Inside and Outside money at the end of the yield curve: a footnote

Back in April I gave a presentation at a conference in Oxford in which I discussed some brilliant work by Branko Milanovic, Charles Goodhart and Ben Broadbent , and posited that if squinted your eyes just so, lots of things made sense in a way that might be a little against the consensus. Specifically, the asset boom story of the past thirty five years, decline of labour power and increase in inequality in the West, general disinflation and a lower trend nominal GDP in developed markets might all just be an expression of the radical globalisation and rise of China that has transformed our day to day lives. If so, then Summers’ Secular Stagnation thesis might prove to be a needlessly elegant paradox for central bankers to muddle over. Furthermore, with China approaching a Lewis point, this historical trend could be challenged and potentially thrown into reverse (higher labour power, rates, headwinds for asset prices, and some portfolio construction stuff too).

It went down sufficiently well that I wrote it up, and VoxEU kindly published it on their site giving it a wider audience than it would otherwise have had.
It has been brought to my attention that the terminology I used in the piece is perhaps either a bit confusing or confused (maybe both?). Specifically, I might be too liberal with my use of the term ‘Wicksellian rate’ for economists’ liking. This is carelessness or ignorance on my part rather than an attempt to execute an intellectual sleight of hand. So please take this blog as an extended footnote to the voxeu piece that seeks to explain:

a) what I mean by Wicksellian rate, and;

b) how changes in market expectations of this rate impact asset prices. 

It’s a bit long-winded, but I am trying to be relatively precise, which hopefully will reveal most accurately my confusion in language or content. Feedback welcome!

  1. I understand the Wicksellian rate to be the real rate of interest that keeps an economy that is running at full capacity in balance (eg, the policy rate is neither stimulative nor constrictive). This is another term for the ‘neutral rate’, as outlined by Greenspan here, Broadbent here, and Bernanke here. (I am aware that there is a big literature on whether the neutral real rate is even a legitimate notion to entertain, but have so far through my meagre readings been insufficiently persuaded to drop the notion, and enjoyed Brad DeLong’s recent post on the matter.)
  2. We live in a monetary economy that features outside money (central bank/ state money), and inside money (private money invented by banks in the form of deposits every time a loan is made, and to a meaningful extent invented by anyone who considers an asset to have moneyness and can persuade others of this feature). The Wicksellian rate will be a rate that consists of some mixture of the expected or inferred rate of return on some mixture of outside and inside monies. It would be nice if central banks told us the mix they thought important as this would help market folk like me understand their reaction functions better. And from time to time we do get hints (like footnote 24 in Carney’s Jackson Hole speech, the prominence or otherwise of mortgage spread charts in Bank of England QIRs, etc). And maybe that is fair enough given that central bankers are just doing their best to guesstimate through the fog.
  3. But the Wicksellian rate is set by the economy and not by the central bank. Central Banks seek to guesstimate where it might roughly be (including things like credit premia, liquidity premia etc), and they then manage their nominal (outside money) policy rate and expectations thereof around this guesstimated real rate to either stimulate or restrict demand and return the economy to it’s long run potential.
  4. Monetary sovereign bond markets (eg, the Gilt market in the UK, the US Treasury bond market in the US) can be thought of from a bunch of angles, one of which is that they consist of market participants’ best guesses as to where this overnight rate might be over time (ok, plus a guesstimated term premia, guesstimated liquidity premia, guesstimated premia associated with a raft of regulatory provisions on banks etc). And so by looking at the yields on Gilts or US Treasuries with different maturities you can back-out market participants’ expected term-structure of rate expectations set by the Bank if England or the Federal Reserve respectively.
  5. These monetary sovereign bond yield curves can furthermore be decomposed into a guesstimated path of real rates and a guesstimated path of inflation. And the real part of the curve (eg, inflation linked real rate curve) can be thought of as the market’s best guess at the term structure of the (outside money) Wicksellian rate, +/- near term cycle stuff.
  6. So actually, the long(ish) forward real rate is going to be the market’s best guess as to the (outside money) Wicksellian rate for the economy.
  7. Inside money yield curves are priced off outside money curves. The starting point when pricing term credit (let’s say, the interest rate that a company might have to pay to borrow on a fixed rate basis when borrowing for ten years) is to observe the monetary sovereign yield for that term, and add additional yield premia to compensate for estimated higher liquidity costs, estimated credit costs, some premium to reimburse the costs associated with performing credit analysis etc. (Fellow bond geeks may take issue with this point as being too massive a simplification, but I don’t think much is lost leaving this description in place.)
  8. So you get lots and lots and lots of private (inside money) yield curves describing the market yields associated with different term borrowings of different private borrowers. Many if not most will feature only one point.
  9. These curves consist of yields (aka discount rates) that are used to discount expected cash flows and calculate the asset price in a discounted cash flow (DCF) analysis. If the cash flows are unchanging, a falling yield equates to a rising price and vice-versa.
  10. We can also use DCF when looking at non-bond asset pricing. It’s just that we have to imagine what the cash flows might be and also imagine what risk premia to apply.
  11. So after you have finished building a model of company earnings, you still need to imagine into existence an appropriate discount rate to apply to your model’s resultant cash flows to calculate your assessment of its ‘fair value’. Given that equity is the most junior liability in a company’s capital structure, the discount factor that you would apply to these equity cash flows might still be higher than the one applied to the same company’s most junior debt obligation, which in turn would be higher than its more senior obligations of equivalent term. The observable (inside money) discount factor/ yield curve would in turn be priced as higher than the monetary sovereign’s yield of equivalent term (eg, point 7 above).
  12. I take a bunch of approaches when I look at equity discount rates. A super-simple one is to look at the trading relationship between corporate debt and consensus forward earnings yields. One is a nominal yield, the other one is generally believed to be a real one. But the nominal one contains an estimate of real rates and an estimate of inflation.
  13. With only marginally more complexity, I solve the equity internal rate of return from current equity prices, consensus earnings projections for as far as they are available, and estimates for residual nominal earnings growth rates taken from historical relationships between nominal earnings and GDP, assumptions about profit share of GDP and payout ratios. CAPM is another approach, and I think this one is interesting too.
  14. To cut a long (enough) story a little short, underlying all private discount rates sits the outside money (government bond) yield curve with its pricing of anticipated inflation, near term policy developments, and long-term guesstimates of the (outside money) Wicksellian rate. Changes to that last bit change asset prices all over the shop.

