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Why are non-zero real rates fair?

DisKamper
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8/9/2015 2:53:13 AM
Posted: 1 year ago
From what I see online and on the media, it looks like it is generally accepted that real interest rates should be some positive number. Why though?

Scenario: Tom earns money at his job. One day he decides to buy bonds with $1000 he earned. The Fed offers some positive real rate. Let's say that the rates are super high and he doubles his real money the next year. That means he can buy twice as much as he could last year. But he didn't do any work! Nor did he risk his money at all since the chances of the Fed defaulting are very slim. He basically doubled his investment-for free. What's the justification for his gain?

I considered that maybe there is some psychological element to it; humans would rather have something sooner than later. If this were the case, shouldn't acceptable real rates be some small positive value rather than jumping around all the time?
Diqiucun_Cunmin
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8/9/2015 3:03:23 PM
Posted: 1 year ago
At 8/9/2015 2:53:13 AM, DisKamper wrote:
From what I see online and on the media, it looks like it is generally accepted that real interest rates should be some positive number. Why though?

Scenario: Tom earns money at his job. One day he decides to buy bonds with $1000 he earned. The Fed offers some positive real rate. Let's say that the rates are super high and he doubles his real money the next year. That means he can buy twice as much as he could last year. But he didn't do any work! Nor did he risk his money at all since the chances of the Fed defaulting are very slim. He basically doubled his investment-for free. What's the justification for his gain?

I considered that maybe there is some psychological element to it; humans would rather have something sooner than later.
Yeah, it's called positive time preference.
If this were the case, shouldn't acceptable real rates be some small positive value rather than jumping around all the time?
How does this follow? Real rates aren't just affected by positive time preference...
The thing is, I hate relativism. I hate relativism more than I hate everything else, excepting, maybe, fibreglass powerboats... What it overlooks, to put it briefly and crudely, is the fixed structure of human nature. - Jerry Fodor

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Diqiucun_Cunmin
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8/9/2015 3:51:31 PM
Posted: 1 year ago
At 8/9/2015 2:53:13 AM, DisKamper wrote:
From what I see online and on the media, it looks like it is generally accepted that real interest rates should be some positive number. Why though?

Scenario: Tom earns money at his job. One day he decides to buy bonds with $1000 he earned. The Fed offers some positive real rate. Let's say that the rates are super high and he doubles his real money the next year. That means he can buy twice as much as he could last year. But he didn't do any work! Nor did he risk his money at all since the chances of the Fed defaulting are very slim. He basically doubled his investment-for free. What's the justification for his gain?
Perhaps we can look at it this way. :P The Fed carries out monetary policy to stabilise the economy. Part of monetary policy is the open market sales of government bonds. By cooperating with the Fed's OMO policy, he's helping the Fed achieve its goals... so in going through the trouble of buying the bond, he contributed to the economy as a whole. Do you think this justifies his gain?
The thing is, I hate relativism. I hate relativism more than I hate everything else, excepting, maybe, fibreglass powerboats... What it overlooks, to put it briefly and crudely, is the fixed structure of human nature. - Jerry Fodor

Don't be a stat cynic:
http://www.debate.org...

Response to conservative views on deforestation:
http://www.debate.org...

Topics I'd like to debate (not debating ATM): http://tinyurl.com...
DisKamper
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8/9/2015 5:12:25 PM
Posted: 1 year ago
How does this follow? Real rates aren't just affected by positive time preference...

What I mean is that they should be governed only be a time preference. Anything else would give people unfair losses and gains, right?

Perhaps we can look at it this way. :P The Fed carries out monetary policy to stabilise the economy. Part of monetary policy is the open market sales of government bonds. By cooperating with the Fed's OMO policy, he's helping the Fed achieve its goals... so in going through the trouble of buying the bond, he contributed to the economy as a whole. Do you think this justifies his gain?

Buying the bond itself doesn't really require much- certainly not enough to justify the relatively high rates. I suppose what bond buyers really lose is the ability to spend their money for some time. But this is compensated by the time preference factor. Why should someone get lower or higher gains than they "deserve" just because the Fed has certain goals?
ResponsiblyIrresponsible
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8/9/2015 5:18:14 PM
Posted: 1 year ago
It's basically time value of money: people are rewarded at a later date for a sacrifice they make today. I might forego consumption today for instance so that I can earn a positive return by investing in a stock or a corporate bond. The implication is that a dollar today and a dollar at some later data aren't equal in present-value terms. If I hid a dollar under my mattress, it depreciates in value relative to what it could've produced either via (a) investing it in a productive project, in which case the success (or failure) of that project might yield a return for me or (b) simply, deflation--though you asked about real rates of return, so inflation isn't as much of a concern in longer-term maturities as nominal rates tend to adjust upward.

As for your example, looking aside the fact that individuals can't physically lend to the Fed, I think there is one crucial point of note, which is the balance between risk and return. Indeed, if I were to buy a Treasury bond, the chance of me not being paid back is very slim. They're generally considered riskless, notwithstanding morons in Congress defaulting on debt-servicing payments or something asinine. As a result, I'll tend to earn a very low rate of return because my risk tolerance was low. If I were to invest in a corporate bond, though, there's obviously a lot more risk of me losing my money, and thus the rate of return I'll demand will be much higher -- and the implication is that the rate of return for, say, Google would probably be much lower than the rate of return for a company with more volatile earnings. In particular, those markets are more liquid, which bids up stock prices and pushes down stock returns -- and there's a similar phenomenon with bonds.
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8/9/2015 5:22:04 PM
Posted: 1 year ago
Oh, and I can't believe I didn't mention "opportunity cost." Obviously timing, inflation, etc. are concerns with respect to how I choose to allocate a dollar I earn today, but there's also the question of what else I could've done with that dollar. For instance, if I own a business and can invest in new equipment which might generate X percent return, I'm unlikely to invest in a security that yields less than that return. Because there's always some positive opportunity cost, or some positive return to be earned elsewhere, I'm likely to demand a positive real return.
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DisKamper
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8/9/2015 8:02:56 PM
Posted: 1 year ago
It's basically time value of money: people are rewarded at a later date for a sacrifice they make today. I might forego consumption today for instance so that I can earn a positive return by investing in a stock or a corporate bond. The implication is that a dollar today and a dollar at some later data aren't equal in present-value terms. If I hid a dollar under my mattress, it depreciates in value relative to what it could've produced either via (a) investing it in a productive project, in which case the success (or failure) of that project might yield a return for me or (b) simply, inflation--though you asked about real rates of return, so inflation isn't as much of a concern in longer-term maturities as nominal rates tend to adjust upward.

I was referring to real interest rates rather than nominal interest rates (inflation is accounted for).

