Wednesday, July 19, 2017

Thornton on interest rate humility

Dan Thornton has an interesting essay, ``The Limits of Monetary Policy: Why Interest Rates Don’t Matter.’’

Just why do we think that the Fed raising and lowering interest rates has a strong effect on output (or inflation)? Just why does the Fed control short-term interest rates rather than the money supply, or something else?

Dan's essay is a nice quick tour through the history of this question. No, there is not as much logic and evidence behind this hallowed belief as you might think, and yes, people did not always take the power of interest rates for granted as they seem to do now. Dan's historical tour is worth keeping in mind.

This question is especially relevant right now. We are unlikely to see big changes in interest rates going forward. And central banks are busy thinking of different things to control -- the size of the balance sheet; treasury, MBS, corporate bond, and even stock purchases; use of regulatory tools to control lending. So we may be on the cusp of a fairly major change in thinking about what central banks do -- what their primary tool is -- and how that tool affects the economy. (And, I hope, whether it is wise for central banks to use new tools that come along. Their mandate is not to be the great macroeconomic-financial planner after all.)

As Dan points out,
it is a well-known and well-established fact that interest rates are not very important for investment, or for spending decisions generally.
Quoting Bernanke and Gertler
… empirical studies of supposedly “interest-sensitive” components of aggregate spending [fixed investment, housing, inventories, and consumer durables] have in fact had great difficulty in identifying a quantitatively important effect of the neoclassical cost- of-capital variable [interest rates].
That is by and large true. But I see an alternative breaking out. Investment is strongly influenced by stock prices, by the risk premium in the cost of capital. The total cost of capital is risk premium plus risk free rate, and the risk premium varies much more than the risk free rate. 

Here is the latest version of a graph I've made several times to emphasize this point. ME/BE is the market to book ratio of the stock market, or "Q.'' P/(20xD) is the ratio of price to 20 x Dividends. IK is the ratio of investment to capital. 

Investment responds to the stock market, and the stock market moves because risk premiums move, not because interest rates move. 

The "alternative" then is the increasing amount of attention paid to the Fed's effect on stock and corporate bond prices, together with evidence like this that investment responds to risk premiums in stock and corporate bond prices. 

I am a long-time skeptic of the stories that say low levels of interest rates encourage asset price "bubbles." After all, borrowing at 1% and investing at 5% is the same as borrowing at 5% and investing at 9%. Why should the level matter to the risk premium? But those stories are repeated more and more often (like the story about interest rates!) So overall, what may break out is a story that the central bank can influence risk premiums-- this needs segmented markets, leveraged intermediaries, and other financial frictions, modern heirs to the "credit channel"-- and risk premiums influence investment. Macro-finance is full of this sort of analysis right now. 

I recoil at the idea that central banks should start operating this way -- targeting risky asset prices, using a range of tools to do it, and thereby trying to control investment spending.  Central planners can set prices too, but that doesn't mean they should. But this may be where the world is going. 

Now, back to Dan. After reminding us that consumption and investment spending does not respond (much) to interest rates, Dan's intellectual history. (Excerpts here, the original is worth reading) 
“So why do policymakers believe that monetary policy works through the interest rate channel and that monetary policy is powerful?” Well, there was one important event that brought economists and policymakers to this conclusion. Specifically, the Fed under Chairman Paul Volcker brought an end to the Great Inflation of the 1970s and early 1980s.
Prior to this event, Keynesian economists … believed that monetary policy was totally ineffective. “Why?” Keynesians believed that the only thing monetary policy could affect was interest rates. Since interest rates were not important for spending, the effect of monetary policy actions on interest would have essentially no effect on spending and, consequently, no important effect on output. Keynesians believed that monetary policy was essentially useless.
There was a smaller group of economists called monetarists who believed that monetary policy could have a large effect on output. But they believed this effect was due to the effect of monetary actions on the supply of money, not interest rates. Both Keynesians and monetarists believed that the effect through the interest rate channel would be tiny.
It's worth remembering that the power of pure interest rate changes is a recent idea. Separately, 
Bernanke and Blinder find that monetary policy works through the bank credit channel of monetary policy—not through interest rates. However, … because banks have financed most of their lending by borrowing funds from the public since the mid-1960s, it is unlikely that the bank credit channel is important. …It is now well-recognized that the bank credit channel of monetary policy is very weak.
I'm not sure Bernanke and Blinder (as well as other fans) agree with the last sentence, but the bank lending channel has always suffered the problem that 1) Fed actions have little effect on lending -- as Dan mentions, reserve requirements really don't bite 2) Only very small businesses really rely on bank lending. There are lots of them, but not much GDP. 

