Sign Wars

Does a lowering of a central bank’s interest rates create inflation or deflation? Dubbed the ‘Sign Wars‘ by Nick Rowe, this has been a recurring debate in the economics blogosphere since at least as far back as 2010.

The conventional view of interest rate policy is that if a central bank keeps its interest rate too low, the inflation rate will steadily spiral higher. Imagine a cylinder resting on a flat plane. Tilt the plane in one direction —a motif to explain a change in interest rates—and the cylinder, or the price level, will perpetually roll in the opposite direction, at least until the plane’s tilt (i.e. the interest rate) has been shifted enough in a compensatory way to halt the cylinder’s roll. Without a counter-balancing shift, we get hyperinflation in one direction, or hyperdeflation in the other.

The heretical view, dubbed the Neo-Fisherian view by Noah Smith (and having nothing to do with Irving Fisher), is that in response to a tilt in the plane, the cylinder rolls… but uphill. Specifically, if the interest rate is set too low, the inflation rate will jump either instantaneously or more slowly. But after that, a steady deflation will set in, even without the help of a counter-balancing shift in the interest rate. We get neither hyperinflation nor hyperdeflation. (John Cochrane provides a great introduction to this viewpoint).

Many pixels have already been displayed on this subject, about the only value I can add is to translate a jargon-heavy academic debate into a more finance-friendly way of thinking. Let’s approach the problem as an exercise in security analysis.

First, we’ll have to take a detour through the bond market, then we’ll return to money. Consider what happens if IBM announces that its 10-year bond will forever cease to pay interest, or a coupon. The price of the bond will quickly plunge. But not forever, nor to zero. At some much lower price, value investors will bid for the bond because they expect its price to appreciate at a rate that is competitive with other assets in the economy. These expectations will be motivated by the fact that despite the lack of coupon payments, the bond still has some residual value; specifically, IBM promises a return of principal on the bond’s tenth year.

Now there’s nothing controversial in what I just said, but note that we’ve arrived at the ‘heretical’ result here. A sudden setting of the interest rate at zero results in a rapid dose of inflation (a fall in the bond’s purchasing power) as investors bid down the bond’s price, followed by deflation (a steady expected rise in its value over the next ten years until payout) as its residual value kicks in. The bond’s price does not “roll” forever down the tilted plane.

Now let’s imagine an IBM-issued perpetual bond. A perpetual bond has no maturity date which means that the investor never gets their principle back. Perpetuals are not make-believe financial instruments. The most famous example of perpetual debt is the British consol. A number of these bonds float around to this day after having been issued to help pay for WWI. When our IBM perpetual bond ceases to pay interest its price will quickly plunge, just like a normal bond. But it’s price won’t fall to zero. At some very low level, value investors will line up to buy the bond because its price is expected to rise at a competitive rate. What drives this expectation? Though the bond promises neither a return of principal nor interest payments, it still offers a fixed residual claim on a firm’s assets come bankruptcy, windup, or a takeover. This gives value investors a focal point on which they can price the instrument.

So with a non-interest paying perpetual bond, we still get the heretical result. In response to a plunge in rates, we eventually get long term deflation, or a rise in the perpetual’s price, but only after an initial steep fall.  As before, the bond’s price does not fall forever.

Now let’s bring this back to money. Think of a central bank liability as a highly-liquid perpetual bond (a point I’ve made before). If a central banker decides to set the interest rate on central bank liabilities at zero forever, then the purchasing power of those liabilities will rapidly decline, much like how the cylinder rolls down the plane in the standard view. However, once investors see a profit opportunity in holding those liabilities due to some remaining residual value, that downward movement will be halted… and then it will start to roll uphill. Once again we get the heretical result.

The residual claim that tempts fundamental investors to step in and anchor the price of a 0% yielding central bank liability could be some perceived fixed claim on a central bank’s assets upon the bank’s future dissolution, the same feature that anchored our IBM perpetual. Or it could be a promise on the part of the government to buy those liabilities back in the future with some real quantity of resources.

However, if central bank liabilities don’t offer any residual value whatsoever, then we get the conventional result. The moment that the central bank ceases to pay interest, the purchasing power of a central bank liability declines…forever. Absent some residual claim, no value investor will ever step in and set a floor. In the same way, should an IBM perpetual bond cease to pay interest and it also had all its residual claims on IBM’s assets stripped away, value investors would never touch it, no matter how low it fell.

So does central bank money boast a residual claim on the issuer? Or does it lack this residual claim? The option you choose results in a heretical result or a conventional result.

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What does the data tell us, specifically the many cases of hyperinflation? As David Beckworth has pointed out, the conventional explanation has no difficulties explaining the Weimar hyperinflation; the Reichsbank kept the interest rate on marks fixed at very low levels between 1921 and 1923 so that the price level spiraled ever upwards. Heretics seem to have difficulties with Weimar—the deflation they predict never set in.

Here’s one way to get a heretical explanation of the Wiemar inflation. Let’s return to our analogy with bonds. What would it take for the price of an IBM perpetual bond to collapse over a period of several years, even as its coupon rate remained constant? For that to happen, the quality of the bond’s perceived residual value would have to be consistently deteriorating. Say IBM management invested in a series of increasingly dumb ventures, or it faced a string of unbeatable new competitors entering its markets. Each hit to potential residual value would cause fundamental investors to mark down IBM’s bond price, even though the bond’s coupon remained fixed.

Now assuming that German marks were like IBM perpetual bonds, it could be that from 1921 to 1923, investors consistently downgraded the value of the residual fixed claim that marks had upon the Reichsbank’s assets. Alternatively, perhaps the market consistently reduced its appraisal of the government’s ability to buy marks back with real resources. Either assumption would have created a consistent decline in the purchasing power of marks while the interest rate paid on marks stayed constant.

Compounding each hit to residual value would have been a decline in the mark’s liquidity premium. When the price of a highly-liquid item begins to fluctuate, people ditch that item for competing liquid items with more stable values. With less people dealing in that item, it becomes less liquid, which reduces the liquidity premium it previously enjoyed. This causes the item’s purchasing power to fall even more, forcing people to once again turn to alternatives, thus making it less liquid and igniting another round of cuts to its liquidity premium and therefore its price, etcetera etcetera. In Weimar’s case, marks would have been increasingly replaced by dollars and notgeld.

So consistent declines in the mark’s perceived residual value, twinned with a shrinking in its liquidity premium, might have been capable of creating a Weimar-like inflation, all while the Reichsbank kept its interest rate constant.

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That’s not to say that central bank liabilities do have a residual value and that the heretical result is necessarily the right one. Both possibilities make sense, and both can explain hyperinflations. But to determine which is right, we need to go in and do some gritty security analysis to isolate whether central bank money possesses a fixed residual claim on either central bank assets or future government resources. Parsing the fine print in central bank acts and government documents to tease out this data is the task of lawyers, bankers, historians, fixed income analysts, and accountants. And they would have to do a separate analysis for each of the world’s 150 or so central banks and currencies, since each central bank has its own unique constituting documents. In the end we might find that some currencies are conventional and others are heretic, so that some central banks should be running conventional monetary policies, and others heretic policies. 

In closing, a few links. I’ve taken a shot at a security analysis of central bank liabilities in a number of posts (here | here | here), but I don’t think that’s the final word. And if you’re curious how the Weimar inflation ended, go here.

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