The benefits of any activity should outweigh the costs. Risk should be commensurate with return. In fact and theory, risk and return are inseparable. Analysts say the relationship between risk and return is positive – the greater the risk, the greater the expected reward. The foundations of market theory, CAPM and MPT, are predicated on this.
The influence of these theories is enormous. They underpin astronomical values of investments. They inform economic, financial, monetary, and fiscal policies. Every economics and business student learns them. Professionals and academics build careers on them. That they may be divorced from empirical evidence has not proven an impediment to their use.
Model Good. Data Bad.
In the past year, various studies have redefined the risk-return relationship to accommodate economic realities. Major institutions are adopting new risk models. Practice may be diverging from established theory. These are steps towards a better understanding of the nature of risk and uncertainty.
A new study from Boston University and the London School of Economics turns risk and return on its head. The paper finds “a negative relationship between risk and expected return…in line with empirical evidence but in contrast to standard theories.”
This “inversion,” as the Financial Times calls it, has been empirically evident in equity markets since 1926. Until about 1970, the risk-return relationship was flat. Since 1970, inversion has become increasingly manifest. For 45 years, low-risk stocks have tended to offer better returns than higher risk equities. This is no statistical anomaly – it has persisted for the better part of a century. The Financial Times concludes these findings “suggest deeply distorted markets.”
Nine Decades of Bad Data?
The Great Recession dealt a tremendous blow to financial theory. Nobel prizes aside, theory appears to have been weak from the cradle. Markowitz’s E-V model of risk as volatility is from 1952. CAPM proposed beta as a risk measure in 1961. The Sharpe Ratio (which incorporates E-V ) is from 1966. A 2014 study from Spain’s IESE Business School argues CAPM, “an asset pricing model that relates risk and return…is not supported by empirical evidence.” One wonders if financial theory may have ignored decades of market data.
Are Low Rates Deflationary?
Noah Smith, writing in Bloomberg, points out another fundamental theory bogged down in the reality quagmire: conventional wisdom says pumping money into an economy (such as through Quantitative Easing) leads to inflation. So far, countries employing QE have not seen it. Instead, they struggle with disinflation or outright deflation. Smith asks, what if “low interest rates…are actually deflationary”? What if raising rates stimulates economic growth?
Studies indicate this might be the case, at least under current circumstances. The argument connecting persistent low rates to deflation begins with one of the simplest identities in economics – the Fisher Equation – which essentially says the nominal interest rate equals the real interest rate plus inflation (rnom = rreal + i). In other words, monetary policy to raise rates could very well be expansionary.
The Fisher Equation works. In the following graph, the break-even inflation rate (the black line, calculated using the equation) tracks expected inflation well:
In the graph below, the green line is the nominal rate; blue represents the real rate; and the red line is expected inflation:
This thinking is not new. Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, explained the idea in 2010. The federal funds rate he refers to is the overnight rate at which US banks lend their reserves, held in the Federal Reserve Bank, to each other.
If the Federal Open Market Committee maintains the fed funds rate at its current level of 0 to 25 basispoints for too long, both anticipated and actual inflation have to become negative. Why? It is simple arithmetic. Let us say that the real rate of return on safe investments is 1% and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25%. The only way to get that is to add a negative number, in this case, −0.75%.
In terms of the Fisher Equation, 0.25 = 1 – 0.75. Four years later, the fed funds rate is 0.09%.
William T. Gavin, a Vice President of the Federal Reserve Bank of St. Louis, describes the significance of the Fisher Equation similarly:
The Fisher equation has important implications for the expected inflation rate. If the real economy is currently rebounding to a sustainable growth trend, the real interest rate will rise and the only outcomes possible will be either a higher nominal federal funds rate or a negative expected inflation rate … One reason to worry about deflation is that the federal funds rate is expected to be held near zero.
One influential economist posing this idea is John H. Cochrane at the University of Chicago. In his study, Cochrane describes the phenomenon (he calls it “Neo-Fisherian”) this way:
(After raising nominal rates), we should expect a consumption boom with little inflation, then consumption to revert to normal slowly as inflation picks up…. The prediction that raising nominal interest rates is expansionary is pretty central to the basic structure of this model.
Cochrane admits the Neo-Fisherian thinking is counterintuitive:
The basic logic is pretty simple: raising nominal interest rates either raises inflation or raises real interest rates. If it raises real interest rates, it must raise consumption growth. The prediction is only counterintuitive because for so long we have persuaded ourselves of the opposite, despite the Fisher equation and the consumer’s first order condition linking consumption growth to the real rate.
In a blog post,“Heretics,” Cochrane writes, “we’re getting low inflation or deflation because interest rates are pegged at zero, and maybe the way to raise inflation is for the Fed to raise interest rates.” He is clearly intrigued by the idea and calls for further study.
Theory is not holding up well in the face of reality these days.
