Wednesday, August 7, 2019

Trade and the Fed

Nina Karnaukh of Ohio State sent along this lovely graph of the 6 month Fed Funds futures around the beginning of August. Read this as the market's guess about what is happening to the Federal Funds rate over the next 6 months.

The first drop in price occurs with the FOMC announcement 2 PM July 31. The price drop is equivalent to a a rise in expected future interest rates of about 5 basis points or 0.05%. This has been read as market disappointment that the Fed did not signal more future rate cuts.

The subsequent price spike is this,

That statement caused a 10 bps rise in price, i.e. decline in expected interest rate.  The natural interpretation: The markets expect the  Fed to lower rates in a trade war, either directly or in response to the economic damage the trade war will cause.

I had read the Fed's recent actions as just a case of late expansion jitters, perhaps with a mild response  to slightly lowered inflation. But this is clear evidence that the market sees the Fed reacting to trade news.


Should central banks offset trade wars? I think this is a question nobody is asking but it needs to be asked. Central banks including the US Fed and ECB seem to take for granted that any reduction in economic activity demands "stimulus" to offset it. But stimulus can only provide "aggregate demand." What if the problem is "aggregate supply" -- an economy humming along at full demand, and then someone throws a wrench in the works, be it a trade war, a bad tax code, or a regulatory onslaught? (I'll stop using quotes, to signal my dislike for these terms.)

Conventional wisdom ways that central banks should not offset reductions in aggregate supply. You can fight a lack of aggregate demand, but monetary policy cannot fight a decline in aggregate supply. The first job of a central bank should be to distinguish demand from supply shocks, so it can react to the former, but not to the latter.  This standard wisdom emanates from the 1970s, where central banks kept rates low to offset the effects of oil price shocks -- supply shocks -- and ended up producing worse recessions and inflation.

Yet expressing this view at central banks these days, people stare at me with blank expressions. Distinguish... supply... from... demand... shocks....why would we do that? The view from about 1960s Keynesianism that all fluctuations in output, employment and prices come from demand, seems to have flowered again.

Now, in this conventional (i.e. 1980 Keynesianism vs 1965 Keynesianism) view the problem with offsetting a "supply" shock is that the monetary stimulus causes inflation. And now we have inflation once again drifting slightly lower. So perhaps the trade war is a "demand" shock? It's hard to see how though.

More plausibly, perhaps the policy uncertainty about the trade war is causing a decline in "demand." Why build a factory if any day now another tweet  could render it unprofitable? The prospect of a trade war -- or the kind of serious political and trade turmoil that would follow Tianamen II in Hong Kong -- is a "confidence" shock. But the uncertainty is genuine. A rise in risk premium in an uncertain environment is genuine. People should hold off building factories that depend on a Chinese supply chain until we know if there is going to be a trade war. Unless the Fed is stepping more and more into the role of psychologist in chief, to decree that such fears are irrational, it's not obvious that the Fed should try to goose investment by artificially lowering the short term rate in response to a  rise in trade fears.

A second possibility arises from more 1980s economics. A "supply" or productivity shock also lowers the expected return on investment. So the real  interest rate should decline in response to such a shock. That is another reason perhaps for some interest rate decline in response to a negative supply shock. But how much? This still does not justify the same response to all sources of output decline, or (in our case) fear of output decline that has not happened yet.

The other possibility is that the Fed is now watching the exchange rate, as most other central banks do. The one thing that still does seem to work is that raising interest rates raises the value of the currency. The trade war raises the value of the dollar, and the US clearly wants to manipulate the dollar back down again.


  1. does anyone really think lower interest will generate biz investment when rates already so low?
    If so, i doubt they ever worked in a biz. where they had to make capital allocation decisions. Most likely, non committed investment will be postponed until those making the capital investment decisions can feel comfortable with forecasts, and ROI objectives which may be for now to hard to pin point

  2. A trade war increases wedges between domestic and foreign prices. We get expenditure switching from foreign to domestic goods. Domestic supply increases [but real income declines]. All this amounts to pressure for a real appreciation. Lower interest rates are supposed to nullify that, I suppose. They can't ... in the not even so long run.

  3. That's the second country this week labeled a currency manipulator. This designation is arguably more credible, and just as potent.

  4. As another economist has said about this blog post, isn't there actually a demand shock in some sense? In the sense that demand for US exports is now lower due to reciprocal action.

  5. These so-called "trade war" is garnering the headlines but I think the real story is that major global central banks have been too tight and have been chronically tight for decades, but now lack the tools to stimulate nominal GDP growth.

