Are low Fed rates a Price Floor or a Price Ceiling?
Brad DeLong talks about how other economists view Fed interest rate policies as “price controls”. Then he makes a comparison to the present situation with on an example of a “price floor” in agricultural products. But are low interest rates a price floor or a price ceiling?
If you think that interest rates need to go lower to efficiently clear the market than the zero lower bound would be a price floor. In effect, you cannot lower the price of money. This is how Brad DeLong views the current interest rate policy.
If you think that interest rates need to go higher to clear the market than the zero lower bound would be a price ceiling. In effect, the price of money is being pushed low. This is not how Brad DeLong would see current interest rate policy. Yet this is how the others are seeing it.
Compare this Biz cycle to the last
What do we know about a price ceiling? In a price ceiling, suppliers are less willing to supply the good or service. Is that why bank lending is down so low this business cycle? (link to graph)
Or is bank lending down due to deleveraging?
Also in a price ceiling, there is demand to raise the price. There is demand for the good or service. So is there demand for money? Well, corporate bond liabilities are up high in this business cycle which would imply that there is a higher demand for money. (link to graph)
Yes, there is demand for money through selling bonds, but not through borrowing from the banks.
In this business cycle compared to the last, it would seem that banks might be reluctant to lend with the price of money so low. Banks would prefer a higher price to sell the money. So banks limit their supply of loanable funds. Yet corporations that want money have gone to selling bonds to investors who are reaching for some yield. So it seems that the marketing clearing price might be higher which upon a first approximation says that low interest rates are a price ceiling, not a price floor.
Comments? Reactions?
Way simplistic comparison. Demand for corporate bonds is demand for higher yields at greater risk levels. What are corporation spending their bond sales income on? The have hoards of cash and productivity isn’t increasing much nor is unused production capacity increasing much. Seems to me they’re using bond sales to buy back stock to increase share values without doing anything else.
This is an apples and oranges comparison.
Longtooth,
I agree, like I say in the post, “…corporations that want money have gone to selling bonds to investors who are reaching for some yield.”
And I agree with your point about apples and oranges. This business cycle is not like the previous cycle. They really are apples and oranges.
The banking industry is being dysfunctional in this cycle. With all the reserves that they have and low interest rates to offer, corporations prefer to borrow money through corporate bonds. Either the banking industry does not want to lend out the money to compete with the bond market or corporations are not accepting the terms of the bank loans.
I think this just makes a point that Adair Turner has been highlighting in his book tour : There is no , single , “natural rate”. There are multiple natural rates in a heterogeneous economy , which implies that the use of some kind of “credit guidance” is required to balance supply and demand for credit. Also to prevent credit bubbles in certain sectors , like real estate.
Banks are making less direct loans. They are creating securities and selling them instead of making the loans that are retained on their balance sheets.
Why are the banks doing this? Because of Dodd Frank and the new capital requirements for loans.
EL thinks this is happening because of low interest rates – WRONG AGAIN!
If companies are selling bonds rather than borrowing from banks, the implication is that banks are inefficient suppliers of corporate credit as compared with bond underwriters. If the banks could undercut the bond market, companies would borrow from banks. The market seems to be clearing just fine.
The banking business is ripe for disruption. It has a terrible cost structure. Banks can effectively borrow at zero percent, but they still can’t make enough money to cover their loan issuing costs. The bond markets can undercut them. Kickstarter can undercut them. J. Random venture capital firm can undercut them. The government in its “wisdom” bailed out a dying industry.
Would banks lend more at higher interest rates? Possibly, but they’d still be at a disadvantage. It would still be cheaper to issue bonds or raise money on some web site or do a dog and pony show in San Francisco.
Kaleberg,
I think you hit the target. The banking industry is dysfunctional, and thus the Fed’s policies are dysfunctional because they rely so much on the banking industry.
But if the Fed rate rises just imagine what will happen to all those bonds… their prices will drop. So the dysfunctional banking industry was replaced by corporate bonds.
Now the Fed may disrupt the bond market by giving the banks a higher rate. You can see that bank lending is on the rise. The banks may want to lend more money now and may want higher rates. There is dysfunction in the system. Evidence is in the graphs above. The huge diffeerence between this biz cycle and the last is suspect.
Marko,
Yes multiple real rates just like different industries have such different levels of capacity utilization. Macro is a wonderful thing.
Kaleberg “Dying industry” you say? The “bond markets” undercut them?
For the record – in the past five years US bank lending has increased $3.7 Trillion. During that same period total US GDP has increased by $3 Trillion. So bank lending ins increasing faster than GDP. Not quite dead…
Who are the top bond underwriters? That would be JPM Chase, Bank of America and Citicorp. They are also the biggest banks. The big banks control the bond market.
