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46:05
Transcript
0:16
let me um continue with the eslm PC
0:20
model in fact I want to I Rush a little
0:23
because I was over excited with the svb
0:26
bank event H and and I want to make sure
0:30
that you
0:31
certainly understand this this mle it's
0:34
going to be very
0:36
important and I think it's one of the
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0:38
most important moles in in this course
0:40
as I said
0:41
before also I want to use a little bit
0:45
more the this Mo itself to explain what
0:47
is going on right now today we got hit
0:49
by a second shock from the financial
0:51
system and uh so so it's getting it's
0:55
getting exciting these days so let me
0:59
skip all this and remind you that that's
1:02
what we we that's that's the ISL MPC
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1:05
model which I said is nothing else and
1:08
just integrating the islm analysis with
1:11
the Philips curve this is the part and I
1:13
said and at this point I will follow the
1:16
book and and assume that the central
1:18
bank can control the real interest rate
1:20
rather than the nominal interest rate
1:22
which is what really controls in
1:23
practice H but I'm going to make that
1:26
assumption so the pictures have less
1:27
curves moving around when when things
1:29
are mov moving H as when we do Dynamics
1:33
okay but that's just a eslm nothing
1:37
different um then we look at the Philips
1:42
curve and I said well we can we can uh I
1:46
this is not very useful because you know
1:48
in the as part I have output here and in
1:52
the Philips curves I have inflation but
1:54
then I have an employment and I don't
1:55
want to be carrying around sort of three
1:57
variables endogenous variables
2:00
ER and and and so it's you know it's
2:03
difficult to diagrams in in three
2:05
dimension is everything less clear so
2:07
I'm going to replace H this unemployment
2:11
here for for output and it's very easy
2:14
to do that with the production function
2:15
we have because output is just equal to
2:18
employment and employment is just equal
2:21
to the labor force time one minus the
2:23
rate of unemployment and we could Define
2:25
a concept of potential output as simply
2:28
that output that happens when employment
2:30
is equal to the Natural level of
2:32
employment which is equal to the labor
2:34
force Time 1 minus the natural rate of
2:37
unemployment and taking the difference
2:39
subtracting the second line from the
2:41
first one you get a concept that is used
2:43
very frequently in microeconomics which
2:45
is called is a concept of the output gap
2:47
an output Gap refers to the difference
2:49
between actual output and potential
2:51
output in which potential output is
2:53
nothing else of the level of output that
2:55
you get when employment when an
2:57
employment is at the natural rate of an
2:59
employment
3:00
so we get this output Gap is related to
3:02
the employment gap and now we can
3:05
replace the employment gap from here
3:08
with the output Gap and we end up with a
3:11
Philip Cur in the space of inflation and
3:13
output gap which is something we can
3:16
integrate very easily withm model that
3:19
has output in it okay so that's H so the
3:23
snpc model is
3:25
really combining this equation with that
3:29
equation and some model about expected
3:31
inflation that's what the MPC model is
3:35
so I gave you one example here one model
3:38
of inflation this is a case of that
3:40
central banks do not like the an Anor
3:42
unanchor inflation expectation that's my
3:45
model of expectation then my Philips
3:47
curve I plug this into my Philips curve
3:50
and I get this relationship between the
3:52
change in inflation and the output Gap
3:55
and it's an increasing relationship and
3:57
that's what I'm plotting here for any
3:59
given
4:00
level for any given level of YN then as
4:03
a increase output the Philips curve the
4:07
change in inflation the left hand side
4:09
the difference between inflation expect
4:10
to inflation Rises that's the reason
4:12
this upward is sloping and the reason
4:14
this Rises has to do with all the things
4:16
that happen in the labor market no if an
4:18
employment if output Rises meaning an
4:21
employment is falling you need more
4:23
employment to produce more output if
4:24
that's the case it's more wage pressure
4:26
that leads to a price pressure because
4:29
there is a the market in between wages
4:30
and prices and that's the way you get
4:33
into inflation okay so I gave you one
4:37
example says okay
4:40
suppose that we have some equilibrium
4:42
level of output this which is the result
4:45
of this monetary policy this rate set by
4:48
by by the central bank and and that's
4:52
the is which is a function of you know
4:54
the fiscal policy of the country how
4:55
confident are consumers and all these
4:57
kind of things so in quiz one we really
5:01
worry only about this top diagram okay
5:03
and all the shocks we had were shocks
5:05
that happen in this top diagram and we
5:08
and we look at what happened to Output
5:10
to equilibrium output as a
5:12
result now this hasn't changed it hasn't
5:15
change that block is the same as it used
5:17
to be the only difference that we have
5:19
here is that this level of output H
5:22
which is the equilibrium level of output
5:24
at any point in time needs not be equal
5:26
to potential output and if it is not
5:28
equal to potential output that will lead
5:30
to something with inflation either
5:32
inflation disinflation or something of
5:34
that kind in this particular case the
5:37
equilibrium level of output which is
5:39
still determined as we used to determine
5:40
it happens to be higher than the natural
