Bond vigilantes call for “Day of Rates”

Flustered by the obstinate refusal of US interest rates to move up, bond vigilantes are resorting to the revolutionary tactic du jour: Twitter!

In a thread dubbed “The Day of Rates”, the vigilantes are calling on Americans to liquidate their holdings of government bonds this Monday and help spread the word by tweeting “sell”.

The appeal is in protest against what they call the government’s "exorbitant privilege” of getting away with very low borrowing rates even while the deficit keeps ballooning.

Twitter pros attested that, within hours, the thread had attracted 4.3 million followers with profile names as diverse as @JoeThePlumber, @MsWatanabe and @Broncho_Billy.

The latter is rumored to be pseudonym for legendary bond trader Bill Gross, who only last month was reported to have sold his entire stock of US government bonds held in his $237 million Total Return Fund.

Confronted with the rumor Mr. Gross gave only an indirect response: “The behavior of US interest rates has defied economic logic” he said. “Usually, I put on a trade, publicize it on CNBC and markets follow. This time round it looks like we need to broaden our audience.”

Former Federal Reserve Chairman Alan Greenspan agreed: “It’s a conundrum”, he tweeted, when asked to comment on the path of interest rates.

Meanwhile, Republican Representative Michele Bachmann offered a potentially compelling explanation.

“Every time interest rates go up, some foreign factor intervenes to push them down again,” she observed at a recent town hall meeting. “First it was the Greeks. Then the Irish. Then the Arabs. Now the Japanese!”

“It's obvious,” she continued. “This is a global conspiracy to plunge America deeper into debt. And President Obama is biting the bait. I mean, I’m not necessarily blaming him but the Kobe earthquake also happened under a Democrat President… It's an interesting coincidence…”

Meanwhile, Federal Reserve Chairman Ben Bernanke played down the threat of excessive market volatility due to millions of “sell” tweets.

“The Fed stands ready to use all available tools to preserve financial stability,” he tweeted.

Fed pundits have interpreted the Chairman’s tweet as a sign he is bracing for what they called the "nuclear" option.

In response, Mr Bernanke regretted the term as "inopportune", saying the media must learn to settle with less sensational jargon, "like QE3". He added that recent experience has shown QE to be "a monetary policy tool 4 all seasons", though he did not elaborate, likely due to tweet constraints.

Fed insiders say Mr. Bernanke still struggles with Twitter and has enlisted pop star Lady Gaga to help him master the new medium. Reportedly, her top recommendations have been to reduce FOMC statements to 140 characters or less and to change the Chairman’s profile name from @Ben to @MoneyHoney.

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and just in case you started selling.....
Happy Aprl Fool's!

The end of gradualism?

Back in 2004, on the heels of the Fed’s tightening cycle, Ben Bernanke gave a speech in defense of “gradualism”—the idea that, under normal circumstances, economies are better served when central banks adjust their policy rates gradually, moving in a series of moderate steps in the same direction.

Yet, current gossip has it that this thinking may be shifting.. in other words, the Fed may be open to the idea of what Bernanke called in that speech the “bang-bang” approach: Raising rates in a more aggressive manner, instead of a well-televised “measured pace”.

Before I go any further, I should reiterate the word “gossip”, since I, at least, have yet to see a Fed speech expressing this view explicitly. But what I want to do here is to ask whether there is any reason to revisit the case for gradualism, esp. in the aftermath of the financial crisis.

So let’s look at the rationale for gradualism in the first place… Ben’s speech lays it all out.

One reason stems from the uncertainties under which policymakers operate: Uncertainty about the true state of the economy in “real time”, e.g. due to noise in the data, difficulties in measuring variables such as the output gap, etc; and also, uncertainty about the exact impact of policy actions on the economy (i.e. uncertainty about the accuracy of an economic model’s specification and/or the precision of the estimated structural parameters).

Because of this, gradual policy adjustment is preferable to a more aggressive approach, as it allows policymakers to observe the impact of their actions and avoid potentially destablizing “overshootings”.

A second reason has to do with the monetary authorities’ ability to influence the term structure of interest rates (and, therefore, financial conditions) in the presence of forward-looking market participants. The argument goes that, when investors are forward looking, the mere expectation of a series of small, measured interest rate increases in the future will lead to higher rates across the yield curve today—i.e. the Fed does not NEED to raise rates aggressively in one go to achieve a desired increase in long-term yields.

The advantage of gradualism here is that the Fed can achieve tighter (or looser) financial conditions without prompting an unnecessary spike in the volatility of short-term interest rates.

A third reason has to do with financial stability—ensuring that banks, firms and households are not exposed to large capital losses from undue swings in bond markets. Only here, the optimal policy response is not just gradualism, but gradualism combined with transparency in central bank communications about its intended policy path. As Ben put it in 2004:

“the FOMC can attempt to minimize bond-market stress in at least two ways: first, through transparency, that is, by providing as much information as possible about the economic outlook and the factors that the FOMC is likely to take into account in its decisions; and second, by adopting regular and easily understood policy strategies”.

So what, if anything, has changed since then that might prompt a shift in the Fed’s thinking?

One possible change could be renewed attention to the so-called “risk-taking channel” of monetary transmission—the idea that monetary policy can affect agents’ risk-taking behavior, leading, for example, to potentially unsustainable increases in leverage and/or a deterioration in the quality of banks’ assets.

In my view, attention to the risk-taking channel would be a very welcome development, especially in light of the recent experience and the destabilizing effects of careless risk-taking by both banks and households. However... I have a feeling that the implications for monetary policy have little to do with the pace of adjustment (ie the gradualism vs. bang-bang debate) and more to do with the level of policy rates.

To see this, one has to examine the channels through which monetary policy affects risk-taking behavior. To this effect, a recent BIS paper discussing this link seems to suggest that it’s the levels of interest rates that matter for risk-taking behavior.

For example, low interest rates raise asset prices (through lower discount rates), increasing the value of collateral and, in turn, the willingness of banks to extend more credit to the non-financial sector (the financial accelerator effect). Similar effects can lead to perceptions that bank balance sheets are healthier, making bank funding cheaper and encouraging them to raise their leverage to potentially damaging levels (esp. if they can “creatively” bypass capital requirement restrictions by shifting risky assets off balance sheet!).

In addition, low interest rates for an extended period could encourage investors to search for yield by shifting capital towards higher-risk investments. This may be because of inertia in asset managers’ performance targets, which often focus on nominal returns (e.g. for institutional/contractual reasons); and/or “money illusion”—ie when investors are slow to absorb the fact that lower interest rates are simply a response to lower inflation.

Note that little has been said here about the effect of a given pace of change in interest rates on risk-taking behavior. It’s all about the levels.

So what are the implications for policy?

Well, for starts, emphasis on the risk-taking channel of monetary transmission throws fresh light on the (in)appropriateness of the Fed’s monetary stance back in 2003-06. First, by keeping rates low for a long period, the Fed likely contributed to the "search for yield" cult defining that period. More importantly, even when the Fed did raise rates, the impact on financial conditions (and risk-taking behavior) was very limited: Volatility declined steadily to historic lows, while long-term yields only rose temporarily in 2004, only to resume their decline later in 2005.

Now, to anyone as familiar with monetary theory as the Fed Chairman and his entourage, this should have raised the red flags about the workings of the transmission mechanism. Instead, the Fed was busy making up names for this new wonderful state of affairs: The Great Moderation… the conundrum… etc.

Criticisms aside, the point is that, given that the level of interest rates affects risk-taking behavior (with potentially damaging effects, if left untamed), monetary policy would have to be “blunter” (to use Bernanke’s expression) when the risk environment is exceptionally benign.

But back to gradualism... For all the implications for the level of interest rates, the inter-linkages between monetary policy and risk-taking behavior seem to say little about the appropriateness of the gradualist approach. So in the absence of a compelling framework that associates a transparent and steady (if not *that* measured) pace of policy adjustment with risk-taking behavior, I have a hard time understanding why the Fed would wish to change tack vis-à-vis gradualism.

Maybe it is just gossip after all. But if it’s not, I hope we get a darn good explanation beforehand.

On Carry and Other Tales...

I’m amazed with the number of academics, journalists and “pundits” in my field who keep on talking about “the carry trade” as if it’s some sort of cult… “The end of carry as we know it”… “Carry-trade silence”… “Carry makes a comeback!”…

Since last week, the carry trade has also found a mother, a father and some heavyweight patrons (like the Fed) who, apparently, keep on feeding it to monstrous and potentially self-destructive proportions.

