“Markets are now firmly signaling recession in euro zone”, aka continuing in the folly of more inversions, more recessions

 

Following the ECB December meeting, which brought strong hawkish surprise, we woke up to headlines of markets now more firmly signaling recession for euro zone, given that German yield curve has inverted. These articles we accompanied by graph showing inversion between 2yr and 10yr yield curve reaching levels not seen in decades.  Among other places, here is FT from Dec 16^th:

 

Of course, the movements in the yields after the ECB meeting were not in any way driven by expectations of coming recession. The 2yr yield jumped by 25bps (a 6-sigma event, apparently) on the day of the meeting, and surged by further 20 bps since then. The 10yr yield also increased, albeit by smaller 14bps on the day, and since then by further 30 bps. This is hardly the stuff preceding recessions. Aren’t yields supposed to go down in recessions?

The story is the same as in U.S.. The ECB made it clear it will go further above neutral then previously thought, with markets now pricing further 125bps hikes or so in coming months. This will take the overnight rates to around 3.25%, way above any reasonable estimate of long-run neutral rate. By simple arithmetic in the form of expectations hypothesis, this means much higher 2yr yield than 10yr yield, since policy rates will be above neutral only temporarily.

So no, markets are not suddenly signaling recession in euro zone. They are just signaling that the central bank will take rates further above neutral and stay there longer. Of course, this makes recession more likely – my subjective recession odds have increased on the day – but that is not what is behind the market moves.

 

 

The folly of more inversions, more recessions

 

With the whole yield curve now inverted (see below), and 2s-10s yield curve most inverted since 1980s,  the talk of inversions signaling recessions is growing louder and louder. This, to me, is simply baffling.

 

The case for linking inversions to recessions was always simple. Indeed, it is more of an observation connected with somewhat sound logic: Inversions occurred before all the recessions[1], and there is reason why inversions could be reflection of collective wisdom about coming decrease in interest rates below neutral due to coming recession (and hence signal of coming recessions).

That is all fine. Where I get lost is how does this apply to current inversions. For example, the 2s-10s inversion deepened significantly following the lower than expected US CPI report two weeks ago. This report led markets to (a) reprice the future path of federal funds, (b) correspondingly lower the 2-year yield, and also (c) lower the 10yr yield. Since (c) happened to a larger extent than (b), we ended up with deeper inversion.  On face of it, this might seem to somebody like bad news causing deeper inversion, right?

Do not count me in that camp. To see why, notice that the decrease in 10yr yield was different from the decrease in 2yr yield in that it mostly was not about lower expected path for fed funds rate.[2] Moreover, in so far as it was it was about expectations about future policy, it did not reflect expectations that policy rates will move eventually below neutral level, which is at the core of the signaling theory of yield curve inversion. Rather it reflected expectations that policy rates will rise less above neutral than was expected before. And if it was not about below neutral expected future rates, it is hard to argue that it was in some reflection of markets increasing their odds of recession, even though the inversion deepened significantly. If anything, it is hard to find anybody who thought the news were not good, as indicated by a positive stock market reaction. I am therefore struggling to follow the people who say that this development to them suggests risk of recession has increased.

Or take the most extreme example, the policy rate yield curve, which inverted only now. Is this in any way further strengthening of a signal of coming recession? Again, I struggle to see the argument. There are two reasons why the policy yield curve inverted now: the drop in 10yr yield, which I already argued was not a portend of coming recession; and increase in fed funds rates by the Fed during the November meeting. Of course, the increase in fed funds rate on its own can cause recession, but that is not the argument of yield curve believers. Rather, they argument is “Hey, it inverted, it must be a bad signal.” But if the inversion is caused by the central bank that increased fed funds rate, as expected, how can anybody interpret it as a signal of anything? Will it recession suddenly become much more likely on December 14, when policy yield curve will invert even more following the next hike, compared with December 13? I did not think so.[3]

So why are we having inversions if it is not because markets are pricing lower future rates because of recession? In other words, what do I say to somebody who might argue that long-term rates are always above short-term rates, unless markets expect policy rates to decrease, which is typically due to recession? Well, as you might guess, it is the typically, which is the problem. This inversion is not typical in that it is caused by the central bank itself. In other words, the central bank’s plan is for policy rates to follow an inverted “roof-shaped” path – rising significantly and temporarily above neutral before declining back to neutral.

This on its own should mean inversion, if bond yields are expected average future short-term interest rates (aka the expectations hypothesis). Therefore, the current inversions do not need to signal anything about the financial markets’ recessionary beliefs, just that they believe Fed’s intentions to go above neutral.[4] And this is what makes current inversion different from previous experiences: Back then, central bank was not hell-bent on going above neutral in fight against inflation, rather, it was trying to find neutral. And this, I think is an appropriate end to blog that has “folly” in its title: ending it with variation on the biggest folly of all, “this time is different”.

