Blunt or blunter? Emerging markets (try to) return in kind

The one thing we can’t accuse central banks of these days is lack of creativity. The latest gem came from the Central Bank of Turkey (CBT) last week, when, on one hand, it cut its policy rate by 50bps to 6.50%, while at the same time increased the reserve requirement ratios (RRR) for short-term bank funding (deposits and repo) to help lengthen the maturity structure of banks’ liabilities.

I don’t want to dwell exclusively on the Turkish example, which, in my view, is fraught with confusion about what exactly the authorities are trying to achieve. What I do want to do is examine under what conditions, if any, a hike in reserve requirements can be effective in tightening monetary conditions. This is particularly relevant at a time when many emerging markets think they can “get away” with avoiding raising interest rates by employing alternative tools, to avoid attracting further capital flows from abroad.

Changes in the RRR are meant to influence monetary conditions through the so-called bank-lending channel of monetary transmission. Accordingly, bank funding relies in large part on demand deposits, which are subject to reserve requirements. Raising the RRR increases banks’ demand for reserve deposits at the central bank (CB). If the CB does not accommodate that demand, short-term interest rates will rise to bring demand for reserves in line with supply. Monetary conditions then tighten because banks will pass on their higher funding costs to corporates and households, in the form of higher lending rates, in order to safeguard their profitability (interest rate margins).

Against this backdrop, for a RRR hike to be effective in tightening monetary conditions, the following have to hold:

Banks should be limited in their ability to switch to other sources of short-term funding that are not subject to reserve requirements. In the case of Turkey for example, the RRRs (which are different across different liability maturities) have been applied to both deposits and repo funding from abroad and from domestic customers. However, they do not apply to repo transactions with the CBT and among domestic banks. For this reason, it’s unclear how the hike in RRRs can materially increase banks’ cost of short-term funding, if the CBT is effectively committed to supplying enough reserves to keep its target rate at (the now lower) 6.50%.

To make things more tangible, suppose a bank has 100bn liras worth of short-term liabilities and the RRR is raised from 6% to 8%. Suddenly, demand for reserves at the CBT rises by 2bn liras. Banks would then have to sell 2bn of their other assets, to meet the requirement, putting upward pressure on interest rates and, in the process, also shrinking the quantity of credit in the economy. However, by committing to maintain the target interest rate at 6.50%, the CBT effectively commits to creating enough reserves to meet any additional demand at that rate.

How will it do that? It will go to the open market, purchase TRY2bn worth of government securities and fund the purchase with the creation of bank reserves. Alternatively, it can go to the FX market and purchase TRY2bn worth of, say, US dollars, again funded with bank reserves. In that way, banks’ reserves go up without them having to shrink their loan book. On the contrary: new liquidity has come into the system (as the cash received by the sellers of the bonds or the foreign exchange has been deposited at the banks), which can be employed for further loan creation.

Note that the measure might still be desirable from a prudential perspective—e.g. to the extent that higher RRRs on foreign repo funding might encourage a shift towards lira-denominated funds, thus avoiding undesirable currency mismatches on banks’ balance sheets. But what I’m arguing here is that the RRR hike is unlikely to restrain credit growth because (a) it would not have a material impact on the price of credit; and (b) it might even contribute to increasing the quantity of credit, if the CB commits to accommodating whatever additional demand for reserves at the going 6.50% rate (via securities purchases or unsterilized FX accumulation).

Looking beyond Turkey, my bigger point is that measures that do not materially raise the cost of capital (and, indeed, that are intended to lower it, to fend off foreign capital inflows) are unlikely to tighten monetary conditions. Not only because their impact through the bank-lending channel will be diluted; but also because they ignore other important channels of monetary transmission—notably the wealth and financial accelerator channels.

For example, if short-term interest rates remain low, cash will seek riskier assets, boosting their prices and leading to positive wealth effects. This in turn triggers pro-cyclical investment and consumption and, potentially, overheating (the wealth channel). Admittedly, when capital markets are global, low foreign interest rates can also play a big role in boosting asset prices, so an increase in the local short-term rates might not be enough to generate the desired tightening.

Similarly, rising asset prices increases the value of collateral and thus, the perceived creditworthiness of borrowers, encouraging more lending (the financial accelerator channel). Higher RRRs on domestic banks, IF binding, could restrain the extent of such an increase, but even then, in an open economy, at least part of the capital “shortfall” is likely to be covered by foreigners.

Finally, “here and there” policy measures may be ineffective or counterproductive, by creating confusion about what a central bank is trying to achieve and undermining its credibility. Is it lower credit growth to curb domestic demand and a widening of the current account deficit? Is it the promotion of financial stability through the change in the maturity structure and currency composition of banks’ liabilities? Is it the discouragement of capital inflows and the prevention of “excessive” exchange-rate appreciation? What about that price stability?

Clearly, there are no easy answers to the policy dilemmas of our times. My suspicion is that we should be bracing for blunter measures in the year ahead.

Global Imbalances and the War of Attrition

Back in 2005, Ben Bernanke, then (“just”) Governor at the Federal Reserve Board, coined the term “global savings glut” to describe the “significant increase in the global supply of saving” that, as he argued, helped explain the increase in the US current account deficit and the low level of global real interest rates.

In short, a deliberate rise in emerging market (EM) savings from c. 2000 onward flooded the world with cheap money, helping finance an ever-widening US trade deficit and contributing to the perverse lending incentives that eventually led to the 2008 financial collapse.

Five years later, Ben has a chance to restore the global savings-investment landscape; i.e. help force a “correction”, in the form of an exchange rate adjustment and/or a decline in EM net savings. The key here is to recognize that a repeat of the EM savings glut story is less feasible because of important differences between then and now. And the Fed has the capacity to make it, if not impossible, at least extremely costly.

The first difference is that, back then, crisis-ridden EMs in Asia, Latin America and Eastern Europe saw a need to raise their savings in order to pay down foreign debts acquired during their crises. Today, with the EM deleveraging more or less done (or not as urgent), this channel for absorbing any accumulation of dollar (or euro) reserves is no longer there.