I want to use this post to respond to some of the points raised in these op-eds, notably with regard to the role of policy in feeding carry trades and, in turn, asset bubbles. But before I get there, let me deal with the cult notion first...

The carry trade is NOT a cult… “Carry trade” is another way of describing “risk-taking” in financial markets. Anyone who invests their money in anything riskier than a safe, cash-like asset (e.g. US Treasury bills or money market funds) is effectively a carry trader: They are short cash and long a risky asset such as a stock, a corporate bond, a foreign currency, etc.

Indeed, the term “carry” is a literal description of that risk-taking process: When you buy shares in Microsoft, for example, you decide to forego the safety of a US T-bill and instead “carry” the risks embedded in Microsoft’s stock: Risks related to the company’s management, its capital structure, the growth and/or regulatory outlook of the IT industry and so on. Similarly, investors in a foreign currency have to “carry” risks related to the foreign country’s external imbalances, inflation prospects, politics, etc.

Now, to be fair, what many refer to as “carry trades” in the press are leveraged investments. In the above examples, investors use their own capital to make the risky investment. But when they are leveraged, they borrow multiples of their capital short-term and invest the funds in higher-yielding products (e.g. asset-backed securities or currencies like the Brazilian real) to make the spread.

The principle is exactly the same as before—risk taking—only that the use of leverage helps multiply profits in good times (and totally destroy them in bad times!).

OK... now to 2009. Since March this year, most risky assets have seen stellar returns, be it global stocks, corporate bonds, emerging market assets, higher-yielding currencies, etc. How big a role has the “carry trade” played in driving this price action?

Let’s see… One important driver has been the positive surprises in some parts of the real economy (remember those “green shoots”?) As a result, investors revised upwards their baseline forecasts on the economy. In statistical terms, their distribution of expected returns shifted to the right (i.e. a higher mean).

A second driver was the Herculean backstop measures by governments and central banks the world over, aimed at eliminating extreme downside risks. These basically cut off the left (negative) tail of investors’ expected-return distribution.

Neither of these can be said to have encouraged “carry trades” in the leveraged sense. But by shifting the distribution of expected payoffs from risky assets in a favorable way, both factors encouraged (some) investors get out of safe assets and take on risk.

Then you have the Fed’s (and other major central banks’) low-for-long interest rate policy. Is that contributing to “carry trades” and/or to asset price bubbles? There are at least three ways in which the low-for-long interest rates can impact asset prices:

First, the policy “condemns” investors to earning near-zero return on their cash assets for an extended period. This, together with a restored confidence, helps push investors out of zero-yielding cash towards riskier assets.

Asset flow data are supportive of such shifts, but it is important to understand that the low interest rate is only one of the drivers: Factors that changed the mean and the shape of the expected return distribution were arguably more important—recall that in the midst of the panic of 2008, investors were willing to sit on US Treasuries with negative (but certain) yield!

Second, the low interest rates are helping asset prices by boosting the profitability of banks. Think about it: Banks borrow short-term (e.g. depositors’ money or in money markets) and invest in long-term, higher-interest-rate assets like corporate or mortgage loans.

By fixing their borrowing rates at near zero, the Fed is helping banks make profits even in a difficult lending environment. In turn, this helps prevent the negative feedback loop we saw last year, when financial institutions fire-sold their risky investments to preserve their capital, driving down asset prices.

Third, the low-for-long rate can arguably encourage the fresh build up of leveraged carry trades: Investors could borrow short-term at low rates and invest in riskier assets like equities.

Maybe… but… Evidence of such leverage is lacking: Flow of funds data show that the liabilities of the US financial system on aggregate actually declined in Q2 2009--even as new capital was raised. True, we don’t have data yet for Q3, when asset prices kept shooting higher. But then, please, show me data that point to an ongoing “highly leveraged carry trade”! I’d love to see them, along with many in the markets who try to assess systemic risk on a real-time basis!

Even (even) if leverage were indeed occurring, the point that “traders are borrowing at negative 20% rates to invest on a highly leveraged basis on a mass of risky global assets” is grossly unfair: The “minus 20%” is the ex post cost of borrowing in dollars to invest in a basket of major foreign currencies, following the dollar’s depreciation since March.

But this ex-post analysis completely ignores the tremendous amount of uncertainty surrounding investors’ forecasts back then. No offence to my female cohorts in the industry, but it took gigantic balls to re-enter that market, especially when a LOT of asset managers were already deep underwater and capital preservation was the ultimate priority.

So to recap—low interest rates are just a small part of a broader set of policies and real-economy data that have helped boost asset prices since March. Importantly, based on available data, leverage has yet to manifest itself as the key driver of the price action.

Now, this doesn’t mean that systemic risk is not rising. In fact, IF that were so, the Fed should take notice. But is that so?

Some cite as evidence of systemic risk the high correlation between different risk assets recently (equities, commodities, EMs, etc). I’m not convinced: Since everything collapsed in tandem last year, the recovery in risk appetite should make everything recover in tandem. In other words, the high correlation is not necessarily a cause of alarm at this juncture.

Still.. high correlation means that, if there is a negative surprise, risk assets will all move down in tandem again. Which would be pretty bad! But here is the real crux of the debate: Have the prices of risky assets already moved “too much, too soon, too fast”? Are we already in bubble territory and, hence, at risk of a sharp correction as soon as “reality” strikes?

Well, it depends on your outlook of “reality” in the coming months/years, and on your framework for translating that outlook into a forecast for asset prices. It could indeed turn out that the world is in much worse shape than the average investor thinks (/hopes!)

But let’s get this straight: It is one thing to claim that current valuations reflect forecasts that are overly optimistic given the “true” state of the economy; and it’s another thing to say that the Fed’s low-for-long interest rates are feeding highly leveraged carry trades, which are in turn feeding asset bubbles.

I personally see the Fed’s promise of low interest rates for an extended period (or the ECB’s term lending at low fixed rates) as a plea to investors to take on risk. The idea is to help assets reflate; support consumption through positive wealth effects; and help lending to the real economy through positive valuation effects on collateral.

Investors are slowly heeding, taking on more risk, some even levering up—but still in an environment of heightened uncertainty about the future. We’ll find out “the truth” about the future when it happens. And some will get the chance to say “I told you so!”. But given the scale of today’s uncertainty, nobody can credibly claim that investors (or “carry traders”) are taking on risk for free!

PS My apologies to those who have recently received some of my old posts, looks like Blogger has gone about recylcing old ideas, please ignore them if they recur, I seem to have no control over this!

Decoding Kevin Warsh

I’m on the verge of changing my early morning routine of TV business news for the food network… The decision has been brewing for a while, but my "aha!" moment came last Friday, during an interview with a "market-intelligence" pundit, who was asked to interpret an op-ed piece by the Fed’s Kevin Warsh the day before.

So the guy goes on a spree of conspiratorial drivel about the Fed’s “true” intentions, following which, an unquestioning anchor likens his remarkable “code-breaking” skills to those of Robert Langdon!

Truth be told, Warsh’s article, and subsequent speech in Chicago, caused a bit of commotion and confusion in the market, for being seen as somewhat contradictory to the Fed’s official line a day earlier…. “exceptionally low”, “extended period” and all that.

Yet, all that Warsh did was to state the obvious… that the Fed is currently walking on a very thin line: Unlike back in March, when the “extended period” language was first introduced, the Fed’s management of downside risks on growth may be coming increasingly at odds with the management of upside risks on inflation.

At the crux of this tension is the level of banks’ excess reserves—currently at $850 billion (from $60 billion a year ago), by virtue of the Fed’s various asset-purchase and credit-easing schemes. In turn, the monetary base skyrocketed from $85 billion in August 2008 to around $1.7 trillion by end-2008, and has hovered around those levels ever since.

Is that a problem?

The standard argument would go that, yes, it is, because once banks begin to lend these walls of money, inflation will get out of control. Indeed, if you belong to the “mulish monetarists'” camp, you’ve been probably raising red flags ever since the Fed embarked on its various emergency facilities last year.

Clearly, that would have been wrong: The Fed was simply responding to a colossal, unanticipated increase in the demand for money in its most liquid form that nobody else was able or willing to provide.

But the story is different now. Risk aversion has been receding. Cash is becoming too expensive to hold and is gradually searching for higher returns—in stocks, bonds and the like. And, while commercial bank lending to the real economy—i.e. to companies and consumers—is stagnant at best, liquidity in capital markets is slowly coming back, repo markets are showing signs of life, and companies are increasingly able to raise money in the bond markets. Asset prices are "reflating".