So how did belief in the power of interest rates come about? 
When he became chairman of the Fed, Paul Volcker made ending inflation the goal of policy. … He announced that he wanted to pursue a new approach to implementing monetary policy that “involves leaning more heavily on the [monetary] aggregates in the period immediately ahead.” …it seems to have worked. Inflation declined from its April 1980 peak of 14.5% to about 2.4% in July 1983….The policy change was also followed by back-to-back recessions…. the fact that the change in policy was followed by a marked reduction in both inflation and output led economists and policymakers to dramatically change their view about the power of monetary policy to effect output and inflation.
…economists debated whether the success of the Volcker’s monetary policy was due to a marked reduction in the supply of money or to higher interest rates. But the growth rate of M1 monetary aggregate changed little over the period. Moreover, the growth rate of M2 actually increased. In contrast, the federal funds rate, which was 11.6% the day the FOMC changed policy, increased to a peak of 17.6% on October 22, 1979. The funds rate then cycled, hitting cyclical peaks above 20% in late 1980 and mid-1981. Given the behavior of the M1 and M2 monetary aggregates and the behavior of the federal funds rate during the period, a consensus formed around the idea that the success of Volcker’s policy was attributable to high interest rates not to slow money growth. 
Like the Phoenix, the idea that monetary policy worked through the interest rate channel rose from the ashes. … the FOMC adopted the federal funds rate as its policy instrument in the late 1980s, circa 1988. … Policymakers pay essentially no attention to monetary aggregates…
And academic analysis of monetary policy is focused entirely on interest rates. Dan doesn't mention new-Keynesian models, but they epitomize the current thinking. The Fed sets interest rates, with no money at all, and higher interest rates induce people to spend less today and more tomrrow. 
The problem is that nothing else changed. There have been no new studies showing that spending is much more sensitive to changes in interest rates than previously thought. … Bernanke and Gertler’s statement that monetary policy does not work through the interest channel is as true today as it was 20 year ago. What has changed is economists’ belief that monetary policy works through the interest rate channel. … economists’ and policymakers’ belief that monetary policy has strong effects on output through the interest rate channel is more akin to religion than to science. It is built on a belief that it seems to have worked once. 
This belief is reinforced by fact that few economists believe that policy could work through any of the other possible channels of policy: the exchange rate channel, the wealth effect channel, the money supply channel, or the credit channel. Monetary policy seems to work, but it cannot work through any of these other channels. Conclusion: it must work through the interest rate channel.
Quoting Alan Greenspan
We ran into the situation, as you may remember, when the money supply, nonborrowed reserves, and various other non-interest-rate measures on which the Committee had focused had in turn fallen by the wayside. We were left with interest rates because we had no alternative. … – Alan Greenspan, FOMC Transcript, July 1-2, 1997, pp. 80-81. 
Where does this leave us? In the short run, the fact remains. We have no alternative. If I were to wake up as Fed chair tomorrow, I'd move the interest rate levers just about the same way as anyone else does. In the short run, I think these reflections should add to our humility -- we really don't understand the mechanism as well as most analysis suggests, and a new idea will come sooner or later.

