The Interest-Rate Enigma

Claudio Borio, Piti Disyatat

JUN 11, 2014

Newsart for The Interest-Rate Enigma


BASELToday, the United States government can borrow for ten years at a fixed rate of around 2.5%. Adjusted for expected inflation, this translates into a real borrowing cost of under 0.5%. A year ago, real rates were actually negative. And, with low interest rates dominating the developed world, many worry that an era of secular stagnation has begun.

How problematic low real rates are depends on the reason for their decline. The prevailing view is that the downward trend largely reflects a fall in equilibrium or “naturalinterest rates, driven by changes in saving and investment fundamentals. In other words, a higher propensity to save in emerging economies, together with investors’ growing preference for safe assets, has increased the supply of saving worldwide, even as weak growth prospects and heightened uncertainty in advanced economies have depressed investment demand.

This perceived decline in “naturalinterest rates is viewed as a key obstacle to economic recovery, because it impedes monetary policy’s capacity to provide sufficient stimulus by pushing real rates below the equilibrium level, owing to the zero lower bound on nominal rates. How to stem the decline in equilibrium rates has thus become the subject of lively debate.

Conspicuously absent from the debate, however, is the role of financial factors in explaining the trend decline in real rates. After all, interest rates are not determined by some invisible natural force; they are set by people. Central banks pin down the short end of the yield curve, while financial-market participants price longer-dated yields based on how they expect monetary policy to respond to future inflation and growth, taking into account associated risks. Observed real interest rates are measured by deducting expected inflation from these nominal rates.

Thus, at any given point in time, interest rates reflect the interplay between the central bank’s reaction function and private-sector beliefs. By identifying the evolution of real interest rates with saving and investment fundamentals, the implicit assumption is that the central bank and financial markets can roughly track the evolution of the equilibrium real rate over time.

But this is by no means straightforward. For central banks, measuring the equilibrium interest ratean abstract concept that cannot be observed – is a formidable challenge. To steer rates in the right direction, central banks typically rely on estimates of unobserved variables, including the equilibrium real rate itself, potential output, and trend unemployment. These estimates are highly uncertain, strongly model-dependent, and subject to large revisions.

Moreover, central banks’ policy frameworks may be incomplete. By focusing largely on short-term inflation and output stabilization, monetary policy may not pay sufficient attention to financial developments. Given that the financial cycle is much more drawn out than the business cycle, typical policy horizons may not allow the authorities to account adequately for the impact of their decisions on future economic outcomes. The fact that financial booms and busts can occur amid relatively stable inflation does not help.

With financial-market participants as much in the dark as central banks, things can go badly wrong. And so they have. Over the last three decades, several credit-induced boom-bust episodes have caused major, sustained damage to the global economy. It is difficult to square this reality with the view that interest rates, which set the price of leverage, have been on an equilibrium path all along.

The focus on fundamental saving and investment determinants of interest rates is entirely logical from the perspective of mainstream macroeconomic models, which assume that money and finance are irrelevant (“neutral”) for the output path in the long run. But successive crises have shown that finance can have long-lasting effects. Financial factors, especially leverage, not only can amplify cyclical fluctuations; they can also propel the economy away from a sustainable growth path. Indeed, a growing body of evidence shows that output is permanently lower in the wake of a financial crisis.

All of this suggests that the trend decline in real interest rates does not just passively mirror changes in underlying macroeconomic fundamentals. On the contrary, it also helps drive them. Low interest rates can sow the seeds of financial booms and busts.

Policies that do not lean against the booms but ease aggressively and persistently during busts induce a downward bias in interest rates over time, and an upward bias in debt levels. This creates something akin to a debt trap, in which it is difficult to raise rates without damaging the economy. The accumulation of debt and the distortions in production and investment patterns induced by persistently low interest rates hinder the return of those rates to more normal levels. Low rates thus become self-reinforcing.

This alternative perspective highlights the trade-off inherent in ultra-accommodative monetary policy. Monetary policy cannot overcome structural impediments to growth. But the actions that central banks take today can affect real macroeconomic developments in the long term, primarily through their impact on the financial cycle. These medium- to long-term side effects need to be weighed carefully against the benefits of short-term stimulus. While low interest rates may be a natural response to perceptions of a chronic demand shortfall, such perceptions are not always correct – and can be very costly over time.