As for your example, looking aside the fact that individuals can't physically lend to the Fed, I think there is one crucial point of note, which is the balance between risk and return. Indeed, if I were to buy a Treasury bond, the chance of me not being paid back is very slim. They're generally considered riskless, notwithstanding morons in Congress defaulting on debt-servicing payments or something asinine. As a result, I'll tend to earn a very low rate of return because my risk tolerance was low. If I were to invest in a corporate bond, though, there's obviously a lot more risk of me losing my money, and thus the rate of return I'll demand will be much higher -- and the implication is that the rate of return for, say, Google would probably be much lower than the rate of return for a company with more volatile earnings. In particular, those markets are more liquid, which bids up stock prices and pushes down stock returns -- and there's a similar phenomenon with bonds.

Historically, real rates for Fed bonds have gone above 5% (in the 1980s for instance). I don't think the risk warrants nearly that high of a rate.

Oh, and I can't believe I didn't mention "opportunity cost." Obviously timing, inflation, etc. are concerns with respect to how I choose to allocate a dollar I earn today, but there's also the question of what else I could've done with that dollar. For instance, if I own a business and can invest in new equipment which might generate X percent return, I'm unlikely to invest in a security that yields less than that return. Because there's always some positive opportunity cost, or some positive return to be earned elsewhere, I'm likely to demand a positive real return.

If a company offers good rates then people invest in it- why does the Fed need to compete with businesses? When businesses see a big potential for growth and increase their returns, the Fed can keep its real rates low and sell fewer bonds. After all, the Fed is not a business that needs investment to stay ahead in the market.

My guess is the Fed increases rates so that savings don't suddenly fly out of banks and into more risky territory like stocks. Maybe this has some value to the economy like preventing bubbles- but doesn't it still give more to lenders than they 'deserve'?
ResponsiblyIrresponsible
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8/9/2015 8:26:19 PM
Posted: 1 year ago
At 8/9/2015 8:02:56 PM, DisKamper wrote:
I was referring to real interest rates rather than nominal interest rates (inflation is accounted for).

I said that, though the implication is that, unless we're talking about inflation-protected bonds, actual real interest rates differ from ex-ante interest rates, and thus the *threat* of inflation might bid up nominal interest rates, and should actual inflation deviate from expected inflation, bid up real interest rates. Inflation is *not* accounted for in the way you think it is unless we're talking about TIPS. But the paragraph you responded to readily acknowledged this, and pointed out another factor: time. The third post I made addressed the most central factor, which is opportunity cost.

Historically, real rates for Fed bonds have gone above 5% (in the 1980s for instance). I don't think the risk warrants nearly that high of a rate.

I just looked it up, and 10-year Treasury bonds actually were as high as 15 percent in the 1980s. Again, there is no such thing as a "Fed" bond. The Federal Reserve does not issue bonds; the Treasury does.

Second, the 1980s is a horrible benchmark for what constitutes a "normal" interest rates, especially the early 1980s. Indeed, that followed the stagflation of the 1970s and the subsequent Volcker Disinflation, so prior to about 1983, there was a great deal of volatility in interest rates. Particularly, yields rocketed in the late 70s as inflation expectations were bid up, and as Paul Volcker raised interest rates upward of 19 percent, and then plummeted as inflation expectations plummeted.

Third, the historical fed funds rate is somewhere around 4 or 5 percent. That's a reasonable benchmark for short-term Treasury notes, sure, though longer-term notes would tend to be much higher. They've been on a downward spiral for several decades now, and in fact global real rates of return have been plummeting, but the question isn't of whether the risk "constitutes" that rate of return. Riskless real rates, at least in the short run, are set by the monetary authority, which is effectively targeting the Wicksellian equilibrium real rate which varies with the fundamentals of the economy. There really isn't a question of "tail risk" with Treasury bonds, unless there were some unforeseen spike in risk premia, as there was in the May-June Taper Tantrum.

But, really, there is no objective basis for whether the risk premium is "merited." It's a relative basis. A measure of risk might be, for instance, a credit spread: the spread between some corporate bond and a risk-free Treasury, the rate of which is effectively set by the Fed. From there, the question is what might raise credit spreads. Some of it might be the fundamentals of the economy or the corporation issuing the bond, and some might be policy-induced. For instance, QE and liquidity provisioning by the Fed significantly reduced the buildup in financial frictions following the financial crisis.

If a company offers good rates then people invest in it- why does the Fed need to compete with businesses?

You keep insinuating that the Fed is issuing bonds, and that's just not true. The Fed doesn't issue Treasury bonds. It is illegal to do so. It might buy Treasury bonds on the secondary market, but it *cannot* issue them.

Second, the premise of your question is just silly. Companies don't "offer" real rates of return. Those returns are determined by supply and demand, which is to say they're determined my market liquidity, investor preferences and perceptions, economic fundamentals, policy, etc.

Third, it's not even a matter of competition, nor is that the intention of the U.S. Treasury in issuing bonds. The Treasury issues bonds to fund government expenditures, but the types of investors who would confine themselves to Treasuries are far different from people who make a living investing in index funds or corporate bonds. It's a completely different risk calculus, so notwithstanding the fact that troubled times might lead to a flight-to-safety in government bonds, as with German bonds following the recent implosion of Greece, you're not going to see Treasuries actually *substitute* for some other investment.

When businesses see a big potential for growth and increase their returns, the Fed can keep its real rates low and sell fewer bonds.

Again, the Fed doesn't sell any bonds at all. This is just wrong.

Second, the Treasury, which issues bonds, doesn't control the price or the yield at which they're sold: again, that is set by the Fed for short-term rates, and by market expectations for long-term rates. There are three components of long-term rates: inflation expectations, expected path of the policy rate (short-term benchmark rate set by the Fed), and term premia.

Third, during good times governments tend to cut their deficits back, which means they issue fewer bonds -- and that tends to reduce yields relative to what they would've been had the government continued to issue them at the same rate they would during a downturn when it might be wise to run budget deficits. But again, yields are set by supply and demand, not by the Treasury or by companies issuing securities.

After all, the Fed is not a business that needs investment to stay ahead in the market.

This is true, and this is why it (a) doesn't issue bonds and (b) doesn't make silly calculations as to the health of its own portfolio when setting interest rate policy. It's statutorily mandated to set rates in such a way so at to keep employment and prices stable, and that's the path it often takes, lest there be some ruthless conflict of interest. I don't think you're accusing the Fed of that -- and if you were, I'd be dying to see some hard evidence of it. But, once again, the Fed *sets* one interest rate, and that's the short-term riskless rate. There's even a disconnect now for the transmission of that rate to other short rates, and much less to long-term rates. Rates are determined by supply and demand.