5:43
rate of
5:44
output and if if output is higher than
5:47
the rate of output that means this is
5:50
positive which means inflation is rising
5:52
and that's exactly what we see here it
5:55
means inflation is above expected
5:56
inflation when expected inflation is
5:58
equal to lag inflation
6:00
then that means inflation is rising okay
6:03
and that's what we have
6:05
here so any question about that so this
6:08
is we just what we did is kept analysis
6:11
we used to have and now we added this
6:14
diagram here at the bottom because it
6:16
turns out that yes any equilibrium here
6:19
if I move the inter around I'm going to
6:21
change the equilibrium level of output
6:22
those all those are equilibrium levels
6:24
output but that doesn't mean that that
6:27
they're consistent with the natural ER H
6:29
with potential output and if it's not
6:32
equal to potential output it's a valid
6:34
equilibrium at any point in time but
6:35
it's going to lead to issues on the
6:38
inflation front that's all that the the
6:40
second diagram here tells you that we
6:43
get issues on the inflation front with
6:46
any equilibrium level of output that is
6:49
different from the natural rate of
6:51
output that's what this diagram
6:54
does so then I said well and that's what
6:57
happen in the short run that's what it
6:58
does so we keep doing what we used to do
7:00
in the first seven lectures or so and uh
7:04
this diagram just tells us what are the
7:05
implications for inflation that's in the
7:07
short run the medium run we said is when
7:10
we is that process in which output
7:13
converges back to the Natural rate to
7:16
potential output how does that happen
7:19
well it involves the central bank but
7:22
it's not that the central bank is doing
7:23
crazyy things effect Central Bank is
7:25
reacting to what the economy is telling
7:27
it needs to do here is a central bank
7:29
that supposed had
7:31
was before doing whatever change in the
7:33
interest rate or in the deliver this
7:36
equilibrium output here had an inflation
7:38
of around 2% that was consistent with
7:40
the target it had now suddenly it finds
7:42
itself in a situation like this and
7:44
inflation starts climbing okay you get
7:47
3% one year 4% the next one 6 nine in a
7:51
situation like that well it's very
7:53
natural for that Central Bank if it's a
7:54
responsible Central Bank to react to
7:56
that and the only reaction a central
7:58
bank can have
8:00
the main the main reaction can have is
8:01
to raise interest rates okay and that's
8:03
exactly what it starts happening if the
8:05
Central Bank finds itself with inflation
8:07
in this Cas is that is accelerating it
8:10
will start increasing interest rate and
8:13
this process of acceleration of
8:14
inflation in this case would only stop
8:17
when output is equal to the Natural to
8:19
potential output okay and output is
8:22
equal we can Define implicitly what that
8:25
interest rate is and we can call it the
8:26
natural rate of interest rate sometimes
8:28
we call it we sell
8:30
interest rate of interest rate neutral
8:32
interest rate R star lots of names for
8:35
this interest rate but this interest is
8:37
simply the one that gives us an
8:39
equilibrium output in our asln diagram
8:41
that is equal to potential output that's
8:46
that's all that this RN means and here
8:48
I'm solving it you know it's is the rate
8:51
that implicitly gives us an equilibrium
8:53
output here H that is equal to the
8:55
Natural rate of output okay that defines
8:58
it implicitly
8:59
okay there we are is all that
9:04
clear yes okay I think you're going to
9:07
have a a big chunk of your current pie
9:09
set is about this model and so on and
9:12
and that's a good thing and you'll see
9:13
it also in the next one this again I
9:15
think this is important then I talk
9:17
about the difference between anchor and
9:20
an anchor expectations I said look here
9:23
we have a situation that suppose we
9:25
started at 2% and then we found ourself
9:28
in a situation like that that means
9:30
inflation start building up we got to 9%
9:33
or so so now the FED gets scared and it
9:35
starts raising interest rates so that's
9:37
what we're moving up lower in output and
9:39
as it lowers output reduces the output
9:41
Gap and therefore reduces the change in
9:45
inflation here but inflation keeps
9:47
rising in this particular model because
9:49
expected inflation is an anchor and I
9:52
said well suppose that eventually the
9:53
FED gets to that interest rate here so
9:56
we get to situation like that and I
9:58
asked the question has the FED solved
10:00
the problem now okay finally we got to
10:03
situation where the the interest rate is
10:05
equal to an natural rate of interest
10:07
rate that tells me that output is equal
10:09
to potential output that tells me here
10:11
that inflation is not changing problem
10:14
is that we already had inflation of 9%
10:17
at some point so so here inflation stops
10:20
rising in this particular model with
10:22
expected inflation an anchor expected
10:24
inflation but stopping is not enough
10:27
because that's gives leaves us level of
10:29
inflation of
10:30
9% that means that the FED in order to
10:33
bring back inflation to 2% it needs to
10:36
go into this region so inflation starts
10:39
coming down from 9% 7% 6% 5% and so on
10:44
okay so if you have an anchor
10:46
expectation and and inflation overshoots
10:49
you're going to have to cause a
10:50
recession and probably a severe
10:52
recession there's no way around that and
10:55
that's what the FED has been struggling
10:56
to do is is struggling not to because
10:59
the Fed we are in a situation not only
11:01
in the US but in the US in particular
11:03
