THE FISHER EFFECT UNDER DEFLATIONARY EXPECTATIONS

January 2011

David Glasner Federal Trade Commission* dglasner@ftc.gov

Abstract: The response of nominal and real interest rates to expected deflation becomes problematic when nominal interest rates fall toward zero while the expected rate of deflation is increasing. As nominal interest rates approach their lower bound, further increases in expected deflation cannot cause the nominal rate to fall. Either the Fisher equation is violated or the real rate must increase. One way for the real rate to rise is asset prices to fall. Regressions between 2003 and 2010 of the daily percentage change in the S&P 500 on the TIPS spread measuring inflation expectations show little correlation between asset prices and expected inflation from 2003 until early 2008. However, since early 2008 the correlation between changes in stock prices and in inflation expectations has been strongly positive and statistically significant. JEL Classification: E31, E43, E52, E63, F41 Key Words: Fisher Effect, Interest Rates, Nominal Interest Rates, Real Interest Rates, Inflation, Deflation, Expectations, Asset Prices, Stock Prices, Monetary Policy, Exchange Rates, FOMC * The views expressed in this paper do not necessarily reflect the views of the Federal Trade Commission or of individual Commissioners.

Electronic copy available at: http://ssrn.com/abstract=1749062

THE FISHER EFFECT UNDER DEFLATIONARY EXPECTATIONS I. Introduction In most renditions, the Fisher equation relating the nominal interest rate to the real rate and the expected rate of inflation is treated as if it followed necessarily from the axiom of rationality, any violation of the Fisher equation becoming deeply problematic or paradoxical. Of course, the Fisher equation, like the equation of exchange, is a mere tautology, but it is usually interpreted in the light of the Fisherian theory of interest in which the real rate of interest reflects real, not monetary, factors, so that the real rate of interest should not, at least as a first approximation, be affected by monetary factors like a mere change in the price level (Hirshleifer 1970). Gibsons Paradox, the observed correlation between interest rates and price levels, is paradoxical precisely because, given the Fisherian theory of interest, the Fisher equation seems to disallow it. My objective in this paper is to explore another, less well known than Gibsons Paradox, difficulty with the Fisher equation: the effect of deflationary expectations on nominal and real interest rates. The adjustment of nominal and real interest rates to expected deflation becomes problematic when nominal interest rates fall to the neighborhood of zero at the same time that the expected rate of deflation increases. Because the nominal rate of interest cannot fall any further should expected deflation increase, the question arises, how can the Fisher equation hold when nominal rate of interest is at its lower bound and the sum of the real rate and the expected rate of deflation is less than the lower bound?1

I still recall when, during his graduate microtheory sequence, Jack Hirshleifer, who resurrected the once neglected Firsherian theory of capital, interest, and investment, showing how it could be applied to solve the problem of the optimal investment decision by firms (Hirshleifer 1958), discussed the Fisher equation, deriving it directly from the definition of

Electronic copy available at: http://ssrn.com/abstract=1749062

Because the nominal rate of interest cannot fall below its lower bound (whether zero or some positive number), for expected rates of deflation above some threshold, the Fisher equation can be satisfied only by sadjustment in the real rate of interest. It may be instructive to spell out the process by which the real rate of interest would adjust to an expected rate of deflation above the real rate. Because the expected yield from holding money would exceed the expected yield on any real asset or combination of real assets (i.e., any feasible real investment project), asset markets could not achieve equilibrium. Asset prices would have to fall -- more likely, crash -- with asset holders vainly seeking to liquidate their positions at current prices. Thus, during a disequilibrium involving inconsistent expectations, the Fisher equation, having no economically feasible solution, becomes an inequality. The Fisher equation is therefore a special case of a more general relation: I = r + pe for i > 0 and
e

i r + pe for i = 0,
e

where i is the nominal rate of interest, r the real rate of interest, and pe is the expected rate of
e

