Wednesday, December 16, 2015

ZIRP is over ... let the experiment begin.

So it looks like it was option C: a 25 basis point hike to a range of 0.25% to 0.5%.


Now the experiment begins ...

The graph above shows what will happen to the monetary base if the information equilibrium model is right (0 represents the no change path) and the rate holds for a couple years (it probably won't, I imagine Summer of 2016 will see a second rise).

Also note that the information equilibrium model doesn't tell us about the non-equilibrium adjustment process, so we don't know how fast the base will fall. Keep checking the bi-weekly adjusted monetary base -- it should stop around 2.6 trillion dollars for option C unless there is another rate change intervening.

27 comments:

  1. Jason, have you found any other macro bloggers out there with your enthusiastic "Let the experiment begin!" type attitude? Anybody who's got a quantitative model they're checking with this experiment?

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    1. Actually, the first thing I saw was some hedging on Andolfatto's blog about testing neo Fisherism.

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  2. So you're testing to see if your model accurately predicts the bi-weekly adjusted monetary base consistent with the fed funds corridor of .25 to .5? Or put differently, what's the dollar value of treasuries (or other securities) the fed will have to sell to hit their fed funds rate target?

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  3. Yes, now that ZIRP is over we will really be testing theories. I think inflation starts to become a problem soon because velocity of money goes up as interest rates go up. Where we are on Hussman's graph it seems even a tiny increase in interest rates can cause lots of inflation. Interesting times.

    http://www.howfiatdies.blogspot.com/2015/09/punchbowl-removal-difficulties.html

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  4. If we assume inflation stays the same then, by Hussman's graph, the monetary base has to go way down. Just don't see how this could happen though. Can you explain how the monetary base could go down as much as in your graph? At 0.375% do you see the Fed withdrawing money from the economy? If monetary base can not go down, then I think inflation must go up.

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    1. In this model, you'd probably have to go to rates above 2% in order for physical currency to be removed from the economy. I'll find the exact figure when I get a chance.

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  5. Tom, I think you could fit a curve to Hussman's graph and read off numbers that let you make a quantitative prediction of inflation. I have not done that though.

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  6. Hmmm. Hussman's graph shows a roughly hyperbolic relationship between the yield on 3 month Treasury bills and "Monetary base per dollar of nominal GDP", the latter being on its face a curious variable. However, Hussman tells us in the text that nominal GDP is "equal to the monetary base multiplied by the “velocity” of the monetary base." IOW, monetary-base/nominal-GDP = 1/velocity-of-monetary-base. It would have been nice of him to make that simplification.

    So the graph tells us that the yield of the 3 month T-bill is roughly proportional to the velocity of the monetary base. :) Not a huge surprise.

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    1. BTW, to see that proportionality more clearly it would have been better to make a graph of T-bill yield vs. velocity. :)

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    2. One point being that the supposed proportionality might not show up in the yield vs. velocity graph. :)

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    3. Yes, it is more clear if you do yield vs velocity. I did this for 10 years here and the fit is amazing: http://www.howfiatdies.blogspot.com/2015/09/punchbowl-removal-difficulties.html

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    4. But if velocity is roughly proportional to interest rate, then going from 0.125 to 0.375 on the interest rate could make for a huge increase in velocity and a surprising amount of inflation. So the experiment has been started. I for one will be interested to see how the experiment turns out. Jason and I are on different sides of this prediction.

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    5. That's one point of Hussman's graph. We can't really tell the relationship between velocity and interest rate from the graph of interest rate and 1/velocity. Especially when the interest rate is small, and vice versa. Furthermore, the errors seem one-sided in Hussman's graph, above the hyperbola. As I said, the rough proportionality might well disappear in a graph between interest rate and velocity. The graph is really not very informative.

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    6. Furthermore, Hussman did not graph the relationship between the Fed rate and velocity. Even if there is a correlation between the Fed rate and the 3 month T-bill rate, the T-bill rate is not best evidence. It really is a crappy graph.

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    7. I added a graph for Fed rate and velocity at the end of my post: http://www.howfiatdies.blogspot.com/2015/09/punchbowl-removal-difficulties.html

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    8. Thanks, Vincent. :) Interesting graph.

      One reassuring thing is that the velocity does not change as rapidly as the Fed rate, so that even if a change in the Fed rate will cause a change in velocity, we should not expect any sudden large change. :)

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    9. The scary part is that the excess reserves could come out fast.

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    10. Hi, Vincent.

      Why would the excess reserves come out fast?

      Thanks. :)

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    11. Why would reserves come out fast? Imagine that reserves are paying 0.375% and inflation is 5%. Then on average buying random long lived things would be a better investment than the interest you got on reserves. But as people pulled out their money and put it into things, that would cause more inflation. Then at 10% inflation people would have to be crazy to leave money someplace paying 0.375%. So even more would pull out money and spend it. You can get an "inflation bonfire" that starts from a spark. The reserves would be a big part of the fire dynamics.

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    12. I have trouble connecting the current small rise in the Fed rate with 5% inflation. How does that happen?

      Thanks. And Happy New Year! :)

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  7. Vincent,

    According to this:
    http://finance.yahoo.com/news/the-fed-hikes--5-key-takeaways-193730587.html

    Interest on reserves was also raised from 0.25% to 0.50%.

    Are you taking that into account?

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    1. We have never had a Fed tightening cycle where they were paying interest on excess reserves before, so there is some uncertainty in what this will do. But my graph and Hussman's graph don't depend on excess reserve levels, so I think our claim stands.

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  8. Jason, my question to Vincent above is for you as well: does the fact that IOR was raised from 0.25% to 0.50% factor into your analysis at all?

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    1. It seems to me that if the Fed didn't want to unwind its balance sheet (i.e. withdraw all excess reserves from the economy by use of open market sales), then this rise in IOR rates was not coincidental or optional; instead it was probably required as part of an overall rate rise. Thus if they raise the rates again (w/o first unwinding), I predict they will again raise the IOR rate to match the top rate bound of the new target rate window.

      Also, there must be a reason they did not unwind. Perhaps they deemed it to be too disruptive in some sense?

      Assuming no unwind, can a case be made that the IOR rate moving in lockstep with new higher Fed rates should be factored into a model? Of course a slow motion unwind will happen anyway as Treasuries held by the Fed mature (if they are not replaced): so eventually (if I'm right) the Fed will have nothing to unwind and thus they reduce IOR below the interest rate window they set, perhaps all the way back down to 0% (where it started in 2008).

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    2. Should read:

      "...and thus they CAN reduce IOR below the interest rate window they set."

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