Posts Tagged nominal interest rate
Paul Krugman: Return Your Nobel Prize
Bernanke In Space
I call on Paul Krugman: return his Nobel Prize in economics. My request is based on his article in the April 29 New York Times magazine. Titled “Earth to Ben Bernanke,” the article actually supports many of Dr. Bernanke’s actions, specifically the quantitative easing program. (Dr. Krugman, for some reason, does not like this name, calling it “This is the strategy that has come to be known, unhelpfully, as quantitative easing.” Really? Unhelpfully?
So what does Dr. Krugman believe the Fed should do? I can summarize his proposal in one phrase: announce a higher target for long-term inflation. Currently the Fed’s implicit inflation target is probably around two percent. Krugman believes, with some empirical support, that raising the inflation target would cause people and businesses to increase their spending because they will expect the purchasing power of their money holdings to depreciate faster. However, there is another point that Krugman overlooks that is at least as important as increasing velocity.
Higher inflation expectations mean higher nominal interest rates. Krugman seems to be following the lead of Dr. Olivier Blanchard, now “Economic Counsellor and Director, Research Department” at the IMF. Prof. Blanchard is currently on leave from M.I.T. He once proposed that increasing the inflation target would increase interest rates, giving the central bank more room to — get this — lower interest rates. Let me quote from my blog entry in March, 2010:
“Blanchard’s argument is that by raising the inflation target, nominal interest rates would be higher. This, he proposes, would give central banks more room to reduce interest rates to stimulate the economy.
Unfortunately, Prof. Blanchard has made an error that should make him blush. It is the real interest rate, not the nominal interest rate, that affects most economic activity. The only way Prof. Blanchard’s model can work is by appeal to the long-discredited “money illusion” hypothesis.”
Spending depends on real interest rates, not nominal rates. Increasing inflation expectations will indeed increase nominal interest rates and raise spending a bit by increasing the velocity of circulation of money. But the increase in spending won’t be very large because real interest rates have not changed.
Dr. Krugman has one Nobel Prize, while Dr. Blanchard has none. Krugman’s proposal today is no more valid than Blanchard’s was two years ago. I call on Dr. Krugman to return his Nobel prize in economics for failing to see a fundamental flaw in his proposal.
Use Market Data to Measure Expected Inflation
Posted by TonyLima in Using economic data on October 14, 2011
Introduction
Economists take it for granted that everyone knows the definition of the real interest rate: r = i – p where i is the nominal interest rate and p is the inflation rate. The real interest rate measures the net transfer of purchasing power from borrowers to lenders. Lenders will be repaid i dollars per hundred dollars loaned per year, but the purchasing power of those dollars will decrease by the inflation rate, p. The purpose of this post is to show you how to use market data to measure expected inflation
In principle this is easy. If the market interest rate is 3% and inflation is 1%, the real interest rate is 2%. But if we want to look at future interest rates we need some measure of expected future inflation.
Individuals are, naturally, free to develop their own forecasts of the future inflation rate. This article shows how to use publicly available data to calculate the market’s average expectation of future inflation rates.
TIPS
TIPS stands for Treasury Inflation-Protected Securities. These securities are issued by the U.S. Department of Treasury. Follow that link to learn the details of how it works (links to Treasury site). Since TIPS are adjusted to compensate for inflation, their yield to maturity is the real interest rate. It’s helpful to know that TIPS are issued in maturities of 5, 10, and 30 years. The minimum purchase is a measly $100.
Calculating Expected Inflation
The expected future rate of inflation over 5, 10, and 30 year horizons is the difference between ordinary Treasury securities with those maturities and the yield on TIPS. This is an approximation because coupon payments on ordinary Treasuries are constant, but the coupon (and maturation value) on TIPS securities adjust to the inflation rate. But let’s not allow details to get in the way of a good story.
As of October 14, 2011, here’s what the markets are forecasting for expected inflation:
|
Maturity (years) |
Nominal yield |
TIPS yield |
Expected Inflation |
|
5 |
1.12% |
-0.54% |
1.66% |
|
10 |
2.26% |
0.28% |
1.98% |
|
30 |
3.22% |
1.12% |
2.10% |
Prof. Blanchard Gets It Wrong — Again
Posted by TonyLima in Economic policy on March 9, 2010
Prof. Olivier Blanchard (of M.I.T., currently at the I.M.F.) has a long history of getting it wrong when it comes to macroeconomic policy. His most recent pronouncement, unfortunately, continues this trend. Even worse, his policy prescriptions are now being made from the lofty pulpit of the International Monetary Fund where he is chief economist.[1]
Let’s see what Dr. Blanchard has to say. This from an interview in the Wall Street Journal:
“So should we change the inflation target?
Blanchard: If I were to choose inflation target today, I’d strongly argue for 4%. But we have started with 2%, so going from 2% to 4% would raise issues of credibility. We should have a discussion about it.”[2]
Blanchard’s argument is that by raising the inflation target, nominal interest rates would be higher. This, he proposes, would give central banks more room to reduce interest rates to stimulate the economy.
Unfortunately, Prof. Blanchard has made an error that should make him blush. It is the real interest rate, not the nominal interest rate, that affects most economic activity. The only way Prof. Blanchard’s model can work is by appeal to the long-discredited “money illusion” hypothesis.
For those who are a bit rusty, recall that the nominal interest rate is made up of two parts. The first is the real interest rate. This is the net transfer of purchasing power from borrowers to lenders. The second part is the expected future inflation rate. Changes in the expected future inflation rate, however, have no – zero – impact on the real rate.
This is especially true if (or when) the central bank announces the new inflation target in advance. Thus by publishing his paper Prof. Blanchard has destroyed any possible impact from the very policy he is advocating.
This stuff ain’t all that hard. Frankly, it’s embarrassing when highly-placed economists get it this wrong.
[1] Technically his title is Economic Counsellor and Director of the Research Department of the International Monetary Fund. For more biographical information see http://www.imf.org/external/np/bio/eng/ob.htm. Accessed March 9, 2010.
[2] “Q&A: IMF’s Blanchard Thinks the Unthinkable” by Bob Davis. Wall Street Journal Real-Time Economics blog, February 11, 2010. Available at http://blogs.wsj.com/economics/2010/02/11/qa-imfs-blanchard-thinks-the-unthinkable/?KEYWORDS=Blanchard+IMF. Accessed March 9, 2010. Those who want more details should see Blanchard, Olivier J. ; Dell’Ariccia, Giovanni ; Mauro, Paolo, “Rethinking Macroeconomic Policy,” Staff Position Note No. 2010/03, International Monetary Fund, February 12, 2010. Full text available at http://www.imf.org/external/pubs/ft/spn/2010/spn1003.pdf. Accessed March 9, 2010.
Posted via web from Gonzo Economics
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