inflation. A sufficiently large reduction in asset values could drive down the expected rate of deflation below the real rate of interest. However, the very process that destroys asset values the rate of interest as an intertemporal rate of exchange between present and future consumption. Since price level changes in one time period relative to another do not alter the terms of intertemporal substitution determined by real factors, the real rate of interest must be invariant to expected changes in the price level. That was all there was to the Fisher equation. I raised my hand and asked how the Fisher equation would hold if expected inflation exceeded the real rate of interest. Hirshleifers response, as I recall, was that he had never considered that contingency and would have to give it further thought. I never followed up with him, but some later time, I found the question discussed in, I believe, one of Harry Johnsons innumerable publications which I can no longer locate. The upshot of Johnsons discussion, which still seems to me to be essentially correct, is that an increase in expected deflation would cause investment to stop until the capital stock fell enough for the real rate of interest to rise to match the expected rate of deflation.

might well drive both the real rate and expected deflation further away from, not toward, each other -- further away from, not toward, a new equilibrium. Such perverse dynamics may characterize the panics and financial crises with which crashes in asset prices are associated. In such situations, establishing an exogenous commitment to stabilizing asset prices may be an essential condition for restoring asset market equilibrium. A key problem for any explanation of Gibsons Paradox is how to make inferences about the rate of expected inflation or deflation. The most successful study, that of Barsky and Summers (1988), explained Gibsons Paradox by positing that, since the price level was roughly constant under the classical gold standard from 1870 to 1913, the expected rate of inflation could be taken to be roughly zero, so fluctuations in the nominal interest rate corresponded to changes in the real rate of interest. Because gold is a durable commodity demanded and willingly held by non-monetary users, its real value is sensitive, and inversely related, to the real rate of interest. But under the gold standard, the real value of gold is simply the inverse of the price level, so Gibsons Paradox follows directly from the assumption that expected inflation is zero under the gold standard. Because expected inflation is not directly observable, empirical studies of Gibsons Paradox have had to rely on independently untestable assumptions about inflation expectations and how they are formed. However, since 2003, when the US Treasury began to issue inflation-indexed (TIPS) bonds, market data on both real interest rates and expected inflation (TIPS spreads) have become available, providing a way to observe the actual interaction of real and nominal interest rates with inflation expectations. Inasmuch as prices generally, by most measures, were actually falling during the financial crisis of 2008, while short- to medium-term inflation expectations (as measured by TIPS spreads) turned negative or deflationary during the crisis, it is feasible

to study the interaction of inflation expectations with asset prices to determine whether the market dynamics implied by the Fisher equation when nominal interest rates are at or near their lower bound were actually observed.2 In the following section I outline the basic theory of asset pricing on which my empirical analysis is based. According to the basic theory, expected inflation, at least at low or moderate levels, should have at most a weakly positive relationship to asset prices. Similarly, real interest rates have an ambiguous relationship with asset prices, depending on which underlying factors happen to be causing interest rates to change. Thus, in normal periods, one would not expect to observe a strong correlation between either real interest rates or inflation expectations and asset prices. In section 3, I show the results of regressions between 2003 and 2010 testing the hypothesis that the normal weak or nonexistent relationship between real interest rates or inflation expectations on the one hand and asset prices on the other is observed. I find that between 2003 and 2007 there was little evidence of any correlation between the daily change in either real interest rates or inflation expectations and the daily change in the S&P 500. Since 2008, however, the relationship between the daily change in the S&P 500 and both real interest rates and inflation expectations has been strongly positive. I interpret the increased correlation between inflation expectations and stock prices since the financial crisis to mean that the crisis and the recovery are evidence of a reverse Fisher effect in which the ex ante return on holding real capital has been less or only marginally greater than the return on holding money. In this environment increases in inflation expectations have generally been

In fact, even if expected inflation is positive, the perverse dynamics occasioned when expected deflation exceeds the real rate can arise as well if the expected yield on capital is negative and exceeds (in absolute value) expected inflation.