My guess is the Fed increases rates so that savings don't suddenly fly out of banks and into more risky territory like stocks.

No, this isn't remotely true. Rates are heavily procyclical and the Fed often increases or decreases them in tandem with movements in the equilibrium real rate. The stock market is completely ancillary to the Fed's mandate: it doesn't target the stock market, and insofar as the stock market doesn't bear on the real economy, it's doubtful the Fed will even care.

Maybe this has some value to the economy like preventing bubbles- but doesn't it still give more to lenders than they 'deserve'?

First, Fed policy doesn't cause bubbles. I understand that's a misnomer that a lot of know-nothings like Peter Schiff like to tout, but there's just no evidence for it whatsoever, and plenty of research suggesting that increasing interest rates would actually *increase* asset growth in shadow banking organizations -- i.e., lending institutions not subject to regulations. Regulatory failure, not the Fed, is responsible for bubbles.

I don't know what the gauge of "deservedness is." I mean, "maybe," but you shouldn't blame the Fed for that -- blame supply and demand, lol. Blame the current state or structure of the bond market, or the state of competition in the corporate world or investor and/our household preferences: that's what determines the rate of return lenders actually receive.
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ResponsiblyIrresponsible
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8/9/2015 8:33:15 PM
Posted: 1 year ago
@OP:

I'm not sure if you've ever heard of the Capital-Asset Pricing Model (CAPM), but it's often used to determined the expected/required return on stocks. There are problems with it, but it's a decent benchmark.

k = rf + Beta * (rm - rf)

k = return on equity
rf = risk-free rate set by Fed
Beta = regression coefficient for market risk, equal to the covariance of stock returns with the market divided by the variance of the market (or, if you regress stock returns with market returns, with market returns as the explanatory variable, this would be the slope coefficient).
rm = expected return on the market
rm - rf = market risk premium: the return in excess of the risk-free rate demanded by the market.

The model only accounts for so-called "market risk." The market would have a beta of 1. If a stock had this same beta, it means that as market returns rise by 1 percentage point, the returns of that stock would likewise rise by 1 percentage point. A beta of 1.5 means that as market returns rise by 1 percentage point, returns on that stock likewise rise by 1 percentage point -- and that the individual stock itself is probably more risky than the market portfolio. This only accounts for market risk, instead of firm-specific risk: the implication is that the latter can be handled by diversification, so again this model has its limitations.
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8/9/2015 8:34:07 PM
Posted: 1 year ago
Oops, a beta of 1.5 means that market returns would rise at a ratio of 1:1.5 with market returns.
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DisKamper
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8/9/2015 11:08:27 PM
Posted: 1 year ago
I said that, though the implication is that, unless we're talking about inflation-protected bonds, actual real interest rates differ from ex-ante interest rates, and thus the *threat* of inflation might bid up nominal interest rates, and should actual inflation deviate from expected inflation, bid up real interest rates. Inflation is *not* accounted for in the way you think it is unless we're talking about TIPS. But the paragraph you responded to readily acknowledged this, and pointed out another factor: time. The third post I made addressed the most central factor, which is opportunity cost.

Sure, if inflation expectations are wrong then real rates will change accordingly. But assuming predictions are perfect, then all bonds work like TIPS, right?

As for the time factor, I assumed you were talking about the cost of not being able to use the money used to by the bond somewhere else. This decomposes into the positive time preference factor and the opportunity cost factor. My point about the first factor is that it should be a relatively small, constant influence on rates. The latter factor I address later.

I just looked it up, and 10-year Treasury bonds actually were as high as 15 percent in the 1980s. Again, there is no such thing as a "Fed" bond. The Federal Reserve does not issue bonds; the Treasury does.

Ok, true, but Federal reserve heavily influences the prices by changing the Federal Funds target rate, right? And the Fed buys and sell Treasury bonds even though it doesn't issue them, right

Second, the 1980s is a horrible benchmark for what constitutes a "normal" interest rates, especially the early 1980s. Indeed, that followed the stagflation of the 1970s and the subsequent Volcker Disinflation, so prior to about 1983, there was a great deal of volatility in interest rates. Particularly, yields rocketed in the late 70s as inflation expectations were bid up, and as Paul Volcker raised interest rates upward of 19 percent, and then plummeted as inflation expectations plummeted.

OK, I still don't get why expectations of inflation should change actual real rates unless the expectations are wrong.

Third, the historical fed funds rate is somewhere around 4 or 5 percent. That's a reasonable benchmark for short-term Treasury notes, sure, though longer-term notes would tend to be much higher. They've been on a downward spiral for several decades now, and in fact global real rates of return have been plummeting, but the question isn't of whether the risk "constitutes" that rate of return. Riskless real rates, at least in the short run, are set by the monetary authority, which is effectively targeting the Wicksellian equilibrium real rate which varies with the fundamentals of the economy. There really isn't a question of "tail risk" with Treasury bonds, unless there were some unforeseen spike in risk premia, as there was in the May-June Taper Tantrum.

Ok, so the federal funds rate has almost nothing to with the risk. I guess my real question boils down to why the monetary authority sets riskless real rates to anything other than a small positive value (determined only by time preference).

Second, the premise of your question is just silly. Companies don't "offer" real rates of return. Those returns are determined by supply and demand, which is to say they're determined my market liquidity, investor preferences and perceptions, economic fundamentals, policy, etc.

I get that companies don't choose their returns and that the market decides for them.

Third, it's not even a matter of competition, nor is that the intention of the U.S. Treasury in issuing bonds. The Treasury issues bonds to fund government expenditures, but the types of investors who would confine themselves to Treasuries are far different from people who make a living investing in index funds or corporate bonds. It's a completely different risk calculus, so notwithstanding the fact that troubled times might lead to a flight-to-safety in government bonds, as with German bonds following the recent implosion of Greece, you're not going to see Treasuries actually *substitute* for some other investment.

Hmm, ok. So do the returns on investment in the market for businesses not factor into the federal funds rate? It seems that historically when the market has good returns the federal funds target rate increases. I assumed this was causal... but if not then what factor makes the fed change its target rate? Inflation?

Second, the Treasury, which issues bonds, doesn't control the price or the yield at which they're sold: again, that is set by the Fed for short-term rates, and by market expectations for long-term rates. There are three components of long-term rates: inflation expectations, expected path of the policy rate (short-term benchmark rate set by the Fed), and term premia.

I still don't get why inflationary expectations impact actual real rates unless the predictions are wrong. The second factor is indirectly controlled by the fed. The term premia should be pretty small and constant, right?