In the longer run, those new ideas seem to be breaking out. Central banks, increasingly gargantuan financial regulators, are using a wide range of tools to influence the economy via asset prices. In my own view this is a bad idea. But like most bad ideas it is slipping in sideways largely un noticed.


  1. You rarely write about the international aspects of such policy decisions. Recently on Twitter there was some discussion of Lael Brainard's remarks on how central banks can influence exchange rates and flows of capital. It's difficult for any of us to know which way the world is going, but I hope that we can follow her instead of the alternative that you have noted here.

  2. Monetary policy is a "string" - Volcker could pull but Bernanke could not push.

    I was a young lawyer in 1981. The high interest rates worked through cash flow. Signicant numbers of borrowers were not simply able to pay on a cash flow basis.

  3. More info on Dan L. Thornton can be found here:


    "What Dan does not mention, and I have above, is that central banks now do seem to have an alternative, and it's pretty scary --well, to me at least. Controlling investment by controlling stock prices."

    Why would the Fed have any better results controlling output through a stock market channel? Even your graph shows the correlation between Market Value / Book Value and investment.

    Sure the Fed could go out and buy up a bunch of stock, but that would push up BOTH the Market Value AND the Book Value of the stock. By your own graph, that would have no effect on investment or output.

  4. There’s a flaw in both the options: controlling investment via interest rate adjustments and via stock prices. It’s thus.

    There is no obvious reason why, given a recession, the problem is inadequate investment rather than a deficiency in some other element of aggregate demand, like general consumer confidence or exports.

    The basic purpose of the economy is to produce what people want: both the stuff they consume out of disposable income and the stuff they vote to have government supply via public spending. A recession equals an inadequate production of those items. Thus the logical response to a recession, unless someone can produce very good reasons for thinking otherwise, is to give people more of the stuff that enables them to purchase what they want out of disposable income, and that stuff is called “MONEY”. I.e. household incomes need raising via tax cuts etc.

    Second, public spending needs to be increased. And there’s no need to increase the debt to do that: a deficit can be funded via new base money, as pointed out by Keynes almost a century ago.

    Moreover, those with a fetish about investment should note that raising consumer and public spending will AUTOMATICALLY raise investment spending where relevant corporations and firms deem that appropriate.

  5. Valter Buffo, Recce'd, MilanJuly 20, 2017 at 2:34 AM

    Start from "I recoil at the idea that central banks should start operating this way -- targeting risky asset prices, using a range of tools to do it, and thereby affecting investment spending. But this may be where the world is going.". I personally think we are already there (unfortunately). The sole pillar holding up the whole theorization behind this policy is that: "Investment is strongly influenced by stock prices, by the risk premium in the cost of capital. The total cost of capital is risk premium plus risk free rate ...": but if you analyse the last ten years of (macro and finance jointly) data, it seems that simply did NOT work, at all. This fact leads me (and others) to think that "real-economy investments" were NOT the ultimate goal of asset-price targeting policies. What do we need to get out of here safe? In my view, first of all we'd need a strong innovative theorization to show that risk premia do not exist in asset pricing, since "all is already in the current market price". Market prices we observe every day, as you know, are risk-neutral.

  6. The Rules of the London Stock exchange state that " A member firm trading in a security shall not do any act or engage in any course of conduct the sole or main intention of which is to move the price of that security or the level of any index of which that security is a component..."

  7. Great stuff and fun reading.

    I have sometimes wondered if Paul Volcker, who I much admire, "got lucky."

    That is, there was a confluence of non-monetary structural factors that brought down inflation on his watch, including declining share of the labor force in unions, the Carter-era dereg of finance, telecommunications, and transportation (remember Alfred Kahn?), lower top marginal tax rates (freeing up growth capital), more global trade, and more illegal labor.

