6 ms·

We are in a tough spot. The Fed has held interest rates at 0 (negative, real terms) which makes all cash flows effectively infinite net present value. When ra

We are in a tough spot. The Fed has held interest rates at 0 (negative, real terms) which makes all cash flows effectively infinite net present value. When rates are this low, small perturbations can be catastrophic for the NPV of, well, pretty much everything. I expect a lot of chaos with the economy whipping between inflation and deflation over the next few years as the Fed tries to ride the tiger. It's a good reason to never let rates get this low in the first place. From zero, any increase is an infinite increase in interest rates, and a corresponding crater of NPVs. Welcome to the long run, folks. At least Keynes is dead, so, good for him, I guess.

naveen99 5y ago
Volatility adds a real time value of money on top of nominal interest rates.
- pramanat 5y ago
  can someone explain this?
  - recursivedoubts 5y ago
    A naive NPV calculation discounts a cash flow by a real discount rate: https://www.investopedia.com/terms/n/npv.asp https://www.investopedia.com/terms/n/npv.asp when the discount rate is 0, the NPV is simply the sum of all payments in the series, so an infinite series of payments (e.g. rental income) is worth infinity in reality, bad stuff happens: building burn down, renters leave, etc. so the right thing to do is to discount the payment stream by some risk function, particular far off payments
- 18nleung 5y ago
  How does this work? (I thought volatility mainly affected the value of options, not the underlying cash flows?)
  - naveen99 5y ago
    Options expire and decrease in value as time passes.
- deleted 5y ago
  [deleted]
sokoloff 5y ago
NPV is discounted by a combination of risk-free interest rate and uncertainty. For most investment/capital allocation decisions, the uncertainty term has been dominant for decades already.
- recursivedoubts 5y ago
  yep, obviously but not much of one when the fed has backstopped everything that matters another policy error, in my uniformed opinion
eldavido 5y ago
> a good reason to never let rates get this low in the first place My brother-in-law remarked that "the fed is overdue to raise rates". My reply: asset prices don't matter to ordinary people. You already know this, but the Fed's mandate is "price stability and full employment". Full employment is going great -- the job market is tight, low-end labor is seeing lots of wage growth, everyone who wants a job is getting one. Price stability was also fine until about 6 months ago. The thing I keep coming back to, is how incredibly little asset prices really matter, in the larger scheme of things. What does matter is things like employment, the price of milk, and whether people have a roof over their heads (rental affordability). In the larger sense, the fed's hands are tied, unless their legal mandate is amended to include "not creating asset bubbles". The distributive and stability effects of today's monetary policy might be the longest-lasting intellectual shift to come out of all this.
- recursivedoubts 5y ago
  i don't think the fed's real mandate is price stability and full employment, those are nice to haves and they have to say that so they aren't run out of town on a rail but their real mandate is: "protect the banks" at this point, that may be changing to "protect their necks" rock and hard place, we'll see what happens
  - arcticbull 5y ago
    > i don't think the fed's real mandate is price stability and full employment, those are nice to haves and they have to say that so they aren't run out of town on a rail but No that's literally their mandate. The Federal Reserve Act mandates that the Federal Reserve conduct monetary policy "so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." [1] https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm https://www.federalreserve.gov/monetarypolicy/monetary-polic...
    - recursivedoubts 5y ago
      Right. I know they have to say that. But I think they are lying. many such cases
lumost 5y ago
Said another way, holding interest rates below inflation devalues assets relative to cash flows. If the gap is relatively small (e.g. 5-15%) then the economy can adapt to lower asset prices relative to cash. Workers get more margin, businesses invest in cash generating activities, speculative bets get hammered, asset returns are low. If anything I'd say this exercise shows the limits of Federal Reserve power. Without the tight labor market of the pandemic, low interest rates simply raised asset prices. We should take the lesson that the fed should not be solely responsible for driving the economy.