where inflation is way above the target
11:05
level H but expected inflation has been
11:08
more or less stable and so this when
11:11
people talk about being able to restore
11:14
sort of reasonable levels of inflation
11:17
in a soft landed manner with a soft
11:20
Landing that means that you don't need
11:22
to cost a b recession to bring inflation
11:25
back to 2% you just can bring it
11:28
smoothly here with this model of
11:30
expected inflation doesn't work but if
11:32
expect if the Bank Central Bank has
11:34
credibility H and inflation remain Anor
11:37
people continue to believe that the FED
11:39
will go back to 2% then you don't need
11:41
to cause a big recession otherwise you
11:43
need to invest in bringing expectations
11:45
down and that the only way you can
11:47
invest in doing that is causing a
11:48
recession okay but that's the reason I
11:51
said central banks worry so much about
11:54
keeping inflation credibility because
11:56
otherwise they need to
11:57
overshoot in order to restore um long
12:03
run balance
12:05
okay
12:07
good
12:09
now you may Wonder well this I mean this
12:12
looks pretty simple to do no just if you
12:15
have a problem like this just go quickly
12:18
to that point there no and then the
12:21
problem is over you don't let inflation
12:23
build to 9% or something like that you
12:26
react immediately the problem is there's
12:28
a f sentence that was going by Milton
12:31
fredman is that monetary policy acts on
12:34
the economy with long and variable lags
12:37
so first of all it's very difficult at
12:39
any point in time to know where is
12:41
potential output or what is the natural
12:43
rate of unemployment I mean you sort of
12:45
sense it but the truth is that the only
12:47
way you really know is is by looking at
12:50
inflation so it's inflation that really
12:52
tells you that you're one side of the
12:53
other it's very difficult to you you
12:56
have some historical average and so on
12:58
but these things do move move around so
13:00
it's difficult at any point in time to
13:01
know whether you you are at our end or
13:04
not the second thing is that here
13:07
everything happens immediately if I move
13:10
immediately then output immediately
13:11
jumps here that's not the way monetary
13:13
policy operates in practice it takes
13:15
time for monetary policy to to to affect
13:18
the economy and so this the situation
13:22
that happened I I would say until last
13:25
week was the FED knew that the inflation
13:28
was still to too high but it but it also
13:31
knew that it had done a lot he had hiked
13:33
rates very aggressively by a lot and
13:35
since there are lags between the the
13:38
increasing interest rate and and the
13:40
declining output the fed's concern was
13:44
well it's clear that I still have
13:45
inflation but it may well be the case
13:47
that when this thing finally hits the
13:49
economy it hits us too much and we end
13:51
up in a recession and an unwanted
13:53
recession that was a concern okay H now
13:58
with what is happening right now there's
13:59
a little bit of a concern that we got to
14:01
that point because things were very slow
14:03
for a variety of reasons but now
14:05
something broke and the question is now
14:08
that something has broken well will we
14:11
sort of decelerate the economy very very
14:13
fast and that's a concern that's what is
14:15
happening right now okay but that's what
14:18
makes monetary policy much more
14:20
difficult than this little diagram is
14:21
that you you have all this lags these
14:23
uncertainties and all these
14:25
nonlinearities and Sly things happen
14:30
okay let me tell you when things can go
14:33
really really wrong it's not the issue
14:35
now but but we're very close to that
14:38
during the global recession Japan has
14:41
experienced several episodes like this
14:43
which is the following suppose you have
14:45
a situation where ER your inflation is
14:50
low typically these things happen in
14:52
situations where your inflation is low
14:54
and for whatever reason your natural
14:57
rate of unemployment is is
14:59
negative so you have inflation close to
15:02
zero say and then the natural rate
15:06
of interest rate is
15:08
negative what's the problem suppose you
15:11
have a zero lower
15:12
bound well if you have a zero lower
15:14
bound means that you're not going to hit
15:16
this
15:17
rate the best you can do if inflation is
15:20
around zero then you set the nominal
15:21
interest rate to zero and then the real
15:23
interest rate is around
15:24
zero well the problem is that at zero
15:29
you generate negative
15:33
inflation but if you generate negative
15:36
inflation and the nominal interest rate
15:38
is fixed at zero then now you get a
15:40
positive real interest rate because the
15:42
real interest rate is equal to the
15:44
nominal interest rate which is zero
15:46
minus inflation expected inflation but
15:49
if expected inflation or inflation is
15:52
negative minus minus is positive so that
15:54
means your real interest rate is
15:56
actually positive so your really you you
15:59
wanted something negative but you end up
16:00
with something
16:02
positive that means now you have a big
16:04
gap
16:05
here so
16:07
inflation you get into a deflation now
16:10
now inflation is very very low it gets
16:11
very negative well your real as
16:14
inflation gets more and more negative
16:16
your real interest keeps climbing so you
16:18
keep moving further and further away
16:20
from the natural rate of interest rate
16:23
that's something that is very scary for
16:26
an economy is a def deflationary trap
16:29
and that's the way you get
16:31
into deep recessions in fact that's what
16:34
happened during the Great Recession in