markedly favorable to stock prices and have been the strongest indicator of a future rebound in economic activity. II. Asset Prices, Inflation Expectations, and Real Interest Rates Asset values reflect expectations of the future. The basic theory of finance tells us that asset values represent the expected future cash or service flows from those assets appropriately discounted to the present. If, for simplicity, we take the market portfolio of assets as a benchmark, changes in the value of that portfolio correspond either to changes in the size or pattern of expected future cash flows, highly though not perfectly correlated with the expected aggregate future output of the economy, or in the rates at which those future flows are discounted to the present. In this simple model, expected inflation ought to occasion precisely offsetting effects on expected cash flows and (via the Fisher effect) on rates of discount, leaving present values, and hence asset prices, unchanged. Because unanticipated inflation can have no immediate effect on asset prices, though it might well affect them over the course of an inflationary episode, our concern in this study is only with expected inflation. However, by raising the nominal rate of interest, the opportunity cost of holding money, expected inflation may exert an indirect effect on asset values, by reducing the quantity of money demanded (at least that portion of the quantity of money not bearing competitively determined interest), the consequent shift from holding money into holding real assets causing a once and for all increase in the price level thereby raising asset prices (via increases in expected future cash flows). A reduction in expected inflation would of course have the opposite effect, reducing asset prices. These effects are well known, having been recognized at least since the early 1960s in the literature on inflation and growth, which held that a shift from money into real assets caused by inflation would encourage real capital accumulation

and stimulate growth. Failing to distinguish either between inside and outside money, or between interest-bearing and non-interest-bearing money, the inflation and growth literature overstated the growth-enhancing effect of inflation. However, unless all money balances yield competitive interest, expected inflation must, at least directionally, have some positive effect on asset prices. The literature also implicitly assumed that holding money provides no real service flow to money holders, raising the obvious question why anyone would be willing to bear the opportunity costs of holding real cash balances in the first place. Without assuming the real services generated by holding money out of existence, the literature could not have arrived at the unambiguous conclusion that increasing inflation necessarily increases growth. Under normal conditions (i.e., when the nominal rate is not too close to its lower bound, so that the real rate of interest exceeds the expected rate of deflation by more than a trivial amount3), the effect on asset prices of a change in inflation expectations inducing a shift from cash into real assets would not be very large, inasmuch as the shift would involve only a rebalancing at the margin in the proportions of money and real assets in asset portfolios. The extent of the rebalancing is given by the interest-elasticity of demand for the non-interest-bearing portion of the cash holdings of the public. However, as noted above, there are also plausible theoretical reasons to believe that expected inflation, even if the above argument were unassailable, could tend to depress asset prices. Moreover, the direction of the overall effect might well depend on the amount of expected inflation.

The real interest rate need not always be positive. If the real interest rate is negative, then the condition for avoiding a reverse Fisher effect is that the rate of expected inflation exceed the real rate of interest. In other words, if the real rate is negative two percent, inflation must be greater than two percent in order to avoid asset market disequilibrium and a flight from real assets into money, generating a crash in asset prices.

Thus, although theoretically there is some basis for a conjecture that expected inflation, under normal conditions, would tend to raise asset values, the effect, if it exists at all, seems modest, and arguments are not lacking for why inflation would tend to reduce asset prices, especially as the rate of inflation increases. However, under abnormal conditions, when the ex ante real rate of interest is less than the expected rate of deflation, a flight from real assets into cash implies a strong positive relationship between expected inflation and asset prices. Thus, in periods in which expected deflation exceeds the real rate of interest, one would expect to observe at most a weekly positive correlation between between changes in expected inflation and asset prices. However, in periods in which expected deflation was less than the real rate of interest, the observed relationship between expected inflation and asset prices ought to be strongly positive. Under normal conditions, the relationship between asset prices and real interest rates is as ambiguous as that between asset prices and expected inflation. Real interest rates themselves respond to underlying fundamental causes. Real interest rates might, for example, change because of expectations of increasing technological progress and future economic growth. Those expectations would tend raise real interest rates, but they would also tend to raise expectations of future cash flows. Under that scenario, it is likely that one would observe rising asset prices along with rising real interest rates. However, if real interest rate were caused by an increasing demand for present as opposed to future consumption without any change in expected future technological progress, the rise in real interest rates would likely be accompanied by falling asset prices. There is therefore no strong theoretical basis for expecting that real interest rates would be either positively or negatively correlated with asset values.

