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Central banks can only set the nominal rate of interest. The real rate of return on capital is independent from monetary policy. If the central bank sets the

by lottin 5y ago

Central banks can only set the nominal rate of interest. The real rate of return on capital is independent from monetary policy. If the central bank sets the nominal rates below the real rate, it's possible to make a profit by borrowing money at the nominal rate and investing it in a business and earning the real rate.

adam_arthur 5y ago
Yes, but the central bank influences the real rates. Real rates are a function of the nominal rates and level of inflation. Tighter monetary policy will lead to lower levels of inflation, thus higher real rates. Central banks are also doing QE and distorting nominal rates on treasuries by shrinking their supply in the market. e.g. Fed buys a 10yr treasury, now it sits on their balance sheet for the next 10 years, rather than floating in the free market. If the Fed hadn't bought trillions of treasuries over the last two years, what would the nominal yield on treasuries be? Beyond the mechanical, the Fed has created a psychology that the treasury market is no longer a free market, which discourages investors to sell or go short. Similar to equities. People believe the Fed will backstop any turmoil, so valuations begin to matter less. So current Fed policy pushes both variables in the equation towards lower real rates, both in mechanical and in psychological terms.
- lottin 5y ago
  > Tighter monetary policy will lead to lower levels of inflation, thus higher real rates. Tighter monetary policy will also lead to higher nominal rates. Nominal rates, inflation and the quantity of money cannot be set independently of one another.
  - adam_arthur 5y ago
    You seem to be in agreement with me then. Higher nominal rates will also lead to lower inflation, thus pushing real rates even higher. So a hike acts on both the inflation side and nominal rate side to push real rates higher. But speaking to the immediate circumstances, the fed primarily influences the short end of the rate curve. (Once QE is ended) If the fed were to surprise hike interest rates this week, you can bet yields on the long end of the curve would come down. Because the market would anticipate a hike in short term rates leading to end of inflation fears, and potentially triggering a deflationary event due to the surprise nature of it. E.g. recall the times when the yield curve becomes inverted. You can see over the past two weeks the yield curve has started inching towards an inversion. Actually the 20yr and 30yr inverted for the first time ever last week. It's only speculation to say what this means, but to me seems a pretty obvious signal that the market expects the Fed to have to tighten faster than they're saying to curb inflation. E.g. look at how quickly the 2yr has risen, while the 10yr has been in decline Of course this inversion move is almost entirely due to how slow the Fed has moved. If they had moved faster, there would be less concern with a tightening. Now they may be late to the game if inflation pressures don't begin to ease soon. We may actually be at full employment already, due to lifestyle changes leading to permanently lower labor force participation rate. In which case the Fed is years behind the curve on tightening. We'll know after a few more employment reports.
    - lottin 5y ago
      No, we are in disagreement. I agree with the view that the real rate is determined by the supply of savings and the demand for funds. According to this view, in the context of monetary policy, the real rate of interest is an exogenous variable, and the central bank can choose to set the rate of inflation or the nominal rate of interest, but not both.
      - adam_arthur 5y ago
        Help me to understand your math then, because it doesn't track logically. realRate = nominalRate - inflationRate Raising nominal rates increases real rates due to higher nominal rate. Raising nominal rates decreases inflation, also raising real rates. Decreases inflation by reducing availability of credit, thus reducing effective money supply/demand. Please explain how the relationship works otherwise
        lottin 5y ago
        The relationship is pretty simple nominal_rate = real_rate + inflation_rate where the real rate is set exogenously. This implies a positive correlation between the nominal rate and the inflation rate, which is consistent with what we observe, e.g. https://miro.medium.com/max/1400/1*b3RDeRT7rPxYEdoFnZEJRg.png https://miro.medium.com/max/1400/1*b3RDeRT7rPxYEdoFnZEJRg.pn...
        adam_arthur 5y ago
        Interest rates are correlated with inflation because the Fed historically raises interest rates when inflation rate is high. This is an obviously true observation and easily borne out by looking at history. Long term rates are distorted by QE right now. The market will price long term rates higher, when inflation is higher, sure. Short term rates typically set a floor on long term rates, outside of rare yield curve inversions. So not sure how your data relates. Short term rates set a floor on longer term rates, thus raising short term rates increases real rates on both fronts.