    There is also a study from the Richmond Fed that the Fed actually started to tighten under the much-maligned Arthur Burns (as measured by a Taylor Rule-type metric) and has been tightening ever since (which makes sense, given declining inflation and interest rates ever since Volcker).

    I agree we are entering a new era of monetary policy--but perhaps re-entering an old stage in Japan.

    In Japan, the BOJ has fixed at zero interest rates on 10-year government bonds, instituted negative IOR, has purchased about 43% of the national debt (JGBs), and is buying equity ETFs.

    If 20 years ago you asked any Western orthodox macroeconomist what would be the result of the BOJ's program, and the answer would be "Runaway inflation, like Man O'War on LSD."

    The BOJ can't seem to hit their 2% inflation target.

    It was the Japanese Finance Minister Korekiyo Takahashi who deployed money-financed fiscal programs to success in the Great Depression years in Japan, allowing that nation to largely sidestep the global economic calamity.

    So maybe Japan is not entering new ground for monetary policy, as much as revisiting old ground. The combination of Japan fiscal deficits and QE sure looks like money-financed fiscal programs.

    This may be the path forward for the U.S.: money-financed fiscal programs. Adair Turner and Michael Woodford like the idea. Thornton says tinkering around with interest rates is iffy. Money-financed fiscal programs (ala helicopter drops) would likely have concrete results.

    OT but not:

    "For example, the last recession was characterized by an excess supply of real capital, in the form of residential and, to a lesser extent, commercial real estate. In such circumstances, it is reasonable to assume that it would take a much larger reduction in interest rates to have much, if any, effect on spending."--Thornton, from post.

    I think Thornton is suggesting too much capital flowed into real estate, which is heavily zoned and supply-constrained in the U.S. Actually, the bust in commercial real estate prices almost exactly matched the residential bust.

    There is a fascinating paper from the NY Fed that concludes house price bubbles were caused by large current account trade deficits. Foreign capital flows into housing.

    Certainly, the evidence is strong for this conclusion.

    Yet we saw the Fed was able to crack, even crush real estate values in 2008 by raising rates. Unfortunately, our financial system was heavily, heavily exposed to real estate. Oh, that?

    It may be property prices are "artificially" high due to the confluence of property zoning and foreign capital. But if the Fed is able to engineer a credit contraction, real estate values will start to fall from precarious heights. Foreign capital takes to sidelines, and you have a bust. Once real estate values start going down, banks are loath to lend on real estate, btw, making for something of a self-fulfilling prophesy.

    In conclusion, the real villain of 2008 is probably property zoning, a nearly radioactive topic.

    "Due the imperatives of globalism, you can no longer zone property in your neighborhood," has a lot of charm, no?

    Perhaps the Fed is held hostage by real estate. Engineering a decline in property values is like inviting a deep recession into the living room.

    If the US can do little about property zoning, then perhaps a new trade policy is in order.

  8. Dr. Cochrane,
    1) It is certainly true that the "Interest Rates Do Not Matter", there is indeed ample evidence for that [1].
    2) You wrote:"Controlling investment by controlling stock prices"
    There is however no evidence that this is the case. If one were to plot the All Federal Reserve Banks: Total Assets (WALCL) using weekly averages (ending Wednesday) on a year over year percent change basis and NASDAQ Composite Index© (NASDAQCOM) on the same basis it could be seen[2] that during some periods there is indeed a positive correlation, such as between January 2013 and August 2016 but that through other periods there is a negative correlation such as between 2008 and 2010.
    During the period where data is available from the Federal Reserve Bank on their webpage, i.e. March 10, 2004 and August 24, 2016, a periods of 651 weeks the overall correlations using the Pearson Product Moment Correlation (PPMC) was actually negative, R2 = -0.556 p <0.00001. If one examines the periods between April 4, 2004 (n = 199) and December 26, 2007 the correlation is weaker, R2 = -0.30 P 0.00002. The period from 2014 to August 2016 there is indeed a positive correlation (R2 = 0.828, p<0.0001, n = 191). The period of 2008 to 2013 has a negative correlation as well (R2 = -0.691, p < 0.0001, n = 313). So over some periods there is a positive correlation and others there is a negative correlation.
    What is to be made of this? A direct causative association seems unlikely. Why would increases in Federal Reserve Bank asset holding cause a decrease on the NASDAQ at one time and an increase during another time? Moreover, what would the mechanism be? Through what channel would an increase in FRB assets impact stock prices, either up or down?
    Consider now if Nominal Gross Domestic Product (GDP) is plotted[2] using quarterly averages on a year over year percent change basis. There would appear to be positive correlation between GDP and NASDAQ and a negative correlations between FRB Assets and GDP. In fact the PPMC is indeed negative R2 = -0.770 (p <0.00001 n = 49). So rather than FRB assets driving the NASDAQ up and down the NASDAQ is more likely responding to changes in overall economic activity as measured by changes in GDP as is the FRB which is adjusting it holdings.
    Stock prices do not appear to be influenced by FRB policy at all, they are largely correlated with overall economic activity.