bko 5y ago
I don't think this can be solved by just tweaking interest rates. The fact is there are a lot more dollars in the field chasing the same number of products. Making it marginally more expensive to borrow money won't sop up enough dollars to prevent price inflation. Don't you love it how banks are not raising their interest rates on savings accounts? I remember in 2007 I was getting 4% on my savings accounts. There's nowhere to park your money and earn a return even approaching inflation. Why not just front-load your future purchases and further drive inflation?
- recursivedoubts 5y ago
  I don't think the physical amount of dollars matters as much as most people do. Credit spends the same as money, so I view total credit as the real thing to watch. That's one reason why, given the insane fiscal and monetary policy of the last two decades, we really haven't seen hyperinflation yet (and, in fact, briefly saw deflation.) It's an unorthodox take, admittedly, but Steve Keen is a good economist to read on the topic.
  - bko 5y ago
    Total bank credit jumped 5% in about a month when the pandemic started and is continuing to grow at a very high rate historically. This is in addition to personal savings rate jumping from around 7% to over 30%. There's a lot of money and credit is amplifying it https://fred.stlouisfed.org/series/TOTBKCR https://fred.stlouisfed.org/series/TOTBKCR https://fred.stlouisfed.org/series/PSAVERT https://fred.stlouisfed.org/series/PSAVERT
- pmorici 5y ago
  You can get 8% on stable coin deposits with Gemini Earn and BlockFi. After taxes it’s probably still a slight loss.
  - deleted 5y ago
    [deleted]
dcolkitt 5y ago
> The Fed has held interest rates at 0 (negative, real terms) which makes all cash flows effectively infinite net present value. This is only true for cash flows discounted by the risk-free rate. The discount rate of risk assets comes from the risk-free rate with a risk premium added on top (probably 6% or so today for the average blue chip equity).
- RC_ITR 5y ago
  Yeah, I mean, talk to any stock-picking hedge fund and ask them how much the 10Y treasury yield factors into their discount rate (I'd say not a single one would say it does at all). Classic HN 'Confidence = knowledge' comment.
  - recursivedoubts 5y ago
    i know my gp comment reads w/ a lot of confidence, but I really have no idea what's going to happen I do believe that even stocks, in the long run, will be discounted against a general opportunity cost and that really low interest rates make small movements really significant in that regard we'll see
    - RC_ITR 5y ago
      The part you're missing is the 'Equity Risk Premium' which historically has behaved independently of the risk-free rate. https://learn.robinhood.com/articles/5FDKWbZjnNFHfEPYRNhLtE/what-is-equity-risk-premium/ https://learn.robinhood.com/articles/5FDKWbZjnNFHfEPYRNhLtE/...
danielmarkbruce 5y ago
This isn't right. The fed basically controls the very short end of the curve. The 30 year rate is above 2 (it briefly touched around 1.3 or something during the start of the covid panic). No one is/was discounting cashflows 10 years into the future at 0 so "all cash flows" didn't have infinite net present value.
- voisin 5y ago
  Still, 2% over 30 years when inflation is running at 7%+ is negative in real terms. So maybe not infinite, but the key point is that investors are rewarded for holding effectively anything when real rates are negative.
  - danielmarkbruce 5y ago
    If you are going to use inflation to turn nominal rates into real rates, you also have to adjust (reduce) the cashflows themselves. Ie, you discount real cashflow with real rates or nominal with nominal. You'll find as you reduce the nominal cashflows by the inflation rate to arrive at real cashflows.... they stop being a cashflow pretty quickly.
- hedora 5y ago
  I just refinanced a mortgage, and discounted the cashflow on assuming an effective interest rate of -2% to -5%, pre-inflation, assuming the borrowed cash is in a diversified portfolio. Maybe I'm an idiot, but if so, I'm not alone. Multiple major investment firms are recommending this to their clients. Anyway, I gotta go count my Krugerrands.
  - danielmarkbruce 5y ago
    You have to be consistent. You either discount real with real or nominal with nominal. As soon as you are consistent you'll see either the discount rate isn't negative (nominal) or, your cashflow is ~zero (real). Put aside finance theory for a second - does it make sense that, even in theory, my rental house earning $100 per month more than the cost to upkeep it, is worth infinity? Of course not.
