David Glasner in a recent blog post referred to a paper he wrote in January 2011 on The Fisher Effect Under Deflationary Expectations. The paper is well worth reading for anyone interested in the interplay between monetary policy, asset prices and the recent financial crisis.
The paper argues that during a recession caused by a slump in aggregate demand, because the nominal rate of interest cannot fall below its lower bound, asset markets do not reach equilibrium. As the expected yield from cash is much higher than the expected yield on falling asset prices due to a fall in profits, there is little equilibrating tendency with a higher demand for money. Consequently by raising inflation expectations, asset market equilibrium can be restored. Ie the demand for money should fall if inflation expectations are higher resulting in flows in to real assets and an equilibrating effect.
Glasner sets out the theory but recognises there are a number of issues with it. For example, the theory states that the pattern of future expected cash flows is highly correlated with expected aggregate future output. Although in deep recessions there is a correlation, this is not the case the rest of the time. Indeed, long run econometric analyses of GDP growth and equity returns have consistently demonstrated no relationship between these two variables.
Glasner concludes with two observations: Firstly he rightly argues that sharp downturns in asset prices are associated with deflationary expectations when ex ante real interest rates are low. Second, he believes that the key to a recovery in asset prices is to raise inflation expectations above the real rate of interest to induce asset holders to shift out of cash into real assets. As such a monetary policy that aims to keep inflation expectations constant during an adverse supply shock may drive down profit expectations and real interest rates further.
But the challenge for trying to boost asset prices by boosting inflation expectations is twofold. Firstly, given asset prices may have fallen by as much as 40%, inflation expectations would need to be at quite high levels a la Argentina to force asset allocation out of cash into equities. Such high levels bring other quite serious problems in terms of falling rates of investment, which also makes equities less attractive. So it’s not obvious that if inflation expectations were say 2% it would have much effect on asset allocation decisions to shift into equities. Clearly one would see this effect in the debt market though which would see an increase in demand. Indeed, QE has undoubtedly had an impact on the pricing of debt with US high yield bonds seeing their yields fall from highs of nearly 10% in 2010 to under 5% in 2013. They are now back up to near 10% levels given the higher level of default rates expected this year. Secondly, Keynes in the General Theory argued that an increase in the quantity of money may reduce effective demand and hence may not drive inflationary expectations if this signal is interpreted that the economy is in poor shape. Indeed, it is hard to see how it could not be seen as being the case as why else is a boost needed? As such although the Central Bank might decide to boost the money supply, it is not a given that this money will be channelled into the real economy through increased demand beyond raising bond prices.
The other area of the paper that needs further elaboration is where Glasner equates the ex ante real rate of interest as reflecting the state of business confidence and the expectations of profitability or what Keynes called the marginal efficiency of capital. Keynes following on from Fisher argued that the rate of interest from investments would converge with the money rate of interest as projects will continue to come on to the market until the marginal return equates to the money rate itself. But the empirical evidence does not show this, and there can remain large differences between the two rates.
Finally, it is hard to argue that since QE started there has been much of a positive impact on inflation expectations, but asset prices have recovered dramatically. The key drivers of this asset recovery were due to an initial substantial reduction in head count giving a once-off boost to productivity growth in 2010. Also, as a result of QE, firms have also been able to refinance their existing debt at far lower rates. And demand has increased from the depths of the slump too.
However, since 2015 the rate of profit growth has slowed, or a decelerating marginal efficiency of capital. When the rate of profit growth slows, asset prices tend to correct which is they are doing at the moment. But the implication from the Fisher Effect is that such a fall in asset prices is bad and therefore should result in a monetary response. There are perhaps two reasons why this might not be a good idea. Firstly, any monetary response is potentially pushing back the incentive for firms to improve productivity growth to drive profits instead of depending on easy wins such as financing at lower rates. Secondly, a further monetary boost might not achieve anything anyway as it might signal worsening expectations thereby choking off the nascent recovery in business investment. Empirical evidence shows that investment tends to rise with rising interest rates as this is signalling rising demand. Thirdly, given that there is no correlation between equity returns and growth outside of deep recessions, it is not obvious that such a response would achieve much for growth either.
But Glasner’s basic argument that money was too tight in 2008 is still highly relevant and something that future central bankers should learn from, thereby embarking on monetary easing earlier.