  9. The Fed takes away the punch bowl once per recession cycle.
    On a generational cycle the Fed get a regime change and government defaults.

  10. The Fed doesn't set interest rates (plural). The Fed sets one rate, and the market sets the rest. Does the Fed funds rate influence the rest? Of course.

    But I think it is the difference (or the spread) between these rates that is the important mechanism. If banks can borrow for significantly less than they can lend, then they will hold minimal reserves, and they will capitalize on this spread. However, there is risk (credit risk, interest rate risk, etc.) in this transaction, and they will not take on this risk unless there is sufficient compensation. So, the Fed cuts the overnight rate. This rate falls. Relative compensation for risk taking increases. And investors take on more risk. This idea is briefly suggested above, but I think that it is central. A steep curve interest rate curve is stimulative. A steep credit curve is stimulative. The level of rates, doesn't really matter.

    Interest on reserves is an important change in monetary policy since 2008, that deserves more investigation. Where it used to be that banks received no compensation for holding excess reserves, now they do. This effectively makes the risk-free rate much higher than it otherwise would be, and cuts into the rewards for risk.

  11. Surely the key difference is that in 80's the USA was still a more or less closed economy in financial terms. There were no massive sovereign wealth funds etc to neutralize the effects of a Fed liquidity squeeze and the dollar exchange rate mattered to ROW, but not to USA (as John Connolly observed).

  12. Apologies for the seemingly dumb question, but why would m2 increase if the fed funds rate was increasing? Isn't the fed funds rate determined by the supply of m2?

    1. M2 includes interest-paying bank accounts, whose supply is not fixed by the Fed. To simplify enormously, imagine I write you an iou, and you trade the iou for a beer. We have created money, independent of the Fed. At best the funds rate used to depend on the supply of bank reserves. Even that story didn't really work in practice, as interest rates went up when the Fed said they should go up, and bank reserves only adjusted slowly. Now, the funds rate and everything else depends on the rate the Fed pays on bank reserves.

    2. I'm trying to understand the mechanism. I was under the impression that only the FED can create money via electronic transfer and only the treasury can print money via the printing press. For the supply of m2 to increases, that iou gets circulated until someone coverts it to hard cash. That cash has to come from somewhere, so without it being printed and for m2 to increase, it would have to come from somewhere where it was just held passively. I feel like I'm missing the obvious

    3. James,

      When a private bank makes a loan, they often times don't have the available capital to lend right at that instant. They will make the loan and then determine how to obtain the money to lend. That money to lend can come from a number of sources:

      1. Retained earnings from existing loans that the bank holds
      2. Sale of equity shares
      3. Borrowing in the money markets / commercial paper markets
      4. Sale of assets (buildings, equipment, other)
      5. Sale of certificates of deposit
      6. Borrowing from Fed discount window (usually overnight)
      7. Sale of assets to the Fed (open market operations)

      In all instances other than #6 and #7, the private bank is simply re-lending money that already exists (aka fractional reserve banking).