Given the availability of market-generated data on inflation expectations since 2003 when the US Treasury began selling inflation adjusted bonds, it is possible to compare market-based data on inflation expectations and real interest rates and to determine whether there have been any periods in which expected deflation exceeded the real interest rate. However, the real interest rate implied by the TIPS spread is not necessarily the relevant real interest rate for our purposes. Nominal interest rates may reflect a liquidity premium, especially in periods of crisis. In such situations, even though the real interest rate corresponding to the ex ante rate of return on investment is likely to be negative even, the nominal rate of interest rate may be, at least for a short period of time, well above zero. Thus, even though market data on inflation expectations are now available, the relevant ex ante real interest rate is not directly observable. III. Expected Inflation and Asset Prices from 2003 to 2010. I shall now examine the data on stock prices (as measured by the S&P 500) which stand as a proxy for asset prices in general and their relationship to expected inflation and real interest rates during the period from 2003 to 2010 for which real interest rates can be inferred from the yield on TIPS securities and inflation expectations from the TIPS spread. For real interest rates, I rely on the yields on 10-year constant maturity TIPS and for inflation expectations I rely on the TIPS spreads between constant maturity 10-year Treasuries and the corresponding constant maturity 10-year TIPS bonds as reported daily by the St. Louis Federal Reserve Bank. TIPS securities at 5- and 10-year maturities became available in January 2, 2003, the initial point of the data set with which I have been working. TIPS securities of other maturities have since been issued, while inflation expectations over time horizons shorter than 5 years may be empirically relevant in some time periods, especially during the financial panic in the autumn of 2008, the meaning of TIPS yields and

spreads during the crisis became doubtful during the crisis, because the yields on TIPS bonds seem to have been spiked as the liquidity premia attaching to conventional Treasuries during the crisis also increased, thus overstating the implied increase in deflation expectations represented by the TIPS spread. Longer term TIPS Treasuries seem to have been less subject to the liquidity effect than shorter term TIPS Treasuries, so that there is less distortion in the yields on TIPS bonds and TIPS spreads at 10-year maturities than on TIPS bonds and TIPS spreads at shorter maturities. For observations since September 2005 I have also gathered data on the two-year inflation expectations inferred from TIPS spreads as reported on the Bloomberg website. Regressions on observations from October 2008 through January 2009 using the shorter term using the shorter term TIPS yields and spreads lead to anomalous coefficient estimates which tend to confirm that the shorter TIPS yields and spreads overstate real interest rates and deflationary expectations as a result of liquidity premia on conventional Treasuries. As an additional indicator of inflationary or deflationary expectations, I also used the dollar/euro exchange rate inasmuch as many investment portfolios include both dollar and euro assets with the relative proportions of dollars and euros depending on expectations of future movements in the dollar/euro exchange rate, movements reflecting expectations of relative future rates of inflation in terms of dollars and euros. Furthermore, the dollar/euro exchange rate may, under certain conditions, also reflect expectations about future monetary policy, as I will suggest in the discussion of the empirical results.4

I also estimated regressions with both the trade weighted foreign exchange value of the dollar and the Dow Jones/UBS commodity price index as supplementary indicators of inflation expectations. The trade-weighted value of the dollar had little or no explanatory value, suggesting that if the dollar/euro exchange rate had explanatory power it was because it was associated with the substitution of dollars for euros in individual or corporate portfolios. Although regressions with the DJUBS commodity index as an independent