Now, that’s not necessarily a problem. After all, the whole point of the Fed’s credit and quantitative easing operations was to catalyze the return of private-sector liquidity, help reverse the destruction in wealth from the collapse in asset prices and avoid a deflationary spiral.

What is the problem is the uncertainty about the fundamentals: Is the markets’ recent “exuberance” reflective of a true, steady improvement in the economic outlook? Or just wishful thinking, fuelled further by cheap money, and bound to correct itself?

The implications for policy in each case are different: The latter would justify the Fed’s low-for-long mantra; the former would call for an earlier reversal of the exceptionally accommodative monetary stance.

This uncertainty about the fundamentals is complicating monetary implementation. But uncertainty is nothing new when it comes to formulating monetary policy. What is different this time is that the mountain of excess reserves in banks’ books is an obstacle to the Fed’s traditional preference for playing it safe on growth. Basically, while the Fed would love to go for the “wait and see” approach, the level of excess reserves makes this a very risky route.

The reason is simple: $850 billion of excess reserves can do a much bigger damage, faster, than, say, $50 billion, if banks regain their appetite to recycle them into the system. Put differently, it would take a much smaller increase in the money multiplier (which has collapsed since the crisis began) to cause a much bigger damage, with excess reserves at these levels.

Up till now, the Fed had downplayed the size of reserves as a potential constraint to its policy implementation. As NY Fed President Bill Dudley said back in July:

“…in a world where banks could not be paid interest on excess reserves, these persistent high reserve balances would indeed have the potential to prove inflationary. […] But that is not the world in which we now live. Because the Federal Reserve now has the ability to pay interest on excess reserves (IOER), it also now has the ability to prevent excess reserves from leading to excessive credit creation.

“[..] For this dynamic to work correctly, the Federal Reserve needs to set an IOER rate consistent with the amount of required reserves, money supply and credit outstanding consistent with its dual mandate of full employment and price stability. If demand for credit exceeds what is appropriate, the Federal Reserve raises the IOER rate to reduce demand.” (my emphasis)

Right. Only that Dudley assumes that the Fed knows what the interest rate consistent with its dual mandate is! But, as I’ve been arguing here, right now the Fed doesn’t, because of the uncertainties above—uncertainties that Fed officials have themselves acknowledged.

The risk is that, guided by standard measures of slack (unemployment, capacity utilization etc), the Fed will keep rates at zero, even while banks begin to recycle excess reserves in the system.

Clearly, there is one way to go: Begin to unwind the reserves, soon. This will allow some flexibility in the interest rate decision—some room for a “wait and see” approach—until the data coming out of the real economy begin to look resolutely better.

As a matter of fact, that’s exactly what Ben & Co. seem to be planning, with reverse repos the latest word on the street. The idea is for the Fed to avoid selling the securities it owns outright (and any undesired price impact thereof), but place them directly with money market funds, which seem to have both the balance sheet capacity and the appetite to absorb large quantities of “safe” assets like US Treasuries or Agencies.

I see Warsh’s statements precisely in this light—and, therefore, not as inconsistent with the FOMC’s “extended period” message. The Fed still wants to play it safe on growth, but would prefer to avoid screwing up in the unlikely(?) case the financial system moves faster than the Fed expects based on traditional economic fundamentals.

So what I'd expect to see in the coming weeks is the Fed to start moving to drain reserves, while postponing the interest rate increase decision until fundamentals look more compelling.

That said, if the Fed wants to avoid the possibility of destructive volatility in bond markets, it should do away with the constructive(?) ambiguity in its policy message and come out with a clear communication about the sequencing of its exit strategy (and I’m not talking about pre-announcing rate decisions here).

Capital markets are still fragile and clarity in the Fed’s message will be key for a smooth transition process… Even more so, if the Fed truly has to deal with a market that is as “perceptive” as Robert Langdon!

Treasury myths

So that’s what it takes these days, huh? A few “bps” along the yield curve, scattered wobbles in the equity markets and a falling dollar for people to start prating about inflation scares, monetary debasement and what to do about it!

Big deal, I say. Headlines aside, the market moves we’ve seen in recent weeks are not only minute by inflation-scare standards but, actually, have little to do with inflation at all. Instead, they should be seen as part of the markets’ steady march towards normality.

Let me throw in some evidence:

The “sell-off” is global: First, the recent rise in long-term yields is not just an American phenomenon but a global one. Ten-year yields have gone up in countries like Germany, France or Canada, which haven’t yet embarked on quantitative easing (i.e. the purchase by the central bank of government bonds or other assets to reduce long-term yields and boost aggregate demand). Even Japan, which is already in deflation territory, has seen its long-term yields rise!

Sure, the rise in US yields has been larger than in those countries: Ten-year US yields have gone up 1.50% this year, i.e. more than twice the increase in European or Canadian yields.

But that’s from the absurdly low levels reached late last year, as the financial crisis deepened and investors rushed into the liquidity and “safety” of US Treasuries. So, effectively, US yields are now playing catch-up with foreign ones, as investors feel better about the health of the financial system and are beginning to look for higher returns elsewhere. The steady decline in corporate spreads, even as Treasury yields trod upwards, only confirms that view.

Misleading TIPS: Then you have the TIPS—the Treasury Inflation-Protected Securities. These are government bonds indexed for inflation. Analysts have historically looked at the difference between the yields of standard (or “nominal”) Treasuries and those of TIPS of the same maturity to derive an estimate of investors’ inflation expectations.

Since the beginning of the year, the difference between five-year nominal and real yields has “spiked” up by roughly 1.5%, prompting sounds of alert in some segments of the investor community.

But the analysis is misleading: The comparison of TIPS with nominal Treasuries is not an “apples to apples” one. There are two opposing forces affecting the yields of TIPS that make the comparison an art more than a science.

The first force is related to the uncertainty about the inflation outlook. When you invest in nominal Treasuries, the yield you require will be equal to the real interest rate plus your expected future inflation rate; but it will also include additional compensation for your (or the market’s) uncertainty about the inflation outlook. TIPS eliminate that uncertainty and therefore their yields will in theory be free of that inflation premium (i.e. lower).

The second force works the opposite way and is related to the relative liquidity of nominal Treasuries and TIPS. TIPS are less liquid that standard Treasuries and investors will therefore require additional compensation for holding on to them—a liquidity premium.

The bottom line here is that deriving the “true” inflation expectations from a comparison between TIPS and nominal yields requires disentangling these two effects—it’s not a simple act of subtraction.

If this disentanglement has been an art in the past, today it has moved well inside the borders of abstraction. The reason is that, as the crisis escalated last year, the relative liquidity advantage of nominal Treasuries became such a dominant factor that the yield investors demanded from TIPS moved above the yield of nominal Treasuries! In plain terms, not only were you getting inflation protection; you were also getting paid for it!

The decline in TIPS yields this year should therefore be seen in the context of normalization of liquidity conditions and risk appetite, rather than a “surge” in inflation expectations. Indeed, survey-based measures of inflation expectations such as the University of Michigan’s 5-year-ahead inflation expectations or the Conference Board’s 12-month-ahead number do not point to any measurable increase in expected inflation.

The dollar’s woes: The dollar’s broad-based sell-off is part of the same story: A story of normalization in liquidity conditions, appetite for risk and higher yields, and renewed investor focus on economic fundamentals. It has nothing to do with fears of monetary debasement.

The dollar surged at the height of the financial crisis for reasons largely unrelated to the health (or not) of the US economy relative to its peers: One reason was the flight to the safest and most liquid securities around, which are (still) the US Treasuries. Another was the tremendous funding pressures faced by banks.

Basically, as Lehmans collapsed, banks across the globe found themselves short of cash and, in particular, short of dollars—which had been the currency of choice for funding all the “exotic” stuff that originated in the US, like mortgage-backed securities, collateralized debt obligations and so on. Demand for dollars surged therefore, and so did the dollar’s exchange rate.

But funding pressures have been coming down. You can see that for example in the Fed’s balance sheet: Term auction credit to US banks has declined by $80 billion this year, while the Fed’s swap facilities set up to provide dollars to foreign central banks (which, in turn, lent them to their own banks so that they can meet their dollar needs) have shrunk by $370 billion.

Market indicators also point to the same direction: I’m about to get a bit nerdy here but you can look for example at the difference between the short-term interest-rate differentials between, say, the dollar and the euro as implied by exchange-rate forwards; and as implied by the LIBOR (interbank lending) market.

These should be almost equal in normal times due to arbitrage. But at the height of the crisis, as the LIBOR market shut down, investors turned to the FX markets for their dollar funding needs, creating a large spread between these two differentials that pointed to a huge premium for owning dollars. The spread has now come back to normal levels.