Third, during good times governments tend to cut their deficits back, which means they issue fewer bonds -- and that tends to reduce yields relative to what they would've been had the government continued to issue them at the same rate they would during a downturn when it might be wise to run budget deficits. But again, yields are set by supply and demand, not by the Treasury or by companies issuing securities.

Yes, yields are set by supply and demand and the Fed is a major player in the market- allowing them to influence the yields at least for short-term bonds, right?

I don't know what the gauge of "deservedness is." I mean, "maybe," but you shouldn't blame the Fed for that -- blame supply and demand, lol. Blame the current state or structure of the bond market, or the state of competition in the corporate world or investor and/our household preferences: that's what determines the rate of return lenders actually receive.

What I mean is that this equality should hold:
(The goods and services I can buy today)*(Preference for consumption today over tomorrow) = (The goods and services I can buy tomorrow)
In practice, the right side is greater than the left and I think that indicates that people are getting goods and services for free. Obviously these aren't actual quantities, but I think the idea is still valid. The Fed's goal is to stabilize employment and prices; why does it do so at the expense of violating this equality.

As far as how rates are determined, short term rates are heavily influenced by the Fed, right? So why is the Fed not to blame at least when it comes to the short term?

k = rf + Beta * (rm - rf)

Basically my question is about rf.
slo1
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8/9/2015 11:41:16 PM
Posted: 1 year ago
At 8/9/2015 2:53:13 AM, DisKamper wrote:
From what I see online and on the media, it looks like it is generally accepted that real interest rates should be some positive number. Why though?

Scenario: Tom earns money at his job. One day he decides to buy bonds with $1000 he earned. The Fed offers some positive real rate. Let's say that the rates are super high and he doubles his real money the next year. That means he can buy twice as much as he could last year. But he didn't do any work! Nor did he risk his money at all since the chances of the Fed defaulting are very slim. He basically doubled his investment-for free. What's the justification for his gain?

There is real risk investing in bonds. If rates go up, he is holding a bond with a lower rate, which means it has depreciated in value. Of course he can hold it for the full term, but if rates goes up most likely inflation goes up and it is very possible he has a negative return when adjusted for inflation. Bonds are not as easy as you portray, especially if trading them.

I considered that maybe there is some psychological element to it; humans would rather have something sooner than later. If this were the case, shouldn't acceptable real rates be some small positive value rather than jumping around all the time?
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8/10/2015 12:16:18 AM
Posted: 1 year ago
At 8/9/2015 11:08:27 PM, DisKamper wrote:
I said that, though the implication is that, unless we're talking about inflation-protected bonds, actual real interest rates differ from ex-ante interest rates, and thus the *threat* of inflation might bid up nominal interest rates, and should actual inflation deviate from expected inflation, bid up real interest rates. Inflation is *not* accounted for in the way you think it is unless we're talking about TIPS. But the paragraph you responded to readily acknowledged this, and pointed out another factor: time. The third post I made addressed the most central factor, which is opportunity cost.

Sure, if inflation expectations are wrong then real rates will change accordingly. But assuming predictions are perfect, then all bonds work like TIPS, right?

Yes, that's true, though of course that depends on the measure of inflation we're using. Headline CPI is used to determine inflation compensation in the TIPS market, for instance, and that tends to run higher than PCE inflation the Fed cares about by about 30 to 50 basis points. But, yeah, if expectations were perfect, that should be the case.

As for the time factor, I assumed you were talking about the cost of not being able to use the money used to by the bond somewhere else. This decomposes into the positive time preference factor and the opportunity cost factor. My point about the first factor is that it should be a relatively small, constant influence on rates. The latter factor I address later.

Fair enough.

I just looked it up, and 10-year Treasury bonds actually were as high as 15 percent in the 1980s. Again, there is no such thing as a "Fed" bond. The Federal Reserve does not issue bonds; the Treasury does.

Ok, true, but Federal reserve heavily influences the prices by changing the Federal Funds target rate, right?

Yup.

And the Fed buys and sell Treasury bonds even though it doesn't issue them, right

True.

OK, I still don't get why expectations of inflation should change actual real rates unless the expectations are wrong.

That's pretty much the reason, save for an increase in risk premia which might raise the return investors require to hold those bonds. Those are, of course, very small for Treasury bonds barring some massive shock.

Ok, so the federal funds rate has almost nothing to with the risk. I guess my real question boils down to why the monetary authority sets riskless real rates to anything other than a small positive value (determined only by time preference).

Because it's targeting the equilibrium real rate -- or the rate at which markets would clear -- and it moves the funds rate up and down over time to attempt to target that rate, because prices and wages are sticky can't adjust quickly to equilibrate markets.

Second, the premise of your question is just silly. Companies don't "offer" real rates of return. Those returns are determined by supply and demand, which is to say they're determined my market liquidity, investor preferences and perceptions, economic fundamentals, policy, etc.

I get that companies don't choose their returns and that the market decides for them.

Alright then.

Hmm, ok. So do the returns on investment in the market for businesses not factor into the federal funds rate?

They might factor indirectly because the equilibrium real rate changes with the state of the economy, and returns on business investments are procyclical, but not directly.

It seems that historically when the market has good returns the federal funds target rate increases. I assumed this was causal... but if not then what factor makes the fed change its target rate? Inflation?

I think this is certainly the case, but market returns are also procyclical with the economy during normal times, and that would cause the Fed to raise the funds rate. There are a number of factors since policy is generally discretionary (especially at the ZLB), but during normal times it's effectively a Taylor Rule: deviations of output from potential and inflation from target.

I still don't get why inflationary expectations impact actual real rates unless the predictions are wrong.

That's true, though .

The second factor is indirectly controlled by the fed.

Indirectly; it depends on how well the Fed communicates its policy intentions. It has at times screwed that up royally. Mid-2013 is the best example of that.

The term premia should be pretty small and constant, right?

Generally, yeah, though not necessarily constant. A good example is Europeans buying a bunch of nominal Treasury bonds: term premia fall, yields fall, etc., and that actually suggests that inflation expectations fall as though (the spread narrows) though that isn't necessarily the case, though a falling dollar might reduce expectations.

Yes, yields are set by supply and demand and the Fed is a major player in the market- allowing them to influence the yields at least for short-term bonds, right?

Precisely. The covariance of short rates is sort of muted right now due to the Fed's balance sheet size, the illiquid fed funds market, the fact that IOR is a permeable floor, etc., but during normal times, yes.

What I mean is that this equality should hold:
(The goods and services I can buy today)*(Preference for consumption today over tomorrow) = (The goods and services I can buy tomorrow)

Okay, I can see this, though the opportunity cost factor is also fairly important, and the implication is that investing in a profitable project would necessarily yield higher returns, though obviously more risk in the process. I'm inclined to think opportunity cost is a larger factor.