Figure 1 plots the natural log of the S&P 500 from the beginning of 2003 until the end of 2010 along with the yield on the 10-year TIPS bond, 10-year TIPS spread, and the dollar/euro exchange rate over the same period. The time period is divided almost at the midpoint in March 2007, the housing bubble having peaked in the first quarter of 2007, and the broader financial implications of the failure of housing prices to continue rising becoming increasingly apparent. I divide the first and second periods into subperiods reflecting my subjective impressions of more or less important events that may have been economically significant. The sub-periods are enumerated in Table 1.

variable had higher R-squares and positive and significant coefficients for the variable, the meaning of a regression with commodity prices as an independent variable explaining movements in the S&P 500 as a proxy for movements in asset prices in general is questionable insamuch as commodities are also held as assets.

TABLE 1 Period 1a 1b 1c 1d 2a 2b 2c 2d 2e 2f 2g Beginning Jan-03 Jun-03 Jul-04 Oct-06 Mar-07 Aug-07 Mar-08 Sep-08 Mar-09 Apr-10 Sep-10 Ending Jun-03 Jun-04 Oct-06 Mar-07 Aug-07 Mar-08 Sep-08 Mar-09 Apr-10 Aug-10 Dec-10 Characteristics weak recovery, high uncertainty about start of Iraq War Fed Funds cut to 1 percent, recovery strengthens, housing bubble begins Fed Funds rate gradually riased to 5.25 percent, housing bubble gains momentum, recovery continues peak of housing bubble, first signs of financial stress bursting of bubble, increasing financial stress increasing financial turbulence, start of recession, failure of Bear Stearns deepening recession, rapidly rising food and oil prices financial crisis, deflation, asset price collapse QE1, bottom of recession, beginnings of recovery Greek debt crisis, weakening euro, weakening recovery QE2, strengthening recovery

Although there is no obvious line of demarcation between the two periods, the housing bubble bursting in the first quarter of 2007, with no major sell-off in stocks till August 2007, and stocks staging a recovery and reaching their all-time high in October 2007 after the Fed to cut its discount rate in August and then the Fed Funds rate in September in response to the August dip in stock prices. As is evident in the Table 2 in which I present regression results, the March to August period emerges from the data as a transitional period, and could have been assigned about as plausibly to period 1 as to period 2. The discussion in the previous section implies that under normal conditions there should be little or no correlation between asset prices and either real interest rates or inflation expectations. However, if asset prices are falling because the expected yield from holding cash -- the expected rate of deflation -- exceeds the expected yield from holding real capital assets, the ex ante real rate of interest, so that asset holders are all attempting to shift from real assets into cash, then we should observe a strong positive correlation between asset prices and both inflation expectations and ex ante real interest rates. The same correlation would presumably also hold in the post-crash recovery period in which asset prices rise from the low levels reached during the crisis. To test this theory of asset pricing during asset price crashes and recoveries, I posit a simple econometric model with the natural log of the S&P 500 as the dependent variable, and the yield on the 10-year constant maturity TIPS (a proxy for the real interest rate), the constant maturity 10-year TIPS spread (a proxy for inflation expectations) and the dollar/euro spot exchange rate (reflecting relative inflation expectations in terms of the dollar and its closest substitute currency) as the independent variables. I estimated regressions for the entire sample period and for the periods before and after the end of the housing bubble and for the various sub-periods listed in Table 1. For each period, I

estimated a regression in terms of levels and in terms of first differences.5 The results for the level regressions are reported in Table 2, but being unable to attach any economic meaning to those results, I shall discuss only the results for first differences in the remainder of the paper.