Given the widely known weaknesses of the American economy, and opportunities for higher returns elsewhere, it was only a matter of time before the dollar began to sell off. The gradual normalization in financial markets, together with perceptions that some foreign markets might be more resilient to the global slowdown than the US itself, prompted investors to seek to put their money at work elsewhere.

Indeed, as mutual funds data suggest, US investors have been net buyers of foreign equities for 11 consecutive weeks now. Clearly, this may not be a one-way street, and may reverse as the global economic outlook changes. But my point here is that the dollar’s recent sell-off is unrelated to putative concerns about monetary debasement.

I could keep going but I’ll stop here for brevity’s sake… with one additional point, especially for my friend Ben:

Credit conditions have been easing, even while Treasury yields are rising. Indeed, the increase in Treasury yields is partly the result of credit easing. Therefore, the case for the Fed’s Treasury purchase program, whose stated objective was “to improve overall conditions in private credit markets”, is now weaker than ever.

If Ben wants to expand the purchases beyond the original $300 billion, as some analysts have called for, he will have to find another reason. And, frankly, the only reason I can think of is “to avoid at all costs disappointing the markets”!

Never mind the gap

In case you were looking forward to my judicious insights on how to best get off the subway, you're about to be disappointed: It’s the output gap I’m gonna talk about—the difference between aggregate demand and an economy’s potential supply.

Some inflation hawks out there have taken the task of trashing the usefulness of the output gap as a guide for monetary policy decisions, in order to extrapolate scenaria of high inflation as a result of the Fed’s current money-printing enterprise.

But the argument is misplaced… Not because the possibility of high inflation is far too remote (I’ll come back to that in a minute); nor because the criticism re. the output gap is unfair (it isn’t). It’s just that the inadequacies of the output gap framework fail to provide a reason for casting Cassandra-isms on the inflation outlook.

But let me go a step back.. on the output gap... The concept has been used for years now by economists—including the Fed—as an important component of their modeling toolkit to forecast inflation and guide their monetary policy decisions.

The idea goes like this: When aggregate demand is higher than potential supply, inflation should be expected to go up—therefore the Fed should raise interest rates to prevent an undue acceleration of prices. The opposite holds when aggregate demand is lower than potential supply, which is believed to be the situation today.

The problem with this framework is that nobody has ever seen an output gap—the “potential output” of an economy is unobservable and has to be modeled for. As such, it is subject to a lot of uncertainty, given different model specifications and/or the frequent data revisions that occur as our information about the economy improves over time.

That may not be as big a deal for someone who wants to conduct a historical analysis. But it’s a serious issue when it comes to policy-making in real time, as has been frequently pointed out by renowned monetary economist Athanasios Orphanides (formerly at the Fed). Orphanides has found that the often inevitable mismeasurements of the output gap in real time could lead to inferior policy responses, even compared to policy responses that are guided by a simpler framework, e.g. one that uses past output growth instead.

That’s all solid and good. But is there any connection with the inflation omens of our times?

One supposed connection is the idea that we may be mismeasuring the output gap right now, by a significant amount. In other words, the Fed may be under the illusion that aggregate demand has fallen way short of potential output and, as a result, keep monetary policy too loose for too long.

The reason for the illusion could be that the economy’s potential supply has fallen beyond imagination: For example, the "equilibrium" unemployment may have risen as laid off workers need time to retrain in order to find new jobs; meanwhile, firms may shy away from putting new capital to work as they seek to repair their balance sheets a retool for a tougher financing environment.

While plausible, the drop in potential supply would have to be pretty severe to justify a high inflationary scenario based on the output-gap framework. It's like saying that the "natural" unemployment rate has gone up to 9-10% (ie near or above current levels). Not impossible, only that since nobody has perfect information about the current output gap, the conjecture is as inadequate for guiding the Fed's policy decisions as the argument of the opposing camp.

Then you have to think of the alternatives. I mean, fine, academic research has shown that the Fed’s output gap framework is not the holy grail of real-time inflation forecasting: Alternative models of future inflation could produce superior policy responses, e.g. models of inflation based on past inflation alone, or a combination of past inflation with past output growth.

But what would these models tell us today? With both inflation and output growth having gone downhill recently, even these “superior” models would still fall short of predicting a scary inflationary scenario.

So hawks need additional ammunition. And they find it in the Fed’s expansion of base money—the result of its credit/quantitative easing operations. But now things become flakier.

As I’ve argued in past posts, the usual monetarist argument that a large-scale expansion of money supply leads to inflation appears naïve at present, as it assumes a stable demand for money. But this has clearly not been the case, as people, banks, everyone rushed away from risky assets towards liquid alternatives (read “money”!).

So should we sleep in peace then?

Well no... I didn't say there has been no policy blunder. In my view there has been, though not in the choice of an inflation model, but in the effort to manage inflation expectations.

First by communication: The Fed has yet to be crystal clear about the hierarchy of its objectives in the case where inflation, growth or credit conditions start drifting in conflicting directions (e.g. inflation heading up while growth remains subpar).

Importantly (and I can’t say this enough), the Fed screwed up in my view by deciding to buy Treasuries. Apart from the very shaky empirical evidence on the effectiveness of Treasury-buying in bringing down long-term rates, the policy has spread confusion about the Fed’s intentions, fuelling suspicions about debt monetization at a time when the incentives to do so are pretty strong. (See here for more on this issue).

Indeed, one could conceive a spiraling scenario whereby large Treasury purchases end up undermining confidence in the Fed’s credibility and the US dollar, prompting a sell-off in the currency, leading to inflation, undermining the Fed’s credibility further and so on. We kind of saw tiny hints of this last week with the dollar sell-off gaining momentum.

I don’t want to sound like a Cassandra myself. Especially because economists have a very poor understanding of how agents form their inflation expectations and, importantly, how expectations react to different sets of policies.

So I could go on speculating that the Fed’s Treasury buying will fuel inflation via a collapse in the dollar, while you argue for the opposite by pointing to the various indicators of inflation expectations (TIPS, surveys to economic forecasters, wages, commodity prices, etc), which (still) remain fairly well-contained.

Perhaps if there is any conclusion to be drawn out of this is an admission that we are all pretty much clueless.

Zero till the cows come home...

If I had to single out *the* one issue I have with Ben, it’s his communication policy. For someone who has researched and written himself about the efficacy of communication as an instrument of monetary policy, his execution has been at best confounding.

Take his commitment to keep the Fed Funds rate low “for an extended period”. The idea here is that, by guiding markets to expect near-zero short-term rates for long enough, long-term rates would also fall, since they are, by and large, composites of expected future short-term rates.

But till when is “long enough”? Till the output gap closes? Till unemployment falls to a certain level? Till inflation is restored to a preset target? Till a Taylor rule dictates a rise in interest rates? Till mortgage or corporate debt yields decline to desired levels? Till the cows come home??! Longer than that??!

It’s not clear! And this dilutes the Fed’s ability to achieve its objectives for two reasons: First, in the absence of a clear Fed target, each market participant will have a different view as to how many periods ahead the short-term rate will stay at near-zero. I mean, it’s unrealistic to expect that all these goals will be magically fulfilled at exactly the same moment in the future. Any impact on long-term rates will be blurred, therefore.

Importantly, different views about the Fed’s priorities could exacerbate differences in the market’s views about the due shape of the yield curve: For example, I may think that the Fed is focused on reducing unemployment, and is prepared to tolerate more inflation. You, on the other hand, might think that the Fed is targeting a specific long-term interest rate with the view of kickstarting credit markets.

Not only will “extended period” mean different things for you and me; we will also have different expectations about the macroeconomic environment and the risks that would emerge as a result of the Fed trying to deliver on its priorities. In other words, we will likely have different views about the due slope and curvature of the yield curve, which doesn’t really bode well for the Fed’s attempts to manage our expectations on that front.

Similar problems surround the Fed’s purchases of long-term Treasuries. After a few back and forths, Ben finally threw the bombshell on March 18th and announced the purchase of “up to $300 billion” worth of Treasuries over six months. But where did the $300 billion come from? In the absence of a clear stated target, it looks like it came out of thin air.

“That’s unfair!”, Ben protests. “Look at the FOMC statement, the objective is there, ‘to help improve conditions in credit markets’”. Well, maybe, by clearly the markets disagreed.

If in doubt, see what happened last Wednesday. Ten-year Treasury yields jumped above 3% (the “ceiling” markets thought Ben might have had in mind) after the FOMC stopped short of announcing the expansion of the Treasury purchase program. Basically, in the market’s opinion, maintaining the 10-year rate at 3% or lower takes more than $300 billion!