karmasimida 5y ago
They will have no option but to raise rate. I don't think this is meant to be a balance act or achieving that is possible at this point.
RC_ITR 5y ago
Wait wait wait. >I expect a lot of chaos with the economy whipping between inflation and deflation over the next few years as the Fed tries to ride the tiger. So you expect inflation to remain @ the 2-ish percent target but with extreme volatility? It's an interesting theory, why do you think that?
avz 5y ago
> The Fed has held interest rates at 0 (negative, real terms) which makes all cash flows effectively infinite net present value. No, it doesn't. Net present value (NPV) of future cashflows is defined [1] as the sum over time periods of the ratio of the cashflow in the k-th period to one plus the discount rate raised to the power of k: NPV = sum_k r_k / (1 + i)^k where i is the discount rate. Note that we are dividing by (1+i)^k, not by i^k. Thus, when i=0 the formula above simplifies to NPV = sum_k r_k and NPV is just the sum of all future cashflows. No infinity enters the picture. [1]: https://www.investopedia.com/terms/n/npv.asp https://www.investopedia.com/terms/n/npv.asp
- recursivedoubts 5y ago
  thanks right, so the net present value of, say, a rental unit (or any ongoing productive investment) is the sum of an infinite number of payments which, if my math is correct here, is infinity (regardless of the recurring payment amount) of course there is a risk discount as well, which, as I mentioned on a sibling comment, has been removed in many cases by the fed backstopping a lot of investments there's a reason we don't see actual infinite prices, after all my general point is that as interest rates get very low, npv gets really whippy and I expect that to be what we see going forward just a guess and I'm not an economist, although experience suggests that's a point in my favor
  - avz 5y ago
    No, it still isn't infinite. Under reasonable assumptions the series is actually bounded from above by a geometric series [1] which is famous for having a finite sum when ratio is <1 [2]. In this case, the ratio r=1/(1+i) is indeed <1. More importantly, no asset exists an infinite amount of time, so the sum is actually finite anyway. Perhaps we should dispose with all the math though as it should be intuitively clear that if we discount future cashflows at zero rate, i.e. if we do not discount future cashflows, then their present value should be equal to the future value. After all, discounting just means that you value future money less than today's money. If you don't discount, you value both the same, so whatever formula for discounting you use it must be true that plugging in zero rate yields NPV equal to the sum of future cashflows. Agreed about risk discount. Perhaps what you mean by "whippy" is that as the risk-free interest rate goes to zero NPV becomes increasingly sensitive to the risk discount. [1]: https://en.wikipedia.org/wiki/Geometric_series https://en.wikipedia.org/wiki/Geometric_series [2]: See [1]. Also, as an example, recall that 1+1/2+1/4+1/8+...=2.
jbay808 5y ago
Agreed. We've also seen that interest rate cuts amd QE are very weak at stimulating inflation, and very strong at stimulating asset values. I'm coming around to the view that UBI should be used to fight deflation, and interest rates to fight inflation.
titzer 5y ago
> I expect a lot of chaos I am extraordinarily skeptical of essentially the whole comment except this. Economies are very complicated systems composed of many non-rational actors. All economics is voodoo IMHO. It's akin to try to predict the fluctuations in current on a motherboard's bus without having any conception of what program is running. Total guesswork on top of a system more complicated than human understanding. We want to understand economies in terms of pipes and pressure and the complexity-equivalent of simple machines, when in reality the future is going to be dominated by black swans: crazy things like cryptocurrencies, cyberattacks, once-in-a-millenium climate/weather events, political revolutions, and fads. Chaos, indeed!
- recursivedoubts 5y ago
  > I am extraordinarily skeptical of essentially the whole comment except this. You and me both!
jcadam 5y ago
Given the current debt, the Fed simply can't raise rates to the degree Paul Volcker did the last time we had inflation like this. So they're going to play around with rates in the low single digits and then go back to zero when the economy starts sputtering.

