Asymmetric policies

“We’ve got to reverse QE and do so quickly” says Tim Worstall. I don’t want to take a view on that. What interests me instead is that reverse QE might be a misnomer, because central banks selling bonds doesn’t have the same effects as them buying bonds. “Reverse QE” is not simply QE with the opposite sign.

What I mean is that the first round of QE in particular worked (pdf) through two mechanisms. One was a portfolio rebalancing effect. The Bank’s buying of gilts forced yields down, and this helped reduced yields on equities and corporate bonds as investors rebalanced their portfolios towards those assets. The other was a signalling effect. QE signalled to everybody that the Bank intended for interest rates to stay low for a long time. This reduced gilt yields simply by reducing the expected path of short rates.

With QE, these two effects worked together. With reverse QE, however, they’ll work in opposite directions. Yes, central bank selling of bonds will tend to depress their prices and raise yields. But the signalling effect will work against this. Investors might interpret reverse QE as an alternative to rate rises – because if policy is being tightened via the portfolio rebalancing effect, it won’t need to be tightened so much via higher short rates.

The net impact of reverse QE is therefore unclear.

What we have here is an asymmetry. Policy works differently in one direction than it does in the other.

Which brings me to a more interesting question. How large is this set of asymmetric policies? I suspect it Is quite big.

Fiscal policy at the zero bound might be another example. If policy tightens, multipliers (pdf) might be large because there might be little reliable monetary offset; how true this is depends upon your view of the reliability of QE*. But if policy loosens, multipliers might be smaller because there is a monetary offset: rates can rise.

Brexit is another example. Having left the EU, we might not be able to rejoin it on the terms we currently enjoy: we might, for example, have to join the euro.

Another set of examples concern hysteresis effects. Simon says that austerity might have reduced trend growth by creating an innovations gap. Reversing austerity might not close this gap. It’s possible that memories of years of slow growth post-2008 will continue to depress animal spirits even under more sensible fiscal policy.

The Lawson boom of the late 80s might be an example of this. It led to higher inflation in part perhaps because the Thatcher recession had destroyed skills and industrial capacity. Reversing tight policy did not therefore undo the damage of that policy.

Other examples centre on cultural effects. To take a long-term historical example, freeing slaves did not fully reverse the damage of slavery, as its adverse effects are still with us.

I fear that inequality falls into this category. The IFS said this week that inequality has fallen. This might not, however, swiftly reverse the damage done by increased inequality in the 80s and 90s – for example, the reduction in trust and in productivity.

Perhaps top tax rates are another example. The cut in these in the 80s led to (or at least was associated with) a sense among the rich that they are entitled to their pre-tax incomes. It reduced tax morale – the rich’s willingness to comply with tax laws. And this in turn means that raising tax rates would lead to more tax-dodging, emigration or retirement than would otherwise have been the case. Reversing tax cuts might not therefore raise very much revenue.

Maybe you can think of other, better, examples from other fields.

My point here is that we shouldn’t assume that policy-making is a simple hydraulic process of pulling and pushing levers. Pulling a lever doesn’t always simply reverse the effect of pushing it. Bill Phillips Moniac model is perhaps sometimes a bad analogy. Instead, I prefer the wisdom which I associate with Joseph Schumpeter (although I can’t track down the source): “If a man has been hit by a truck, you do not restore him to health simply by reversing the truck.”

* I think reliability is a key issue. Maybe there was a particular amount of QE the Bank of England might have done to offset fiscal austerity. But given the Bank’s inability to know this quantity precisely in 2010-11, a full offset was very difficult.

Comments

[Ralph Musgrave]

We have a recession sparked off by excessive and irresponsible borrowing. The solution adopted is to cut interest rates so as to encourage more borrowing. So far so logical.

But when that proves inadequate, QE is adopted so as to encourage even more borrowing. Even more logical.

And more logical still: the people who advocate more borrowing as a solution to excessive and irresponsible borrowing simultaneously give somber warnings about excessive household debts, i.e. borrowing. Or as I think Positive Money put it, “The Bank of England’s solution to excessive household debt is more household debt”.

The moral: we can all sleep soundly in the knowledge that the great and the good know what they are doing.

[James Peach]

Hi Chris, been a lurker here for a long time and your blog is the best on the sphere. ALways a fresh burst of wisdom. i have attached a blog post on the effectiveness of some of the Bank's newer monetary policy tools if you're interested.

https://stepchangedotblog.wordpress.com

[James Peach]

Ralph I do not know any of the MPC personally but I would be willing to hazard a guess that if any of them could, they would scream from the high hills: do not take on more debt.