Secondly, in the aftermath of the 1990s EM crises, many EMs saw a need to increase their resilience to foreign “hot money” with a commensurate increase in their foreign exchange reserves. This may have been possible then, but it’s considerably less so now, partly "thanks" to Ben's QE.

The reason is that this “asset swapping” from the US to the EMs and back can come at a cost: An EM central bank effectively borrows at the local short-term interest rate (the cost of sterilizing the inflows) to purchase medium/long-term US Treasuries.

For countries with historically high interest rates (e.g. Brazil, South Africa or Turkey), sterilization costs have always been high, so the "insurance" benefits of any additional FX reserve accumulation have had to be juxtaposed against such costs. However, for low-interest rate countries (incl. China, Malaysia, Singapore, Taiwan or even Korea) the “cost” of sterilization during the boom years was actually not a cost but a profit! Yields on, say, 5-year US Treasuries rose from around 3.2% at end-2003 to about 5% in 2007, which was above these countries’ short-term interest rates (i.e. they enjoyed a positive “carry”).

Today, the “carry” has turned negative even for coutnries like Malaysia and China, due to the extremely low nominal US rates across the US yield curve. This makes EM FX accumulation financially costly and politically unpalatable.

On top of that there is a third important difference: Back in the “2000s”, many EMs were operating at below-full capacity, either because of the crises of the late 1990s or because of a structural excess in the supply of unskilled labor (e.g. China). In that context, they saw it fit to promote export-led growth through an “undervalued” exchange rate, while domestic demand remained weak, and in the process maintain relatively loose monetary conditions at home.

Today, domestic demand in some major EMs is rising fast, putting pressure on inflation. Under normal circumstances, this would point to either an increase in imports to meet excess demand (--> a gradual closing of the imbalances) or a rise in interest rates to curtail demand—although the latter would come at the “expense” of a more costly sterilization of any FX interventions due to a more negative carry.

An alternative route of course is to respond by trying to cutrail foreign inflows through the imposition of taxes (or other controls) on foreign capital. But these can only be at best a temporary solution, not least because the EMs themselves do not want to stop all capital from entering. This creates an assortment of loopholes for willing, yield-seeking investors to find their way in. And in case one needed further evidence of the long-term ineffectiveness of capital controls, I'd say, "ask China!"

In that case, the Fed arguably holds the key for the reshaping of the global savings-investment landscape: If it could credibly commit to keep nominal US yields at ultra-low levels for a sufficiently long time, it could force EM action by turning current policies financially costly (through an increasingly negative carry) and politically difficult to sustain.

Of course, that's a big if. First because, unless low rates reflect (very weak) US economic fundamentals, the Fed will have to devote an increasing amount of resources to hold rates down. And the more Treasuries it buys, the larger the negative-carry costs on its own balance sheet, when the time comes to raise its own policy rate beyond 2.5-3%.

Second, in light of the widespread (and misinformed, I might add) outcry against QE in the US, it is questionable whether the Fed can credibly commit to mobilizing sufficient resources to keep yields low for long enough—that is, for longer than many major EMs can sustain their own distortionary policies.

Against this backdrop, global monetary policy-making has not been reduced to a global currency war, as Brazil's Finance Minister recently suggested. It is rather a war of attrition.

What do the Fed's policy and poker have in common?

It is no accident that, at the last FOMC meeting, one of the “outsiders” present was NY Fed economist Gauti Eggertsson, of Eggertsson and Woodford (2003) fame—the paper he co-authored with Michael Woodford discussing a central bank’s policy options when nominal interest rates are near the zero bound.

Two of the paper’s conclusions could point to the Fed’s thinking in the months ahead, in my view. First, that quantitative easing is redundant as a tool for preventing deflation, over and above central bank commitments with regard to the interest-rate path. (Although some of the assumptions they make can be challenged, especially for situations like 2008/09, where markets were dysfunctional). In the words of the authors,

“neither the extent to which quantitative easing is employed when the zero bound binds, nor the nature of the assets that the central bank may purchase through open-market operations, has any effect on whether a deflationary price-level path will represent a rational-expectations equilibrium. Hence the notion that expansions of the monetary base represent an additional tool of policy, independent of the specification of the rule for adjusting short-term nominal interest rates, is not supported by our general-equilibrium analysis of inflation and output determination.” (my emphasis)

Second, rather than quantitative easing, the optimal policy consists of a commitment to a “history-dependent” rule driven by the price level (i.e. not the rate of inflation of the consumer price index). Under that rule, the central bank commits to a given path for the level of the price index, and undertakes to make up for past inflation shortfalls (which would drive the price level below the target) by allowing future inflation to be sufficiently higher to bring prices back up towards the target path.

The motivation behind a rule like this is to bestow the central bank the ability to manage inflation expectations (and, thus, control the level of the real interest rate), even when the nominal rate is stuck at the zero bound. By raising inflation expectations, the Fed could provide stimulus by lowering real interest rates, as well as penalizing cash holders, thus forcing them to put that cash to alternative uses—consumption or investment.

While conceptually appealing, the proposed rule is vulnerable to lack of credibility. This is because, in order to conduct policy, a central bank needs not only a rule but also a tool to implement that rule. But here, the rule and the implementation tool virtually coincide: The rule is the central bank’s intention to allow higher inflation in the future in the event of past inflation shortfalls; and the tool is simply the verbal expression of that intention.

This makes monetary policy akin to bluffing in poker: If the market buys the bluff, inflation expectations rise, real rates fall, cash gets spend, aggregate demand recovers. But why would the market buy the bluff, if, for example, it suspects that the central bank will renege on its “promise” of higher inflation in the future, and that it will “cheat” by raising interest rates once aggregate demand picks up?

In short, how can a central bank demonstrate its commitment to higher inflation, besides simply stating that this is its intention?

A number of economists have sought to address this question, including Eggertsson and Woodford (E&W) in their 2003 paper. One approach, proposed by Lars Svensson involves a price-level targeting rule combined with the pegging of the domestic currency to a foreign one after it has been depreciated by a certain amount. By pegging to the currency of a trading partner that is experiencing (positive) inflation, the central bank can demonstrate that it is serious about generating inflation at home.