by lottin 5y ago

adam_arthur 5y ago

Yes, but the central bank influences the real rates. Real rates are a function of the nominal rates and level of inflation. Tighter monetary policy will lead to lower levels of inflation, thus higher real rates. Central banks are also doing QE and distorting nominal rates on treasuries by shrinking their supply in the market. e.g. Fed buys a 10yr treasury, now it sits on their balance sheet for the next 10 years, rather than floating in the free market. If the Fed hadn't bought trillions of treasuries over the last two years, what would the nominal yield on treasuries be? Beyond the mechanical, the Fed has created a psychology that the treasury market is no longer a free market, which discourages investors to sell or go short. Similar to equities. People believe the Fed will backstop any turmoil, so valuations begin to matter less. So current Fed policy pushes both variables in the equation towards lower real rates, both in mechanical and in psychological terms.

lottin 5y ago
> Tighter monetary policy will lead to lower levels of inflation, thus higher real rates. Tighter monetary policy will also lead to higher nominal rates. Nominal rates, inflation and the quantity of money cannot be set independently of one another.
- adam_arthur 5y ago
  You seem to be in agreement with me then. Higher nominal rates will also lead to lower inflation, thus pushing real rates even higher. So a hike acts on both the inflation side and nominal rate side to push real rates higher. But speaking to the immediate circumstances, the fed primarily influences the short end of the rate curve. (Once QE is ended) If the fed were to surprise hike interest rates this week, you can bet yields on the long end of the curve would come down. Because the market would anticipate a hike in short term rates leading to end of inflation fears, and potentially triggering a deflationary event due to the surprise nature of it. E.g. recall the times when the yield curve becomes inverted. You can see over the past two weeks the yield curve has started inching towards an inversion. Actually the 20yr and 30yr inverted for the first time ever last week. It's only speculation to say what this means, but to me seems a pretty obvious signal that the market expects the Fed to have to tighten faster than they're saying to curb inflation. E.g. look at how quickly the 2yr has risen, while the 10yr has been in decline Of course this inversion move is almost entirely due to how slow the Fed has moved. If they had moved faster, there would be less concern with a tightening. Now they may be late to the game if inflation pressures don't begin to ease soon. We may actually be at full employment already, due to lifestyle changes leading to permanently lower labor force participation rate. In which case the Fed is years behind the curve on tightening. We'll know after a few more employment reports.
  - lottin 5y ago
    No, we are in disagreement. I agree with the view that the real rate is determined by the supply of savings and the demand for funds. According to this view, in the context of monetary policy, the real rate of interest is an exogenous variable, and the central bank can choose to set the rate of inflation or the nominal rate of interest, but not both.
    - adam_arthur 5y ago
      Help me to understand your math then, because it doesn't track logically. realRate = nominalRate - inflationRate Raising nominal rates increases real rates due to higher nominal rate. Raising nominal rates decreases inflation, also raising real rates. Decreases inflation by reducing availability of credit, thus reducing effective money supply/demand. Please explain how the relationship works otherwise
      - lottin 5y ago
        The relationship is pretty simple nominal_rate = real_rate + inflation_rate where the real rate is set exogenously. This implies a positive correlation between the nominal rate and the inflation rate, which is consistent with what we observe, e.g. https://miro.medium.com/max/1400/1*b3RDeRT7rPxYEdoFnZEJRg.png https://miro.medium.com/max/1400/1*b3RDeRT7rPxYEdoFnZEJRg.pn...
        adam_arthur 5y ago
        Interest rates are correlated with inflation because the Fed historically raises interest rates when inflation rate is high. This is an obviously true observation and easily borne out by looking at history. Long term rates are distorted by QE right now. The market will price long term rates higher, when inflation is higher, sure. Short term rates typically set a floor on long term rates, outside of rare yield curve inversions. So not sure how your data relates. Short term rates set a floor on longer term rates, thus raising short term rates increases real rates on both fronts.