Thursday, February 18, 2016
Get “Real” on Gold Fever
Standard monetary theory states that the short-term nominal interest rate should be lowered to stimulate the economy whenever there is low inflation or economic slack—that is, when economic resources are not being fully used to their most efficient level. However, the nominal interest rate has a lower bound that is typically around zero. In theory, Eggertsson and Woodford (2003) showed that when the zero lower bound is binding, it is desirable to allow inflation to overshoot its target to promote a faster recovery in real economic activity.
At the heart of the Eggertsson-Woodford argument is the idea that economic slack increases with the real interest rate, which is the nominal short-term interest rate minus the expected future inflation rate. If prices and wages were able to adjust to economic conditions instantaneously then the economy would operate at its efficient level and there would be no economic slack. However, in normal conditions, prices and wages take some time to respond to changes in economic conditions, which leads to economic resources being underutilized. If this so-called economic slack is substantial—for example, following a financial crisis that restricts credit and pushes down consumption and investment spending—then according to the normal policy prescription policymakers would lower the short-term nominal interest rate. In turn, this would bring down the short-term real interest rate to stimulate the economy and reduce the slack. However, this policy prescription becomes ineffective if the nominal interest rate is at the zero lower bound. Because of this constraint, policymakers cannot engineer a decline in the short-term real interest rate to stabilize economic activity, and economic slack ends up larger than it would otherwise be. In other words, the real interest rate would still be too high. To make matters worse, elevated economic slack puts downward pressure on inflation and inflation expectations, which pushes the real interest rate up further, triggering even more slack.
Despite the zero lower bound, policymakers can still bring about a lower short-term real interest rate if they can generate higher inflation expectations. One way to do this is by communicating that the central bank intends to keep the nominal short-term interest rate low for longer than would otherwise be dictated by economic conditions; this has been a motivation behind the Federal Reserve’s forward guidance policy in recent years. Expecting a more expansionary monetary policy in the future should help boost future inflation and thus raise current inflation expectations, translating into a lower real short-term interest rate. Taking this theory a step further, by allowing future inflation to temporarily rise above target, the central bank can bring about a greater decline in the real interest rate and stabilize economic activity faster. – Is There a Case for Inflation Overshooting?
As always, for longer-term investors on the right side of the tracks, these prospective short-term moves are eventually rendered meaningless. The bigger picture read for us, is that as the virtuous disinflationary cycle turns down with equities here in the US, assets such as gold and silver that are tied to the direction of real yields – should once again outperform. And although equities continue to mirror the leading pivot structure of gold over the past several months, the wider-angle view tells a much bigger story – one the Canseco camp managed to boil down to under 144 characters.