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[1] Of course, the statistician in me wants to scream something about N<10, but that is not the point for today.

[2] This is of course unsurprising, because changes in expectations about future rates rarely shift enough to move the 10yr yield, which is presumably the average expected value of fed funds rate over the whole 10yr horizon. Rather, the CPI report was catalyst for more broad repricing, which showed up as much lower real 10yr yield. Personally, I think it was in the spirit of coordination games a signal that this is finally the time when everybody will stop worrying that 10yr yield will rise further, and hence signal for everybody to buy 10yr yield, but that is purely speculation on my part.

[3] Similar argumentation applies to the 3m-10yr yield curve, even though there things are of course continuous.

[4] Note that the standard rules of logic apply – I am not saying markets are not expecting recession, or that recession will not happen, just that current inversions do not imply that markets are expecting one (even if they might be).  

The Swiss option for renumeration of excess reserves, reconsidered

 

When the Swiss central bank announced change to its renumeration of excess reserves held by commercial banks, I voiced skepticism that this would work. Specifically, I wrote that “when the system has large amount of excess reserves then this renumeration scheme should negate the increase in policy rates” and later that “one could address this by increasing the threshold [b]ut this would negate the desired goal of this policy which is decreasing the sums paid to commercial banks”.  Few months later, we know that the Swiss central bank did exactly what I said in the second part of the quote: it set the threshold above which excess reserves earn 0% interest to very high number – 28 times the required reserves. So while marginal excess reserves do pay 0% interest rate, the point where this marginal rate starts to apply is very high, so high that most (or no?) banks actually reach it.

In terms of the overnight market this means that there are banks that will borrow excess reserves at rates close but below the deposit rate, since they will be able to earn the deposit rate. In aggregate, the overnight (SARON) rate will stay close to the deposit rate, something we have indeed observed since the change (see picture below). The only difference is that the overnight rate is slightly below the deposit rate, rather than slightly above deposit rate, as was the case before the change. This reflects the fact that the banks lending reserves out now earn rate below deposit rate (0%), while borrowers earn deposit rate, so that the price of the transaction has to be in between those two. (Before lenders earned deposit rate, so the lower bound was the deposit rate; borrowers presumably would have to borrow at equivalent of marginal refinancing rate).

What about the effect on the payments from central bank to the commercial banks, which is presumably the main motivation? Of course, the policy means that for the 28-multiples of required reserves it is the deposit rate that applies, which means that the central bank is still paying large sums of money to commercial banks, despite the change it did. So, this policy should achieve very little in the direction of the desired outcome of lowering payments to commercial banks and corresponding losses for the central bank. That said, it does not achieve zero effect: as long as some banks are above the 28-multiple threshold, which is presumably the case, they are being paid less than what they would be paid otherwise.

So why did the Swiss central bank do it? It is hard to say. Partly, it might be simple theater for the public: setting the marginal rate for excess reserves to 0% means that the central bank can claim it did something. Equally, it might be issue of redistribution of excess reserves and profits: the change pushes excess reserves towards banks that are below the threshold and punishes banks with largest amount of excess reserves. What else? I think the evolution of ESTR, which stayed close to deposit rate despite it rising above 0%, makes it clear that the change can hardly be motivated by desire to impact the market interest rates, as the bank claimed; if anything, the move leads to slightly lower market interest rates.[1]

What does all this imply for the future behavior of the ECB? The fact that this is a lot about playing politics, rather than macroeconomic or financial policy, it is hard to know what the ECB will do. There are arguments for it not to do anything. First, it would avoid the whole messy business, including possible unintended consequences, perspective that might win given the limited effect on what it is supposed to achieve. Second, since it leads to lower overnight rate, and the magnitude of the effect might be hard to calibrate – especially in euro zone money market with much larger number of commercial banks and much bigger heterogeneity of excess reserves (see below).

 

 

 

That said, the ECB might still go for it despite the limitations. Apart from doing something for the sake of doing anything, even if the savings for the central bank would be small, the main motivation I could see is the positive effect on the redistribution of excess reserves: with potentially large costs of missed opportunity for banks above the threshold, there would be strong incentive for them to lend their reserves to banks below threshold. In environment of much higher overall interest rates this could have desirable financial stability effects. That said, since German banks would be hurt the most in terms of lost profits, the redistribution effects could also be a reason why this does not pass – the German central banker might not be too happy about this.