Laying the foundations of a sustained recovery requires measures to strengthen public- and private-sector balance sheets, together with structural reforms aimed at raising productivity and improving growth potential. More stimulus may boost output in the short run, but it can also exacerbate the problem, thus compelling even larger dosages over time. An unhealthy dependence on painkillers can be avoided, but only if we recognize the risk in time.


Claudio Borio is Head of the Monetary and Economic Department at the Bank for International Settlements.


Piti Disyatat is Director of Research at the Bank of Thailand.


June 11, 2014, 11:47 AM ET

U.S. Economy’s First-Quarter Contraction Could Be Even Worse Than You Thought

ByBen Leubsdorf




The U.S. economy may have contracted more than previously thought during the first three months of 2014, private economists said Wednesday based on new health care-sector data from the government.

Some analysts said economic output may have contracted at a 2% pace in the first quarter. That would be its worst performance since the recession.

The Commerce Department’s latest estimate of gross domestic product, the broadest measure of output across the economy, said GDP shrank at a seasonally adjusted annual rate of 1% in the first quarter. A revised estimate will be released June 25, and it could show an even larger contraction.

That’s based on the Commerce Department’s Quarterly Estimates for Selected Service Industries report for the first quarter, released Wednesday. It showed that revenue in the U.S. health-care and social-assistance sector fell 2% in the first quarter from the fourth quarter of 2013, not adjusted for seasonal variations or price changes. Hospital revenue fell a seasonally adjusted 1.3% from the prior quarter.

The Commerce Department’s last GDP report, though, said inflation-adjusted spending on health-care services surged to a seasonally adjusted annual level of $1.848 trillion in the first quarter from $1.808 trillion in the fourth quarter of 2013. That estimate for spending on health care boosted overall GDP growth by 1.01 percentage point, keeping the 1% contraction from being even worse.

J.P. Morgan Chase economist Daniel Silver and Pierpont Securities economist Stephen Stanley both cautioned that it’s not clear exactly how the Commerce Department will adjust GDP to account for the new health-care services data.

But they and other analysts downgraded their estimates for the first quarter based on the new survey, as well as other recently released data. Mr. Silver predicted GDP declined at a 1.6% pace in the first three months of the year. Mr. Stanley predicted contraction at a 2% paceMacroeconomic Advisers also estimated GDP shrank at a 2% pace.

Ouch,” Mr. Stanley said in a note to clients.


Rethinking Democracy

Dani Rodrik

JUN 11, 2014
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Newsart for Rethinking Democracy


PRINCETONBy many measures, the world has never been more democratic. Virtually every government at least pays lip service to democracy and human rights. Though elections may not be free and fair, massive electoral manipulation is rare and the days when only males, whites, or the rich could vote are long gone

Freedom House’s global surveys show a steady increase from the 1970s in the share of countries that arefree” – a trend that the late Harvard political scientist Samuel Huntington dubbed the “third wave” of democratization.

The dissemination of democratic norms from the advanced countries of the West to the rest of the world has been perhaps the most significant benefit of globalization. Yet not all is well with democracy. Today’s democratic governments perform poorly, and their future remains very much in doubt.

In the advanced countries, dissatisfaction with government stems from its inability to deliver effective economic policies for growth and inclusion. In the newer democracies of the developing world, failure to safeguard civil liberties and political freedom is an additional source of discontent.

A true democracy, one that combines majority rule with respect for minority rights, requires two sets of institutions. First, institutions of representation, such as political parties, parliaments, and electoral systems, are needed to elicit popular preferences and turn them into policy action

Second, democracy requires institutions of restraint, such as an independent judiciary and media, to uphold fundamental rights like freedom of speech and prevent governments from abusing their power. Representation without restraintelections without the rule of law – is a recipe for the tyranny of the majority.

Democracy in this sensewhat many call liberal democracy” – flourished only after the emergence of the nation-state and the popular upheaval and mobilization produced by the Industrial Revolution. So it should come as no surprise that the crisis of liberal democracy that many of its oldest practitioners currently are experiencing is a reflection of the stress under which the nation-state finds itself.