16:36
the
16:36
US the
16:38
no during the Great Depression in the US
16:42
okay during the Great Recession we were
16:44
close to it but we didn't get quite
16:46
there in in because lots of things were
16:48
done to prevent a repeat of the Great
16:52
Depression the one of the biggest
16:54
problems with the Great Depression ER
16:57
was that ER monetary policy was not
17:01
against the zero lower bound but it was
17:03
very slow to
17:04
react okay they were in a situation like
17:07
in this diagram
17:10
here and and but they kept the interest
17:12
rate high and they moveed very slowly
17:16
and when they tried to catch up well
17:18
they were into deflation environment so
17:20
the real interet was moving away from
17:22
them despite the fact that they were
17:24
moving the nominal interest rate down
17:26
and that you can see here so there the
17:28
Great depression starts around 1929 it
17:31
starts really in
17:33
1929 H an employment initially was low
17:36
then nominal interest rate was around 5%
17:39
and inflation rate growth declined very
17:41
rapidly in inflation rate was around
17:44
zero so you had a one year the real
17:47
interest rate was around 5% as well okay
17:50
well things got worse and employment
17:53
began to climb very rapidly and so the
17:57
FED began to lower interest rates
17:58
nominal interest rate you know it went
18:00
from 5% to 4% those were unusually low
18:04
interest rate for the time but the
18:06
problem is that the inflation by then
18:08
was minus 2 and a half% so the real
18:11
interest rate they were lowering the
18:13
nominal interest rate but the real
18:14
interest rate was rising and
18:16
unemployment accordingly was Rising as
18:19
well it kept going no look see then they
18:23
began to cut the interest rate more
18:24
aggressively okay but but we got into
18:28
real deflation minus 10% or so so the
18:31
real interest rate kept
18:33
climbing at that point was a very poor
18:36
Le time interest rate hike was a
18:39
disaster for unemployment and because it
18:42
really hied the interest rate real
18:44
interest rate even more and eventually
18:46
got got out of it with a bunch of
18:48
policies that were non monetary policies
18:49
but but
18:51
um but that's that's what happened so so
18:53
the Great Depression was very much a
18:55
story of this
18:57
kind in which essentially we get we fall
19:01
fell into depression so that interest
19:03
rate when began to climb and got the
19:05
economy deeper and deeper into recession
19:07
and employment Higher and Higher and so
19:09
on and at some point monetary policy
19:11
just didn't work so that's the reason
19:13
you have essentially do massive fiscal
19:15
policy to get out of
19:19
it let's let me talk about some of the
19:22
shocks we have discussed in the context
19:24
of this more complete model now ER and
19:27
and actually okay let me go let me talk
19:31
about sort of two canonical type shocks
19:33
you can have two broad type of shocks or
19:36
or policies in in this
19:38
Ms that you want to
19:40
analyze some of them are aggregate
19:42
demand either policies or shocks
19:44
whatever those are things that you know
19:46
aggregate demand policies move the is
19:48
curve okay the is and the LM but moves
19:52
operates in the in the in the in the
19:54
Goods Market so this is one case of a
19:57
contractionary f policy no a fiscal
20:00
consolidation so what happens here
20:02
suppose you start an equilibrium level
20:04
of output H equal to Natural rate of
20:07
output but now for whatever reason we're
20:08
running deficits that are very large you
20:10
want to reduce the size of the deficit
20:13
well you move the is to the left no you
20:15
cut government expenditure you increase
20:17
taxes that will bring output below the
20:19
natural rate of output you go to the
20:21
Philips curve here that means inflation
20:23
now you you get into deflationary forces
20:26
or inflation starts declining the result
20:29
of that so in the short run you get
20:30
exactly what we had in lecture five six
20:32
or whatever know you get a contraction
20:35
in real output but on top of that you
20:37
start getting inflation coming down or
20:40
even going negative and as a result of
20:42
that the central bank will react and it
20:45
will react and that reaction will stop
20:47
when in the long run well when output
20:49
goes back to the initial level of output
20:52
it's natural rate of output okay so the
20:54
point of this picture that is new
20:57
relative to things you already knew
20:59
is that in the short run you get very
21:01
much the type of responses we had
21:02
earlier on in the medium run that is
21:05
when now in the medium run you don't get
21:07
that a fiscal consolation does not
21:09
reduce output in the medium Run Okay a
21:12
fiscal consolation what does is reduces
21:14
the real interest rate in the in the in
21:16
the long in the medium run okay so you
21:18
see here output eventually goes back to
21:21
that level with a much lower real
21:23
interest rate and and
21:25
U the the point is sometimes this this
21:29
path this path that takes you output
21:31
down initially and then comes back can
21:33
be very painful it can take a long time
21:36
generate a recession and so on and
21:38
sometimes it can happen in easier
21:41
conditions and be faster and so on many
21:43
of the policies agreements that people
21:45
have people that understand what they're
21:47
talking about had to do with the speed
21:50
at which these things happen so
21:51
sometimes you know people can agree that
21:53
you need a fiscal consolidation but
21:55
someone think no this stuff is going to
21:56
be very slow and so I don't want to
21:59
incur in a very deep recession for very