Clearly, while this might be a tool available to countries like Japan or Sweden (the latter being the only country to have actually experimented with price-level targeting in the 1930s, and one that involved an eventual peg to the British pound), it is not a policy available to the Fed today.

A dollar devaluation would be unacceptable to any one of the three major economic areas (the EU, the UK and Japan), given that they face a similar economic quagmire to that of the US. And of course, a peg to a basket of emerging market currencies is not credible, given that the size of foreign asset purchases the Fed would have to make would be too large compared to the size of these markets—not to mention the capital controls (see China) that prohibit the entry of foreign players into domestic markets.

So is the Fed powerless? Not entirely. But the solution rests on calling a spade a spade—or, in the current context, calling the Fed’s large-scale asset purchases of (domestic) Treasuries (or LSAPs) “debt monetization.” In this way, the LSAPs can serve as the tool with which the Fed can make its commitment to higher future inflation credible. E&W make this point:

“[T]he tax cut can be financed by money creation, because when the zero bound binds, there is no difference between expanding the monetary base and issuing additional short-term Treasury debt at zero interest. This is essentially the kind of policy imagined when people speak of a "helicopter drop" of additional money into the economy, but here it is the fiscal consequences of such an action with which we are concerned.

[I]f the central bank also cares about reducing the social costs of increased taxation—whether because of collection costs or because of other distortions—as it ought if it really takes social welfare into account, the result is different. As Eggertsson has shown elsewhere, the tax cut will then increase inflation expectations, even if the government cannot commit to future policy.”

The bottom line here is one I’ve been arguing all along: that the only real way to boost aggregate demand at this stage is through a fiscal operation—one that is targeted towards safeguarding the economy’s productive capacity and/or facilitating the deleveraging of companies and households that remain overwhelmed with debt. (Mind you, this is not necessarily something that I, as a taxpayer, would be crazy about—I am talking strictly on economic grounds.)

The Fed’s role in this operation would be to facilitate its financing and, in the process, raise inflation expectations and help the economy avoid falling in (or escaping from) a liquidity trap. In other words, the stated motivation behind any LSAPs should not be the so-called “portfolio balance” effect (whose impact is doubtful at this juncture) but the outright monetization of government debt.

How likely is that the Fed will come out and say so on November 3rd? Don’t hold your breath—especially with a pretty nasty US midterm election a day before! In which case, the Fed’s policy will continue to resemble bluffing in poker for a little while longer.

Ben’s new rabbit: Inflation expectations

Once again, we find ourselves holding our breath for a new fluffy rabbit coming out of Ben’s hat on November 2nd (the day of the next FOMC meeting). In previous pieces I have discussed the limitations of unconventional measures (QE in particular) in stimulating aggregate demand. Here, I want to revisit this discussion in light of Bernanke’s new magic trick: that of managing inflation expectations.

The starting point is the two principal factors restraining aggregate demand currently: First, the ongoing balance-sheet repair by a certain segment of households, corporates and banks; and second, the fact that economic agents that are cash-rich maintain a strong preference for liquidity. Put differently, those with little cash and lots of debt can’t spend; and those with lots of cash and little debt won’t spend.

So the question is: What tools does the Fed have available for addressing these two problems? Pre-empting my conclusion, Large-Scale Asset Purchases (or LSAPs) of US Treasuries are an ineffective—indeed, a counterproductive—tool for addressing any of the two problems above; the kind of LSAPs that would work are *not* available to the Fed in the current political climate. But there is certainly hope in the Fed’s intention to manage inflation expectations. The issue there is where exactly inflation expectations should be guided towards, and how best to achieve that.

Starting with balance-sheet repair... I have argued before that the Fed’s LSAPs of mortgage-backed securities (MBS) and US Treasuries (ie "QE 1.0") have not been an effective tool for tackling the problem. This is because, by design, they fail to target those segments of the economy undergoing balance sheet repair.

As an example, the drop in mortgage rates that followed the Fed’s MBS purchases helped prompt an increase in mortgage refinance activity. But the cash boon from lower mortgage payments only benefited people who could afford to refinance—ie those with jobs, income and positive equity in their home, instead of the cash-strapped households facing foreclosure. Meanwhile, foreclosures kept on rising as recently as September 2010.

Ditto for corporates: Large firms with access to capital markets benefited from higher investor demand for “safer” fixed-income assets such as high-grade corporate bonds (arguably triggered by the LSAPs). But small firms with no capital market access continue to face tight lending standards.

Against this backdrop, for any new LSAPs to work, the Fed would have to be far more adventurous in terms of the assets it purchases (for more on this see here and the comments on that piece). Unfortunately, in the current US political climate such an “adventurous” LSAP program is not an available policy tool—esp. since it would require the cooperation of the Treasury. So what’s left?

Come out the new rabbit—the guidance of inflation expectations. There are two issues here: First, how does the management of inflation expectations help stimulate aggregate demand? Second, what should “managing inflation expectations” mean at this juncture and how can the Fed best achieve it?

Starting from the first question, there are two ways in which the guidance of inflation expectations can help aggregate demand at this juncture. First, by preventing real interest rates from increasing to undesirable levels: with nominal interest rates at record lows, sustained declines in inflation expectations would translate into rising real interest rates—a rise that the Fed would be unable to “fight” by cutting the nominal interest rate further. Hence the need to work on the inflation-expectations front.

But the *appropriate* management of inflation expectations can go further in my view. It can help address the second problem I mentioned in the beginning—agents’ preference for liquidity.

Currently, with inflation (and inflation expectations) at low levels, holding cash is “cheap” because of the low opportunity cost. But an increase in inflation expectations would make holding cash expensive, provided it is accompanied by a Fed commitment to keep nominal short-term rates low even if inflation eventually exceeds the Fed’s medium-term “target”. Note that in the absence of such a commitment, agents would expect the Fed to raise short-term rates as inflation moves higher. This which would in turn preserve their real return on cash, eliminating the incentive to switch into less liquid investment instruments, consumption and/or hiring (in the case of corporates).