A syndicate of 8 banks just signed up to finance $49B of the $67B Dell takeover of EMC.
Trust me – the banks are lending big bucks and they are making a ton of money doing it. Far from dead.
OK, I am not an economist, but I don’t see how the Fed’s discount rate prevents banks from lending at a higher rate. Granted, the overnight rate is going to be constrained, because there’s no point borrowing from another bank if they ask higher interest than the fed. I can see why the discount rate can encourage a lower prime rate, but I don’t see how it can enforce it, and not all bank customers get the prime rate, anyway. How is the Fed preventing banks or insurance companies from charging higher rates? Payday lenders and credit card issuers don’t seem to have any problem charging high interest.
Is the Feds analysis flawed if it is still using the Phillips curve as a key component in its interest rate hike/no hike decision-making process?
The Fed And The Phillips Curve
https://www.linkedin.com/pulse/phillips-curve-fed-interest-rates-what-happens-ifwhen-michael-haltman
Mike
It is an input to prices, and the lower the rate the smaller the price increase in the future. So with a zero-rate policy, the spot price of a commodity and its price for delivery any time in the future is the same – assuming no other storage costs. Not sure if that is a ceiling or a floor.
Michael Haltman,
I do not believe in the Phillipp’s curve. Inflation is dependent upon wage increases. We have had an environment where labor share has been dropping since 2000. This puts downward pressure on inflation.
but with China having troubles, we may see some jobs coming back. We have not seen this yet. But if we do, we may see some wage increases that actually spark some inflation.
So the phillip’s curve only works when there are dynamics in place to raise wages. We actually have weak dynamics due to weak unions, low minimum wages, little jobs coming back…
Matt McOsker,
In the futures market, you have prices listed out into the future for the dates of delivery.
I look at soybean futures.
http://www.cmegroup.com/trading/agricultural/grain-and-oilseed/soybean.html
Nov 2015 and Nov 2016 have the same price. Basically that is saying that in the soybean market, they are seeing 0% inflation. So if your interest cost is 2%, your real interest cost would be 2% at delivery.
EL – Say you own a home and have a 6% mortgage. Then rates fall to 4%. What would you do? You would refi to a cheaper mortgage. A bank would give you a new mortgage and then the bank would sell the loan to Fannie Mae who in turn would lump your mortgage with others and create a new 30 year bond.
Now assume that you’re a CFO of a company. Because long term rates are at historically lows you issue bonds with a long maturity at a low rate. You lock in today’s low rates for decades.
Understand that banks make loans at short term floating rates (Libor or Prime). Banks do not make fixed rates long term loans.
So in today’s world if you are a borrower you want long-term and at a low fixed rate. That means bonds, not loans. This is why bond issuance has increased so much. People want to issue bonds because it is attractive to do so.
This has nothing to do with a price ceiling or a price floor.
Edward, using the risk free rate versus carry cost interest
Futures Price = Spot Price × (1 + Risk-Free Interest Rate – Income Yield)
More applicable to non-perishables. There are other factors that influence price like supple, demand and carry costs. But little need to raise prices above what you would get holding cash.
Matt,
Noted… Not surprising that we see future prices so low, yeah?
EL says above: “Not surprising that
we see future prices so low, yeah?”
Hmmm. I suspect that EL does not follow commodities markets too closely.
As of today the December 2015 WTI crude contract closed at 43.87 while the June 2016 contract closed at 48.00. A $4.13 premium over six months. That comes to a real rate of 9.4% and annualized rate of nearly 19%. This is one of the larger premiums in history.
And EL says “Not surprising that we see future prices so low”. An uninformed opinion.
Bkrasting – there are other factors that influence spot and future prices. The one you point to above is probably contango. Carry costs and storage are big factors, but not to be confused with the risk free rate in pricing. The spot and future prices should converge as the futures contract expiration approaches. Also keep in mind oil prices have declined significantly too.
Matt – a little help?
Can you give us a description and an example of “risk free rate in pricing”??
BK,
Try my best in simplest form. The basic formula excluding any carry costs:
Futures Price = Spot Price × (1 + Risk-Free Interest Rate – Income Yield). The risk free rate is basically the t-bill rate. Most commodities don’y have “yield”, but could have lease rate income by loaning it out. Essentially the higher the risk free rate the higher the future price assuming zero carry costs. Right now you might use just a few bps, but if rates go up, then use the prevailing rates.
Now you have to factor in carry costs, which includes storage, insurance, transport, etc…
Of course other factors and scenarios come into play like contango, backwardation supply demand.