Risk, Return, and Macroeconomics: More Like Trying to Stop a Charging Rhinoceros with a Deer Rifle...
Paul Krugman writes:
Meh -- And I Mean That: OK, the Fed moved. It was a bit stronger than expected — and BB and company stood up to the GOP. But seriously, they’re trying to use a water pistol to stop a charging rhino…
It's not that bad. A water pistol is about 1/10000 the weapon you need to stop a charging rhino. This is more like 1/10 of what I think the Fed should be doing.
Paul then goes into one of the things he does very best--making complicated issues of economic institutions and market responses crystal clear:
Conventional monetary policy operates by changing the supply of monetary base, which is a unique, uniquely liquid asset. Increase the supply of green pieces of paper with pictures of dead presidents, and you start a hot-potato process in which people try to get out of that asset into higher-yielding but less liquid assets, interest rates fall all along the curve, and big real things can happen. Right now, however, people are holding monetary base at the margin simply for its role as a store of value [because in a liquidity trap its zero interest rate is a rate of return competitive with that provided by other stores of value], so conventional monetary policy doesn’t do anything.
The Fed is therefore trying to operate on a different margin, swapping short-term for long-term securities. The trouble here is that it’s not at all clear that this has much traction. To a first approximation, long-term interest rates are determined by expected future short-term rates, and if that were the whole story, the Fed would be accomplishing nothing at all. Now, to a second approximation, risk plays a role; and what the Fed is trying to do is play on the margin created by the difference between the first and second approximations. OK. But we’re talking about very big markets here. Total nonfinancial debt in the US is around $36 trillion, and the Fed is talking about shifting $400 billion of that total from short-term to long-term assets. How much effect can that have?
Well, the present-value discount on the cumulative cash flows from holding long-term Treasury bonds has two components: an expectation that short-term interest rates will rise in the future, and a reward for bearing risk. At the moment ten-year Treasury bonds are selling at a present-value discount of
20 14%, and thirty-year Treasury bonds are selling at a present-value discount of 45%. Guess that half of these discounts are expectations of interest rate changes and half are rewards for risk bearing. Then if the Fed buys half 10-year and half 30-year bonds it takes risk currently valued at $60 billion off of the private sector's balance sheet. A ten-year corporate investment project of about $150 billion carries $60 billion worth of risk with it, so if this works and if the risk-bearing capacity freed-up by this version of quantitative easing is then deployed elsewhere, we will have an extra $150 billion of business investment over the year or so it takes to roll out this program and for it to have its effect.
$150 billion is, as Christina Romer likes to say "not chopped liver"--not even in a $15 trillion economy. But it is about 1/10 of our current problem--maybe less when you reflect that our current-problem is a multi-year problem.
Better, Paul says, for the Federal Reserve to act on inflation expectations rather than simply acting to free up some of the risk-bearing capacity of the private market:
The main way in which unconventional Fed policy can work is by changing expectations — especially expected future inflation. And that’s not happening. In fact, expectations of inflation over the next 5 years have been falling fast:
And let me 100% endorse Krugman's conclusion:
So kudos to the Fed for defying the right’s threats, and I guess this is better than nothing. But is it remotely enough? No.