On balance, I now think that the ECB will stay clear of any change. It feels like that if they would do anything, they would have done it already when the changed the LTRO terms. The fact that back then they went for lowering the interest rate on required reserves – from main refinancing rate to deposit rate – but not for tiering suggests that they might have decided that going down this road offers too little benefit and too much risk. But of course, the ECB could easily surprise me once again.

 

 

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[1] Specifically, the bank said that it “ensures that the secured short-term Swiss franc money market rates remain close to the SNB policy rate”. True, they mention secured rates, which in euro zone are disconnected from the deposit rate, but that is mostly down to collateral shortage, and I don’t see how renumeration change affects that.

Addendum to ‘What other tools might ECB use?’

 

One option for the ECB the previous blog post did not explicitly consider is what (as of today) can be called the Swiss option: raising the deposit rate, but not applying it to all the excess reserves, but only fraction of excess reserves. This is exactly what the Swiss National Bank has done today: Banks’ deposits held at the SNB will be renumerated at the policy rate up to certain threshold, and by 0% above this threshold. Effectively, this is the reverse of the option discussed in previous post, where only excess reserves above, but not below, some threshold are renumerated.

Why did I not consider this option? Because it should not work. In principle, when the system has large amount of excess reserves - higher than the amount of sum of all the “allowances” – then this renumeration scheme should negate the increase in policy rates, and hence be effectively identical to the option of not raising deposit rate at all, which I have discussed.  

To see this, consider situation of two commercial banks, one with excess reserves above the threshold, and one with excess reserves below. The one with excess reserves above threshold is earning zero on its reserves above this threshold, so should be willing to lend them out at any interest rate above 0%.[1] Meanwhile, the bank with excess reserves below threshold should be willing to borrow for any rate below the deposit rate, since it can earn deposit rate. As price of lending is the interbank interest rate, this should push the interbank rate close to the deposit rate. That is, as long as there is a bank which did not exceed its threshold, so that it can earn the deposit rate on marginal excess reserves. But this last condition is crucial: If the amount of excess reserves is so high that all banks are above their thresholds, then there will not be any bank willing to borrow at rates close to the deposit rate, because no bank will be earning the deposit rate on its marginal excess reserves, all banks will be earning 0%. This will push the interbank rate towards the 0%, negating the increase in deposit rates. This is the same mechanism that allowed central banks to push interbank rates to negative values: when there are excess reserves, interbank rates tend to deposit rate.

 Arguably, the SNB and ECB are in this latter situation. Of course, one could address this by increasing the threshold. But this would negate the desired goal of this policy which is decreasing the sums paid to commercial banks. So, in my opinion, the option cannot work, at least in absence of some other action. SNB mentions liquidity absorbing operations, which could be this other action. But for them to work, they will have to pay interests higher than 0%, which will again clash with the desired goal.

The overall conclusion? Central banks do not have neat options of avoiding paying large sums to commercial banks, all the options are fraught with complications. This should not be surprising:  back when the goal was to lower interest rates, excess reserves were a useful tool, as they allowed the central bank to push interbank rates close to deposit rate. Now, however, central banks are increasing rates. In such situation, excess reserves are an obstacle. Not insurmountable obstacle – you can just pay higher deposit rate – but when combined with political desire to avoid paying money to commercial banks, it becomes troublesome obstacle indeed.

 

 

 

 

 

 

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[1] Again, ignoring the risks associated, since rather than lending them out it could buy assets.

What other tools might ECB use?

 

For decade-and-half since 2007, most of the action in terms of euro zone monetary policy was focused on the so-called unconventional policies. First came the liquidity infusions in summer of 2007, which were gradually enhanced and culminated in the switch from fixed allotment to full-allotment policy in the fall of 2008. With the onset of the euro zone sovereign debt crisis then came the asset purchase programs related to the transmission of monetary policy, namely the Securities Market Program and Outright Monetary Transactions program. Finally, the low-inflation period starting in 2014 lead to introduction negative deposit rates and targeted long-term refinancing operations (TLTROs), and culminated in systematic asset purchases under the Asset Purchase Program.

For now, the shift to normalization of monetary policy also meant shift away from unconventional and back to normal policy instruments: the interest rates. After the asset purchases have been discontinued in first half of this year, and TLTROs are no longer expanded, the central bank started raising all it policy rates. Already the first hike ended the 8-year long policy of negative rates, and by the end of this year the policy rates will in all likelihood be approaching something what can be considered normal or neutral levels.

However, this does not mean that the other policy instruments will not be tampered with. Indeed, there are reasons to believe that the central bank will take steps that will reverse some of the unconventional moves taken in the past, some of which will have potentially important implications for monetary policy stance. True, any change in strategy regarding the stock of assets purchased during last 10 years is unlikely in the near term. Instead, the central bank might take two actions that were not part of the usual tightening cycles before the Global financial crisis: It might make asymmetric moves in policy rates, and it might take step that will directly or indirectly alter the renumeration of excess reserves.  