      As John points out, M2 includes assets are treated as "near money" - see:

      Money that you take from a checking account and place in a money market mutual fund causes M1 to go down, but M2 stays the same. Money market accounts are considered "near money" because they are not quite as liquid as cash on hand or checking accounts. Before a money market account can give you your money back, some securities held by the money market account must either reach maturity or be sold.

    4. Frank,

      So in your opinion, which mechanism caused M2 to increase during this period?

    5. James,

      "So in your opinion, which mechanism caused M2 to increase during this period?"

      My understanding of your question is this - how can both interest rates and money supply (M2) simultaneously go up?

      I don't have an opinion on the matter. I can only speculate.

      One possible scenario is a shrinking term structure on existing debt. Remember that money markets (part of M2) hold primarily short term debt - that includes short term loans AS WELL AS long term loans that are close to maturity. As term structure shrinks, bond buyers shift money from long term bond funds into short term money market funds. This will cause M2 to rise with no change in M1.

      A shrinking term structure on debt can have a multitude of underlying causes - over leverage / unstable banking institutions, governments using short term structures to reduce deficits, or just general uncertainty about what the future holds.

      A second possible explanation for rising M2 and interest rates is an inverted yield curve. In some circumstances, short term borrowers pay a higher interest rate than long term borrowers. That will lead to a flow of money out of long term bond funds into money market funds. Again M2 will rise with no change in M1.

  13. Interesting analysis about interest rates not being as much a factor as we suppose. But Professor Cochrane, what's your view on the idea that interest rates should be a factor largely TAKEN OUT of the equation, so called Permazero, an idea endorsed by James Bullard of the Fed, who cites your work appreciatively a lot.

    Regarding permanently low rates over a large horizon, announced in advance - Warren Buffett said, "If the government absolutely said interest rates are going to be zero for 50 years, the Dow would be at 100,000,"

    Would Permazero really be so bad, Professor? I think it would be awesome! Hope to hear your thoughts. Thanks and God bless.

  14. Absalon hints at it.

    You can put a horse to water, but can't force it do drink.

    If horse is thirsty, however, you can open the gates and it will drink indeed.

    (How does financial distress gets solved? By nominal GDP growth, aka inflation. Money->consumer->prices. Buying bonds is not printing money)

  15. "We have no alternative" That's inane. Nothing's changed in over 100 years. Monetary policy objectives should be formulated in terms of desired rates-of-change, 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".

    And Alfred Marshall's cash-balances approach (viz., a schedule of the amounts of money that will be offered at given levels of "P"), viz., where at times "K" is the reciprocal of Vt, or “K” has the dimension of a “storage period” and "bridges the gaps of transition periods" in Yale Professor Irving Fisher’s model.

    Roc's in R-gDp have to be used, of course, as a policy standard.
    Neither financial transactions not “animal spirits” are random:
    American, Yale Professor Irving Fisher – 1920 2nd edition: “The Purchasing Power of Money”:

    “If the principles here advocated are correct, the purchasing power of money — or its reciprocal, the level of prices — depends exclusively on five definite factors:
    (1)the volume of money in circulation;
    (2) its velocity of circulation;
    (3) the volume of bank deposits subject to check;
    (4) its velocity; and
    (5) the volume of trade.
    “Each of these five magnitudes is extremely definite, and their relation to the purchasing power of money is definitely expressed by an “equation of exchange.”
    “In my opinion, the branch of economics which treats of these five regulators of purchasing power ought to be recognized and ultimately will be recognized as an EXACT SCIENCE, capable of precise formulation, demonstration, and statistical verification.”

  16. Your discussion of Volcker's performance is wrong. And in fact, the statistics used are wrong. You can thank Dr. Richard Anderson for the errors.


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.