been a bit of a puzzle for economists. As the Kimballs speculate how easy it is to index payments to negative interest rates, so economists speculate how easy it is to index payments to inflation. Yet it seems not to happen.

So this point of view strikes me as a bit of a catch-22 for its advocates, who generally are of the frame of mind that prices and nominal contracts are sticky and that’s why negative nominal rates are a good idea to "stimulate demand" in the first place.  If we can have negative nominal rates and change all these legal and contractual zero-rate promises to allow it, then prices won't be sticky any more!   Conversely, I should be cheering, as it amounts to a broad push to unstick prices. That has long seemed to me the natural policy response to the view that sticky prices are the root of all our troubles. It would allow negative rates, but eliminate their need as well.

Alas, the world seems remarkably resistant to time-indexing all payments.