Spreading the policy spread

Before the Global financial crisis the world of central bank policy rates was pretty simple. There was the main refinancing rate (MRR), at which bank could borrow from the ECB during the regular tenders. It was the main policy rate influencing market interest rates, hence its name. The other two policy rates – the deposit rate (DR) and the lending rate – were 1 percentage point above and below the MRR, respectively, and always moved in lock-step with the MRR.

This all changed in the following years. First, in the world of excess reserves, which emerged in 2008 and remained with us since, the MRR was no longer the “main” rate, since the deposit rate became by far more important for market interest rates. So much so, that by now the MRR is almost irrelevant and all the focus is on DR. Second, from 2013 the spread between MRR and DR was no longer the fixed one percentage point, but rather the central bank started changing rates asymmetrically. First, the spread between the two was decreased in 2013 and 2014, reaching low of 0.25%, and then it was increased again, reaching high of 0.5%.

During its first hike in July the ECB moved all rates in lock step, mostly in order to keep things simple. However, this does not mean that the central bank cannot change the spread between the two rates, and there are reasons to think it might. For example, during one of the fall meetings it could increase the MRR more than the DR, in order to increase the spread back to the presumed desired long-term level of 1 percentage point. This would have the additional advantage that the bank could portray this as step up in the inflation fight. Importantly, in reality this would not amount to significantly faster tightening  of financing conditions. Indeed, it would virtually not amount to any tightening at all, much like cuts in MRR in 2013 did not amount to any easing as far as market rates are concerned. Hence, it would be a PR victory without any real costs. This could even play well with the dynamic inside the governing council, as the doves could use it as a concession to the hawks without worrying about undue impact on the economy. This reasoning suggests to us that we are likely to see such move during one of the upcoming meetings.

Ever heard of negative re-numeration?

The other unusual move we are quite likely to see is a change in renumeration of excess reserves, something the bank has already hinted in its July meeting. However, in this case the situation is much more complicated fraught with risks, and the motivation here is purely in terms of political optics.

Up until now, the central bank was renumerating any excess balances with the deposit rate. Prior to Global financial crisis this renumeration amounted to almost nothing, given that banks faced powerful incentives to not hold any excess reserves. Afterwards, when the deposit rate went to zero there was no renumeration whatsoever.

When the ECB moved to negative rates, it turned the renumeration principle on its head: Rather than paying commercial banks when they had excess reserves, it started charging them, by making the deposit rate negative (and shutting down avenues to avoid this). This was combined with large-scale asset purchases under the Asset Purchase Program, which resulted in large amount of excess reserves being infused into the system. As a result, the ECB was pocketing huge profits: not only was the bank earning interest on its assets, at least as long as those remained positive, which on average they did. But it was also pocketing huge sums thanks to its liabilities being “renumerated” with negative interest rate. It is as if you borrowed money from a friend, invested them at profit, and yet your friend would be paying you for lending you money.

This was putting a strain on the profits of commercial banks, which is why the central bank introduced tiering of excess reserves renumeration in fall 2019, when it restarted asset purchases. This way, it kept the pass-through from deposit rate to market rates intact, while not raising worries about commercial banks solvency.

Re-labeling excess as required

Of course, this is all going to change when deposit rate rises above 0%. This will mean that the ECB will be paying money to commercial banks, rather than receiving money. With excess reserves standing at 4 trillion, this would amount to tens of billions of euros as soon as deposit rate would rise significantly above 0%. Unsurprisingly, the central bank is thinking about how to avoid this. Not only it would hit its profit, turning it from positive to negative. More importantly, it would amount to very bad politics: The headlines would be full of stories about commercial banks getting money from the central bank, something very unpleasant in normal times, and much less so when everybody is undergoing unprecedented cost-of-living crisis.

The problem is how to go about this. Consider first the option of raising MRR without raising DR. While this sounds great in theory, in practice it would defeat the goal of raising market interest rates, which now respond only to movements in DR. So this is not an option in so far as the ECB wants to tighten policy stance. This leaves as an alternative avenue only two options: changing the amount of excess reserves by re-labeling them as required reserves, or changing how excess reserves are renumerated.

Start with the first option. The central bank could easily just say that banks are suddenly required to hold much higher level of reserves by changing what is called the reserve-requirement ratio. This currently stands at 1%, meaning that bank needs to have reserves equal to 1% of its deposits. Changing this ratio is not unheard of. It used to be an active policy tool in western world in the last century, and the emerging markets central banks, such as central bank  of China uses is to this day.