Put simply, in order to facilitate a switch away from cash, the Fed has to commit to allowing inflation to go above its medium-term projection. Now, before you accuse me of pushing the Fed into some treacherous territory, check out what Ben said on Friday:

Recognizing the interactions between the two parts of our mandate, the FOMC has found it useful to frame our dual mandate in terms of the longer-run sustainable rate of unemployment and the mandate-consistent inflation rate.

Repeat: “mandate-consistent.”

Later in that the same speech, Bernanke added that

“The longer-run inflation projections in the SEP indicate that FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below.”

Now that’s for the “longer-run”—i.e. beyond 2012. In my view (and that’s just *my* view), the “mandate-consistent” inflation in the nearer-term is above that level, precisely for the reason I mentioned above: Economic agents with lots of cash at hand need an incentive to part with their cash.

So much about the economic rationale. How about implementation? In my view, hints of such an approach were given by Bernanke on Friday:

A step the Committee could consider, if conditions called for it, would be to modify the language of the statement in some way that indicates that the Committee expects to keep the target for the federal funds rate low for longer than markets expect [my emphasis]. Such a change would presumably lower longer-term rates by an amount related to the revision in policy expectations.

The problem with Ben’s specification however is that “longer than markets expect” does not condition the period of low rates on the inflationary path. As such, it falls short of achieving the liquidity-preference objective I mentioned above.

But there is also a second problem (read “systemic risk”) with the Fed’s overall policy framework—one that brings me back to reiterating (for the nth time) my aversion to the LSAPs. This is the inconsistency between the Fed’s attempts to “force down” long-term yields to levels that are misaligned from the Fed’s own medium-term targets for inflation and growth!

Basically, it’s one thing to intervene in order to correct a misalignment of asset prices from fundamentals (like the Fed did with its liquidity interventions in 2008). It’s another thing to intervene in order to engineer a misalignment of asset prices away from fundamentals—the very fundamentals you (Fed) are trying hard to achieve! This latter is not only non-credible; it is also dangerous, as it creates bond-market bubbles that can unwind with potentially disruptive effects for the financial system (it’s no accident that the hot topic at the IMF meetings last weekend was when will the bond bubble burst).

So with all that in mind, my call to Ben would be “a little more inflation and a little less LSAPs please”. LSAPs of Treasuries or MBS have little power to stimulate aggregate demand but carry too many risks for the financial system. Instead, the FOMC should find the language to convince the world that a little more inflation in the near-term is the way to go.

QE and its unintended consequences

In raising the possibility of QE2 at his Jackson Hole speech, Ben Bernanke mentioned two potential costs that would have to be assessed against any benefits of a QE - round #2, before the Fed makes a decision to that effect.

One had to do with the potential rise in inflation expectations due to perceptions that the Fed would have difficulties unwinding its vastly expanded balance sheet in the future.

The second had to do with economists’ insufficient understanding of the exact impact of central bank asset purchases on financial conditions (let alone aggregate demand). As Bernanke put it, “we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. […]. [U]ncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.”

Here, I want to add a few more potential risks into the list: Are there any unintended consequences of the Fed’s asset purchases (and low-for-long interest rates more broadly), other than a possible spike in inflation expectations? For the sake of brevity I’ll just keep a list format, with the intention to elaborate on each one of the issues separately in future pieces.

So the first concern has to do with the potential systemic risks associated with the behavior of institutions such as insurers and pension funds in an environment of low (and falling) long-term interest rates. For starts, falling interest rates have increased the net present value of their liabilities (and have lengthened their duration). This does not have to have a negative balance sheet impact, provided that the asset side of these institutions benefits from matching capital gains as interest rates fall.

However, news reports and market talk suggest that this is not what has happened: Before the Fed’s hint of QE2, expectations that long-term rates had to go up from record low levels saw many institutions holding conservative duration exposures on the asset side of their balance sheet. The result has been a smaller gain on the asset side (with the concomitant increase in the funding gap) and a recent push towards long-duration positions to address the duration mismatch between assets and liabilities. The “systemic” risk here is that, if and when long-term yields begin to rise, the unwinding of these positions can lead to a much sharper rise in yields and volatility in the bond market.

A second concern has to do with the hedging behavior of mortgage/MBS investors. Low interest rates increase the probability of refinancings and, as a result, reduce the expected duration of MBS securities (and the underlying mortgages). MBS investors hedge against this prepayment risk by holding instruments of long duration, such as long-term Treasuries or interest rate swaps. Once again, if and when interest rates start going up, unwinding these positions can become destabilizing, as everyone enters the market in the same direction. (The impact of this is of course mitigated by the fact that the Fed itself holds a substantial chunk of the mortgage market).

Third on the list is the potential build-up of leveraged positions (or “carry trades”) “thanks” to the Fed’s promise of low-for-long interest rates. The risk is that crowded carry positions can unwind fast once Fed rates begin to rise, especially since the earlier leverage build-up has pushed asset valuations to stretched levels.

Now, unlike many pundits out there, I do not believe there is an empirically established causality from the Fed's policy rates to investors’ leverage. For example, the academic literature has failed to find a definitive link between the level of advanced economy interest rates and emerging market spreads (which would be obvious beneficiaries of carry trades). What does matter is investors’ risk appetite (e.g. proxied by the VIX).

And here is the challenge for the likes of the Fed: Economists do not have a complete understanding of how monetary policy affects investors’ risk-taking behavior (the so-called “risk-taking channel"). But this does not mean that it’s something to ignore, simply because it doesn’t fit into some well-established theoretical framework. More so since the framework supporting the Fed’s asset purchase program (the “portfolio balance channel”) has little to say about the build-up of leveraged positions and any associated risk from their unwinding.

A final concern—and maybe the least interesting—is the impact of low interest rates on the viability of money market funds (MMFs). Low-for-long nominal rates, combined with new regulations to increase the liquidity and reduce the maturity and riskiness of MMF investments has been squeezing the sector’s profitability. Add to that the fixed expense ratios of around 0.2-1% of assets, and the low rates can force at least some of the less efficient MMFs to closure.