The institutional set up is the problem. With a government making fiscal policy irresponsibily tight, an inflation targeting central bank has one choice; loosen monetary policy or fail to hit its target. The MPC iis accountable for this to parliament.

No central bank wants to fail to fulfill its mandate and lock horns with the government by actively criticising the fiscal stance. It's a sure step to getting fired or managed out. I fear they just have to accept the situation and work accordingly.

[reason]

Ralph
"But when that proves inadequate, QE is adopted so as to encourage even more borrowing."

QE is not designed to encourage more borrowing.

[reason]

P.S. I agree with you in principle, yes we need looser fiscal policy, better still if financed by printing money (i.e. QE).

[James Peach]

As far as I am aware that is precisely what Q.E attempts to do.

Reduce yields, increase issuance, and stimulate bank lending (according to mainstream theory).

Stimulating lending = increasing borrowing.

[James Woods]

The merits of QE aside, the discussion of irreversible processes was most interesting. Within thermodynamics it is well known that the vast majority of processes are irreversible as most processes result in an increase in entropy. It'd be interesting to see this analogy expanded upon.

[Spencer]

(1) "All twelve US recessions since 1955 were preceded (approximately 12 to 18 months earlier) by an inversion in the yield curve (Estrella, 2010)." Et. al.

(2) "it is very common to have a recession without a yield curve inversion first. In-fact, there were 6 of them following The Great Depression into the 1950’s."

The Fed had no prescience: St. Louis Fed's senior technical staff: “Although the evidence is mixed, the MSI (monetary services index), overall suggest that monetary policy was ACCOMMODATIVE before the financial crisis when judged in terms of liquidity (just like before the Great Depression). —Richard G. Anderson and Barry Jones.

The facts, what SA author The Nattering Naybob coined: “Elephant Tracks”, argue otherwise. It is Yale Professor Irving Fisher’s pioneering distributed lag effect of my monetary flows, volume Xs velocity, that determines a “Hyman Minsky moment” (“A Minsky moment is a sudden major collapse of asset values which is part of the credit cycle or business cycle”)

All boom/busts, U.S. recessions since 1933 (regardless of their monetary transmission mechanisms), are entirely the Fed’s fault.
https://en.wikipedia.org/wiki/Monetary_transmission_mechanism

If the Fed pursues a restrictive monetary policy, interest rates tend to rise in concert with their policy rate hikes. This places a damper on the creation of new money, but paradoxically drives existing money (voluntary savings) out of circulation into stagnant commercial bank-held savings deposits (creating disequilibria / instability – not homeostasis).

In a twinkling, the economy begins to suffer (as evidenced by a deceleration in R-gDp during the same period), and / or with a monetary offset, subsequently generates higher levels of stagflation (drop in incomes).

Thus the Fed is given false signals relative to real growth prospects. In order to maintain their AD trajectories, instead of boosting R-gDp, the Fed, being stagflationists, boosts N-gDp (principally increasing gDp’s inflation component). So the FOMC falls victim to schizophrenia, do I stop? >because inflation is accelerating; or do I go? >because the economy is slowing).

That was exactly the FOMC dilemma in July 2008 (just before the substantive drop in AD stemming from the sudden and sharp deceleration from the unvarying distributed lag effect of M*Vt (contrary to Friedman’s and Schwartz’s inference of “long and variable”). That means Ludwig von Mises and Friedrich Hayek had the Austrian Business cycle theory of mal-investment all wrong.

Monetary policy objectives should be formulated in terms of desired rates-of-change Δ, RoC's, in monetary flows, M*Vt (volume X’s velocity), relative to RoC's in R-gDp. RoC's in N-gDp (though "raw materials, intermediate goods and labor costs, which comprise the bulk of business spending are not treated in N-gDp"), can serve as a proxy figure for RoC's in all transactions, P*T, in Professor Irving Fisher's truistic: "equation of exchange". RoC's in R-gDp have to be used, of course, as a policy standard.

The recent rate hike by the Fed is prima facie evidence – as the FRB-ATL’s GDPNow model’s forecasts were once again, repeatedly - revised downward.

https://www.frbatlanta.org/cqer/research/gdpnow.aspx?panel=1

ALM rebalancing/rollover of wholesale NBFI funding is not yet complete (as opposed to the DFIs, where lending/investing is not predicated on the prevailing level of free-market clearing interest rates).

As I said one year ago (after the experience with the 1st rate hike): "The economy is behaving exactly as it is programed to act. Raise the remuneration rate and in a twinkling the economy subsequently suffers. The Fed's 300 Ph.Ds. in economics don't know the differences between money and liquid assets." Apr 28, 2016. 11:25 AMLink