In practice, the right side is greater than the left

I'm not sure I'm convinced this is the case.

and I think that indicates that people are getting goods and services for free.

I also don't understand this point.

Obviously these aren't actual quantities, but I think the idea is still valid. The Fed's goal is to stabilize employment and prices; why does it do so at the expense of violating this equality.

I'm not exactly convinced that it does, especially since when we talk about risk premia we're talking about premiums in excess of the riskless rate; that rate is generally factored into, say, stock valuations as a discount rate. For instance, we might calculate the present value of a stock with the following formula:

(D1 + Pn + Dn) / (1+k)^n

which is basically discounting future cash flows at some constant discount rate, or a rate of return someone could have earned. Of course, it's an imperfect proxy since "k" is required return, but at times it might fly because the risk-free rate is at least a substitute for other productive investments.

As far as how rates are determined, short term rates are heavily influenced by the Fed, right? So why is the Fed not to blame at least when it comes to the short term?

It certainly does, but what would you want to blame it for exactly? Again, it's only targeting an unobservable equilibrium rate that moves with the growth rate in the economy.

k = rf + Beta * (rm - rf)

Basically my question is about rf.

So, you're asking why it's positive?
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8/10/2015 1:20:07 AM
Posted: 1 year ago
There is real risk investing in bonds. If rates go up, he is holding a bond with a lower rate, which means it has depreciated in value. Of course he can hold it for the full term, but if rates goes up most likely inflation goes up and it is very possible he has a negative return when adjusted for inflation. Bonds are not as easy as you portray, especially if trading them.

With inflation protected bonds real rates are always positive. Also, unless inflation is way above expectations, you can expect regular bonds to have positive real returns (maybe not in the current economic climate, but in general).
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8/10/2015 1:32:26 AM
Posted: 1 year ago
At 8/10/2015 1:20:07 AM, DisKamper wrote:
There is real risk investing in bonds. If rates go up, he is holding a bond with a lower rate, which means it has depreciated in value. Of course he can hold it for the full term, but if rates goes up most likely inflation goes up and it is very possible he has a negative return when adjusted for inflation. Bonds are not as easy as you portray, especially if trading them.

With inflation protected bonds real rates are always positive.

This isn't actually true. Real rate in the TIPS market were negative for a period of time during the financial crisis. There were -- and still are -- also negative real rates in Europe.

Also, unless inflation is way above expectations, you can expect regular bonds to have positive real returns (maybe not in the current economic climate, but in general).

During normal times, I'd say this is the case. However, there's a lot of debate amongst economists as to what the equilibrium real rate is -- or what an appropriate value for the short-term nominal interest rate, less the 2 percent inflation target, is. Believe it or not, it might actually be 0, so I think that's doubtful. It's probably closer to 1 percent.
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8/10/2015 2:17:07 AM
Posted: 1 year ago
What I mean is that this equality should hold:
(The goods and services I can buy today)*(Preference for consumption today over tomorrow) = (The goods and services I can buy tomorrow)

Okay, I can see this, though the opportunity cost factor is also fairly important, and the implication is that investing in a profitable project would necessarily yield higher returns, though obviously more risk in the process. I'm inclined to think opportunity cost is a larger factor.

So I suppose you are saying that the amount you boost profits should be a factor in how much you get tomorrow. But I don't get why because there is a lot of opportunity for profits in the market I should be able to buy a lot more goods and services at a later date.

In practice, the right side is greater than the left

I'm not sure I'm convinced this is the case.

The preference for consumption today over some future is probably not to big- probably not enough to, say, justify being able to buy 2% more goods and services in just a single year. I think in practice, in normal times, I can buy more goods and services in the future than just time preference warrants.

and I think that indicates that people are getting goods and services for free.

I also don't understand this point.

What I mean is that people shouldn't get more goods and services at a later date without having to pay a real cost- not an opportunity cost. In essence, I don't think that just because there is an opportunity to profit by investing somewhere, the amount of goods and services I deserve to get should change. Consider a market in perfect competition. I think it would be safe to say that I would get lower returns in such a market than in real markets. My question is: why should the market's competitiveness be a factor in how many goods and services I can buy at some future date?

As far as how rates are determined, short term rates are heavily influenced by the Fed, right? So why is the Fed not to blame at least when it comes to the short term?

It certainly does, but what would you want to blame it for exactly? Again, it's only targeting an unobservable equilibrium rate that moves with the growth rate in the economy.

Ok, so I suppose the core of my question is on why the equilibrium real rate moves with the growth rate.

This isn't actually true. Real rate in the TIPS market were negative for a period of time during the financial crisis. There were -- and still are -- also negative real rates in Europe.

That's a surprise. I imagine, though, that officials try to avoid this happening for extended periods of time.

During normal times, I'd say this is the case. However, there's a lot of debate amongst economists as to what the equilibrium real rate is -- or what an appropriate value for the short-term nominal interest rate, less the 2 percent inflation target, is. Believe it or not, it might actually be 0, so I think that's doubtful. It's probably closer to 1 percent.

It's a surprise that its so low. Based on the real rates people expect it seems like it would be higher.
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8/10/2015 2:48:06 AM
Posted: 1 year ago
At 8/10/2015 2:17:07 AM, DisKamper wrote:
So I suppose you are saying that the amount you boost profits should be a factor in how much you get tomorrow.

I think that's fair, yeah, but in most cases, at least when it comes to price setting, it's probably a matter of the return you expected from some other project.

But I don't get why because there is a lot of opportunity for profits in the market I should be able to buy a lot more goods and services at a later date.

I'm not really seeing your point here. We're still looking at opportunity cost. Indeed, there will be a lot of goods and services to purchase at a lower date, especially if there are profitable investment ventures, but you're also withholding spending until that date, and thus you're able to actually purchase those available goods and service, assuming of course that they improve over time as a byproduct of productive investment. I'm not sure what you're really getting at here.

In practice, the right side is greater than the left

I'm not sure I'm convinced this is the case.

The preference for consumption today over some future is probably not to big- probably not enough to, say, justify being able to buy 2% more goods and services in just a single year.

I'm really not sure where the 2 percent comes from, especially when we can't really equate the yield on a bond to 2 percent more goods and services. If we wanted to compare it PV terms to the amount of goods and services we could purchase by consuming now as opposed to later, we could do so, but that would of course factor in return, the face value of the bond, etc., any dividends we might receive from holding a stock etc., and we'd need to discount all of those future cash flows back to the present. In many cases, if we were to do that, we find that the security is undervalued, which presents an opportunity for arbitrage: basically, we hold constant the level of risk, and short sale a security with a lower expected return to take a long position on a security with a higher expected return. In many cases, because securities are often mispriced, investors can profit substantially off of them -- and this often takes place in high-frequency trading scenarios.