The attack on the nation-state comes from above and below. Economic globalization has blunted the instruments of national economic policy and weakened the traditional mechanisms of transfers and redistribution that strengthened social inclusion

Moreover, policymakers often hide behind (real or imagined) competitive pressures emanating from the global economy to justify their lack of responsiveness to popular demands, and cite the same pressures when implementing unpopular policies such as fiscal austerity.

One consequence has been the rise of extremist groups in Europe. At the same time, regional separatist movements such as those in Catalonia and Scotland challenge the legitimacy of nation-states as they are currently configured and seek their breakup. Whether they do too much or too little, many national governments face a crisis of representation.

In developing countries, it is more often the institutions of restraint that are failing. Governments that come to power through the ballot box often become corrupt and power-hungry

They replicate the practices of the elitist regimes they replaced, clamping down on the press and civil liberties and emasculating (or capturing) the judiciary. The result has been calledilliberal democracy” or “competitive authoritarianism.” Venezuela, Turkey, Egypt, and Thailand are some of the better-known recent examples.

When democracy fails to deliver economically or politically, perhaps it is to be expected that some people will look for authoritarian solutions. And, for many economists, delegating economic policy to technocratic bodies in order to insulate them from the “folly of the massesalmost always is the preferred approach.

With its independent central bank and fiscal rules, the European Union has already traveled far along this road. In India, businessmen look wistfully at China and wish their leaders could act just as boldly and decisively that is, more autocratically – to address the country’s reform challenges. In countries like Egypt and Thailand, military intervention is viewed as a temporary necessity in order to put an end to the irresponsibility of elected leaders.

These autocratic responses are ultimately self-defeating, because they deepen the democratic malaise. In Europe, economic policy needs more democratic legitimacy, not less. This can be achieved either by significantly strengthening democratic deliberation and accountability at the EU level, or by increasing the autonomy of the member states to set economic policy.

In other words, Europe faces a choice between more political union and less economic union. As long as it delays making the choice, democracy will suffer.

In developing countries, military intervention in national politics undermines long-term prospects for democracy, because it impedes the development of the necessary culture,” including habits of moderation and compromise among competing civilian groups. As long as the military remains the ultimate political arbiter, these groups focus their strategies on the military rather than one another.

Effective institutions of restraint do not emerge overnight; and it might seem like those in power would never want to create them. But if there is some likelihood that I will be voted out of office and that the opposition will take over, such institutions will protect me from others’ abuses tomorrow as much as they protect others from my abuses today. So strong prospects for sustained political competition are a key prerequisite for illiberal democracies to turn into liberal ones over time.

Optimists believe that new technologies and modes of governance will resolve all problems and send democracies centered on the nation-state the way of the horse-drawn carriage. Pessimists fear that today’s liberal democracies will be no match for the external challenges mounted by illiberal states like China and Russia, which are guided only by hardnosed realpolitik. Either way, if democracy is to have a future, it will need to be rethought.


Dani Rodrik is Professor of Social Science at the Institute for Advanced Study, Princeton, New Jersey. He is the author of One Economics, Many Recipes: Globalization, Institutions, and Economic Growth and, most recently, The Globalization Paradox: Democracy and the Future of the World Economy.


Is Silver Set Up For A Huge Short Squeeze?

Jun. 12, 2014 6:53 PM ET

by: Dave Kranzler


  • The hedge fund gross short position in Comex silver futures is at a record high.
  • Hedge funds are net short a record amount of silver futures.
  • Producer/Merchants hedging is near a record low.
  • Backwardation in silver futures has been observed in China.

An interesting and rare set-up has developed in the Comex silver futures Commitment of Traders weekly position report (COT report). This is a report issued by the CFTC (Commodity Futures Trading Commission) which shows the long/short futures positions for various categories of traders. The position report issued last Friday for Comex silver futures traders shows extreme positioning for both the "commercial" and "managed money" segments. In addition, there are signs of possible supply/demand stress for physical silver in China. As I will detail below, both indicators are indicative of a possible short squeeze developing in silver.

First, I suggested in some previous articles on Seeking Alpha that the low-close last June was a defined bottom for silver. As you can see from this chart, silver has trended quietly higher off its June 26, 2013 low-close of $18.53:


(click to enlarge)


Silver is roughly 1% above the June 2013 low, with several successful retests of the low-close price a year ago.