The reason this is the least interesting problem in my view is that the economic impact is unlikely to be meaningful. Users of MMFs tend to be high-quality corporate borrowers who could easily tap bank or capital market financing. True, the costs of borrowing might be marginally higher, but this is most likely dwarfed by the impact of record-low interest rates thanks to the Fed's policy.

Still, I thought I should mention it, first because some economists have raised this issue in the past, and second because I was personally amused by Bernanke’s own take on this concern. Here is Ben in 2004:

“In thinking about the costs associated with a low overnight rate, one should bear in mind the message of Milton Friedman's classic essay on the optimal quantity of money (Friedman, 1969). Friedman argued that an overnight interest rate of zero is optimal, because a zero opportunity cost of liquidity eliminates the socially wasteful use of resources to economize on money balances. From this perspective, the costs of low short-term interest rates can be seen largely as adjustment costs, arising from the unwinding of schemes designed to make holding transactions balances less burdensome. These costs are real but are also largely transitory and have limited sectoral impact.”

That’s right… Bernanke (then-Fed Governor) responded by going philosophical, citing a supposed structural argument (something like, “MMFs are probably not that useful and zero interest rates can help eliminated them”), grounded on a much-debated theory (Friedman’s rule) to support a policy that is strictly cyclical in nature!

Anyway.. A mini-diversion from the main point, which is that the potential costs from further QE, and low-for-long yields more broadly, go beyond the possible rise in inflation expectations and the threat to the Fed’s credibility. Against this backdrop, any cost-benefit analysis should consider not only policymakers’ uncertainty over QE’s impact on aggregate demand but also their uncertainty about the potential risks for global financial stability.

Leaving the Plaza Accord behind

Once again, Japan’s experience post-Plaza Accord has been brought up as a mistake to be avoided, against the backdrop of the escalating pressures on China to revalue the renminbi.

This time it was Chinese economist and member of the Central Bank’s monetary policy committee Li Daokui, who said last week that "China will not go down the path that Japan did and give in to foreign pressure on the yuan's exchange rate.”

I personally find the parallel misplaced and the reason is that it confuses the legitimacy of the objective (=revalue an undervalued currency to help towards the correction of global imbalances) with the (in)appropriateness of its implementation. Still, revisiting Japan’s situation during and after the 1985 Plaza Accord can offer valuable lessons for how to do things better this time round—both for China and its trading partners.

So, the mantra linking the Plaza Accord with Japan’s subsequent economic malaise goes like this: The large revaluation of the yen prompted large amounts of speculative capital inflows into Japan which, together with a loose monetary policy, fuelled an asset bubble that then burst pretty spectacularly.

In my view, the key weakness of the argument is in its presumed causality from the yen’s appreciation to Japan’s asset bubble. Of all the factors cited in the literature as contributing to the asset price boom and then bust, the yen’s move is at best an incidental one.

First of all, the rise in asset prices, notably real estate, had been building up even before the Plaza Accord. One key reason behind the increase was the aggressive growth in credit, notably to the real estate sector. This was itself prompted by a host of structural reasons, including inter alia:

The liberalization of interest rates, which, by raising deposit rates, reduced banks’ profit margins and forced them to look for higher-yielding lending opportunities; the opening up of capital market access to corporates, which shifted part of the corporate funding away from the banks and towards the capital markets—this pushed banks to look for new clients to lend, often with higher risk characteristics; and a distorting tax regime governing the real estate sector, which encouraged the holding onto real estate assets, thus restricting supply, while demand was rising.

If there is a lesson for China here, it has little to do with exchange rate policy. Instead, it is that preventing the build-up of bubbles requires a robust regulatory framework for the financial sector—one that penalizes excessive risk-taking and dampens the procyclicality of credit (a lesson that we have come to learn yet again in the aftermath of the subprime debacle).

The second lesson from Japan’s experience has to do with the role of monetary policy in contributing to the boom and bust. And here is where the Plaza Accord deserves criticism—though not for its prescription on exchange rates!

You see, the agreement was not *just* about foreign exchange intervention to realign the nominal exchange rates; it also prescribed global coordination of macroconomic policies to correct the global BoP imbalances. This latter component was a key factor behind the Bank of Japan (BoJ)’s loosening of monetary policy during 1986-87.

As three Japanese academics document here, the BoJ had expressed concern early on about the easy money, the concomitant speculative activity in the real estate and stock markets, and the dangers of a subsequent debt deflation. However, the BoJ proceeded with rate cuts, partly in the face of pressures by its trading partners to stimulate domestic demand (these pressures were made explicit in the Louvre Accord in February 1987, under which Japan pledged another 50bp rate cut in its policy rate).

One can debate of course how big a role monetary policy in itself can play in fuelling asset bubbles of the scale experienced in Japan in the late 1980s. Indeed, those who object to the premise will find a staunch ally in Ben Bernanke! But my main criticism here is that, by calling for stimulative monetary and fiscal policies, Japan’s trading partners confused the cyclical from the structural causes of the global imbalances. The result was a monetary stance that was too loose for Japan; and the diversion of attention away from corrective measures that had to be taken by the likes of the United States.

The situation is somewhat different at the current juncture with China. First, few people dispute that the key reasons behind China’s external surpluses are structural—and, therefore, nobody is really asking China to take inappropriately stimulative measures to increase domestic demand. In the same vein, there is no doubt that structural reforms to rebalance growth domestic demand and, notably, private consumption, would be welcome by the global community.

But this is no reason to dismiss the exchange rate revaluation as *one* corrective tool: First, as I argued here, China has yet to bear the brunt of the (cyclical) correction of global imbalances since the onset of the financial crisis: Even as its own trade surplus has shrunk, the US trade deficit with China has barely moved in US GDP terms. Most of the US adjustment has been borne by other countries.

Importantly, a large exchange rate undervaluation in a country as large as China contributes to the misallocation of global resources—e.g. by prolonging the survival of inefficient companies/exporters in China and/or by encouraging the outsourcing of business to China thanks to an artificially low cost structure.