So while it is clear to Woodford et al that the Wicksellian rate is a real variable relating to the marginal return on capital rather than a real (eg, inflation-linked) market rate, in my analysis it is also the market’s best guess of the likely medium to long-run unobserveable equilibrium (Wicksellian) real interest rate. And crucially, as the market expectation of this real rate falls, so asset prices (the present value of cash flows that use this falling market rate in some way, eg, #7-10 above) rise correspondingly.

This raises what now feels like a perennial market-circularity question: to what extent have rising asset prices been a function of diminishing rather than improving prospects in the West? (Eg, when weaker cash flows are accompanied by a lower discount rate for those cash flows, the asset price implication is ambiguous rather than negative.) Or, in the phraseology of my voxeu blog, to what extent might demographically-driven resurgence in labour power raise the Wicksellian rate in the West, and with it deliver a headwind for asset prices and challenges for portfolio construction?

In my day job I have plenty to say on this, but it would be inappropriate to say anything on my private blog. Instead, here’s a link of me and Joe Weisenthal chatting about it a couple of weeks back.


5 thoughts on “Inside and Outside money at the end of the yield curve: a footnote

  1. Fantastic post.

    Bit of a basic question on the Wicksellian rate..
    In point 1 you say “I understand the Wicksellian rate to be the real rate of interest that keeps an economy that is running at full capacity in balance (eg, the policy rate is neither stimulative nor constrictive).”
    So if outside money rate is set by the central bank to either provide a stimulative or constrictive effect, then is the Wick rate the rate that presumes the lack of either deflation or inflation?
    ie, does it presume a balanced economy as its starting position, or does it have a hand in balancing the economy? Further, how do we know what a balanced economy is, or are we guesstimating that too? (I’ll avoid asking how you would measure full capacity)

  2. Thanks Lorcan!

    A balanced economy is the starting point, but you’re right – we have to guesstimate what this looks like.

    Your other point/ question is really interesting about whether Wicksellian rate presumes a lack of inflation or deflation. The textbook answer is that the central bank sets an inflation target, fiddles with rates to achieve this target, and once there cruises. See for example page 6 of this report that is specifically on that point.

    I must admit though that while the narrative is compelling, I would be interested to read an argument against the idea that the same real rate could be in place in an economy targeting 15% inflation to one targeting 2% inflation. If you see one, please pass over.

  3. Very thoughtful piece. Judging what the unobservable Wicksellian rate is, if it truly exists, is the key challenge. This is made more difficult by competing (small) industrial and (vast) financial circuits as Keynes noted. Whatsmore, even if they know the Wicksellian rate can policy-makers get to it? Their problem right now is that the Central Bank balance sheet is no longer (post-early 2000s) the monetary base of the economy. Financial innovation and poor regulation has blurred definition. The Fed it grappling to retain control, viz its latest attempts to bring the huge ($15 tr) wholesale markets under its spell. But this may prove disruptive in coming weeks when it tries to raise FF. We’ll see.

    • Thanks. Your comment makes me wonder whether we (or at least me) should really stop talking about a rate, and move on to discuss the Wicksellian curve – acknowledging and bringing front and centre the notion that the real rate has term structure to it. And if this is the case, the challenge for policymakers can be thought to be more complex than it generally is regarded as being.

  4. Pingback: Policy making in an Elysium scenario | principlesandinterest

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