22:00
long just to adjust a little bit the
22:01
fiscal deficit and others may think the
22:04
opposite okay it's it's mostly about the
22:06
speed but shorter response to a fiscal
22:09
consolidation or to any aggregate demand
22:11
contraction is different than the medium
22:14
ter
22:18
response and again the signals for the
22:21
central bank that it needs to move
22:22
interest rate they all come from this
22:23
block here inflation falling that tells
22:25
the Central Bank oops we may have a
22:28
problem and so on another kind of shock
22:32
that is is is is is more complicated and
22:35
that has played a role actually very
22:37
much in the recovery from covid is some
22:39
sort of supply side shock for example an
22:43
oil shock okay price of energy goes up
22:45
or something like that well that one how
22:49
do you analyze that the a supply size
22:51
shock is not something that comes from
22:53
the that we go to the slm part of the
22:56
mall a supply size shock remember we
22:58
analyze it when we did analyze the
23:00
natural rate of natural rate of
23:01
unemployment it's something that affects
23:03
the supply side of the economy we can
23:06
model that as an increase in the markup
23:09
and we know that an increase in the
23:11
markup will increase the natural rate of
23:14
unemployment that means that that that
23:18
this shock will do what to potential
23:24
output so an energy shock especially if
23:27
it's a persist one will operate like a
23:30
markup shock and that we know will
23:34
increase the natural rate of
23:36
unemployment so what happens to the to
23:39
potential
23:41
output goes down of course it's it's
23:44
know output is equal to employment to
23:46
labor force times 1 minus the natural
23:48
rate of unemployment if the natural rate
23:49
of unemployment goes up then the
23:51
potential output goes down so that is
23:54
not a shift in the top diagram it's a
23:56
shift in the lower diagram it says we
23:58
used to have this Philips curve and now
24:01
the Philips curve has shifted to the
24:03
left because we have a new natural rate
24:06
of an output and remember the natural
24:08
rate of output is that point when a ER
24:12
output equal to the Natural rate of
24:14
output doesn't produce inflationary
24:16
forces okay so what happened with this
24:20
shock here so suppose the economy was in
24:22
this equilibrium here and now it gets
24:25
hit by an oil shock
24:29
in the short run if no one reacts
24:31
nothing happens to Output doesn't move
24:33
much but what
24:41
happens you see if I don't move
24:43
something in this part of the diagram
24:45
and not move equilibrium output in the
24:47
short run equilibrium output is
24:49
determined exactly in the same way we
24:50
have determined up to now so if we get a
24:52
markup shock nothing happens to Output
24:56
if no no one no if no moves nothing
24:59
happens to help in the short but what
25:05
happens that we may not like yeah
25:08
exactly what happen is the the Philips
25:11
curve went up before that level of
25:13
output was consistent with no changes in
25:16
inflation now it's not we get an
25:20
increase in inflation so the first place
25:22
where you'll see a the effect of the of
25:26
of of the oil shock here is inflation
25:28
will pick up remember the price of
25:29
gasoline going up and all those things
25:31
well that's where you see it first
25:33
before activity Falls you see it there
25:36
that's what mess up the Philips curve
25:37
also in the 70s and 80s we going to see
25:40
lots of shocks of this kind initially
25:42
unemployment didn't move M much but
25:44
inflation keeps
25:46
climbing so that's what happens well
25:48
obviously when that happens if it's
25:50
persistent typically central banks if
25:51
they think it's very short live they're
25:53
not going to react to this stuff but if
25:54
if it is persistent and they think it's
25:56
persistent then the reaction is what
25:59
well they need to this only means that
26:02
the natural rate of
26:03
an the the natural rate of interest has
26:06
gone up no because I need to for that
26:08
same is I need to bring down equilibrium
26:12
output that means I need a higher
26:14
natural rate of interest rate or a
26:16
higher rst star so what the FED needs to
26:19
do the Central Bank needs to do is just
26:20
start increasing interest rate that's an
26:22
natural
26:23
response a lot of what happened during
26:25
the covid why inflation pick up so much
26:28
much in in Co is because we had a shock
26:30
of this kind it was not energy the
26:33
energy shock came later but it was
26:35
supply side transport transport cost and
26:38
stuff like that the network the
26:40
production Network and things like that
26:41
that broke down but they thought it was
26:44
going to be very temporary so
26:47
understanding this model they thought
26:48
okay look this this Curve will come back
26:51
come back that but by itself so better
26:54
not react right now why cause a
26:55
recession if really this Curve will come
26:58
down back down by itself well the
27:02
problem is that it didn't come back by
27:03
itself that fast some things came up
27:06
fairly fast some others did not in
27:09
particular labor for participation did
27:11
not come sufficiently fast back and so
27:15
that's the reason we stay too long in a
27:17
situation like this and that's one of
27:20
the main reasons inflation sort of creep
27:23
up in in the US and also in other places
27:25
in the world in Europe the big reason
27:29
for for why inflation picked up there is
27:31
because this curve move a lot up why is
27:40
that exactly you know they had a massive
27:43
energy shock and so that moved that
27:45
curve up a
27:48
lot
27:50
good let's I want to now return to what