So maybe Ben should announce an explicit ceiling for the long-term yield? If credible enough, it could even turn out that he might not have to spend a single dime on Treasuries, as the markets would adjust to that target on their own.

As a matter of fact, in his famous "It" speech on deflation, Ben pointed precisely to this option:

“A more direct method [to bring long-term rates down], which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields.” (my emphasis)

So how about that for clarity?

I think it’s the wrong kind of clarity. In fact, “it” speech regardless, I personally doubt that Ben will go down that route and would protest if he did.

First, because it’s unclear whether the measure will “succeed.” I am putting “succeed” in quotes, because success here needs to be defined. I have no doubt that the Fed can keep up a promise to maintain the 10-year rate at, say, 3% max. After all, it can go and buy the entire stock of 10-year notes and bonds, if that’s what it takes. So, if success is defined as the narrow objective of bringing down a particular (set of) Treasury interest-rate(s), the Fed certainly has the ability to deliver.

But this is too narrow a definition of success. The whole point after all is to bring down the private cost of borrowing and get demand for credit going. And while, in principle, a decline in the long-term Treasury rates should transmit itself, at least partially, to private long-term interest rates, in practice it might not.

For example, credit supply constraints, say due to a dysfunctional banking sector, may be demanding a steep upward-sloping yield curve to preserve bank profitability. Or it may be that markets see a huge disconnect between the Fed’s target long-term rate and their own economic forecasts. It may even be the case that the Fed’s own policy of massive Treasury purchases raise doubts about its ability to deliver on its price-stability mandate in the future, pushing private long-term borrowing rates up.

So no, the clarity I’m talking about is not one about the Fed’s instrument, but clarity about its endgame. You see, commitments of the “extended period” type, or the “$300 billion” one, can’t effectively guide expectations, unless they are conditioned upon an ultimate metric of success.

In Japan, for example, the Bank of Japan (BoJ)’s commitment to keep interest rates at zero became far more effective in guiding expectations once the BoJ clarified exactly what it meant by the threat of deflation being dispelled (more that TWO years after it embarked on quantitative easing, by the way!).

A harder question is whether binding the Fed’s hands with an explicit objective, or ranking of objectives, makes sense, especially given how complex and multifaceted the problems it’s trying to address are. I’d say it is, since the absence of clarity can undermine the efficacy of the Fed’s unconventional policy toolkit. I should perhaps add that I also think the Fed currently has too much on its plate and it could do with more/better help from the fiscal authorities, the regulators and Congress.

Ultimately, the market needs clear and verifiable metrics, particularly at the zero bound, when the assessment of the monetary stance becomes a complicated affair. So Ben, pick anything you want—a target for inflation, the price level, unemployment, GDP growth, private credit growth, restoration of bank health, or a combination—and give us the clarity we need... Just not the cows, please.. unless you want the entire bond market to move to Wisconsin in search of guidance!

Ben's Shakespearean dilemma

Inflation or deflation? That is the question.

For all the increase in unemployment and excess capacity that this recession has brought (arguably, the perfect incubator for DEflation), there are people out there raising the INflation alarm.

Me thinks it’s the Fed’s fault. Not because of its aggressive expansion of (base) money. The usual monetarist argument that a large-scale expansion of money supply leads to inflation appears naïve at present, as it assumes a stable demand for money. But this has clearly not been the case: The financial crisis led to a sudden surge in the demand for money, as institutions and individuals fled riskier/less liquid assets in favor of liquid alternatives.

The problem has been communication. The Fed, with its actions, has created confusion about its priorities and objectives. Let me explain.

The “positives” first… Since September 2008, right before the “fireworks” began, the Fed’s balance sheet has expanded by $1.2 trillion. But almost half of that is the result of lending facilities (the TAF, CPFF, PDCF and ABCPMMMF) established to fill the funding gap that financial institutions faced, as counterparty risk skyrocketed and banks lost their traditional sources of funding. The corresponding expansion in money supply is therefore a response to a surge in the demand for liquid assets and, as such, it’s inflation-innocuous. Moreover, by design, these facilities are short-term and set to expire once the need for them is eliminated.

Secondly, in his communications Ben has been careful to subsume every single unconventional measure the Fed has taken under the “credit easing” sphere instead of “quantitative easing” (QE). In other words, the arch objective of these measures, we are told, is to help improve conditions in private credit markets (rather than to help create inflation, which was the case in Japan during 2001-06).

Very importantly, Ben has been talking time and again about the Fed’s menu of exit strategies, presumably with the view of addressing fears about inflation once financial conditions normalize.

But that’s where the clarity ends. Then come the (other) deeds.

Beginning with the Fed’s decision to purchase longer-term Treasuries. Not only are there theoretical reasons why they are likely to be ineffective in lowering long-term yields (I promise a post on this). Not only is there empirical evidence from Japan’s own QE suggesting that the so-called portfolio rebalancing channel through which it’s supposed to work had a small impact at best. Not only have long-term yields here in the US actually increased since the Fed’s announcement that it will start buying Treasuries on March 18th…

…Basically, not only are Treasury purchases a waste of money from a “credit easing” perspective; they are also a mistake, in so far as they breed concerns that the Fed is monetizing the government deficit and/or has inflation as an implicit objective.

This is not paranoia. We are in a world where the menu of unconventional central bank policies that Ben talked about in his famous “Deflation speech” are handicapped: The banking system is broke and thus incapable of fulfilling its role in the monetary transmission process (e.g. by lending out the cheap money the Fed is providing). Household and financial sector leverage is high, which means that, even if rates came down, the room for additional borrowing is limited. Importantly, the economy is in recession and the government is engaging in a massive fiscal expansion which, per CBO’s projections, would raise the government debt by a shocking 30% of GDP by 2012.

In other words, the Fed’s Treasury purchases were announced at a time when the Fed’s tools are impaired by a broke banking sector; and when high household debt and a huge fiscal deficit are creating strong incentives for inflating our way out. I mean, sorry, but this is the perfect setting for a “helicopter drop” of money—a measure proposed by Ben himself in that same “Deflation” speech. Combined with the dubious theoretical and empirical case for them, Treasury purchases can only confuse as to the Fed’s policy priorities and objectives.

Priorities, objectives… So here is a second source of confusion. The Fed has a LOT of objectives at the moment. Take a look at the March 18th FOMC statement:

The Fed “will employ all available tools to promote economic recovery and to preserve price stability.” The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities [..] and to increase its purchases of agency debt this year [..] to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses […].”

Everything but the kitchen sink! I should add of course the objective (me now) “to prevent a financial sector meltdown”, which has seen the Fed acting as lender of last resort to Bear Stearns, Citi and AIG; or (coming shortly) “to promote the orderly deleveraging of greedy financial institutions” through the Fed’s participation in the PPIP.

Luckily for Ben, for the moment all his objectives—stirring economic activity, credit easing and “price stability”—point in the same direction. That’s because “price stability” in this environment means avoiding deflation. But what happens if this alignment is broken? What would he do if the objectives become conflicting?

The answer looks unclear right now. On one hand, for the Fed to effectively bring long-term rates down, in the hope of stimulating aggregate demand, it has to credibly guide the private sector to expect that short-term rates will stay near-zero for a long time, even after economic recovery picks up. The Fed has indeed tried to do so, per the FOMC statement above (“conditions are likely to warrant [...] for an extended period”). Upward price stability would be a secondary objective, under this line of thinking.

On the other hand, Ben’s talk about exit strategies suggests that the Fed is very alert to the inflationary implications of the its current policies and stands ready to fight. Sounds reassuring but, if that’s so, it undermines the credibility of the Fed’s “promise” to keep rates low “for an extended period”.

There is no simple solution, obviously. But my preference would be (a) do away with the “try everything and see what happens” approach to policy-making; (b) do away with (or, at this point, contain) Treasury purchases; and (c) clarify that upward price stability will be *the* priority, if the environment warrants it, even if such clarity comes at the cost of a smaller “expectation effect” on the yield curve from the commitment to keep rates low for some time.

Ben is trudging through tough territory, I admit. But by dispelling “the question” about inflation once and for all, he might find he will not have to “suffer the slings and arrows of outrageous fortune”!

The best is yet to come

In case you were deceived by the title into believing I’m about to offer my perspicacious insights on the future of the stock market, let me say you will be disappointed. In fact, I am about to disappoint you even more…

I will be temporarily cutting down on my weekly blogging activity, which I have (miraculously) managed to keep up for a year now, in order to embark on something, let’s say, bigger. I can see you’re about to be heartbroken so let me reiterate… this is not a “goodbye”, rather a less frequent “au revoir.”