In the level equations a constant term was always included and was always significantly different from zero. For first differences, I report results with the constant term suppressed inasmuch as in most cases the estimated constant term was insignificantly different from zero and R-squares were higher for regressions in which the constant term was suppressed. Differences in estimated coefficients with and without the constant terms were slight and in no case did the significance of an estimated coefficient at the 95-percent confidence level depend on whether the constant term was suppressed.

TABLE 2 Levels or First Differences Levels First Differences 1 Jan-03 Mar-07 Levels First Differences 2 Mar-07 Dec-10 Levels First Differences 1a Jan-03 Jun-03 Levels First Differences 1b Jun-03 Jun-04 Levels First Differences 1c Jul-04 Oct-06 Levels First Differences TIPS coefficient (standard error) 137.77 (5.629) .06 (.005) 189.03 (8.326) .022 (.006) 144.672 (7.183) .078 (.007) 14.614 (16.861 .119 (.022) -31.497 (7.708) -.001 (.009) 138.711 (7.986) .009 (.007) TIPS spread coefficient (standard error) 256.683 (5.156) .107 (.007) 98.494 (11.888) .016 (.009) 340.098 (7.913) .138 (.011) -369.359 (31.202) .091 (.032) 106.474 (7.039) .023 (.014) 27.422 (23.396) -.008 (.012) $/euro coefficient (standard error) 1049.756 (28.438) .234 (.043) 1689.921 (56.488) -0.043 (0.044) 201.845 (65.319) .312 (.07) 252.572 (121.809) -.211 (.186) 654.417 (41.171) .014 (.073) -8.988 (58.86) .022 (.053)

Time Beginning Ending Period

R2

Jan-03

Dec-10

0.673 0.153 0.735 0.023 0.731 0.226 0.853 0.288 0.851 0.014 0.417 0.003

Time Beginning Ending Period

Levels or First Differences

TIPS coefficient (standard error) 210.733 (15.98) .04 (.018) 132.384 (12.553) .059 (.021) 295.309 (13.913) .093 (.013) -25.868 (23.363) .108 (.015) 95.669 (11.489) .14 (.028) -44.797 (16.079) .015 (.011) 3.518 (12.089) .036 (.012)

TIPS spread coefficient (standard error) 105.877 (35.004) .004 (.31) 254.306 (43.809) 0.078 (.05) -17.696 (48.231) .051 (.042) 5.534 (50.938) .114 (.029) 119.865 (11.367) .195 (.035) 282.392 (9.606) .093 (.015) 167.662 (8.788) .148 (.017)

$/euro coefficient (standard error) 1468.454 (79.007) .168 (.176) 1508.745 (218.912) .386 (.262) 2117.36 (216.471) .145 (.195) 567.031 (256.031) -.521 (.148) 2023.115 (117.559) .393 (.243) 196.888 (75.232) .42 (.098) 734.154 (83.658) .524 (.099)

R2

1d

Oct-06

Mar-07

Levels First Differences

0.792 0.048 0.676 0.101 0.87 0.276 0.132 0.404 0.809 0.28 0.827 0.206 0.854 0.476