naveen99 5y ago

Volatility adds a real time value of money on top of nominal interest rates.

pramanat 5y ago
can someone explain this?
- recursivedoubts 5y ago
  A naive NPV calculation discounts a cash flow by a real discount rate: https://www.investopedia.com/terms/n/npv.asp https://www.investopedia.com/terms/n/npv.asp when the discount rate is 0, the NPV is simply the sum of all payments in the series, so an infinite series of payments (e.g. rental income) is worth infinity in reality, bad stuff happens: building burn down, renters leave, etc. so the right thing to do is to discount the payment stream by some risk function, particular far off payments
18nleung 5y ago
How does this work? (I thought volatility mainly affected the value of options, not the underlying cash flows?)
- naveen99 5y ago
  Options expire and decrease in value as time passes.
deleted 5y ago
[deleted]

sokoloff 5y ago

NPV is discounted by a combination of risk-free interest rate and uncertainty. For most investment/capital allocation decisions, the uncertainty term has been dominant for decades already.

recursivedoubts 5y ago
yep, obviously but not much of one when the fed has backstopped everything that matters another policy error, in my uniformed opinion

eldavido 5y ago

> a good reason to never let rates get this low in the first place My brother-in-law remarked that "the fed is overdue to raise rates". My reply: asset prices don't matter to ordinary people. You already know this, but the Fed's mandate is "price stability and full employment". Full employment is going great -- the job market is tight, low-end labor is seeing lots of wage growth, everyone who wants a job is getting one. Price stability was also fine until about 6 months ago. The thing I keep coming back to, is how incredibly little asset prices really matter, in the larger scheme of things. What does matter is things like employment, the price of milk, and whether people have a roof over their heads (rental affordability). In the larger sense, the fed's hands are tied, unless their legal mandate is amended to include "not creating asset bubbles". The distributive and stability effects of today's monetary policy might be the longest-lasting intellectual shift to come out of all this.

recursivedoubts 5y ago
i don't think the fed's real mandate is price stability and full employment, those are nice to haves and they have to say that so they aren't run out of town on a rail but their real mandate is: "protect the banks" at this point, that may be changing to "protect their necks" rock and hard place, we'll see what happens
- arcticbull 5y ago
  > i don't think the fed's real mandate is price stability and full employment, those are nice to haves and they have to say that so they aren't run out of town on a rail but No that's literally their mandate. The Federal Reserve Act mandates that the Federal Reserve conduct monetary policy "so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." [1] https://www.federalreserve.gov/monetarypolicy/monetary-policy-what-are-its-goals-how-does-it-work.htm https://www.federalreserve.gov/monetarypolicy/monetary-polic...
  - recursivedoubts 5y ago
    Right. I know they have to say that. But I think they are lying. many such cases

lumost 5y ago

Said another way, holding interest rates below inflation devalues assets relative to cash flows. If the gap is relatively small (e.g. 5-15%) then the economy can adapt to lower asset prices relative to cash. Workers get more margin, businesses invest in cash generating activities, speculative bets get hammered, asset returns are low. If anything I'd say this exercise shows the limits of Federal Reserve power. Without the tight labor market of the pandemic, low interest rates simply raised asset prices. We should take the lesson that the fed should not be solely responsible for driving the economy.

bko 5y ago

I don't think this can be solved by just tweaking interest rates. The fact is there are a lot more dollars in the field chasing the same number of products. Making it marginally more expensive to borrow money won't sop up enough dollars to prevent price inflation. Don't you love it how banks are not raising their interest rates on savings accounts? I remember in 2007 I was getting 4% on my savings accounts. There's nowhere to park your money and earn a return even approaching inflation. Why not just front-load your future purchases and further drive inflation?