An additional note is that tax law, interest rate policy, etc. can also induce people to adjust their behavior. Capital gains taxes improve the incentive to consume now as opposed to later, so a hike in cap gains taxes might induce people to bid up yields to increase their after-tax returns. A cut in cap gains tax rates might bid down returns. An expected interest rate hike by the Fed might induce people to sell off short-term bonds -- raising short-term yields -- and purchases higher-yielding assets to soak up some of the capital loss they might incur.

I think in practice, in normal times, I can buy more goods and services in the future than just time preference warrants.

I'm not really seeing why this would be the case, and of course it's not really a question of "more" goods and services. You could think of it as a utility-weighted index based on what people actually want to purchase. Heck, maybe I'm Bill Gates, and I have so much money to my name that I don't really care about consuming a second yacht -- in other words, there's a diminishing marginal returns to my consumption.

and I think that indicates that people are getting goods and services for free.

I also don't understand this point.

What I mean is that people shouldn't get more goods and services at a later date without having to pay a real cost- not an opportunity cost.

But more goods and services than what? Than you could purchase on day 1 of investing in that security? I mean, this isn't exactly the case unless an investment was immensely successful, in which case the risk you took on and the benefits you withheld would often justify that increase in real wealth. I see you're saying, but I think this is ultimately a normative question of whether interest is even morally permissible -- and believe it or not some religions, like Islam, actually ban interest. I think the Catholic Church has a similar policy. I think it's a fundamentally good thing, though, because it's doubtful we'd have any goods and services to actually purchase -- and thus no opportunity cost to not consuming today -- if we didn't have productive investment to produce or improve upon those goods.

In essence, I don't think that just because there is an opportunity to profit by investing somewhere, the amount of goods and services I deserve to get should change.

But I'm not sure where deservedness comes into play. I mean, you could argue the case that someone doesn't "deserve" X percent return, but ultimately they may not end up with X percent return: they could end up with -X percent return. The return is contingent on their risk tolerance, and a boatload of things could go wrong.

I mean, if I own a company, I'm not expecting my earnings to stay flat. I'm expecting to grow and to prosper, and obviously people who helped me get there via investing are likewise expecting their earnings to grow. The key point though is that the present value of my consumption doesn't actually change -- you could even say that insofar as we hold the discount rate positive, the amount of real goods and services I can purchase today really doesn't change. Of course, that may not be the case if I took on an abnormally risky investment and were rewarded for it. But, otherwise, we're simply moving cash flows around.

Consider a market in perfect competition. I think it would be safe to say that I would get lower returns in such a market than in real markets.

Sure, that's fair.

My question is: why should the market's competitiveness be a factor in how many goods and services I can buy at some future date?

Again, that depends, because in PV terms with a constant discount rate the real quantity of goods and services you can purchase might not even change. The utility might, but that's a function of withholding satisfaction.

But, ultimately, I think it's a justifiable system because it encourages to some degree thrift. Just on a fundamental basis, I think delayed gratification is something to be encouraged, especially if it's a calculated risk. If I profited in real terms off arbitrage, then yeah, there's a moral argument that I didn't deserve that return. But I think financial markets are honestly blind to morality anyway.

Ok, so I suppose the core of my question is on why the equilibrium real rate moves with the growth rate.

Basically, when the economy improves it can sustain higher interest rates. Businesses are doing well and returns on projects are up, so they're willing to borrow at a higher rate of interest because it'll allow them to remove profitable. Basically, that equilibrium rate is the cost I as a business owner would be willing to incur to earn some return via investing, and if that rate -- or the rate at which I can borrow money -- in real terms is above what I could earn, I wouldn't invest in that project.

That's a surprise. I imagine, though, that officials try to avoid this happening for extended periods of time.

Absolutely; negative real rates represent a failure, so it's desirable to get them up via improving fundamentals.

It's a surprise that its so low. Based on the real rates people expect it seems like it would be higher.

That really depends on the underlying growth rate in the economy. Because that's been revised down so significantly, it's likely that the long-run equilibrium rate is likewise down.
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8/10/2015 4:53:34 AM
Posted: 1 year ago
But I don't get why because there is a lot of opportunity for profits in the market I should be able to buy a lot more goods and services at a later date.

I'm not really seeing your point here. We're still looking at opportunity cost. Indeed, there will be a lot of goods and services to purchase at a lower date, especially if there are profitable investment ventures, but you're also withholding spending until that date, and thus you're able to actually purchase those available goods and service, assuming of course that they improve over time as a byproduct of productive investment. I'm not sure what you're really getting at here.

Ok, I think I see what you're saying. When profits increase for a company, better goods are available to buy at a later date. Their prices increase by some factor- and if I had invested in that company I would be able to keep up with *their* price increases. If I invested in a company with lower returns then paying for the relatively successful company's products would be a bit more difficult for me.

In practice, the right side is greater than the left

I'm not sure I'm convinced this is the case.

The preference for consumption today over some future is probably not to big- probably not enough to, say, justify being able to buy 2% more goods and services in just a single year.

I'm really not sure where the 2 percent comes from, especially when we can't really equate the yield on a bond to 2 percent more goods and services. If we wanted to compare it PV terms to the amount of goods and services we could purchase by consuming now as opposed to later, we could do so, but that would of course factor in return, the face value of the bond, etc., any dividends we might receive from holding a stock etc., and we'd need to discount all of those future cash flows back to the present. In many cases, if we were to do that, we find that the security is undervalued, which presents an opportunity for arbitrage: basically, we hold constant the level of risk, and short sale a security with a lower expected return to take a long position on a security with a higher expected return. In many cases, because securities are often mispriced, investors can profit substantially off of them -- and this often takes place in high-frequency trading scenarios.

The security is almost always undervalued if we look at it that way, right? There are only a limited number of securities that are not undervalued, and by definition an investment can't be overvalued, right (since we are always comparing to the best possible way to use money)? Thus, there is almost always potential for arbitrage, with the only exception being if all investment present equal rates of return after taking into account factors like risk.

I think I can address the other issues with this thought experiment: suppose the economy consists of a single profit making company. When I invest in it they are able to come up with better products. I get some rate of return. To simplify things let's say there is no risk (must there be risk?). Maybe we can assume normal goods, if that matters. They also sell their better products at higher prices. That means there is some positive inflation rate, right? (Of course, the price increase rates for various products will be different depending on how much innovation is really possible). Is the rate of return from the company greater than less than or equal to the inflation rate? In other words: Let's say that before I could buy some basket of goods and services. After investment can I buy more or less than an improved basket of goods and services? If the former is true then what justifies it? Is there an opportunity cost hidden somewhere in this investment? Is the latter even possible?