2a

Mar-07

Aug-07

Levels First Differences

2b

Aug-07

Mar-08

Levels First Differences

2c

Mar-08

Sep-08

Levels First Differences

2d

Sep-08

Mar-09

Levels First Differences

2e

Mar-09

Apr-10

Levels First Differences

2f

Apr-10

Dec-10

Levels First Differences

Although the level regressions appear uninformative, the first-difference regressions tell a clear story, supporting my conjecture that as the sum of the ex ante real interest rate plus expected inflation falls toward zero, asset prices become highly sensitive to changes in inflation expectations and in real interest rates. For period 1 as a whole, the coefficient of the TIPS spread variable, .006, is insignificantly different from zero, and the R-squared of the regression is only .023. Moreover, the only sub-period of period 1 in which the coefficient estimate of the TIPS spread variable was significantly positive (.119) was subperiod 1a (January to June 2003). In that sub-period, the recovery from the 2001 recession was still faltering with expectations of inflation very low and, in the aftermath of the September 11 attacks with a US invasion of Iraq on the verge of starting, uncertainty very high. Thus, sub-period 1a, more than any other sub-period of period 1, resembles period 2, characterized also by low inflation expectations, high uncertainty and unfavorable profit expectations. The coefficient of the TIPS spread variable in period 2 was .138, the t-value implying significance even at a 99.9 percent level. Of the six sub-periods of period 2, only in the first two, 2a and 2b, was the estimated coefficient of the TIPS spread not significantly positive at the 95-percent level. In the last four periods, 2c-2f, the estimated coefficient is not less that .093, and, in period 2d, the period of the financial crisis, as high as .195. These coefficients tell us that a 100 basis point change in the expected rate of average inflation over a 10-year time horizon (say, from 0 percent annually to 1 percent) was associated with a change in the same direction in the S&P 500 between 9.3 and 19.5 percent. Only in period 2a is the R-squared less than .2, and for period 2 as a whole the R-squared is .226. Moreover, the coefficients of the TIPS variable estimated for period 2 as a whole, and for four of its six sub-periods, were significantly positive. However, the conceptually

relevant real rate of interest is the ex ante real rate reflecting the state of business confidence and expectations of profitability. The real rate reflected in TIPS bonds, especially at shorter maturities, is also influenced by current monetary policy and expectations about future monetary policy, causing the interest rate on TIPS to diverge from the unobservable ex ante real rate. The choice of a 10-year maturity was, in part, dictated by an attempt to minimize the influence of short-term monetary conditions on the real rate. In period 1, only in sub-period 1a was the estimated coefficient of the TIPS variable significantly positive. In the other three sub-periods the estimated coefficient was insignificantly different from zero. In period 2, the estimated coefficients of the TIPS variable were significantly positive in all but one (2f) of the sub-periods. This suggests that changes in real interest rates in period 2 reflected changes in expectations of profitability and future cash flows, so that changes in real interest rates were positively related to asset values, as opposed to periods of more stable expectations of future profitability (sub-periods 1b-1d) when changes in real interest rates were not correlated with changes in asset values. If so, the expressed rationale for the Feds quantitative easing policy (Bernanke 2010), namely to reduce long term interest rates and stimulating spending on investment and consumption, reflects a misapprehension of the mechanism by which the policy operates, increasing expectations of inflation and future profitability and, hence, of the cash flows derived from real assets, increasing asset values along with both with inflation expectations and real interest rates. Rather than a policy to reduce interest rates, quantitative easing appears rather a policy for increasing interest rates, though only as a byproduct of increasing expected future prices and cash flows. A few comments are also in order about the dollar/euro variable, whose coefficient estimates differs systematically different in periods 1 and 2: insignificantly negative in period

1 and strongly positive in period 2. The estimated value of the coefficient for period 2 as a whole, .312, says that a 1 percent change in the $/euro exchange rate was associated with a change in the S&P 500 of .31 percent. One way to interpret the result is that a fall in the dollar relative to the euro reduced the incentive to hold dollars and thus reduced the incentive to sell real assets in order to hold dollars. Perhaps another way to interpret the result is that an appreciating dollar may have reflected a tightening money market and a difficulty in obtaining dollars to meet liquidity needs. This was particularly true in the fall and winter 2008 financial crisis during which the dollar appreciated sharply as firms and individuals struggled to obtain cash to meet their obligations, obliging asset sales in order to raise the needed cash. One particular estimate of the coefficient of the $/euro variable requires special attention. The estimated coefficient of the $/euro exchange rate variable in period 2c is -0.521. In absolute value this is the highest estimated coefficient of the $/euro exchange rate of any sub-period in the entire sample. In only two other sub-periods (1a and 1b), was the estimated coefficient of this variable negative, and in neither case was the estimated coefficient significant at a 95 percent confidence level. For sub-period 2c, however, the tvalue for the coefficient in sub-period 2c is over 3. The result seems extremely anomalous, but it appears to me that the result reflects a unique set of conditions that prevailed during sub-period 2c. The recession that began in December 2007 was rapidly worsening, especially during period 2c when real GDP was falling at a 4 percent annual rate and the unemployment rate was climbing rapidly. Despite the deterioration in the economy during sub-period 2c, the Fed, showing more concern about inflation, because of rapidly rising food and energy prices, than recession, fearing that a rapid rise in headline inflation would cause inflation expectations to start rising uncontrollably. The minutes of the Federal Open