27:54
is going on right
27:55
now ER oh actually first I'm going to
27:59
yeah right now meaning the last few days
28:01
so it turns out that this diagram that
28:04
that I use for the fiscal consolidation
28:06
shock can also be used to understand a
28:09
little bit what happens with
28:12
the um Silicon Valley Bank event okay
28:16
remember we model that as a credit shock
28:19
we say like like that X we had it's like
28:21
X going up well X going up that's
28:24
exactly that it moves the yes to the
28:26
left so a shock to
28:30
X to to the a panic of the kind that we
28:34
saw is like that it moves the to the
28:37
left why is
28:38
that so for any given level of the safe
28:41
real interest rate a panic a shock to
28:44
credit and so on moves the a to the left
28:47
why is
28:52
that exactly so so the real the safe
28:55
interest rate doesn't go up but but but
28:58
what goes up is is is the cost of
29:01
borrowing because you know firms need to
29:04
pay this this extra risk premium and and
29:07
then for any given safe interest rate
29:09
real interest rate firms have to pay
29:12
more which means there is less
29:14
investment for any given level of the
29:15
real interest rate and so the is moves
29:17
to the left and if that happens then you
29:20
start getting deflationary
29:23
forces okay so again all this happens
29:27
very quickly here in reality I told you
29:30
there are lots of lags and so on but
29:32
markets begin to anticipate what will
29:35
happen and
29:37
so so markets begin to anticipate so so
29:40
in the in the immediate output doesn't
29:43
collapse immediately anything and
29:44
inflation doesn't be doesn't collapse
29:47
immediately but markets realize that
29:49
there are Long Bar there lcks but but
29:52
there is a shock already so so it's
29:54
likely that these things will
29:56
happen and and and and it's likely that
29:59
this will happen and it's also likely
30:01
that the FED will react to
30:04
that what should be the reaction of the
30:06
FED if this stuff gets to be
30:12
persistent how do you get out of a shock
30:14
like that if you really want to go back
30:18
there you cut interest rates okay in the
30:21
case of the US they were hiking
30:23
interestate because we're deing with
30:25
dealing with high inflation this tells
30:27
you well you should slow down the pace
30:29
of hiking again they don't do it
30:32
immediately they meet next week but the
30:34
markets don't need to wait for the FED
30:36
they anticipate what the FED is likely
30:38
to do okay and they start betting on
30:40
that so let me show you next a bunch of
30:44
charts that show you that someone in the
30:47
market understand these mechanics okay a
30:49
lot of people because the prices are
30:51
moving exactly that
30:56
way so
30:58
this is the ER oh this is something this
31:02
is the one year ahead inflation
31:04
expectation as traded in the market it's
31:06
called inflation break even the one-ear
31:08
inflation break even so if you these
31:11
things are traded in the market and you
31:12
can trade expected inflation at all the
31:15
maturities you want so this is what the
31:18
market was expecting before this shock
31:21
you know infl we getting hotter and
31:22
hotter numbers so the economy was
31:24
inflation expected inflation as price in
31:27
the market Market was climbing okay one
31:31
year out and then the shock came and
31:34
look what happened to expect the
31:35
inflation boom it
31:39
collapse okay why is that well people
31:44
thought this shock that leads to that
31:48
okay that's what they thought this
31:50
bounce was markets got a little excited
31:53
yesterday it was a little risk on
31:55
environment today they lost all that
31:58
but but for a shock I'm going to tell
32:01
you about in a few minutes
32:03
but anyways but the point I wanted to
32:05
highlight is again expected inflation
32:08
was getting a little out of control and
32:11
then this x shock came the the Panic
32:13
shock and then immediately expected
32:15
inflation decline because people
32:17
anticipated something like this okay the
32:20
market anticipated something like that
32:23
what is
32:24
that this is the the
32:28
[Music]
32:29
um the markets expected next hike so
32:34
March 22nd the the FED will decide on
32:37
the increase in interest rate remember
32:39
the FED had decided as I said in the
32:41
previous lecture to go for a path of 50
32:43
basis points initially very high but
32:46
since a couple of meetings ago they
32:47
decided to slow down to 25 basis points
32:49
precisely because they want to wait and
32:51
see a bit what what a mess do we have I
32:53
mean there's long variable lacks they
32:55
have increased rates a lot and and so on
32:58
but so they had gone back to a pace of
33:00
25 so if you see in you know somewhere
33:02
here in in February 22nd if you ask the
33:05
market what what do you think will be
33:07
the next
33:08
hike there will be lots of answers
33:11
trades and so on but the the when I say
33:14
answers I mean what is price what is
33:17
traded this financial instrument the the
33:20
average answer was 30 basis points 30
33:23
basis point is that most of the people
33:25
thought that they were going to increase
33:27
the the interest rate by 25 basis points
33:29
and there were a few guys out there that
33:30
thought the FED doesn't increase the
33:32
interest rate by 33 basis points that's
33:34
25 50 75 okay so this 30 is meant that
33:39
almost everyone thought it was going to
33:41
be 25 but there were a few people that
33:42
were concerned that could be higher than
33:44
that what happened here we start getting
33:47
very hot numbers on inflation and so all
33:50
of a sudden the equilibrium changed
33:51
