Monday, August 24, 2009

The end of the beginning

The Bank of Israel has become the first central bank worldwide to raise interest rates in this downturn.

A few weeks ago, I wrote an elongated blog post titled Does unconventional monetary policy and unusual fiscal policy presage an upsurge in inflation?. This was partly motivated by the concerns of the time (this was in mid-June) about the exit strategy of central bankers. I had argued that inflation targeting gave the right framework for all three phases: the sharp drop in the policy rate, the shift to quantitative easing when the short rate fell to zero, and the eventual rise of interest rates. It is not surprising that the first mover on the exit process is an inflation targeting central bank.

A Taylor rule with an inflation coefficient of 1.5 and an output coefficient of 0.5 gives us a rough approximation to the thinking of inflation targeting central banks. The puzzle then lies in forecasting the extent to which inflation will exceed the target and forecasting the extent to which output will be below the target. These two forecasts are hard to make. But as I said in the above article:
As the financial system comes back to life, as the money multiplier comes back to normal values, the intellectual framework of inflation targeting will shape the responses of the central banks. There will obviously be some mistakes in forecasting inflation, given that the parameter estimates in our models are driven by normal times. But one can expect an average error of zero in the sequencing through which unconventional monetary policy is withdrawn. And when mistakes are made, when de jure inflation targeting is in place, the bond market will know that these are mistakes of execution and not a change in strategy.

1. "Suppose we live in a world where the bond market is working properly. In this case, the various points on the yield curve are linked up by arbitrage. Ultimately, all points on the yield curve are about expectations about movements of the short rate (i.e. the policy rate) in the future."

Expectations of future short rates are only one of the element affecting various points on the yield curve.

1. There is a time varying bond risk premia.

2. Potentially, there is a convexity bias priced into long bonds.

3. Investors prefer certain points on the curve for various reasons.

"So given enough arbitrage capital, price pressure at the 10-year rate will result in a flurry of arbitrage opportunities and an arbitrage-free yield curve will be restored. Since policy rates are low and are likely to stay low for a while, an arbitrage-free curve will be one where rates further out on the yield curve would be pushed down."

I do not agree with your conception (if I have understood it correctly) of arbitrage. Arbitrage by definition implies riskless profit.

Just because the 2-year point seems to be pricing in a path of rates that is difficult to visualize does not mean that there is arbitrage. There is no way to "risklessly" profit from this situation. All that means is that an investor could potentially profit if the expected future short-rate path facored into the security diverges from reality. But there is risk in the trade. And therefore, this would not qualify as arbitrage.

Similarly, price pressures at the 10-year point do not result in "arbitrage" opportunities. All it implies is that the 10-year sector is dislocated. But there is no way to generate "riskless" profit from this anomaly.

Yes, if short rates are expected to remain low for an extended period of time and the yield curve is steep, duration extension will make sense and investors will ride the curve for yield. But this transaction is far from "risk free" arbitrage. And the S&Ls who were caught in Volker's monetary tightening will testify to that.

Effectively, investors are assuming risk and reaping the risk premia.

You can call it "risky arbitrage" if you want to, but there is no arbitrage for sure.

2. Shouldn't the title be 'Beginning of the end'?

I know little bit about your take on inflation target. But the current crisis really was about asset bubbles - whether and when to prick the bubbles. One can make the case that the inflation targeting, even thought it was not officially committed in many country, actually contributed to this current crisis. For example, US Fed saw no reason to raise rates when housing bubble was peaking, to prick the bubble, because inflation was still benign - ie below the unofficial target rate. Any thoughts?

3. this is the nice information shared with us.

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