While last June's low is not guaranteed to be a bottom, if you examine the latest COT report, it would appear as if the silver market is set up for a significant move higher, possibly fueled by the advent of a short squeeze. If you open that COT report link and scroll down to the silver futures section, you'll see categories labeled "Producer Merchant, Swap Dealers, Managed Money (hedge funds), etc." You'll also see the long and short positions in silver futures and, below that, the weekly position change in position for each trader segment.

Currently, the Producer/Merchant segment has its lowest net short position going back to at least the beginning of January 2008 (the following charts are from GotGoldReport.com, any edits in red are mine):




The trader segment consists primarily of mining companies, industrial users of silver and Comex market maker banks. If the net short position is low on a relative basis, it implies that mining companies and industrial companies have significantly reduced their hedging of production/inventory. It also suggests that market makers on the Comex have reduced their short positions. I would opine that this relatively extreme low short position has developed because these sophisticated futures traders believe that the probability of a move higher in silver far outweighs the probability that silver moves lower.

Conversely, the "Managed Money" hedge fund trader segment is now sitting with a record level of gross and net short futures positions:




As you can see from these two charts, the hedge funds are sitting with extreme levels of gross and net short positions. This positioning is of historical proportions on the Comex. Currently, the hedge funds are net short 7,638 contracts, up from 4,226 contracts the week before. I pulled up the COT data going back to 2006, and found that the hedge funds have been net short only three other times: 3,775 as of 12/3/13; 425/657 for the two weeks in 6/2013; and 92 as of 9/4/07.

Prior to 2006 the CFTC did not provide detailed trader segment data, making it impossible to tell if the hedge funds were net short at all prior to 2006. However, open interest levels of silver futures were much lower back then, which suggests that even if the hedge funds were net short at some point prior to 2006, the short position was small.

Historically, the price of silver has made big moves higher when the commercial segment (producers, swap dealers, banks) have assumed a relatively low net short position and the hedge funds have assumed relatively low net long positions. That the commercial traders are close to a record low net short position and the hedge funds are sitting with a historically extreme net short position suggests to me that there's a high probability that silver will move a lot higher from here.

Furthermore, if the price of silver starts to move higher like I expect, we could see the process accelerate due to short-covering. Because the hedge funds are short silver futures, they would have to deliver physical silver to their long counterparty if they continue to hold their short positions into the July delivery period. 50% of the silver futures open interest is concentrated in the July "front month" contract. It is unlikely that the hedge funds will actually stand short and deliver physical silver and thus, if the price is moving higher into the commencement of the July delivery period at the end of June, we could see a short-covering frenzy of buying which would drive the price a lot higher.

Whether or not the higher price level from this is sustainable is another matter. However, recently there have been indications in Shanghai that the availability of physical silver is getting tight. I showed in this article that an enormous amount of physical silver has been removed from the Shanghai Futures Exchange since February. Spot premiums for silver have been running at 6% above the world spot price of silver in Shanghai over the past week. In addition, the condition of "backwardation" (the spot price is higher than the futures price) was observed last week when the current delivery month futures contract was trading at a higher price than the December futures contract. Backwardation in commodities futures is indicative of supply shortages in the underlying physical commodity.

If the supply of silver is starting to get tight in China, I believe that it is likely that price of silver globally will be forced higher from the forces of supply and demand. Please note that evidence shows that the Chinese are taking physical delivery of the silver they are buying via Shanghai silver futures. If spot price premiums are above the global spot price, and if backwardation is occurring in the futures price curve, it demonstrably indicates a supply shortage of physical silver in China. If China's silver demand drives the price higher, that higher price will likely transmit globally and possibly further trigger a short-cover squeeze on the Comex.

In the context of my analysis, I believe silver will move a lot higher in price from here. I also believe silver will experience significantly higher rates of return than gold over the next few years. The safest way to play silver is to buy 1 oz U.S. minted silver eagles and keep them under your own lock and key. If you want to "index" the price of silver for a shorter-term trading play, I recommend buying the iShares Silver ETF (SLV). If you want to leverage SLV you can always buy call options on it. More aggressive traders can get long ProShares Ultra Silver ETF (AGQ), or VelocityShares 3x Long Silver ETN (USLV). I offer some individual stock research ideas on my website (you can access from Seeking Alpha profile).