dramatically and we went to 45 which
33:54
means most people then thought in the
33:56
market that the next hike in in in on on
34:00
March 22nd was going to be 50 basis
34:02
points and a few people St stay at 25
34:05
that's the reason H this is not 0. five
34:09
but it was almost price in that point
34:12
when people say price in they're talking
34:13
about this what is the hike that price
34:15
in is this statistic look that's what
34:19
happened with
34:21
the Silicon Valley Bank event okay a
34:25
collapse in this thing now now is is
34:28
trading at around 13 basis points that
34:31
means most of the people think that the
34:34
Traders here think that there will be no
34:37
hike at all okay so a few days ago they
34:41
all thought there was going to be 50
34:43
basis point which is a big hike H and
34:45
now most people think there will be no
34:47
hike whatsoever but a few think that
34:49
it's going to be 25 me actually it's
34:52
almost 50/50 no I think today is a
34:54
little lower than that but it's almost
34:55
50/50 that is 25 or zero that's that's
34:59
what what it is but had you ask anyone
35:02
around here and certainly around here is
35:04
there any chance of zero and there would
35:06
be no one literally is that contract was
35:09
not traded okay well you see things
35:12
happen accidents happen so now that's
35:15
where where we are
35:17
at
35:20
now if this all last a week and and
35:23
everything gets resolved it doesn't have
35:26
a lot of macro iic consequences okay
35:29
it's just a little Panic you know some
35:31
people make money some people lose money
35:32
and so on but but but but this can be a
35:36
very problematic shock actually because
35:39
what you see here is that this is a size
35:42
this is Silicon Valley
35:44
Bank these are all the rest the banks
35:46
smaller than
35:48
that H it turns out that all these bank
35:51
at this moment are reshuffling their
35:53
portfolios they're becoming very
35:55
conservative because they don't want to
35:56
be exposed to similar risk they realized
35:58
the environment became very unfriendly
36:00
to you know that can be runs on banks in
36:03
any moment despite the fact that it's a
36:05
big policy package out there but people
36:06
are still withdrawing lots of deposits
36:08
from a small Banks small and Regional
36:10
Banks and they all deposi it in JP
36:12
Morgan you know the big Banks so there's
36:14
lots of deposits that despite the the
36:18
the the insurance the the the the the
36:21
blanket insurance that is implicit at
36:23
least at the moment lots of deposits
36:24
from these sectors are moving to these
36:26
major Banks here okay that's called it's
36:29
called a flight to
36:31
Quality now the problem of that for the
36:34
economy as a whole is that small Banks
36:37
and Regional Banks play a huge role in
36:40
in
36:41
lending okay I
36:45
think a little more than 50% for example
36:48
of the commercial and Industrial loans
36:50
are made by small Banks ER 80% of the
36:53
mortgages are given by a small Banks so
36:55
it so it has a big
36:58
potential consequence what I'm trying to
36:59
say is that X may stay high for quite a
37:01
bit of time okay and that's a
37:05
reason this is start there is
37:08
anticipation that this will have
37:09
macroeconomic consequences and as a
37:11
result of that that the FED will react
37:13
that inflation will change and all
37:17
that okay so that's where we were at on
37:20
Monday remember when we had the lecture
37:21
I was telling you more or less that
37:24
story ER what is this
37:28
you can read it there but it may not
37:30
mean M to much to you but I'm what I'm
37:32
highlighting is this this is pretty big
37:35
huh 35% decline this is an equity it's a
37:39
share so this is
37:41
the the value of the
37:44
equity of a pretty major Bank credit
37:47
Swiss okay so credit Swiss have been in
37:51
trouble for a while but today got into
37:54
really big trouble okay and and and you
37:58
saw sort of a massive collap collapse in
38:00
the equity shares in fact they stopped
38:02
trading for a while and so
38:04
on this thing here is H you know I
38:09
updated your slides many times today
38:12
because I began to look at this event
38:14
around here and then this thing kept
38:17
going then they stop kept going and so
38:18
and I I'm not sure where it's at now I
38:20
stopped at what time did I stop 9 in the
38:23
morning I was awake at 4:44 today so
38:26
they tell you this was this was a pretty
38:30
intense um but this what this is is the
38:33
credit default swaps on a credit swis
38:37
credit swap is whenever it's a bond
38:39
issued by a bank you can buy an
38:42
insurance on that Bond okay so it's so
38:44
so if the bond defaults on you you then
38:47
use the insurance and you get
38:50
paid so these things for banks normally
38:52
are very small numbers but for credit SS
38:56
bigger than for other big Banks because
38:57
I've been in in trouble for a while all
38:59
sort of trouble but look at that Spike
39:02
there I mean that's pretty big for these
39:03
kind of things you know it's not Lon yet
39:06
but
39:07
big so anyway that caused a little Panic
39:10
today
39:13
ER this is the the stock prices of the
39:16
main European Banks this is all today
39:20
yeah so look at this it was a little
39:23
rally yesterday and so on I mean this is
39:25
this is the decline as a result of the
39:28
US problem the Silicon Valley Banks then
39:31
a rally yesterday and then credit Swiss
39:34
happen and you has a big decline in h in
39:39
in all the major banks in in Europe the
39:43
US banks are also declining but but that
39:46
was bigger for the major
39:49
Banks the vix remember I told you last
39:51
last week last Monday about this
39:54