There are problems with this approach, though. First, increasing the reserve ratio would mean that the market interest rates would move away from the deposit rate. Since as the amount of excess reserves would decrease, and since the spread between money market rates and deposit rates is negatively related to amount of excess reserve, this would lead to an increase in this spread. Hence, this step would amount to tightening of monetary policy stance. Moreover, this tightening would be hard to calibrate, and the central bank could easily overdo things. This is especially true given that the increase in reserve ratio would be very large for it to have meaningful impact of ECB profits.

However, potentially more important than this average effect would be the distributional effect. The excess reserves are not distribute among banks equally, so increasing the reserve ratio would cause some banks suddenly to be short of reserves, leading them to need to borrow reserves from banks that still have excess.

What is the problem with this, given that this was normal before the Global financial crisis? Mainly, that we are in a very different world already for more than a decade. Ever since the Global financial crisis banks became unwilling to lend to other banks out of fears about solvency. Moreover, as amount of excess reserves increased, there was a less and less need for banks to borrow. Hence, effectively there hasn’t been any lending/borrowing of reserves on significant scale for more than a decade, and it is far from clear how would banks respond if the need arose.

This is especially problematic because the banks with lower reserves are likely geographically concentrated in the euro zone periphery. Putting pressure on these banks could quickly lead to re-emergence of fragmentation in the monetary union, something the central bank is desperate to avoid. It could even spill into the bond markets, as periphery banks could try to sell their bond holdings to raise their reserves.

So overall, it is fairly unlikely that the ECB would choose this as its main approach. This, however, does not mean that the bank would not use this approach on the margin. An obvious step would be for the bank to increase the reserve requirement ratio at least to 2%, where it stood prior to 2012, but possibly more, say mid-single digit levels.

De-numerating the re-numeration

This leaves the other approach of changing how excess reserves are renumerated. There is a clear precedence for this in the tiering introduced in 2019. At that time the ECB followed the Bank of Japan and allowed part of the excess reserves to be renumerated by 0%, rather than the negative deposit rate. Like that the ECB lowered the total amount commercial banks had to pay to it without changing the marginal rate, i.e. the rate that applied to the last euro of excess reserves. This meant that the effect on market interest rates was almost nil.

The central bank could put this logic on its head. Rather than allowing balances below certain threshold to be renumerated by 0%, it could mandate that balances below some threshold would be renumerated by 0%. While this sounds almost identical, the difference is that while before it was 0% instead of negative deposit rate, now it would be 0% instead of positive deposit rate.

What would be the implications of this move? To see this, consider situation of two commercial banks - one with excess reserves below the threshold and one with excess reserves above - when deposit rates were negative.  The one with excess reserves below threshold was paying zero interest on its reserves, while the other one was paying interest on balances above the threshold. In this situation the bank with lot of excess reserves had incentives to lend them to the other bank, and thus lower its bill.[1] The other bank meanwhile was willing to do that because it would still pay zero, as long as it stayed below its threshold. This dynamic had the added advantage from the perspective of the ECB, since it shifted reserves from banks in the core to banks in the periphery, a desirable change in fragmented monetary union fighting low inflation.

Now consider the same situation when deposit rates are positive. The commercial bank with excess reserves below threshold would be earning zero interest on its reserves, while the other one would be earning reserves on balances above the threshold. This is the flip side of the situation we observed before, but this time it creates incentives that are also reversed. Rather than pushing reserves from banks with high balances to banks with low balances, this time around it would create incentive for excess reserves to be pushed towards banks with high balances.

The banks with high excess reserves would have incentive to borrow from banks with low excess reserves as long as the transaction rate would be below deposit rate. Meanwhile, the banks with low excess reserves would have always incentive to lend, since earning positive interest is better than earning 0%.  Indeed, banks below threshold should be willing the lend all of their excess reserves to other banks, and keep only the amount required, while banks above threshold should be always willing to borrow.[2] And this is a potential major flaw of this design, because it would cause bifurcation of distribution excess reserves, with some banks holding large amounts and some banks holding zero. While before there was a stable equilibrium where all banks were close or above their threshold, this time the equilibrium is unstable. Any bank that drops below threshold would have incentive to decrease, and any bank that jumps above threshold should be willing to increase.[3]^,[4]

What about the aggregate effects on market rates? In world of negative deposit rate the effect of tiering on market rates was almost nil, since there remained incentive for reserves to be lent out at rates close to the deposit rate, with banks with low reserves borrowing from banks with high reserves. This kept market rates anchored by deposit rate. This logic would still remain true, as banks above threshold would have incentive to borrow as long as transaction rates would remain below deposit rate, and competition over available excess reserves would ensure that market rates would still remain anchored to deposit rate.[5] As the deposit rate would rise, the market interest rates would follow. That said, the anchoring would be from below, potentially significantly so, and hence from perspective of market interest rates this would amount to easing of policy stance.