Market Committee in June, August and even September 16 (two days after the failure of Lehman!) 2008 show that the Fed repeatedly refused to reduce interest rates to bolster a weakening economy. In this strange economic and policy environment, the public could well have assumed that any weakening in the dollar relative to the euro would reduce the likelihood that the Fed would ease monetary policy, implying a further downward revision in expected future cash flows and a further reduction in asset values. IV. Conclusion My results point to two important conclusions. First, and most obviously, sharp downturns in asset prices are associated with deflationary expectations when ex ante real interest rates are low. Thus if recessions are associated with falling real interest rates owing to falling profit expectations, and if the expected rate of inflation falls below the possibly negative real rate of interest, monetary attempts to reduce inflation may trigger a crash in asset prices, and, in a highly leveraged economy, precipitate a financial crisis. Second, the key to a recovery in asset prices is to raise inflation expectations above the real rate of interest so that asset holders will be willing to shift out of holding cash into real assets. This is not to say that inflation is always desirable. Indeed, the argument for inflation depends on a very low, or negative, real rate of interest which seems to be an exceptional circumstance. Moreover, my results also suggest that the danger of deflation, which has led monetary authorities to generally aim at a low, and steady, rate of inflation, is misplaced for two reasons. First, deflation is dangerous only in an environment of low real interest rates, but in an environment of rapid growth and high real interest rates, mild deflation poses little, if any, downside risk, while rapid monetary expansion to keep inflation positive despite rapid economic growth may itself be destabilizing, though this of course is a highly controversial issue. Second, seeking to stabilize the rate of inflation regardless of

economic conditions can be highly destabilizing in the presence of adverse supply shocks. Adverse supply shocks cause real output to fall, depressing profit expectations and reducing real interest rates even as inflation expectations are increasing. A monetary policy that aims at keeping inflation and inflation expectations constant during an adverse supply shock can drive down profit expectations and real interest rates even further, starving the economy of liquidity in the process. The highly negative coefficient on the dollar/euro exchange rate variable in period 2c, spanning the six months before the financial crisis, supports the notion that transactors were basing their expectations of the Feds policy on the assumption that the Fed was trying to stabilize both inflation and inflation expectations. Thus, the dollar/euro exchange rate became an indicator of future monetary policy so that any appreciation of the dollar signaled that monetary policy would be eased, causing asset prices to rise, while a depreciation of the dollar signaled the opposite. It was not until well after the financial crisis began in September 2008, when inflation and inflation expectations were rapidly falling, that the Fed shifted its policy enough so that transactors stopped using the dollar/euro exchange rate as an indicator of the Feds future policy stance.

REFERENCES Barsky, R. B. and L. H. Summers. 1988. Gibsons Paradox and the Gold Standard. Journal of Political Economy. 96(3):528-50. Bernanke, B. 2010. Monetary Policy Objectives and Tools in a Low-Inflation Environment. http://www.federalreserve.gov/newsevents/speech/bernanke20101015a.htm Hirshleifer, J. 1958. On the Theory of Optimal Investment Decision. Journal of Political Economy. 66(4):329-52. Hirshleifer, J. 1970. Investment, Interest, and Capital. Upper Saddle River, NJ: Prentice-Hall.