Bottom line, evoking Japan’s experience under the Plaza Accord as a reason to rebuff pressures to revalue the renminbi is misplaced, if not disingenuous. While nobody can dispute the need for a score of structural measures to fortify the financial sector and contain the formation of bubbles in China, maintaining an undervalued exchange rate can only serve mercantilistic objectives and/or protecting certain industries at the expense of a balanced, efficient and fair allocation of global resources.

QE the Sequel: Putting Ben’s Money Where His Mouth Is

A consensus is emerging among Fed watchers that the Fed is set to embark on a fresh round of “quantitative easing” (QE), faced with a subpar employment growth and a lingering threat of deflation.

Abstracting from whether the economic outlook is such as to warrant further stimulus, I wanted to focus here on what kind of “QE” might be more effective this time round, if it were to happen.

Pre-empting my conclusion, let me say that my proposal will probably sound like the mother of unconventional measures, but it’s actually a variant of what the Chairman himself proposed back in 2002, at his famous “it” speech on deflation. But let’s start from the beginning.

First of all, “QE” means the purchase by the Fed of a certain quantity of risky assets, funded by the creation of bank reserves. The intended objective is twofold: First, to boost the price (/lower the yield) of the assets purchased (in the case of the Fed’s first round of QE, these would be US Treasury bonds, agency debt and mortgage backed securities (MBS)); and second, to affect the price of other risky assets through the so-called portfolio balance effect.

For details on how the portfolio balance channel is supposed to work you can read Brian Sack’s speech at the Money Marketeers last year (here), but here is an excerpt from that speech that sums it up:

“[T]he purchases bid up the price of the asset [being purchased] and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets.” (my emphasis)

So against this theoretical backdrop, the key questions to ask when contemplating “QE, The Sequel” are two: What assets should the QE program target in order to be effective? And, critically, who should be buying those assets?

To answer the first question, we have to have in mind the endgame, which is the desire to boost aggregate demand. In other words, the true metric for success of an LSAP program is not whether it managed to lower the yield of the security targeted (e.g. mortgage rates) but whether those lower yields translated into a material increase in aggregate demand.

By that metric, the Fed’s past LSAPs have probably fallen short. Clearly, measuring the counterfactual is impossible, but there are reasons to believe that the impact on aggregate demand was small. Why? First, because the reduction in mortgage rates boosted refinancings only by people who could refinance—i.e. people with jobs and some positive equity in their home. Not exactly the most cash-strapped ones who would have spent the extra cash.

Second, the portfolio-balance effect of the LSAPs on the prices of assets like corporate bonds or equities is at best weak, if not counterproductive. The reason (which I explained in detail here) has to do with the fact that US Treasuries and MBS are not “similar in nature” to corporate debt and equities. Unlike the latter, Treasuries/MBS have more of a “safe haven” nature—so that removing them from investors’ portfolios create demand for more “safe” assets, rather than boosting the prices of equities, high yield bonds, etc.

The bottom line here is that, while the LSAPs may have helped boost the cash position of certain financially healthy households and corporates, (a) they were not targeted to achieve a big bang for the buck; and (b) they have failed to boost agents’ risk-taking behavior—in the form of stronger consumer spending or a meaningful pick-up in employment.

Put differently, the LSAPs in their first incarnation failed (as they did in Japan) to remove the right type of risk out of the market. So what should a sequel target then?

The answer is assets in the riskiest part of the portfolio spectrum—small business loans, foreclosed properties, toxic credit card debt, and so on. Now, before I have hundreds of copies of the Federal Reserve Act thrown at me, let me touch a bit on the logistics.

Logistic #1: The “QE” operation should not actually purchase the small business loans or foreclosed properties themselves from the banks. This would be a logistical nightmare for the Fed (which would have to administer those loans), as well as giving rise to unmitigated moral hazard (why would I ever pay back my credit card debt, if the Fed stood ready to buy it off for free?) Instead, the QE operation should aim at injecting capital to banks against mark-downs on existing distressed loans.

Logistic #2: Clearly, this walks and talks like a fiscal operation, right? Well, it is a fiscal operation, with winners and losers, capital allocation to “chosen” institutions and with costs to the taxpayer. As such, the Fed is not the right institution to be in charge—it should be the US Treasury instead. So what is the role of the Fed then?

Enters Ben Bernanke, 2002:

“In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. […] If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.” (my emphasis)

Call it debt monetization par excellence. You set up a “special purpose vehicle”, which funds targeted capital injections to banks with Treasury securities. The Fed then purchases an equal amount of Treasury debt, funded by bank reserves.

The advantages of this approach are that (a) it would remove the right type of risk out of the market, in effect accelerating the “deleveraging” of the economy; and (b) it would distance the Fed from the credit allocation business. A key disadvantage of course is that many people out there (myself included) loathe the idea that irresponsible bozos would end up getting bailed out of their mortgage debt with taxpayer money.

But this is precisely why “QE, The Sequel” (and any QE for that matter) should be the explicit responsibility of the fiscal authority—i.e. an elected governing body: So as to allow voters to ultimately decide the kind of path their economy should follow. This may sound like lunacy in the current political climate, but maybe another quote from that same Bernanke speech can help strike an optimistic tone:

“In short, Japan's deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has. Thus, I do not view the Japanese experience as evidence against the general conclusion that U.S. policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States.”

So there.. a chance for America to show that's it's not going to become Japan.

The “E” and the “M” of the EMU

They say “do not believe anything until it’s been officially denied”. Just last Thursday, ECB President Jean-Claude Trichet categorically denied that the ECB had discussed buying government bonds of peripheral eurozone members.

A market sell-off and a hectic weekend later, it was time for a complete about-face… Per the ECB’s press release on Sunday night, “in view of the current exceptional circumstances prevailing in the market, the Governing Council decided [among other things]

To conduct interventions in the euro area public and private debt securities markets (Securities Markets Programme) to ensure depth and liquidity in those market segments which are dysfunctional. The objective of this programme is to address the malfunctioning of securities markets and restore an appropriate monetary policy transmission mechanism. […]

In making this decision we have taken note of the statement of the euro area governments that they “will take all measures needed to meet [their] fiscal targets this year and the years ahead in line with excessive deficit procedures” and of the precise additional commitments taken by some euro area governments to accelerate fiscal consolidation and ensure the sustainability of their public finances.”