How does the Federal Reserve play into this hypothetical scenario? They have a degree of influence over rates to stabilize employment and prices. Is that their goal, or is it to keep real rates at some set value close to or equal to zero (or are the two goals equivalent)?
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8/10/2015 1:08:39 PM
Posted: 1 year ago
At 8/10/2015 1:20:07 AM, DisKamper wrote:
There is real risk investing in bonds. If rates go up, he is holding a bond with a lower rate, which means it has depreciated in value. Of course he can hold it for the full term, but if rates goes up most likely inflation goes up and it is very possible he has a negative return when adjusted for inflation. Bonds are not as easy as you portray, especially if trading them.

With inflation protected bonds real rates are always positive. Also, unless inflation is way above expectations, you can expect regular bonds to have positive real returns (maybe not in the current economic climate, but in general).

You did not specify TIPS in your sexy example with a 100% coupon rate. Tips also have risks. I think opportunity cost is one mentioned. They tend to under perform in declining inflation environment versus treasuries. Also changes in interest rates can cause the value on the secondary market to drop just like a standard bond can, putting initial investment at risk. The coupon rate remains the same. It is the principle value that changes based upon consumer price index. If you had to liquidate the TIP prior to maturity you could lose money. They also have to pay taxes on phantom income, which is the increase of principle amount due to inflation.

In short buy a 10 year TIP in a high interest environment, pay your taxes on the increased principle, which you don't actually receive until the 10 years are up. Recession hits year 5, inflation drops to negative. Lose your job and have to sell the bond in a deflationary environment. You think you would be ahead or behind in initial investment?

Your imaginary scenario which either has a 1 year 100% coupon rate, or a 1 year and extremely crazy inflation rate, is not realistic nor account for real risk with TIP investments.
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8/10/2015 3:57:36 PM
Posted: 1 year ago
You did not specify TIPS in your sexy example with a 100% coupon rate. Tips also have risks. I think opportunity cost is one mentioned. They tend to under perform in declining inflation environment versus treasuries. Also changes in interest rates can cause the value on the secondary market to drop just like a standard bond can, putting initial investment at risk. The coupon rate remains the same. It is the principle value that changes based upon consumer price index. If you had to liquidate the TIP prior to maturity you could lose money. They also have to pay taxes on phantom income, which is the increase of principle amount due to inflation.

TIPS underperforms relative to regular securities when inflation declines; but in real terms you almost always gain money (unless TIPS has negative interest, which is rare). In real terms, you may lose money with a regular security because of inflation risk.

In short buy a 10 year TIP in a high interest environment, pay your taxes on the increased principle, which you don't actually receive until the 10 years are up. Recession hits year 5, inflation drops to negative. Lose your job and have to sell the bond in a deflationary environment. You think you would be ahead or behind in initial investment?

Well, in real, before-tax terms you still gained money, right? Only when compared to the best possible investment does this lose out- but the best possible investment had inflation risk- and could have lost money in real terms.

Your imaginary scenario which either has a 1 year 100% coupon rate, or a 1 year and extremely crazy inflation rate, is not realistic nor account for real risk with TIP investments.

What I meant was that the 100% was the coupon rate. Inflation could be whatever- since that doesn't matter much with TIPS, right? As far as risk goes, you can never lose out on real money with TIPS unless you can't get a positive rate. Really the inflation risk with regular securities and the interest rate risk with TIPS count the same risk- the risk that TIPS don't perform at the same level as regular securities.
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8/10/2015 4:13:15 PM
Posted: 1 year ago
At 8/10/2015 4:53:34 AM, DisKamper wrote:

Ok, I think I see what you're saying. When profits increase for a company, better goods are available to buy at a later date. Their prices increase by some factor- and if I had invested in that company I would be able to keep up with *their* price increases. If I invested in a company with lower returns then paying for the relatively successful company's products would be a bit more difficult for me.

Exactly

In practice, the right side is greater than the left

I'm not sure I'm convinced this is the case.

The preference for consumption today over some future is probably not to big- probably not enough to, say, justify being able to buy 2% more goods and services in just a single year.

I'm really not sure where the 2 percent comes from, especially when we can't really equate the yield on a bond to 2 percent more goods and services. If we wanted to compare it PV terms to the amount of goods and services we could purchase by consuming now as opposed to later, we could do so, but that would of course factor in return, the face value of the bond, etc., any dividends we might receive from holding a stock etc., and we'd need to discount all of those future cash flows back to the present. In many cases, if we were to do that, we find that the security is undervalued, which presents an opportunity for arbitrage: basically, we hold constant the level of risk, and short sale a security with a lower expected return to take a long position on a security with a higher expected return. In many cases, because securities are often mispriced, investors can profit substantially off of them -- and this often takes place in high-frequency trading scenarios.

The security is almost always undervalued if we look at it that way, right?

Not necessarily; they could actually have overvalued, though investors have different ways of calculating that so there's often disagreement. A security is undervalued if it's expected return is greater than its required return. If, for instance, historical data from the company suggests that you'll earn 3 percent return, but based on the CAPM formula you should only require a 2 percent return given its risk, the stock is technically undervalued. Likewise, if you expected less of a return than you require, the stock is overvalued, and thus you probably wouldn't invest in it.

There are only a limited number of securities that are not undervalued,

I'm not convinced that this is the case. What makes you say this?

and by definition an investment can't be overvalued, right (since we are always comparing to the best possible way to use money)?

No, I think it can be. In theory, you would think if we were actually pricing stocks correctly by accounting perfectly for risk and future cash flows, then sure this wouldn't be the case, though often we're wrong -- and, not to mention, unforeseen shocks can completely throw off the risk calculus.

Thus, there is almost always potential for arbitrage, with the only exception being if all investment present equal rates of return after taking into account factors like risk.

I agree that there is usually always a potential for arbitrage, though that's mainly because this discussion of the highest return per some constant level of risk -- or lowest level of risk per some constant level of return -- is highly theoretical in nature, and financial markets are inherently imperfect, so pricing tends to be fickle.

I think I can address the other issues with this thought experiment: suppose the economy consists of a single profit making company. When I invest in it they are able to come up with better products. I get some rate of return.

Sounds good so far.

To simplify things let's say there is no risk (must there be risk?).

For the sake of the example, I'll go with it, though in the case of a private company there is usually *some* degree of risk. There's even a risk with longer-term Treasuries: interest rate risk, inflation risk, liquidity issues, etc.

Maybe we can assume normal goods, if that matters.

