Monday, October 5, 2015

How I learned to stop worrying and accept deflation


Why can't we create inflation anymore? Maybe it's because money isn't what it used to be.

Money used to be like a car; the market expected it to depreciate every day. When we buy a new car we accept a falling resale value because a car provides a recurring flow of services over time; each day it gets us from point a to point b and back. And since these conveniences are large, the market prices cars such that they yield a steady string of capital losses.

Money, like cars, used to provide a significant flow of services over time. It was the liquidity instrument par excellence. If a problem popped up, we knew that money was the one item we could rapidly exchange to get whatever goods and services were necessary to cope. Given these characteristics, the market set a price for money such that it lost 2-3% every year. We accepted a sure capital loss because we enjoyed a compensating degree of comfort and relief from having some of the stuff in our wallets.

These flows of services are called a convenience yield. Assets that throw off a convenience yield, like cars and money, typically have negative expected price paths. Let's call them Type 1 assets.

Type 2 assets, things like stocks and bonds, don't boast a convenience yield. Without a convenience flow, people only buy them because they promise a real capital return. One way a Type 2 asset provides a capital return is via a positive expected price path. We only hold Google shares because we expect them to rise by around 5-10% a year. Same with treasury bills. The government issues a bill at, say, $97, and they mature a year later at $100.

Another way for a Type 2 asset to provide a capital return is via periodic payments. A bond or an MBS doesn't rise over time. Rather, it provides its return in the form of regular coupon payments.

Could it be that money has steadily lost its convenience yield? If so, it's shifted from being a Type 1 asset with a negative expected price path towards being a Type 2 asset. That would explain our new deflationary era. In the same way that Type 2 assets like Google and t-bills have to offer a positive expected price path if they are to be held, the purchasing power of money needs to improve over time. And since everything in the world is priced in terms of money, that means that the price level can no longer inflate, it has to deflate.

Where has money's once considerable convenience yield gone? The costs of creating liquidity have been steadily diminishing. Wall Street has been able to make a wide variety of assets like stocks and bonds much more liquid at less cost. So whereas money was once the liquidity instrument par excellence, people now have a multitude of liquid instruments that they can choose from. At the same time, central banks, via quantitative easing, have create massive amounts of central bank liabilities. With a sea of liquid assets, maybe liquidity just isn't a valuable commodity anymore.

Welcome to deflation, folks. Into the vacuum left by money's retreating convenience yield, a promise of capital returns has sprung up.

Reversing deflation?

Even if money has become a Type 2 asset, central bankers can still get the inflation rate back to 3%. To do so, they'd have to change the nature of the capital return that it offers. Like Google shares, money now seems to promise a rising expected price path (i.e. deflation). Central bankers need to switch that out with a bond-style promise of juicier periodic payments. This would involve a central banker ratcheting up the interest rate on money balances, or reserves, to an above-market level. Only with an unusually high interest rate on reserves would people once again accept a declining expected price path for money (i.e. inflation).

For an analogy, imagine that tomorrow the U.S. Treasury were to issue a new 10-year bond with an outlandishly high 10% coupon. With the market-clearing yield on existing 10-year bonds sitting at just 2%, the new bond would start trading at a large premium to its $1000 face value and slowly fall over time. Likewise, money that sports an outlandishly high interest rate would steadily lose purchasing power. 

Ratcheting up rates in order to get us back to a 3% inflation path could be a ghastly experience. Before it can start rolling down the hill again, money's purchasing power would have to rise sharply in value. But money is the unit in which everything else is priced, which means the price level would need to rapidly deflate. If prices are sticky, this could result in a glut of unsold labour and goods; a recession.

Alternatively, might a central bank rekindle inflation by forcing interest rates below their market level? In the short term we'd get a quick one-time dose of inflation. But after the adjustments had been made the price level would only continue its previous deflationary descent. A central banker would have to consistently ratchet down interest rates to generate a perpetual series of one-time inflationary pops in order to keep hitting its 2-3% inflation target. This strategy would run into problems. Go much below -1% and a central bank will hit the lower bound. Unless it wants to risk mass cash storage, it won't be able to go further. Even if a central bank devises ways to get below -1%, it'll have to perpetually ratchet rates down in order to spur the next one-time pop in inflation. Once it hits -20%, or -30%, one wonders whether the market won't simply adopt an alternative currency.

Given that these two options don't seem too comforting, maybe we should just get used to a bit of deflation.


Tony Yates responds here and here.

18 comments:

  1. If a bank has to offer an above-market rate of return, then it has issued too much money.

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  2. JP: "Alternatively, might a central bank rekindle inflation by forcing interest rates below their market level? In the short term we'd get a quick one-time dose of inflation. But after the adjustments had been made the price level would only continue its previous deflationary descent. A central banker would have to consistently ratchet down interest rates to generate a perpetual series of one-time inflationary pops in order to keep hitting its 2-3% inflation target."