    Is it really possible that major developed economies would reach very low inflation and negative interest rates after decades of easy money (and all the while ational budget deficits)?

    Trump's latest proposed tariffs on China exports to the United States, that is 10% on $300 billion, amount to a tax increase of $30 billion. The US presently collects about $3.9 trillion a year in taxes---- and that is just at the federal level.

    The fact that there are constant predictions of catastrophic consequences from the "trade war" reflects not reality but rather the powerful voice of globalists and multi-nationals---- and sadly, well-known economists. There is nothing so sacred in current macroeconomic theology as "free trade."

    People can pay $3,600 monthly for a small apartment in Northern California, but what they are really suffering from is Trump's tariffs.

    The idea that communist Beijing may send hobnailed boots into Hong Kong, and that we see a Tiananmen Square II is a worrisome prospect.

    There is still among central bankers the generation that worries about inflation. Those of us old enough to have had parents who lived through the Great Depression know that some people never stopped worrying about the consequences of economic contractions. Maybe that explains Arthur Burns.

    Both the world's largest bond manager, Pimco, and the world's largest hedge fund manager, Ray Dalio, have said they think central banks currently lack the tools necessary to stimulate even nominal GDP growth. The markets are signaling that they think the central banks are armed with popguns.

    I think we must arm central banks with helicopters.

  6. I think the difficulty is in identifying aggregate demand vs. aggregate supply shocks.

  7. No, Fed should not try to "fine tune" trade wars. These are fiscal matters that are province of the White House and Congress. At best the Fed is the alter ego of the Treasury, not an independent branch of government.

  8. Why is lowering the policy interest rate in response to a decline in the equilibrium rate considered 1980s economics? What would "2010s" economics do in this situation?

  9. John,

    Perhaps both AD & AS curves are shifting. However, it looks like the AD curve has shifted further than the AS curve. Evidence for the shift of the AD curve being greater than the AS curve is:

    1. lower TIPS breakevens
    2. lower RGDP (also consistent with leftward shift in AS curve)
    3. the recent sell-off in risk assets
    4. reduction in commodity prices

    Trade issues seem to have the effect of reducing the natural rate of interest - as the Fed doesn't lower the policy rate to match the reduction in the natural rate, we have monetary tightening despite a lower policy rate. This is what I believe is causing the reduction in AD.


  10. The administration imposed tariffs on China and possibly the EU engendering trade uncertainty. Of course we pay the 25% tax. Knightian uncertainty is difficult against which to insure. In a previous blog you said the flat yield curve implied discount rates were too high relative to the ten year. Probably, but that also suggests, in uncertain environments, traders run to safety so to preserve capital.

  11. Compare Brexit, also a real shock. The UK will possibly suffer a decline in its terms of trade, i.e its real income, but with the poor better off as the country slashes its especially high [EU] tariffs on food and clothing. The BoE is bs'ing about all this, presumably 'cause it can't do anything about it. Maybe it doesn't understand it, or doesn't want to.

    A decline in the terms of trade would be traded for other desirable things, like getting free of EU regulations. :-)

  12. When there's a supply shock, prices will rise and the only thing the Fed can do to stop it is by reducing the supply of money. That means running budget surpluses, which is out of the control of the Fed.

    Its' easy to tell the difference between a supply shock and a demand shock: In a supply shock, prices go up, and real GDP goes down. In a demand shock, prices and GDP go up together.

  13. The treasury curve has been steadily flattening since the ten year hit 3% about a year ago. We hit the boundary are have started to rescale. The recession already started, we are just going through a repricing and discovering that fact, ex post.

  14. Dear Prof.Cochrane, you posted an exceptional analysis about how interest rates are moved around in this blog. You kept it simple by taking care only the expected growth part. I think now, its time to consider the "volatiliy" part which comes into with negative sign in the interest rates equation. e.g when the volatility of growth goes up, the rfs go down, the markets go down (ceteris paribus) and the expected returns go up. The Fed simply takes care about the volatility of growth and the trade wars may be consist one reason for that.

  15. This comment has been removed by the author.

  16. Should Fed offset trade wars? An interesting question. I could raise another question: suppose the US elects a populist government that proposes to raise minimum wage to $25/hr. This will lead to a rise in unemployment - something the Fed is supposed to prevent. It can reduce the effects of this policy by allowing inflation to run higher, thus inflating the higher minimum wage away. Should it do so?

    On the one hand, inflating it away is consistent with the Fed's mandate to achieve low inflation and full employment. On the other, doing so may be seen as undermining a policy of a democratically elected government.


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.