recursivedoubts 5y ago
I don't think the physical amount of dollars matters as much as most people do. Credit spends the same as money, so I view total credit as the real thing to watch. That's one reason why, given the insane fiscal and monetary policy of the last two decades, we really haven't seen hyperinflation yet (and, in fact, briefly saw deflation.) It's an unorthodox take, admittedly, but Steve Keen is a good economist to read on the topic.
- bko 5y ago
  Total bank credit jumped 5% in about a month when the pandemic started and is continuing to grow at a very high rate historically. This is in addition to personal savings rate jumping from around 7% to over 30%. There's a lot of money and credit is amplifying it https://fred.stlouisfed.org/series/TOTBKCR https://fred.stlouisfed.org/series/TOTBKCR https://fred.stlouisfed.org/series/PSAVERT https://fred.stlouisfed.org/series/PSAVERT
pmorici 5y ago
You can get 8% on stable coin deposits with Gemini Earn and BlockFi. After taxes it’s probably still a slight loss.
- deleted 5y ago
  [deleted]

dcolkitt 5y ago

> The Fed has held interest rates at 0 (negative, real terms) which makes all cash flows effectively infinite net present value. This is only true for cash flows discounted by the risk-free rate. The discount rate of risk assets comes from the risk-free rate with a risk premium added on top (probably 6% or so today for the average blue chip equity).

RC_ITR 5y ago
Yeah, I mean, talk to any stock-picking hedge fund and ask them how much the 10Y treasury yield factors into their discount rate (I'd say not a single one would say it does at all). Classic HN 'Confidence = knowledge' comment.
- recursivedoubts 5y ago
  i know my gp comment reads w/ a lot of confidence, but I really have no idea what's going to happen I do believe that even stocks, in the long run, will be discounted against a general opportunity cost and that really low interest rates make small movements really significant in that regard we'll see
  - RC_ITR 5y ago
    The part you're missing is the 'Equity Risk Premium' which historically has behaved independently of the risk-free rate. https://learn.robinhood.com/articles/5FDKWbZjnNFHfEPYRNhLtE/what-is-equity-risk-premium/ https://learn.robinhood.com/articles/5FDKWbZjnNFHfEPYRNhLtE/...

danielmarkbruce 5y ago

This isn't right. The fed basically controls the very short end of the curve. The 30 year rate is above 2 (it briefly touched around 1.3 or something during the start of the covid panic). No one is/was discounting cashflows 10 years into the future at 0 so "all cash flows" didn't have infinite net present value.

voisin 5y ago
Still, 2% over 30 years when inflation is running at 7%+ is negative in real terms. So maybe not infinite, but the key point is that investors are rewarded for holding effectively anything when real rates are negative.
- danielmarkbruce 5y ago
  If you are going to use inflation to turn nominal rates into real rates, you also have to adjust (reduce) the cashflows themselves. Ie, you discount real cashflow with real rates or nominal with nominal. You'll find as you reduce the nominal cashflows by the inflation rate to arrive at real cashflows.... they stop being a cashflow pretty quickly.
hedora 5y ago
I just refinanced a mortgage, and discounted the cashflow on assuming an effective interest rate of -2% to -5%, pre-inflation, assuming the borrowed cash is in a diversified portfolio. Maybe I'm an idiot, but if so, I'm not alone. Multiple major investment firms are recommending this to their clients. Anyway, I gotta go count my Krugerrands.
- danielmarkbruce 5y ago
  You have to be consistent. You either discount real with real or nominal with nominal. As soon as you are consistent you'll see either the discount rate isn't negative (nominal) or, your cashflow is ~zero (real). Put aside finance theory for a second - does it make sense that, even in theory, my rental house earning $100 per month more than the cost to upkeep it, is worth infinity? Of course not.

karmasimida 5y ago

They will have no option but to raise rate. I don't think this is meant to be a balance act or achieving that is possible at this point.