The significance of this move is huge, as far as killing speculators goes, but here I want to focus on a key policy dilemma that has emerged since the subprime (and now the eurozone) crisis ever began: The need for a separation between monetary and fiscal policy—what Trichet referred to as the difference between the “E” and the “M” of the EMU (or Economic and Monetary Union) at the ECB’s press conference on May 6th.

In the US for example, this separation was all but blurred by the Fed’s decisions to put its own balance sheet at stake in the bailouts of Bear Stearns, Citi and AIG and, more bluntly, by its decision to buy US Treasuries, GSE debt and mortgage-backed securities. In the event, Congress’ disgruntlement with the AIG saga, monetarists’ concerns about “debt monetization” and valid criticisms about the Fed’s decision to favor a specific sector—housing—with cheap credit, have served to raise questions about the appropriate limits of the Fed’s independence.

Does the European/ECB approach offer an alternative/better(?) route? In my view yes, notwithstanding the latest decision to purchase government bonds.

Ignoring the bond purchases for the moment, recall first that, at the height of the financial crisis, all failed banks were “dealt with” by their corresponding national governments, without any participation from the ECB. To the extent that saving insolvent banks was deemed desirable form a social or financial-stability perspective, the burden was assumed by the elected governments, with ultimate responsibility going to the taxpayers (who voted for them).

Meanwhile, the ECB did not remain idle—on the contrary: It was the first central bank to flood financial institutions with liquidity right at the onset of the crisis in August 2007; and in June 2009, it decided to provide as much funding as demanded by European financial institutions at a low, fixed rate for a 12-month maturity (longer than the Fed’s liquidity operations). In other words, the ECB demonstrated full flexibility and creativity when it came to preserving financial stability and fulfilling its LoLR functions (to illiquid but solvent institutions).

Given the faithful delineation between fiscal and monetary responsibilities, Sunday's decision to step into the government bond market may be seen as an aberration—or worse: A betrayal to the spirit of its price-stability mandate, let alone an anathema to the Germans.

I actually don’t think so. First of all, the interventions are described as—effectively—liquidity operations, to improve the functioning of monetary transmission. This is not a b.s. excuse for back-door debt monetization. Repo transactions using peripheral-economy debt as collateral have been increasingly dysfunctional, undermining the ability of some European financial institutions to fund themselves in private markets.

Now, why is that so different from the Fed’s MBS purchases, which, ultimately, were also aimed to help improve conditions in financial markets? It is different in many ways. First, unlike the MBS purchases, the ECB’s operations will be sterilized—that is, the objective is not to loosen monetary policy further but to relax financial conditions from the currently tight levels by improving funding for financial institutions (and governments).

Importantly, the Fed’s MBS purchases were unconditional: No actions were demanded on the beneficiaries of these purchases (the mortgage borrowers). In contrast, the ECB *had* to extract commitments for further fiscal consolidation from the eurozone governments, so that it could claim that (by its own judgment, rather than the now discredited rating agencies) peripheral government bonds are “safe” enough for its portfolio. We yet have to see whether such pledges will be met, but they are at least a start.

Mind you, the point goes beyond the “narrow” objective of securing the safety of the ECB’s balance sheet. It is about securing a commitment by the eurozone governments that they still see the EMU as a desirable objective and one that is worth making sacrifices for: Namely, further fiscal measures in line with the spirit of the Stability and Growth Pact, and structural reforms to restore competitiveness.

Trichet’s tough talk on May 6th aimed at highlighting exactly that—the limits of monetary policy in preserving financial and economic stability, when the political will to do so is lacking:

“We cannot substitute for the governments. The governments have their decisions to take while we have our own role as an independent central bank, and of course we expect each authority to fulfill its own responsibilities.”

What are the lessons here, including for the U.S. of A.? The first is the realization that, unfortunately, politicians are unlikely to get their act together until things are at the brink of falling apart. And even then, political will may be hard to muster in the midst of the crisis. Trichet’s “bluff”(?) worked in finally stirring bold action. Bernanke had to step in and bail out the likes of AIG with Fed money. But once the emergency is over, any fiscal burdens must be transferred from the Fed’s books to of the US Treasury.

The second is that there was, in fact, an alternative to the MBS/Treasury purchases... which was to buy none! Instead, like the ECB, Fed operations could have focused solely on securing ample liquidity to the financial system, in line with its mandate of safeguarding financial stability. Indeed, as I argued here, the effectiveness of the so-called “portfolio balance” channel over and above the positive impact of the MBS purchases on bank liquidity is dubious. Let alone the hoped-for impact on inflation… has anybody seen the recent US inflation numbers?! (OK, OK, we can’t know the counterfactual!)

The third lesson is that monetary policy cannot be oblivious to fundamental imbalances in the economy, whether these take the form of fiscal imbalances, current account imbalances or large indebtedness in the household, corporate or financial sectors. This applies even to those central bankers fixated with (product price) stability. The reason is that the resolution of such imbalances is often “non-linear”—as in, abrupt and brutal and one that will tend to undermine the very price stability that the central bank claims to defend.

The eurozone came close to its "non-linear" experience by seeing the viability of the euro falling apart. The US (along with the rest of the world) felt it first hand, in the fourth quarter of 2008 and its ugly aftermath.

Both these instances suggest that Trichet may actually be wrong: The “M” and the “E” cannot be that separate after all.

LSAPs: A Tale of Overkill Gone Too Far

With the Fed’s quantitative easing (QE) completed last week, I thought it might be a good time for stock-taking: Did QE achieve its intended objectives? And could the Fed have done things better?

By QE I mean of course the “Large-Scale Asset Purchases” (or LSAPs) of GSE debt, mortgage-backed securities (MBS) and US Treasuries. These were first announced in November 2008, expanded in March 2009 and concluded in March 2010.