indicator of fear in the market which is
39:56
really the price put options I'm
39:58
simplifying things I mean protection for
40:01
for big declines on the equity Market H
40:04
again it began to spike very very
40:08
sharply as a result of this is what
40:10
happened with the US event then
40:12
yesterday we got a rally Rison type
40:15
thing and then today we got a new
40:18
event look at this I like this
40:22
picture what this is let me let me tell
40:24
you what the the the the the blue line
40:28
is the blue line is is the
40:32
market ER
40:35
expected federal funds rate at different
40:38
days in the future okay so you know
40:42
today the federal funds rate is is is
40:44
around four and a half and this is what
40:47
what the market expects okay so they
40:51
expected so they expected the FED to
40:53
continue to hike interest rate and to
40:56
reach a peak
40:58
ER around in June 14th in that meeting
41:02
of the order of five five 5.3% or so
41:05
that's that's what the average there
41:07
lots of dispersion there people betting
41:09
on 6% but that's the average that's what
41:11
people expected the yellow thinks it's
41:14
the number of hikes that you're likely
41:16
to see so you know you're likely to see
41:18
one hike in the next meeting another one
41:20
in the next meeting and another one in
41:22
the next meeting and then stop and begin
41:26
sort of cutting rates that's expect that
41:28
was expected path on Friday 10th was
41:31
Friday more or less around there maybe
41:33
Thursday I don't remember but anyway
41:35
that was expected path you see so still
41:38
hike rates reach a peak of five 5.3% and
41:42
still sort of pretty high interest rates
41:45
by the end of the year okay that was
41:48
expected
41:51
path that's the way it looks
41:54
now very different no now
41:58
people are expecting very small changes
42:00
now I show you it's like 13 basis points
42:02
what people expect okay the still people
42:05
expect sort of a hike but but small one
42:09
now they expect a peak to be sort of in
42:12
May and then the FED to start cutting
42:15
very aggressively to at the end of the
42:17
year end up with much lower rates than
42:20
today
42:22
okay so this is exactly what I was
42:24
telling you before the market is
42:25
anticipating that that we had a huge
42:28
contraction in the is because X went up
42:31
a lot ER the immediate consequences
42:35
that's going to be lower inflation yes
42:37
we have a problem because I mean if if
42:39
the US did not have a 5 and a half% of
42:42
inflation
42:44
today I can assure you that the FED
42:47
would have come out and said we cut the
42:48
rates right now the only reason they're
42:51
not cutting right now is because we have
42:53
a two problems we have the the financial
42:55
Panic on one side and we have the High
42:57
inflation on the other side so so they
42:59
have to balance these two
43:00
forces but but the expectation of the
43:03
market is that the balance of two forces
43:05
going to be dominated by the contraction
43:06
and aggregate demand much sooner than
43:09
people were expecting okay so that's
43:11
what the market is pricing at the moment
43:13
and what I'm saying is I was trying to
43:15
highlight is that this is very
43:16
consistent with
43:21
h with that okay it's just the market
43:25
looking ahead of what it's likely to
43:27
Happ happen it started from a situation
43:29
which is a little bit more complicated
43:31
again because we already had high
43:32
inflation well I do not know really I
43:35
mean it is on one end more complicated
43:39
because we have a problem of high
43:41
inflation on the other hand having high
43:45
inflation allows you to cut the real
43:47
interest rate much more aggressively
43:48
because if you bring the nominal
43:50
interest rate to zero and you have
43:51
inflation of 5% that allows you to cut
43:53
the real interest rate to minus 5% well
43:56
if you start with a situation where your
43:57
inflation is zero you don't have any
44:00
space to cut the real interest rate so
44:02
the FED can be very aggressive here and
44:04
the only reason is not being very very
44:06
aggressive they were very aggressive in
44:07
terms of supporting deposits and all
44:09
that but the the the the the they can be
44:13
very aggressive in terms of interest
44:15
rate cut if the need arises hopefully
44:17
won't but but they have a space because
44:19
we're starting from a much higher level
44:21
of inflation that
44:22
helps it it hurts in the sense that it
44:25
will delay the reaction but it helps in
44:28
the sense that they have much more space
44:30
for for
44:34
policy what is
44:39
this oh this is just interest one year
44:42
interest rates okay that that reflects
44:45
the the the previous picture as well
44:47
people you know one year out rates were
44:52
over
44:53
5% uh a few days ago and now are in the
44:57
low
44:58
force and this picture I kept updating
45:01
as you can see it was really dropping
45:06
fast that's a big change me look the one
45:09
year rate 60 basis points that's a big
45:14
change so that's where we're
45:17
at I'm from the next lecture I want to
45:19
start with growth but any questions
45:21
about this or
45:25
no okay I don't want to start growth now
45:27
in four minutes but uh so the set of
45:30
topics we're going to discuss from the
45:31
next lecture are very
45:33
different ER subject to not having any
45:36
major events if there is a major major
45:38
event I'm going to reffle things so we
45:40
can talk about financial panics and
45:43
things of that kind let's hope that it
45:45
can stick to the program and do
45:47
growth in the in the next week okay good
45:51
or would we do
— end of transcript —
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