Sunday, February 17, 2013

Fed Officials Want to Tackle "Reaching for Yield"

Cleveland Fed President Sandra Pianalto gave a speech on February 15 called "Providing Balance while Managing Uncertainty." She says that the Federal Reserve "has been aggressive and creative in its response to a very challenging economic environment, and our actions have been beneficial for the economy." Nonetheless, her outlook is not among the most optimistic. She predicts that the unemployment rate will be 7.5% at the end of this year, and around 7% at the end of 2014. According to the Fed's threshold rule, the Fed won't raise the funds rate until unemployment falls below 6.5% or inflation rises above 2.5%. By Pianalto's estimation, that won't be happening until 2015 at the earliest.

Pianalto's counterpart at the St. Louis Fed, James Bullard, expounded upon the threshold rule in a speech the day prior to Pianalto's speech. Both Bullard and Pianalto address the Fed's balance sheet policy, QE3.  While Bullard describes the asset purchase program as "potent," Pianalto fears that it will have both "diminishing benefits" and increasing costs:
Over time, the benefits of our asset purchases may be diminishing. For example, given how low interest rates currently are, it is possible that future asset purchases will not ease financial conditions by as much as they have in the past. And it is also possible that easier financial conditions, to the extent they do occur, may not provide the same boost to the economy as they have in the past. In addition to the possibility that our policies may have diminishing benefits, they also may have some risks associated with them.
The first such risk that she notes is the following:
First, financial stability could be harmed if financial institutions take on excessive credit risk by “reaching for yield” —that is, buying riskier assets, or taking on too much leverage—in order to boost their profitability in this low-interest rate environment. 
This is reminiscent of John Taylor in an Op-Ed in the Wall Street Journal called "Fed Policy is a Drag on the Economy." Taylor writes that
The Fed’s current zero interest-rate policy also creates incentives for otherwise risk-averse investors—retirees, pension funds—to take on questionable investments as they search for higher yields in an attempt to bolster their minuscule interest income.
Miles Kimball challenged the logic of this "reaching for yield" concern in two posts. Karl Smith weighed in on Forbes, and I did too on this blog. Kimball argues,
The often-repeated claim that low interest rates lead to speculation cries out for formal modeling. I don’t see how such a model can work without some combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance and irrationality...
I have no problem believing that, indeed, investor ignorance and irrationality and schemes that prey on that ignorance and irrationality do indeed cause people to take on more risk as a result of low interest rates than they otherwise would. This is a genuine cost to the Fed stimulating the economy with low interest rates. But— especially once we figure out the details—it has much bigger implications for financial regulation than for monetary policy...Regulation has serious costs, but so does tight monetary policy in the current environment.
Interestingly, Kimball's point about the appropriate domains of financial regulation versus monetary policy brings up yet another February Fed speech, this one by Governor Jeremy Stein of St. Louis. Stein argues that the Fed should take on what has typically been the role of financial regulators in alleviating "overheating" in credit markets. No surprise, he cites as one cause of overheating the fact that "a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to `reach for yield.'"

Stein alludes to the same sort of model that Kimball has in mind. Stein admits both irrationality ("changes in the pricing of credit over time reflect fluctuations in the preferences and beliefs of end investors such as households, where these beliefs may or may not be entirely rational") and fraudulent schemes ("At any point, the agents try to maximize their own compensation, given the rules of the game. Sometimes they discover vulnerabilities in these rules, which they then exploit in a way that is not optimal from the perspective of their own organizations or society.")

Their models for the causes of reaching for yield are roughly the same, but their policy prescriptions are polar opposites. Kimball says that tighter monetary policy is the worst solution to reaching for yield, and improved financial regulation is the better option. Stein says that monetary policy has benefits over financial regulation. Pianalto apparently comes down on the side of Stein, tentatively suggesting that tighter monetary policy may be necessary to reduce the threat of financial instability caused in part by reaching for yield. She says that "we could aim for a smaller sized balance sheet than would otherwise occur if we were to maintain the current pace of asset purchases through the end of this year, as some financial market participants are expecting."

13 comments:

  1. Taylor, Kimball and others appear to have focused on risk-averse investors that "reach for yield." In a recent post by Ashwin Parameswaran he approaches "reaching for yield" from the opposite side: wealthy borrowers with access to credit.

    IMO this latter result of low or negative real interest rates is more probable (true of the real-world). Risk-seeking borrowers therefore leverage up and move out on the risk curve, buying real assets instead of investing in capital. (http://bubblesandbusts.blogspot.com/2013/02/the-dangers-of-misunderstanding.html)

    Determining the best policy/regulation will depend heavily on which of these various assumptions appears to model reality most closely.

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  2. Yes Josh, policy/regulation will definitely depend on which assumptions are most suitable.

    Are you saying that borrowers become risk-seeking when the real interest rate is low? I couldn't figure that out from Parameswaran's article either... Typically we assume agents are risk-averse. What causes them to become risk-seeking? Does the fact that they are wealthy make them become risk-seeking? Wouldn't that require some type of unusual utility function or behavioral assumption?

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  3. What if institutional investors, banks, etc. are normally risk-seeking? This could reasonably caused by the institutional environment that currently persists. Having worked in various areas of financial markets, most participants take on only a small portion of the downside risk while gaining a far greater percentage of any upside. Lower or negative real interest rates raise the expected value (gains) of holding real assets. This encourages funds, banks and firms to leverage up.