    No. You are implicitly assuming the very long run price level is fixed exogenously (like under the gold standard).

    This is why it's so dangerous to think of monetary policy in terms of setting a nominal interest rate. Instead think of the central bank as a closed-end mutual fund issuing new "shares" via a stock split, and doing so continuously. There is a new equilibrium with the shares depreciating over time as the stock of shares grows.

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    1. "Instead think of the central bank as a closed-end mutual fund issuing new "shares" via a stock split, and doing so continuously."

      Where a reduction in the interest rate on reserves is like a stock split?

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  3. If financial innovation is eliminating the convenience yield for currency, then currency will be driven out of circulation.

    Or, to coexist with other liquid assets, it will have to earn the same rate of return. I'm not sure why the result has to be deflation. I would guess instead that zero-interest currency disappears (except possibly in the black market).

    Electronic versions of currency (interest bearing reserves) could coexist. I think in this case the interest on money would need to be financed with taxes, or other sources of government revenue. In this case we could be making payments via a facility like www.treasurydirect.com.

    I'm not sure about JP's speculations about reversing deflation--doesn't sound right to me. I think Nick's continuous stock split would work. Or issuing new shares and injecting them via helicopter drop would also work. My coauthors and I study such a scheme here:

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2634505

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    1. "Instead think of the central bank as a closed-end mutual fund issuing new "shares" via a stock split, and doing so continuously."

      Out of circulation or valueless? If money shifts from being a combined medium of exchange and a store of value to being just a store of value -- say like an illiquid perpetual corporate bearer bond -- it will continue to be traded. Maybe just not as often as before.

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    2. Whoops. Rereading this, my question was in response to your: "If financial innovation is eliminating the convenience yield for currency, then currency will be driven out of circulation."

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    3. Interest on money finances itself and creates tax if spent. Spending always creates an amount of tax and excess saving.
      "ⁿIf financial innovation is eliminating the convenience yield for currency"
      Money has value as you have to pay taxes in it. But if there were alternatives very liquid I suppose so.

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  4. Price level measures are targeted at consumer goods. Those are exclusively purchased with currency/deposits. What real world alternative does the man on the bus have which could feasibly alter his convenience yield. As interesting as the conjecture is are there not simpler explanations: households over leveraged? Investment falling? Demand growing too slowly.

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  5. IMV, the natural rate of interest is bullshit and unfalsifiable. There is a good criticism of it here (any thoughts?)
    http://bilbo.economicoutlook.net/blog/?p=4656 http://moslereconomics.com/wp-content/graphs/2009/07/natural-rate-is-zero.PDF

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  6. http://bilbo.economicoutlook.net/blog/?p=32049

    "Monetary policy is what we call an indirect policy tool. By changing interest rates it makes borrowing more or less expensive and this is designed to influence behaviour. But investment decisions such as building a new plant are based on longer-term expectations of the net flow of returns and the current flow of investment spending is not particularly sensitive to changes in current interest rates.

    Further, no matter how low interest rates go, borrowers will not borrow if they fear unemployment. Firms will not invest if they are worried that consumers will not be driving sales growth.

    Monetary policy also works through the income distribution – borrowers gain when rates fall but lenders lose. People on fixed incomes lose income when rates fall. What is the net outcome of those distributional impacts? It is very unclear and not even the central bankers know precisely or within reasonable bounds the answer.

    Finally, the bluntness of the interest rate tool means it cannot have spatial (regional) impacts. Recessions impact through the industrial structure which is unevenly distributed across space. To prevent a spending downturn from generalising policy makers need to inject stimulus into regions that are most affected. Only fiscal policy can do that."

    ______________________________________

    Modern Monetary Theory in Canada
    http://mmtincanada.jimdo.com/

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  7. JP, I'm curious how aggregate leverage (debt/cash flow) figures into your worldview. I'd argue that deflation is intimately connected with leverage; i.e. debt-deflationary pressures. When interest rates are near zero, type 1 and type 2 assets begin to look more similar, no?

    Interest rates are only the price of debt. If rates are at zero, then the marginal debtor cannot take on any more leverage low yield = high price = high demand for debt / limited supply of debt).

    Consider the problem as turning the "paradox of thrift"on its head -- if everybody saves, it crushes cash flows. The other side of type 2 asset accumulation (debt as an asset) is liability accumulation. That is, there is a "paradox of debt" at work -- if everybody is overly indebted, then rates are low. Low rates are a sign that there is too much savings/debt at too high a price. Under these conditions, NGDP does not respond to changes in the marginal price of debt.

    Three options when faced with overleverage:
    1) Raise interest rates would force deleveraging - by a bout of defaults and deflation. This would clean out balance sheets for interest rates to "work" again and reflate, with massive adjustments to the economy. Lots of short sharp pain, but debt disappears.
    2), Go negative rates, and price debt yet higher, thereby calling out more marginal leverage and presumably create more debt-fueled expansion. Painless, but total absorption of the economy into banks, with all the totalitarian politics that this carries -- and still is only a temporary measure: the debt still needs discharging.
    3) Rates at zero, but immense monetary base expansion: create until you inflate. This debauches the currency and deleverages in real terms, but likely has nasty and long-lived FX consequences.