Therefore, the distributional effects are clearly problematic - especially in currency union where these redistribution effects are not irrelevant -while the aggregate effects are not. Where does this leave the ECB? In principle, it could ignore the problematic distributional effects in order to achieve its mostly political objective. In practice, the ECB would likely try to have its cake and eat it too. It could do this in two different ways. First, it could set the threshold so low that most banks would remain above, so that almost no banks would have real incentive to de-accumulate excess reserves. Or it could set another threshold over which excess reserves would not be renumerated, so that there would be only a band in which full renumeration would apply. However, to make sure that this would not prevent market rates being anchored by deposit rate, it would have the remain the case that at any given time there are is significant number of banks withing this range.

In either case, the discussion shows that this approach is  fraught with calibration issues, which means that we would not be surprised by the central bank avoiding this minefield altogether. That said, some action is clearly going to occur, the question is how significant it will be.

Not rocking the boat full of bonds

What about ECB’s assets? In contrast to asymmetric changes in policy rates and changes to renumeration of excess reserves, we are not likely to see any activity on the front of the stock of asset purchased in last decade. This is despite the fact that the one option the ECB has in this regard - letting the portfolio mature without re-investments over time – would help with the problem of paying banks large sums.

The motivation is clear here. The normalization of policy rates is already making bond markets skittish, sending fear up the spine of the ECB. This creates very powerful incentive for the bank to avoid rocking this boat any further. Indeed for now the ECB is using re-investments from the Pandemic Emergency Purchase Program as first line of defense against volatility in bond markets by selectively re-investing the proceeds into periphery government bonds. There is little reason the central bank would want to give up this nimble tool and instead add to the fire ending these re-investments. For these reasons, no action on this front is on horizon.

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[1] More true description of reality is probably focusing on other avenue of changing amount of excess reserves, namely buying assets, rather than lending out excess reserves. When commercial bank buys an asset from another commercial bank, it pays it in form of its reserve balances, what then achieves the same outcome of redistributing excess reserves from one bank to another.

[2] Again, more likely avenue through which this would operate would be via asset purchases/sales, see previous footnote. Bank with excess reserves below the threshold has opportunity cost of excess reserves equal to 0%. In contrast, bank with excess reserves above threshold has opportunity cost of money equal to (now positive) deposit rate. Hence the first bank should be more eager to buy assets than the second bank, leading the first bank to (indirectly) buy assets from the second bank, which would eventually lead to the same redistribution of excess reserves as lending between the banks. Note that while in world of negative deposit rates the incentives were for the banks in the euro zone core that were rich in excess reserves to buy assets, this time it would be the banks in periphery that would have incentives to buy assets. This might be undesirable.

[3] Of course, bank just below the threshold might decide to make the decision to go increase its reserves just above the threshold. That said, since this is uneconomical – it needs to accumulate some reserves for which it gets 0% interest, rather then lending them out at above 0% interest – it would apply only to banks close to the threshold.

[4] Note that in practice, there would be other limits to this behavior. The lending banks would face limits imposed by credit-risk rules, which limit how much exposure to single entity should bank have. The borrowing banks might face limits with respect to their size, either in form of liability-to-equity ratio. But the general tendency would hold.

[5] This is the situation in the U.S. where some financial institutions have access to the deposit facility, while others do not.

Why do yield curve inversions predict recessions (and why this time it might not)?

 

The brief inversion of the 2s-10s US yield curve led to a rather typical explosion of commentary discussing whether we are looking at a recession in the US in the next 6-18 months. This commentary is mostly based on the empirical evidence that yield curve inversions are the most reliable predictor or US recessions.[1] This raises the question ‘Why do yield curve inversions predict recessions?’.

Start with establishing what do yield curve inversions predict almost for sure: yield curve inversions are market-based predictions of future decrease in short term interest rates. Since yields of different maturity are equal to expected value of short term interest rates over the length of given maturity, then decreasing yield curve has to imply that market expects short term interest rates to be lower at some point in time in the future.[2]

With this established, the question then becomes why would an expected future decrease in interest rates be a predictor of a future recession. At a first glance, it seems obvious: recessions are associated with a decrease in interest rates. In modern economies this is because central banks decrease nominal interest rates to fight recessions; but even outside of modern economies, this should be the case, as recessions decrease demand for investment/consumption, and hence decrease the natural rate of interest.