    Does that make sense? I haven't fully thought it through before, so I'll be interested to hear your opinion. (Also I don't know if that's what Ashwin was alluding to or not)

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  4. Yes, that makes sense. That is the gist of the model I wrote in an earlier post, http://carolabinder.blogspot.com/2013/01/reaching-for-yield-simple-model.html

    In that model, the government takes on downside risk, and even though agents are risk neutral they behave like they are "reaching for yield." The agents are not technically risk-seeking in the sense of having a utility function with positive second derivative. But they are risk seeking in the sense of choosing the riskier asset.

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  5. "While Bullard describes the asset purchase program as "potent," Pianalto fears that it will have both "diminishing benefits""

    Since most of the impact it had on equity markets was due to irrational confidence and market stupidity ("OMG! Trade QE1!) this is, of course, the case. Not even the gold market is responding properly to QE anymore. And they're a bunch of finger-on-the-trigger loonies.

    "First, financial stability could be harmed if financial institutions take on excessive credit risk by “reaching for yield” —that is, buying riskier assets, or taking on too much leverage—in order to boost their profitability in this low-interest rate environment."

    I'd worry less about this and more on potential speculation on oil and other commodities. This takes income out of peoples' pockets, decreases aggregate demand and is essentially a wealth transfer. If ZIRP policies are driving these to some extent then this is a problem. But they could crack down on this through regulation if they wanted.

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  6. "The often-repeated claim that low interest rates lead to speculation cries out for formal modeling. I don’t see how such a model can work without some combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance and irrationality..."

    Being in the investment business, I talk to institutional clients regularly. The search for yield is reaching desparate proportions. Anything, and I mean anything that has a wrapper that makes it look like it is a yield type investment strategy is selling, most with huge tail risks (in my opinion). This will end badly. The academics who defend the Fed by hiding behind econometric studies either have their heads buried in the sand or are on Fed's payroll.

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  7. "The often-repeated claim that low interest rates lead to speculation cries out for formal modeling. I don’t see how such a model can work without some combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance and irrationality..."

    Translation: I don't believe in speculation and investor quote-unquote "irrationality". Furthermore, I believe that formal models must incorporate rational investors. I challenge you, therefore, to build a formal model that I find acceptable that demonstrates speculation.

    Welcome to the world of the neoclassical. Carola, you seem okay, but you're in really bad company. The above statement has no scientific basis. It is the statement of a priest or a charlatan.

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  8. "Reaching for yield" is a phenomenon of the buy side, and buy-side institutions are seldom backstopped by the government unless, as with AIG, their fall would be so spectacular as to endanger the sell side. So even if you can make moral hazard work in a model, it likely does not apply to the situation.

    There are alternative explanations (though I will leave the modelling to you.) First, there are agency conflicts between asset managers and asset owners. A pension fund manager might be fired if she fails to fund the liabilities of the plan, in which case she may perceive that her personal risk is reduced by increasing the risk to the asset owners. This is basically the complement of the backstop idea.

    Second, there could be anchoring effects related to expectations of "normal" rates of return, or returns that were "counted on". The psychologists tell us that utility functions do not exist and that the same agent who is risk-averse with respect to gains is risk-seeking with respect to recouping losses, even when the situations are identical mathematically.

    Third, the riskiness of a given situation may be perceived differently according to circumstances. An agent with a fixed risk budget may therefore increase leverage nonetheless: "risk homeostasis". This explanation seems better suited to explaining a bubble in a boom than a downturn, though.

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  9. I'm not sure this qualifies as "reaching for yield," but I have a clear idea of why I think low interest rates can be dangerous.
    The interest rate is used to discount future returns. Returns in the near future are relatively easy to predict, but returns in the distant future are very difficult to predict. When the interest rate is high, the value of a long-lived asset depends primarily on predictable near-future returns. When the interest rate is low, the value of a long-lived asset depends primarily on unpredictable distant-future returns. Which is to say, when the interest rate is low, the value of an asset is pretty much just a guess, so under these conditions, we should expect asset prices to be volatile.

    For example, consider an asset whose returns are expected to grow at a constant rate, but the rate of growth is uncertain. In its simplest form the value of the asset is d/(r-g), where d ("dividend") is the current return, g is the expected growth rate, and r is the rate at which future returns are discounted. If r is much greater than g, then a small change in your estimated value of g will have almost no effect on the value of the asset. If r is close to g, a tiny change in g could have a huge impact on the value of the asset. So if you wake up in a slightly better mood one day and decide g is a tiny bit higher than you thought, you go from being growling bear to being a raging bull.

    Now I said "low interest rates can be dangerous," but I should clarify that I think this applies more to the natural interest rate than to the actual interest rate. If the natural rate is r* and a central banker has to choose an actual rate r, should she ever choose r greater than r* (assuming she's not trying to lower the inflation rate)? As a first cut, I'd tend to say no. If you choose r greater than r*, you're setting up for a deflationary spiral in which you'll eventually be forced to reduce r below r*. Despite the risks involved in having a low r, I think it's safer to set r too low rather than too high, because the lower you set r now, the higher you will want to set it in the future.

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  10. Thanks Andy, that's really interesting and something I hadn't thought about before. (I also like that your central banker is a "she"!)

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  11. It's probably not "risk seeking" so much as "risk accepting". Most of them would have been happier with a defined benefits pension.

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  12. Word up, wordsmith.org shows the analgrams that can be formed by "Bullard and Pianalto" comprise the below phrases of 83334 phrases found:

    A Bandana Putrid Loll
    A Bandana Droll Tulip
    A Oddball Urinal Pant
    A Oddball Inapt Lunar
    A Bandana Lid Troll Up

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  13. Mr. Harless is on the right track. The solvency of many pension funds, for example, relies on their achieving some benchmark rate of return. To accept low returns is to admit insolvency sooner rather than later.

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Comments appreciated!