Thank goodness I took Micro long enough to know what that means, lol.

They also sell their better products at higher prices.That means there is some positive inflation rate, right? (Of course, the price increase rates for various products will be different depending on how much innovation is really possible).

It doesn't necessarily mean that, because inflation is the *growth* rate of prices, and it's an average based on some weighted basket of goods and services people buy. If they bought 9 units of some good whose price is declining and 1 unit of the better product, the basket would show deflation. But, for the sake of argument, let's say that prices rise at a fairly gradual rate and that inflation is positive.

Is the rate of return from the company greater than less than or equal to the inflation rate?

It certainly wouldn't be less than that in nominal terms, because then real rates would be negative. From there, that would depend a lot on fundamentals and the returns people could earn elsewhere by making any profitable spending decision. Risk would also come in to some degree. But I'm inclined to think the actual return would exceed the inflation rate.

In other words: Let's say that before I could buy some basket of goods and services. After investment can I buy more or less than an improved basket of goods and services?

I think there are a lot of moving parts there, but assuming a positive level of risk, no unforeseen negative outcomes, and that inflation doesn't severely lag expectations, you could probably buy more -- but also acknowledge that wealth accumulates over time (i.e., if you didn't put your money in that investment, you probably could've created wealth elsewhere) and as time goes on and people innovate, prices tend to fall, so that itself would lead to a higher real balance of goods in the basket.

If the former is true then what justifies it? Is there an opportunity cost hidden somewhere in this investment? Is the latter even possible?

Yeah, I think the opportunity cost is the ability to make that investment yourself in some project or in some other idea. E.g., I could invest in Google versus a Treasury bond, or IBM versus Facebook, etc. I don't have a crystal ball, so I don't know which will do better, but obviously all of those investments are fairly low risk, and thus relative pricing wouldn't deviate that much, though if I invested in a start-up I'd demand a higher return because it's more likely to go bust. Even if I were to invest in, say, Greek bonds, I'd demand a giant risk premium because Greece may default. The example gets a bit muted if we assume away risk, which obviously we wouldn't do in the real world because it always exists in some form.

How does the Federal Reserve play into this hypothetical scenario? They have a degree of influence over rates to stabilize employment and prices. Is that their goal, or is it to keep real rates at some set value close to or equal to zero (or are the two goals equivalent)?

It's to stabilize employment and prices, and the actual level of that the interest rate is less important than rates relative to the equilibrium rate, so they wouldn't necessarily want to keep it near zero, though if the equilibrium rate is zero over the longer run, they'd probably want to keep it there to stabilize inflation. A third leg of their mandate is "moderate long term interest rates," but they don't really tell us what "moderate" means, and usually assume that this goal follows from stable employment and prices. The implication, I think, is that unemployment near the natural rate will yield a funds rate at the long-run equilibrium and that stable inflation expectations will result in stable long-term bond prices.
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8/10/2015 4:41:32 PM
Posted: 1 year ago
At 8/10/2015 3:57:36 PM, DisKamper wrote:
You did not specify TIPS in your sexy example with a 100% coupon rate. Tips also have risks. I think opportunity cost is one mentioned. They tend to under perform in declining inflation environment versus treasuries. Also changes in interest rates can cause the value on the secondary market to drop just like a standard bond can, putting initial investment at risk. The coupon rate remains the same. It is the principle value that changes based upon consumer price index. If you had to liquidate the TIP prior to maturity you could lose money. They also have to pay taxes on phantom income, which is the increase of principle amount due to inflation.

TIPS underperforms relative to regular securities when inflation declines; but in real terms you almost always gain money (unless TIPS has negative interest, which is rare). In real terms, you may lose money with a regular security because of inflation risk.

In short buy a 10 year TIP in a high interest environment, pay your taxes on the increased principle, which you don't actually receive until the 10 years are up. Recession hits year 5, inflation drops to negative. Lose your job and have to sell the bond in a deflationary environment. You think you would be ahead or behind in initial investment?

Well, in real, before-tax terms you still gained money, right? Only when compared to the best possible investment does this lose out- but the best possible investment had inflation risk- and could have lost money in real terms.

It all depends upon your selling price, which depends upon the coupon rate on the TIP and the inflation outlook.

Your imaginary scenario which either has a 1 year 100% coupon rate, or a 1 year and extremely crazy inflation rate, is not realistic nor account for real risk with TIP investments.

What I meant was that the 100% was the coupon rate. Inflation could be whatever- since that doesn't matter much with TIPS, right? As far as risk goes, you can never lose out on real money with TIPS unless you can't get a positive rate. Really the inflation risk with regular securities and the interest rate risk with TIPS count the same risk- the risk that TIPS don't perform at the same level as regular securities.
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8/11/2015 5:06:02 AM
Posted: 1 year ago
How does the Federal Reserve play into this hypothetical scenario? They have a degree of influence over rates to stabilize employment and prices. Is that their goal, or is it to keep real rates at some set value close to or equal to zero (or are the two goals equivalent)?
It's to stabilize employment and prices, and the actual level of that the interest rate is less important than rates relative to the equilibrium rate, so they wouldn't necessarily want to keep it near zero, though if the equilibrium rate is zero over the longer run, they'd probably want to keep it there to stabilize inflation. A third leg of their mandate is "moderate long term interest rates," but they don't really tell us what "moderate" means, and usually assume that this goal follows from stable employment and prices. The implication, I think, is that unemployment near the natural rate will yield a funds rate at the long-run equilibrium and that stable inflation expectations will result in stable long-term bond prices.

So why isn't their goal to stabilize real rates? Does the causation only go one way?

Looking at the Taylor rule:

(interest) = (current inflation) + (assumed equilibrium real interest rate) + p*(current inflation-ideal inflation) + q*ln(current GDP/ ideal GDP)

As far as the equilibrium real interest rate, I think I get why it could be non-zero. In the long term: consumers may expect better goods and services at a future date. Investors are, of course, eager to invest in the most promising projects because they offer the best returns. Innovators may be willing to borrow money at real rates greater than 0 because they are pretty confident of their ability to make higher profits in the future with some investment. In this environment, people are eager to earn money sooner rather than later- since they can use it in these productive ways. It all seems fair as far as interest rates go (if people are so confident of being able to grow their profits, there probably is not enough competition, but that's a different issue altogether).

Ok, so why are p and q not both 0 in the Taylor rule? Maybe making p and q non zero helps the Fed achieve its employment and price goals, via the q and p term respectively, but why are keeping these stable important? Why isn't keeping interest rates equal to the equilibrium rate the most important factor? What are the ideal values for p and q and why? I suppose this more a question of what the goals of monetary policy should be.