    Option 1 seems the best to me: liquidate fast, recover fast. Bottom line, all these savers need to suffer if you want interest rates to "work" again.

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  8. Neo-Fisherism as I understand it says roughly that a central bank setting nominal interest rates can determine equilibrium inflation. Central banks can increase the inflation rate by increasing nominal yields.

    This neo-Slim Pickensian/neo-Strangelove view you describe seems to suggest that the convenience adjusted nominal yield on money determines the rate of inflation/deflation, with net muted consequences for the convenience adjusted real yield on money. If convenience yields drop, then deflation increases and the real inflation/convenience adjusted yield on money is somewhat preserved.

    If this is the case, then convenience yields on money become a determining factor for the rate of inflation/deflation, quite separate from how nominal yields on non-money purport to determine inflation/deflation under neo-Fisherism.

    So these two views seem to have somewhat similar deterministic causality, but are in conflict over competing sources of inflation/deflation rate determination.

    Has the neo-Pickensian/Strangelove view passed its fail-safe point, or do you still have time to call back the bombers?

    Come to think of it, can you call back the Neo-Fisherian one in any case?

    :)

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    1. "If this is the case, then convenience yields on money become a determining factor for the rate of inflation/deflation"

      JKH, I think that's a pretty good summary of the "neo-Strangelove" view.

      As long as central banks are stuck at the lower bound and keep the rate on central bank deposits unchanged (and the economy's health stays the same and the government's finances stay healthy) then the convenience yield is the determining factor.

      "Has the neo-Pickensian/Strangelove view passed its fail-safe point, or do you still have time to call back the bombers?"

      This is just a kicking-the-tires post in need of feedback. I have not yet convinced myself that it is right. Tony Yates had some good counterpoints (here and here).

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  9. Additional question:

    “Type 2 assets, things like stocks and bonds, don't boast a convenience yield. Without a convenience flow, people only buy them because they promise a real capital return.”

    Is there such a thing as the present value of a future expected convenience yield (i.e. convenience payable at maturity)?

    Could nominal yields incorporate such a discounted convenience yield component?

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    1. Yes, I think that's right. Someone who owns an asset with a convenience yield enjoys not only the current dose of convenience that that asset throws off but also expects a repeating flow over time. In pricing an asset's convenience, they would discount these future expected flows of convenience into the present. So even if an asset currently does not provide any conveniences, people may still pay a positive value to own that asset's convenience yield insofar that they expect such a yield to appear in the future.

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    2. I think you said something in that direction in your comment at Yates’ first post:

      “Does a 0% overnight rate mean that all liquidity services have been exhausted? I’m not so sure. A bill in our wallet is expected to yield a stream of liquidity services over the next few days or weeks, not just overnight. This expected flow of pleasure is discounted into the present and sums up to the total pleasure derived from holding money. About all we can say when the overnight rate is at zero is that overnight liquidity services have been exhausted. Until the 1-week and 1-month risk free rates are also at zero, money’s liquidity services haven’t been exhausted.”

      I think you’re were referring there to term structure and corresponding convenience possibilities inherent in the holding period of choice for a given non-maturing asset (money), rather than the term structure of an interest bearing instrument that offers such a prospective holding period on a deferred basis – i.e. once the instrument is matured/sold etc. (my point). Same general point though. Like a futures market for convenience yield.

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    3. One more:

      I’m not sure this is the right way to think about it, but it seems to me that the idea of convenience yield is quantity dependent in a rather pronounced way – in a way in which nominal monetary yields on assets are not. For example, depending on my psychological preference for cash in the wallet instead of credit cards, my convenience yield for $ 300 cash may be far higher than my convenience yield on $ 1000 cash – i.e. convenience yield per dollar of cash. People who use cash make this decision all the time, right – when they go to get more cash from their bank? Put another way, the yield may consist of a relatively constant numerator divided by a potentially highly variable denominator, depending on the situation, causing the effective yield to vary dramatically. (Maybe this works at both micro and macro levels.) Whereas nominal yields on interest bearing assets have far less quantity related yield elasticity by comparison.

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    4. "Like a futures market for convenience yield."

      Yes, I think we're on the same page.

      http://jpkoning.blogspot.ca/2013/09/the-convenience-yield-as-epicentre-of.html

      "...but it seems to me that the idea of convenience yield is quantity dependent in a rather pronounced way."

      Agreed. That's a point I was trying to make here.

      The pre-2008 Fed used to conduct monetary policy solely through altering the convenience yield on reserves via quantity adjustments. A tiny change in quantities could quickly drive the convenience yield to 0% of 100%.

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