Sunday, 27 July 2014

Making Sense of Liquidity Preference

Philip Pilkington has a post on liquidity preference.

I've never liked the textbook version of liquidity preference.  This has the interest rate as being determined through the choice of investors between bonds and money.  It kind of makes sense if you imagine a world with only interest bearing bonds and non-interest bearing money, but it's harder to interpret when you want to factor in banks and bank money, which generally pay some form of interest.

In Pilkington's version, instead of money we take the collection of assets that serve as cash equivalents, e.g. short-term deposits, Treasury bills, money market fund shares, reverse repo, etc.  These will generally be interest bearing and although the individual rates will differ, we can take a single short rate as representative of the return on these assets.  On the other side we have longer term financial assets including government and corporate bonds.  Again, we can take some long term rate as representative of the interest rate on this class of asset.

We thus have two asset classes and two representative interest rates.  Changes in demand (and supply) between the two asset classes can then be invoked to explain, not the absolute level of rates, but the relative rates.  In particular, we can take the short rate as being set by central bank policy, and then take the long rate as being determined by relative demand and supply for short and long assets.  Since the collection of short term assets are often described as being a kind of liquidity pool, we can think of the relative demand for short versus long assets as being a matter of liquidity preference.

This formulation makes more sense to me.  However, whilst it may be useful to understand what drives markets, as economists we may be more concerned with how this might impact on actual demand in the real economy.  When looking at how financial shocks feed through the system, there may be more going on than can be easily described in this model.  Some points are worth making.

Long term interest rates on corporate debt might matter, but they're not the be-all-and-end all.  It may be that the short term rate has a greater impact on real activity.  And, although that may include expectations of future short rates, we need to avoid confusing what causes changes in the long rate.  A change in the long rate due to a change in preference for long-dated assets is not necessarily the same as a change due to a change in expectations about future short rates.
We have to be careful talking about liquidity as the term is not used consistently or, at least, there are different forms of liquidity.  So whilst it can be useful, in a certain context, to think of short term assets as representing liquidity and longer ones as not, that's not always the way it breaks down.  More commonly, the liquidity of an asset is defined as the ease with which it can be sold without affecting the price.  By this measure, long dated government bonds may be more liquid than short-dated corporate obligations (they are treated as such for the purposes of the BIS Liquidity Coverage Ratio).

The divergence between short term rates and long term corporate debt rates reflects a number of things, including the term structure of interest rates and credit spreads, as well as the actual liquidity of the asset.  These do not necessarily move in the same direction, nor do they necessarily have the same impact on demand.   

The causal chain from financial market movements to spending is not only about interest rates.  Financial frictions and institutional structure mean that quantity constraints may be more important.  Lenders may partially respond to changes in funding cost by adjusting their credit criteria, thereby mitigating the effect on lending rates.

In general, we have a whole range of financial assets, each carrying different elements of term structure, credit risk and liquidity.  In addition, we have a variety of financial institutions with different regulatory and commercial structures, which also face certain financial frictions, preventing instant adjustment to new equilibriums.  Sometimes, dividing assets into two distinct classes to illustrate liquidity preference is a useful exercise and can help explain things we see going on.  Sometimes, it's more complicated and simply looking at two classes of asset is inadequate.  In my view, much of what happened in the crisis is difficult to explain purely within the terms of a liquidity preference model.  Either way, understanding the structure of interest rates as the result of demand and supply pressures for different types of asset provides a useful framework for this sort of issue.