However, this answer provides only a partial justification for why do yield curve inversions predict recessions. While expected future recessions should imply downward sloping yield curves, this does not mean that downward sloping yield curves necessarily imply recessions: necessary condition is not the same as a sufficient condition.[3] In other words, a future decline in interest rates does not necessarily mean a full recession, defined as outright decline in economic output. This is especially if one considers nominal interest rates in current environment: for example central banks in CEE have increased policy rates to extremely high levels to fight a bout of inflation, causing inversions in yield curves. However, local market yield curves are just predicting that interest rates decrease towards their long-run equilibrium values, and not below those values, consistent with central bank’s expectations that policy rates will be gradually normalized, reaching the long-run equilibrium levels from above. Therefore, an inversion is not signaling a recession.

The example of CEE countries holds a more general lesson: expected decrease in short term interest rates does not equal a recession, as short term interest rates can decrease outside of recessions. For example, central banks might orchestrate a yield curve inversions if they intentionally temporarily increase short term interest rates above their long-term equilibrium values. Or more generally, natural interest rates might decrease in absence of outright recession, in case of what is often called a growth recession: a temporary decline in the growth rate of the economy without an outright decline in output. A prime example was the 2019 inversion in yield curve, which was prompted by the economic slowdown caused by Trump’s trade war. While we will never know for sure, it is quite likely that if it was not for the pandemic, the US economy would experience just period of slower growth without an outright decline in output.

Turning to today, while there are good reasons to worry about recession in US, there is a good chance why yield curve inversion might not a be signal of one: the Fed is explicit that it wants to increase short term interest rates above the long-term equilibrium values. This alone should imply a yield curve inversion, but one intentionally engineered by the central bank. Of course, this policy might actually cause recession, which will then just add to the mythology surrounding yield curve inversions.

 

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[1] That said, theorical considerations also do play a role: one can construct models in which yield curve inversions cause, rather than just predict, recessions. I will ignore this aspect here.

[2] Strictly speaking, one could construct decreasing yield curve also by postulating term premium that decreases with maturity. While not impossible, especially in current environment with term premium compressed by regulatory requirements and large balance sheets of central banks, this seems to be rather an edge case. Moreover, argument carries less weight when one focuses on changes in yield curve slope, rather than just the arbitrary metric of negative-sloping yield curve: even if long-term yields are compressed due to compressed or even negative term premium, it should still hold that decrease in the slope of yield curve implies that short term rates are either expected to increase less, or to outright decrease. Similarly, the argument does not apply to the near-term yield curve spread, since there term premium plays limited role.

[3] Moreover, downward sloping yield curve is clearly not even a necessary condition: while one would generally expect downward sloping yield curve ahead of predictable recession, this of course does not apply to unpredictable recessions, and most recessions are thought to be unpredictable. Case in point was the pandemic recession, which was clearly unpredictable 6-12 months ahead of time. From this perspective, it actually seems odd that yield curve inversions are such a reliable predictor of recessions: it is as if something that is thought to be mostly unpredictable is being reliably predicted.

Does inflation cause decrease in aggregate demand?

With inflation occupying the headlines, one can often read arguments that high inflation will cause a decrease in the aggregate demand and potentially a recession. What does basic macroeconomics have to say about this argument? The simple answer is that such reasoning is faulty, but the more complicated answer is that in current situation it might hold a grain of truth.

Start with the basic AS-AD model, which has the total output on the horizontal axis and the price level on the vertical one.[1] In this space, the aggregate demand is a downward sloping curve, with higher price level resulting in lower total output demanded. Meanwhile, the aggregate supply is upward sloping curve, capturing that higher price level means higher total output supplied.

On the first (very brief) look it might seem that inflation can indeed cause decrease in aggregate demand, but one should quickly realize that this reasoning is faulty: while the total output demanded will decrease when price level increases, the curve capturing the relationship between output demanded and price level is the same. In other words, this is a macroeconomic analogy of the mistake made by first year students of microeconomics, who struggle to distinguish between decrease in quantity demanded caused by higher price, and decrease in demand caused by some other factor. Since only the change in (aggregate) demand or supply can change the equilibrium price (level), then arguing that higher price (level) leads to lower (aggregate) demand is confusing causes with consequences: the price (level) is an equilibrium outcome of the model, and not a driving force of changes in the equilibrium. As one of my favorite bloggers says, an economist should never argue from a price change!

At this point one could feel that this is just semantics – economists often say that higher price means lower demand, knowing full well that it is really quantity demanded what they have in mind. They do this because they speak to general population that did not go through basis economic course and hence would not understand the terminology of “change in quantity demanded” vs. “change in demand”.