So now, let me do give my penny’s worth of weekly insight, which comes after hearing numerous “voices” wondering whether it may be a good time to add on risk—“all these bargains out there,” “volatility is on its way down,” and “credit markets moving in the right direction, still not enough, but in the right direction.”

Perhaps. Indeed that’s exactly what you see if you look at a number of price-based indicators that market-pros are tracking these days. For example, the so-called “LIBOR-OIS spread”, that is the difference between the rates at which banks lend to each other and the Fed’s rates (as captured by the so-called “overnight indexed swap” rates) has been narrowing dramatically. Interest rates on commercial paper (used to finance companies’ day-to-day business) have been falling. So has the cost of insuring the debt of companies (CDS spreads), financials or other.

All suggesting perhaps that the painful dislocations we endured (and will always remember!) during September and October are thawing.

Or are they? I’m not convinced. You see, it would be marvelous if commercial paper rates were falling because the dawn is about to break, confidence is returning and banks are lending again. It would be splendid if LIBOR-OIS spreads had narrowed because interbank lending is truly rebooting. But I, not sure that’s the case.

My favorite indicators these days come from the Fed... The Fed’s balance sheet to be specific (and for the more cosmopolitan among you, you can also look at the balance sheets of the European Central Bank and the Bank of England). What we see is a pretty spectacular expansion of Fed lending—doubling since mid-September from less than a trillion dollars to two trillion last week. One trillion in a month!

What does this mean? First, that the Fed has effectively taken over financial intermediation. To put it in plain English, the Fed is right now the only functioning bank in this country—taking “deposits” by all the other banks, who cannot/will not lend, and lending it on to those banks who need it. So the decline in LIBOR-OIS spreads is to a large degree the result of the Fed’s (and the Treasury’s) backstop in the interbank market.

Ditto for lending to companies in the commercial paper market. For those relieved to see the issuance of commercial paper going up, let me point that this has been matched one-to-one by the Fed’s buying of that paper. In other words, the Fed has been the (only?) marginal buyer/lender.

Bottom line, financial markets are on a fibrillating mode, the Fed is the defibrillator, and as long as we don’t have a power cut of some sort, the game can keep going for a while, in the hope that the dawn will eventually break.

At least that’s what Ben is surely hoping, although I sense a whiff of despair and confusion in his quarters, with all that re-thinking of the AIG bailout, which has personally baffled me (hello? I though it was the Treasury that was in the bailout business, the Fed into the liquidity/ monetary policy business, and the Bear Stearns a “one-off.”)

ANYWAY. All this to end with a Frank Sinatra quote that encapsulates my mood of the day..

“The best is yet to come and won’t that be fine
You think you’ve seen the sun but you ain’t seen it shine”

When the dust settles...

…the sky opens… the light comes down… Lehman is history… and Fannie and Freddie are happily snuggled in the Federal government’s coffer… what happens to the dollar?

One of the most mystifying developments in recent weeks has been the dollar’s audacity in the face of tremendous and persistent upheavals in America’s financial markets. Upheavals that, somehow, don’t seem to rhyme well with the customary verse that “dollar = safe haven.” Yet, the dollar has been relentless, rising by double-digits against most major currencies—partly the result of a widespread stampede out of risky assets, be it commodities or emerging market stocks.

There are two ways one could proceed here. One is to spend endless sleepless nights, twisting and turning, trying to fathom investors’ psychology at times of generalized panic. Another is to keep cool and try to figure out instead what investors might do with their stack of repatriated dollars once the dust settles and the US Treasury opens the tap to support Fannie, Freddie and their debt/mortgage holders.

Not that the latter is an easier problem to tackle. If history is any guide, larger fiscal deficits have had a mixed impact on exchange rates: For example, the dollar strengthened during the early 1980s, when America’s fiscal deficit increased. Ditto for Japan, in the early 1990s. But other industrialized countries had the opposite experience, seeing their currencies depreciate as deficits widened: France in the early 1980s, Canada in the mid-80s or Finland and Sweden in the early 1990s. But then, is there anything we can say about the future of the dollar?

The good old story: Standard economic textbooks give us the story as first told by economists Robert Mundell and Marcus Fleming. Accordingly, when Hank at the US Treasury raises the budget deficit (say by giving out tax rebates or a fat bailout for Freddie), Americans will likely spend more—be it Heinz ketchup or a new home. Aggregate demand will go up, putting pressure on prices, and forcing Ben at the Federal Reserve to raise interest rates to keep inflation at bay.

Suddenly, American bonds look more attractive, so foreign money floods in to take advantage of the higher yield. Mind you, not only foreigners; Americans too, from pensioners in Topeka, KS, to teachers in St Paul’s, MN might decide that those exotic Japanese bonds they own are not longer as appealing as their American equivalents. And as the money flows in, the dollar goes up. So a larger fiscal deficit should be good for the dollar, right?

Ce n’est pas la vie: Life is not as simple as that… First of all, the story assumes that Ben will play it tough, rather than letting monetary policy loose to accommodate a rise in prices. But if he doesn’t, the higher inflation should be bad for the dollar, eventually. Importantly, the framework set by Messrs Mundell & Fleming makes a number of brave assumptions (for simplicity’s sake).

First, expectations are supposed to be static—meaning that the value of the dollar today will not be affected by how you, the Topekans or the Chinese expect future government policies to evolve. That’s kind of hard to buy—if you thought Hank or Ben might “blow” it at some point down the road, by letting public debt swell or inflation spike, you might want to sell your dollars today and send your money back to Japan… Read “larger deficit bad for the dollar.”

Secondly, the Mundell-Fleming model does not take into account any changes in investors’ perceptions of how risky are American assets compared to assets elsewhere in the world. What could prompt such changes? Uncertainty over future government policies, among other things. For example, if our foreign lenders suddenly feared that a larger deficit (and thus debt) might prompt the government to inflate its way out (i.e. allow higher inflation so that the value of its debt falls in real terms), they might decide to get out today. Read: “larger deficit bad for the dollar.”

How will it play in Beijing? But think of another scenario: What if investors bought US assets like Fannie and Freddie debt and MBSs precisely because they expected the US government to bail these companies out, if they failed? What a terrible disappointment it would be, if Hank let them down! I mean, who cares about the larger deficit (at least for the moment)? “Either you keep your (implicit) promise, Hank, or we get out!” Read: “larger deficit, good for the dollar!”

Arguably, Hank’s bailout of Fannie and Freddie was partly aimed at maintaining the appeal of US assets. For good reason, you might think. With foreigners holding 2.6 trillion of America’s debt, and a hefty chunk of Fannies and Freddies, it’s kind of hard to tell the Chinese “we don’t need you!” (Although… I can’t help thinking of the old motto that “if I owe you 100 dollars, it's my problem. If I owe you 2.6 trillion, it's yours!”) So Hank delivers, bond markets rally, mortgage rates drop… and the dollar?

Ultimately, persistently large budget deficits raise America’s foreign debt. So either the dollar has to fall to boost American exports and help us grow out of our debt (read: “deficit bad for the dollar”); or interest rates will have to rise to keep luring foreigners into buying US debt (read: “bad for mortgage borrowers,” defeating the purpose of the bailout in the first place!).

True, some foreign creditors (like the Chinese government) seem to be “infatuated” with US debt assets for their own growth-policy reasons, even if expected returns are negative. But even those guys are sending subtle signals they are considering alternative options.

Importantly, if I am a private, profit-maximizing investor, there is little to stop me from cashing in my gains from last week’s bond rally and get out of dollar assets—until I see interest rates rising again to levels that compensate me for the risk of higher government debt issuance in the future. Read: “larger deficit bad for the dollar!”

So there you go. A bailout providing short-term respite but building up pressures for both long-term interest rates and the dollar. Hard to see how Hank could stop these... well, unless of course he took out a real, M20B1 Super Bazooka!

Glossary: Mundell-Fleming model, deficit vs. debt, bailout, super bazooka.

Once upon a time in Jackson Hole

I was secretly hoping this year’s symposium at Jackson Hole would evolve into a hot-blooded feud—you know, like in mafia movies, when all the different gangs get together in a room, in the name of harmony and reconciliation, and end up slaying each other to pieces.

The setting was perfect: A menacing mountain, a year-long financial crisis, powerful central bankers, Wall Street high-fliers, renowned academics, eager journalists, a few stuffed bears. I could so vividly see bankers opening fire on rating agencies, hedge funds firing at their brokers, academics shooting at the Fed, Ben running to hide behind a bear, Chuck Prince—still dancing—caught in the crossfire, the IMF (as usual) watching… And, as bodies fell one by one, everyone turning to chase the Chinese.