RC_ITR 5y ago

Wait wait wait. >I expect a lot of chaos with the economy whipping between inflation and deflation over the next few years as the Fed tries to ride the tiger. So you expect inflation to remain @ the 2-ish percent target but with extreme volatility? It's an interesting theory, why do you think that?

avz 5y ago

> The Fed has held interest rates at 0 (negative, real terms) which makes all cash flows effectively infinite net present value. No, it doesn't. Net present value (NPV) of future cashflows is defined [1] as the sum over time periods of the ratio of the cashflow in the k-th period to one plus the discount rate raised to the power of k: NPV = sum_k r_k / (1 + i)^k where i is the discount rate. Note that we are dividing by (1+i)^k, not by i^k. Thus, when i=0 the formula above simplifies to NPV = sum_k r_k and NPV is just the sum of all future cashflows. No infinity enters the picture. [1]: https://www.investopedia.com/terms/n/npv.asp https://www.investopedia.com/terms/n/npv.asp

recursivedoubts 5y ago
thanks right, so the net present value of, say, a rental unit (or any ongoing productive investment) is the sum of an infinite number of payments which, if my math is correct here, is infinity (regardless of the recurring payment amount) of course there is a risk discount as well, which, as I mentioned on a sibling comment, has been removed in many cases by the fed backstopping a lot of investments there's a reason we don't see actual infinite prices, after all my general point is that as interest rates get very low, npv gets really whippy and I expect that to be what we see going forward just a guess and I'm not an economist, although experience suggests that's a point in my favor
- avz 5y ago
  No, it still isn't infinite. Under reasonable assumptions the series is actually bounded from above by a geometric series [1] which is famous for having a finite sum when ratio is <1 [2]. In this case, the ratio r=1/(1+i) is indeed <1. More importantly, no asset exists an infinite amount of time, so the sum is actually finite anyway. Perhaps we should dispose with all the math though as it should be intuitively clear that if we discount future cashflows at zero rate, i.e. if we do not discount future cashflows, then their present value should be equal to the future value. After all, discounting just means that you value future money less than today's money. If you don't discount, you value both the same, so whatever formula for discounting you use it must be true that plugging in zero rate yields NPV equal to the sum of future cashflows. Agreed about risk discount. Perhaps what you mean by "whippy" is that as the risk-free interest rate goes to zero NPV becomes increasingly sensitive to the risk discount. [1]: https://en.wikipedia.org/wiki/Geometric_series https://en.wikipedia.org/wiki/Geometric_series [2]: See [1]. Also, as an example, recall that 1+1/2+1/4+1/8+...=2.

jbay808 5y ago

Agreed. We've also seen that interest rate cuts amd QE are very weak at stimulating inflation, and very strong at stimulating asset values. I'm coming around to the view that UBI should be used to fight deflation, and interest rates to fight inflation.

titzer 5y ago

> I expect a lot of chaos I am extraordinarily skeptical of essentially the whole comment except this. Economies are very complicated systems composed of many non-rational actors. All economics is voodoo IMHO. It's akin to try to predict the fluctuations in current on a motherboard's bus without having any conception of what program is running. Total guesswork on top of a system more complicated than human understanding. We want to understand economies in terms of pipes and pressure and the complexity-equivalent of simple machines, when in reality the future is going to be dominated by black swans: crazy things like cryptocurrencies, cyberattacks, once-in-a-millenium climate/weather events, political revolutions, and fads. Chaos, indeed!

recursivedoubts 5y ago
> I am extraordinarily skeptical of essentially the whole comment except this. You and me both!

jcadam 5y ago

Given the current debt, the Fed simply can't raise rates to the degree Paul Volcker did the last time we had inflation like this. So they're going to play around with rates in the low single digits and then go back to zero when the economy starts sputtering.