However, the problem is that in many situations the writers are not using this as a shorthand terminology, which then leads to problematic lines of reasoning. In case of inflation and aggregate demand, the problematic reasoning goes like this: we are currently seeing high inflation, which will cause a decrease in aggregate demand, and hence we are in danger of economy going into recession.

In this reasoning, the high inflation is what is driving the economy into recession. This reasoning is problematic because high inflation is a response of the model to some shock, not source of shock. To see this consider a scenario in which current inflation is caused by large increase in aggregate demand. In such situation, the AS-AD model tells us that output should increase and so should price level, both of which we observed. Is there a reason to worry about decreasing aggregate demand and recession? No, because we started with increase in aggregate demand!

What about the situation when the higher prices are cause by decrease in aggregate supply, say because of an supply bottlenecks? Here, we will indeed observe decrease in output – a recession – and inflation. However, it is not inflation causing the decline in output, it is the supply shock and corresponding decrease in supply. Worrying about inflation is double-counting: there is no further decrease in output because of the high inflation, all of the decrease is due to the supply shock.

The faulty reasoning can go even one step further: if inflation will cause decrease in aggregate demand, then, some argue, this is all good, because lower aggregate demand will lead to lower prices/inflation, which is what we need. Of course, one then can wonder whether lower prices will not cause higher aggregate demand, which will cause higher inflation… and so on and so on.[2]^,[3]

Overall, we are left with the conclusion that in basic macro saying “inflation will cause decrease in aggregate demand” is a nonsense. Does it mean the argument belongs to garbage bin? Or could we find support for it if we leave the world of basic macro? Every now and then I catch myself being annoyed with some argument which is a bad economics, but that captures some more complicated story that is valid, and I think this is the case here.

To see this, consider abandoning the notion of homogenous output, and considering heterogenous outputs. Large part of the European inflation right now is driven by jump in energy costs, reflecting the combination of diminished supply and revived (global) demand. While the diminished supply in AS-AD world would amount to concurrent decrease in aggregate supply and increase in aggregate demand, resulting in inflation, the AS-AD world is maybe not very suitable for the present situation. Instead, we could think about things in terms economy with two sectors, energy sector and all the rest, and assume that energy is supplied by foreign country. In such situation, increase in price of energy will lead to a decrease in aggregate demand in the rest of the economy, and hence inflation will indeed cause something which is akin to decrease in aggregate demand.

What about savings, not present in basic static macroeconomics, could those create link between inflation and aggregate demand? Inflation clearly leads to decrease in value of savings, so it might seem that inflation will cause decrease in savings, which will cause decrease in aggregate demand. However, this story is not fully satisfying from macroeconomic perspective: in general, higher prices also mean higher profits and higher wages, which should cancel the effect on aggregate demand. But it might be the case that the higher prices are indeed driving decrease in aggregate demand, if we either consider heterogeneity of households or some form of myopic behavior. In case of heterogenous households, it might be that the distribution of costs of higher prices and benefits of higher prices is such that it shifts money towards households who will spend less. In case of myopic households, it might be that higher households are spending for as long as they have money in their accounts, but once they draw down these balances, they stop spending.

So, there, we have it. In general, the argument “inflation will cause decrease in aggregate demand” rings hollow, but it might not be always the case if the inflation is either heterogenous in terms of its source, coming from decrease in supply in particular sector of the economy, or heterogenous in terms of distribution of impacts on households. I don’t think that’s what the pundits have in mind, though.

P.S.: Note the microeconomics equivalent of this blogpost is a blogpost about “Do higher car prices cause lower demand for cars?”. The answer is yes, if one means decrease in quantity demanded, but no, if one means that people will not want to buy cars anymore and that car makers should be worried: as soon as price of cars will go back down, quantity demanded will again increase.

 

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[1] One could re-formulate the model so that we have (surprise) inflation on the horizontal axis instead of price level.

[2] The is again analogical to microeconomics, where you will see students in an endless loop of reasoning: higher price means lower demand, which means lower price, which means higher demand, which mean higher price, which means lower demand, …

[3] This last point points towards a way one could salvage the argument that inflation will lead to decrease in aggregate demand. Maybe, it could be an argument about disequilibrium and dynamics. Maybe, the decrease in aggregate supply was not matched by decrease in aggregate output demanded yet, and hence decrease in output is to be expected in due course. It does not take the form of shift in the curve, but rather movement from disequilibrium position to position back on the curve.

However, this does not solve the puzzle fully: the already observed higher prices mean that we have moved, so current inflation should not cause further decline in output demanded in future. Moreover, in economics it is typically the prices that adjust faster than quantities. After all, the decrease in supply means that we are not able to produce the same quantities as before, so it is hard to see how it is the prices that adjusted first and quantities will adjust later.