But oh no.. This was an economists’ conference after all, where even the most belligerent attacks (like the one by the “colorful” Dutchman Willem Buiter) are met by responses as impassioned as “I respectfully disagree.”

Still, hints of “you should have known better” were indeed made, in the form of academic papers alluding to the possibility that, maybe, had we kept our eyes open while at the wheel, we might have not missed the dazing headlights of a giant truck coming towards us. Among the papers discussed was one by Hyun Song Shin and Tobias Adrian, which argues its case in language readable enough even for those who save their weekends for Martha Stewart’s Living.

Mind the dealers: Accordingly, in their conduct of monetary policy and pursuit of financial stability, central banks seemed to have missed out on an important channel of monetary transmission: The broker/dealers. These are firms that act as both brokers (that is, they execute buy or sell orders on behalf of clients for a fee); and as dealers (trading securities for their own account).

Now, in the (brave?) new world of originate-to-distribute banking, broker/dealers have played a central role in facilitating the securitization of pools of loans, including mortgages. Namely, by underwriting issues of, say, mortgage-backed securities, or by trading such securities for their own account. As such, they have been critical drivers of the overall supply of credit, notably for housing.

Dealers are “special” for a couple of more reasons: First they mark their assets to market, meaning that they tend to value their assets at their current market price rather than at face value. In contrast, “traditional” commercial banks have not historically marked their assets to market. Second, like most financial institutions, broker/dealers are highly leveraged (borrowing at short maturities in money markets to lend at longer terms and for less liquid investments) and their leverage is “procyclical”—it moves in tandem with their size of their assets. In other words, if the value of their assets grows, broker/dealers will borrow more, while if it falls they will seek to reduce their borrowing—or deleverage.

These features combined can give rise to “special effects” such as asset price bubbles or credit booms and busts. How so? Say asset prices rise for whatever reason. Then, broker/dealers’ assets increase in value, prompting them to raise their leverage: They borrow more and use the money to buy more assets. Their demand helps raise asset prices further, inflating the value of their balance sheets more, leading them to borrow even more and so on. An asset bubble is born… I’ll leave it to your imagination to see what happens on the way down.

Complicit in leverage: Where does the Fed come into this? According to the authors, one key driver of the expansion or contraction of broker/dealers’ balance sheets is the Fed funds rate--the Fed’s main policy rate. So by lowering interest rates, the Fed effectively encourages more dealer borrowing, contributing to the credit boom.

Is this a big… deal? Perhaps. Turns out that the dealers’ balance-sheet growth today has an impact on demand tomorrow—particularly on durables consumption and housing investment, which are arguably more sensitive to the availability of credit. Moreover, the increase of housing investment in response to dealers’ asset growth seems to be large and persistent (around three years). The implication would be that broker/dealers’ asset growth should enter into the Fed’s considerations when assessing the outlook of growth and price stability and sets interest rates.

Offering solutions: True to economists’ reputation, the explanation of what happened and/or what the Fed got wrong is not accompanied by definitive policy proposals. Wisely so. Not only are there caveats in the authors’ estimation process (which they acknowledge). It is also difficult to see how to incorporate leverage and asset-growth considerations into an operational rule for monetary policy. How would a central bank decide what is the optimal or sustainable level of leverage? As the IMF’s John Lipsky remarked, “the historical evidence suggests that there is a large structural component to rising leverage [… and that] separating structural and cyclical trends would seem to be quite difficult.”

While hesitant about definitive recommendations, the authors did dare to slip in a mini-bombshell… the idea that transparency in central banks’ communication of monetary policy can be harmful! The reason? Clarity in communication reduces uncertainty about the path of future short-term interest rates and encourages broker/dealers to lever up more and more. Ergo... greater ambiguity might help?? Ouch! Talking about collateral damage when you try to fix one problem and, in the process, you reverse all the benefits of a more transparent monetary policy, e.g. for firms’ productive investment plans.

Finally, the Fed funds rate is declared as “the most potent tool in relieving aggregate financing constraints” during times of distress due to a sharp pullback in leverage. Fair enough: Lower short-term rates would increase the profitability of financial institutions that borrow at short maturities and lend at longer ones. But hey, is that an implicit endorsement of the Fed’s swift 325-basis-point cuts? I hope not... (at least not yet!) Because if it were, we should beg for an analysis that takes into account not only financial stability, but those other things the Fed targets, like inflation and unemployment. Especially since some of these broker/dealer guys, SIVs and their likes might actually deserve to go bust.

So there you go. Looks like the Fed missed out on the truck but gets a pat on the back for its crisis management after the truck hit—far, very far, from the shoot-out I was eagerly anticipating. I guess for that I’ll have to wait for “Once upon a time in Jackson Hole”—the movie.

Glossary: broker, dealer, leverage, mark-to-market, face value, Once upon a time in America.

Between a rock and a hard place

What would you rather have? Exactly three onions a week for your Sunday-night onion soup, no matter the price you pay? Or you’d rather do without the soup for a few weeks, as long as the price of onions remains stable over time?

Let me rephrase the question: Would you rather have stable prices for whatever you consume but find yourself in and out of jobs as the economy fluctuates? Or you’d prefer to keep your job most of the time, but see prices rise so frequently that you can’t be sure whether you'll be able to afford your dream Caribbean holiday next winter?

These are the kind of dilemmas the Fed battles with on a daily basis. Especially recently, as the ghost of “stagflation” has returned to haunt us. Stable inflation or stable growth and employment? As much as we’d like to have both, life often involves trade-offs and the trade-off between inflation and economic growth is one of them. Or is it?

In the long-run… In the long-run we’re all dead, the world returns to equilibrium and, actually, there is no trade-off between the level of inflation and unemployment.

Mind you that’s not what policymakers thought back in the old days. At the time, they liked to entertain the idea that they could cut interest rates to spur growth and job creation, at the cost of just somewhat higher inflation—nothing wrong with inflation at 4 percent instead of 2!

But didn’t they learn better! Turns out the sustainable level of employment is determined by “real” factors such as technological change and productivity, the nature of labor market institutions or population changes. So if the Fed cuts rates to lift employment beyond the sustainable level, all it will achieve is spiraling inflation…

The lesson? In the long run, the Fed would better aim at keeping inflation low and leaving growth and unemployment alone.

No trade-offs, no problem? Not exactly. Many (though not all) economists believe that a trade-off does exist. But the recent buzz is not about the level of inflation and unemployment; it’s about the trade-off between how much each of the two changes—i.e. how volatile they are.

In this universe, life turns out to be a simple, downward-sloping line: As you slide down the line, you’re basically making a choice: Happier stomach or happier wallet? Parking space, front yard but with suburban routine, or “sex in the city” pizzazz but squeezed in a cubicle of an apartment?

Crucially, volatile inflation or volatile growth? Attempts to stabilize one makes the other more volatile. The implication is that, if a shock hits, a Central Bank like the Fed might not want to leave growth alone in the short-run: Instead, it might choose to tolerate rising inflation for a while, to avoid abrupt changes in growth and employment.

This is especially the case because prices tend to be “sticky”: They respond slowly to, say, a drop in demand. So while inflation today may be high enough to suggest immediate Fed action, this may be deceptive: Underneath the surface, firms may be preparing to lower their prices in response to falling demand, and you're ready to accept zero pay rise, to avoid losing your job.

So how tough is the Fed’s dilemma these days? Turns out that some shocks pose more of a dilemma than others. And the shocks today seem to belong to the “more” category on all counts. Let’s see why.

Demand or supply? Demand shocks tend to be easier to deal with than supply shocks. Suppose we suddenly found ourselves with more money—for example because of an error in the measurement of money supply or because the Martians unloaded tons of greenbacks from a giant helicopter. So we begin to buy more things, growth rises above its sustainable level and prices go up.

The due direction of policy looks unambiguous: The Fed should raise rates to bring growth back to sustainable levels and also lower inflation. Yet a trade-off still exists: How aggressively should the Fed raise rates? Is it worth bringing inflation down fast, if the cost is much slower growth?

Still, it can get worse. Think of a supply shock—like a rise in gas prices to the “unheard of” level of $4 a gallon. Inflation obviously goes up, since oil and energy more broadly are part of our consumption basket. But this time output goes down, since people have less disposable income to spend on other (made in America) stuff.

While the due direction of policy is “up” to stop inflation from rising (remember?.. no Fed impact on growth in the long run?), the Fed is now torn: With growth already falling, it would like to be more subtle with rates. But that comes at the cost of higher inflation for a while, possibly together with higher inflation expectations…

Temporary or permanent? A second complication has to do with whether a shock is temporary or permanent. If oil prices shoot up because a hurricane damaged a few oil rigs in the Gulf, you can reasonably assume it won’t last too long; and the Fed can just sit and watch.

But what if oil prices keep on rising with a dumbfounding determination? At some point, they are bound to start seeping into the rest of the economy. But, gosh, isn’t it reasonable to think that the more they rise, the closer they are to “leveling off”? And with demand falling, could the Fed have a case for “waiting to see”? But for how long? What if prices are “getting ready” to rise but we have not seen it yet because they are sticky?

Starting from bliss? Another complication is that, in most theoretical analyses of the optimal course of monetary policy, the starting point is “equilibrium”: The economy is operating at its sustainable employment level and inflation lies near the Central Bank’s target. But what if the starting point for growth is the “emergency room” after, say, a crash in the housing sector and the financial markets? How do you deal with an oil price shock on top of that?

Where’s the line? Finally, truth be told, the downward-sloping line remains a theoretical concept. So even if it exists, its precise shape, slope and position cannot be known with certainty at all times. And that’s a problem: If the Fed sees an increase in inflation volatility, there are at least two ways to interpret it: It could either be because it has been too lenient on inflation; or because the line itself has shifted—say due to a permanent rise in the volatility of global energy and food prices as demand and supply conditions have become tight. The former might require aggressive Fed action, while the latter less so.

So hey, after reading all this, you might want to show some sympathy for Ben and his crew, and the sleepless nights they spend trying to find the right recipe. Because, admittedly, onion soup with a single onion just doesn’t taste as good..


Glossary: stagflation, trade-off, bliss point, sticky prices, helicopter drop of money, onion soup

The euro@10: One currency, fifteen soccer teams

I found myself at a beach in Portugal over the weekend, eating sardines and watching the Eurocup final. For those who don’t know what I’m talking about, that’s the European soccer championship—a tournament that, every four years, ignites passions the world over, with the exception of America and, possibly, Tuvalu.

“Underdog” Spain staged an impressive victory over three-times-champion Germany though, for me, far more interesting was the set up: A sandy beach, beer and sangrias, and a bunch of Europeans—Germans, Spaniards, Portuguese, Austrians—cheering passionately for their chosen favorite.

As I was watching, a thought sprang to mind: Is it remotely conceivable that anyone in the group would ever give up their national soccer team for a pan-European one? I mean, think of the efficiencies: Portugal’s Ronaldo for forward, Germany’s Ballack for midfield, Spain’s Ramos for defense, Italy’s Buffon as goalkeeper… A dream team with far better chances of beating the likes of Brazil at the World Cup.

Unthinkable? Perhaps. But if that’s so, why, when it came to their national currencies, European countries did precisely that?

Coincidentally, year 2008 also marks the 10th anniversary since the inception of the euro—Europe’s single currency. And with 10 being a nice round number, it was inevitable that some stock-taking was conducted to assess whether the euro was a good idea after all. So what’s the verdict?

The wedlock: Think of a currency union (CU) like a marriage—both with their costs and benefits. In the case of marriage, the cost boils down to the loss of one’s independence. When it comes to the benefits, well… you tell me! But at (the very) least, you get economic synergies from paying a single rent and buying napkins in bulk.

Thankfully in the case of a CU the benefits are easier to pinpoint, at least in theory. The CU means the elimination of exchange rate risk among its members, which, in turn, reduces the costs of cross-border trade and investment, fosters price and output stability and encourages a more productive allocation of resources within the CU area. By implication, the more countries trade with, and invest in, each other (i.e. the more “integrated” they are) the higher the benefits they will likely draw from sharing a common currency.

Sharing the same roof: What about the costs? Similarly to a marriage, they have to do with the loss of a country’s “independence”, only the monetary policy kind: As a result of a CU, countries give up their ability to set interest rates as they see fit for their own economic circumstances, for a reason dubbed as “the impossible trinity” (nothing to do with “triangles” here). The one difference with marriage is that not all economists agree that this is a bad thing.

Those who say it’s bad argue that different economies often face shocks at different times and, therefore, must maintain the ability to adjust rates independently in order to facilitate their transition back towards potential output growth and “full” employment. But some disagree, arguing that monetary policy should not (and cannot) target “real” stuff, like how many goods we produce or how many people are employed—instead, a Central Bank should contain its mandate to “nominal” stuff like price stability.

Debate aside, let’s assume here for the sake of argument that there is a role of monetary policy beyond the realm of the “nominal” and that, hence, giving up monetary policy independence is costly. By implication, the costs of entering into a CU are higher the more asynchronous the economies are—i.e. the more their business cycles move out of sync.

Passion or reason? So when is a single currency a good idea? Think marriage again. However strong the initial passion, success is more likely when the parties involved are sufficiently compatible. I mean, what if she can’t live without a pet while you shudder with horror each time the poochy poo rushes to lick your feet? Or (worse?!) what if you, an ardent fan of Germany, are asked to tolerate her (sooo inconsiderate) loud cheering of Spain’s victory? Put it plainly, success requires that the benefits exceed the costs; and compatibility is, if not a sufficient condition, at least a good start.

Same in currencies—however solid the political will, economic compatibility is pretty important. To throw a bit of jargon, the countries contemplating a CU should ideally meet the criteria for an “optimal currency area” (or OCA). For example, are they sufficiently integrated? Are their economies synchronized? Are they flexible enough to be able to adjust to idiosyncratic shocks without the “luxury” of their own interest rates? And, going back to our original question, how does the eurozone fare against these measures?

Let's look at a couple of basic metrics: When it comes to the synchronicity of business cycles, it varies—for example, countries such as Austria, France or the Netherlands tend to have a higher correlation with Germany (the eurozone’s largest economy) than their Mediterranean peers /1. When it comes to trade integration, about half of the eurozone’s total trade is conducted within its membership. Is that “sufficient”? Well, it depends on whether you want to see the glass as half full or half empty. But… does it matter that much?

Love is endogenous: Some argue it might not. Their premise is that, once stuck into the wedlock, “things just happen”… You begin to like the poochy poo, you miss it when you’re gone, and you might even wake up one day to find you support Spain!

Similarly, in a CU things are supposed to happen, "endogenously"—meaning on their own, without the interference of external factors: Trade between the countries increases, financial markets become more integrated, interest rates converge, business cycles begin to move more in sync. As a result, the costs of a CU fall and the benefits rise, bringing the CU members closer and closer to the OCA benchmark.

Indeed, in the case of the eurozone, such a convergence and integration did occur—only that the euro on its own was not exactly the reason. According to a recent report by the European Commission /2, the rise in synchronicity was likely the result of the removal of barriers to trade and capital in the context of the establishment of the European Single Market in 1992 and the subsequent reforms in the run-up of to the euro’s adoption.

Fans of the “endogeneity” theory for OCAs may still read the eurozone’s business cycle convergence as a validation of their premise that “things just happen.” Yet, some other “things” have yet to happen: For example CUs are envisaged to provide incentives for structural reforms to improve their members’ competitiveness. These include, among others, reforms to make wages and prices more responsive to output or productivity shocks, make employment more flexible and more mobile across borders, or encourage research and development to better compete in global markets.

Progress in this area has clearly fallen short. The result being that countries like Italy are seeing their competitiveness on a steady downward spiral, or others such as Greece or Spain building external imbalances of a scale that, one day, might raise questions of sustainability.

Honeymoon is over: With the honeymoon passion over, could eurozone members be entering a phase of wedlock fatigue? And, if the first 10 years were hard enough, how about the next 10, which promise high commodity prices, the eventual unwinding of global imbalances and the admission to the euroclub of numerous more countries that are arguably less “compatible” than the club’s original members? Will countries strive to work things out or could they (as the pessimists like to entertain)… file for a divorce?!

Whatever answer I try to give, at this stage it remains a highly subjective one. All I'll say is that I’d like to believe the divorce option is at least as unthinkable as a pan-European soccer team!


Glossary: optimal currency area, currency union, single market, impossible trinity, real vs. nominal, endogenous vs. exogenous, soccer vs. football

Interesting Reads:
Not so unthinkable? See here: "Betting on the possibility of breaking up the eurozone", in the Financial Times

1 See "Optimal Currency Areas And The European Experience", by the Chair of International Finance

2 See http://ec.europa.eu/economy_finance/publications/publication12682_en.pdf