So let’s start with the intended objectives first. In the case of the purchases of MBS ($1.25 trillion) and GSE debt ($200 billion), the objective was clearly stated at the November 2008 Fed statement:

“[..] to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets”

In other words, at the height of the crisis, the Fed decided to provide enormous support to a specific sector (housing), in the context of its efforts to “improve conditions in financial markets more generally.” As I argued at the time (here and here), by effectively getting the Fed into the credit-allocation business, the MBS purchases were an overreach of its mandate and a potential threat to its independence. They were also unnecessary, as we’ll see below.

Nonetheless… There is no doubt that the Fed achieved its stated objective: Mortgage yields have shrunk since the purchases were announced and the reason is clear: When the Fed buys up an enormous share of the MBS market, it bids up MBS prices and lowers their yield—full stop.

So far so good. But QE was not just intended to affect the price (/yield) of the assets purchased. Another critical objective was to affect the price of other risky assets such as equities and corporate bonds through the so-called portfolio balance effect.

The clearest description of how the portfolio balance channel was thought to work was provided by the NY Fed’s Brian Sack last December (my emphases):

“[T]he purchases bid up the price of the asset [being purchased] and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets.

[..] With lower prospective returns on Treasury securities and mortgage-backed securities, investors would naturally bid up the prices of other investments, including riskier assets such as corporate bonds and equities. These effects are all part of the portfolio balance channel.”

The problem with this argument is that it treats Agency MBS and Treasuries (i.e. the things the Fed bought) as assets that are “similar in nature” with corporate bonds and equities. However, as highlighted in a 2004 paper by Takeshi Kimura and (the Fed’s own) David Small, this may not be true.

The reason is that the returns of equities and corporate bonds (other than high-grade) tend to be positively correlated with an investor’s consumption stream; whereas the returns of “safer” assets such as US Treasuries (and, arguably, GSE(/government)-backed MBS) tend to have a low or negative correlation with private consumption.

This means that, in a portfolio context, such “safer” assets provide a hedge against a drop in consumption during bad times (i.e. during a recession and uncertainty about labor income).

And for this reason, QE operations that remove “safer” assets such as Treasuries (or Agency MBS) from the market give rise to portfolios that are heavily “overweight” pro-cyclical assets (like equities and high-yield corporate bonds) compared to investors’ optimal allocation. In response, investors might actually shed pro-cyclical assets to rebalance their portfolios, raising their risk premium. In other words, the Fed’s LSAPs in their 2008-2010 form may have had the opposite spillover effects from what the Fed had wanted to achieve.

What are the lessons here?

The first thing to note is that, even at the zero bound, the Fed can achieve a great deal without LSAPs. This is via (1) the commitment to keep the policy interest rate at near-zero levels for an extended period; and (2) the ability to extend unlimited amounts of liquidity to the financial system to safeguard financial stability, thus helping address the root of the crisis (like the ECB did).

In my view, it was these two tools (along with the bank stress tests and recapitalizations) that were instrumental for the rebound in financial markets since mid-March 2009. Specifically, the commitment to low-for-long rates helped to:

• bring down the level of private long-term interest rates by reducing the long-term “risk-free” rate;
• lower credit spreads, since lower interest rate levels mean lower debt servicing costs and, thus, lower expected probabilities of default;
• improve the outlook for credit conditions and aggregate demand, which in turn has reduced risk aversion (and, thus, lifted asset prices).

Meanwhile, the liquidity (and recapitalization) programs helped improve financial stability and lift asset prices by reducing systemic risk and volatility.

Against this backdrop, the Fed’s asset purchases can be seen as a supplementary tool, in the context of policy overkill. However: As argued above, for LSAPs to lower the private long-term cost of capital they have to directly target pro-cyclical assets such as equities, high-yield corporate bonds and other “toxic” stuff; not Treasuries and Agency MBS!

Now, you’ll probably say that for someone who cares about the Fed’s financial independence (and I clearly do), this is a toxic proposition. Not really! The Fed already took a large amount of risk on its balance sheet with its involvement with Bear Stearns, Citi and AIG, as well as with the MBS purchases (unless it holds them *all* to maturity).

Once you’ve gone through that route, the case for focusing on Treasuries and MBS alone is weak at best; and it’s also counterproductive and inconsistent with its Fed mandate, as argued above.

What matters for the portfolio balance channel to work is that the Fed removes large amounts of pro-cyclical assets from investors’ aggregate portfolio; the Fed does not need to target a specific asset class.

In fact, had it bought a mix of equities and corporate bonds (indiscriminately, e.g. by buying equity and bond indices) it would have made tons of money AND would have also avoided the fear of causing market havoc when trying to offload these assets later—a dominant concern in the Fed’s and investors’ minds when it comes to unwinding the MBS purchases.

Call me a purist, but I continue to see the Fed’s MBS and Treasury purchases a mistake; I did back then, and I still do now. All I can hope is that researchers can reach consensus about this before the next crisis!

Ludicrous claims about the renminbi

With the Treasury’s verdict on global currency manipulators coming up on April 15th, the debate on the Chinese renminbi has not just been increasingly heated; it’s also turned ludicrous.

The ludicrous took center stage last week after a key figure in the Chinese leadership suggested that the renminbi is not undervalued.

Shortly after, two of the most loyal Ambassadors of Ludicrous—top economists at a couple of brand-name investment banks—argued that “the renminbi is not particularly undervalued…. China is importing a lot”; or that the US should mind its own business and save more.

Needless to say, these claims are, well, ludicrous.

Starting with the US savings argument… Since the third quarter of 2006, the US trade deficit has declined by almost 3% of US GDP—i.e. US national savings have risen by as much. And yet, the bilateral trade deficit with China has NOT. MOVED. (in US GDP terms). All the adjustment in the US external imbalance has been borne by other countries, notably oil/commodity exporters, Japan and the eurozone. China’s own contribution has been practically zero so far.

On top of that, most people refer to the global imbalances as a US vs. China problem. Not true. The eurozone, which has been running a trade surplus, has seen its trade deficit with China rise almost uninterruptedly for years now. Indeed, the increase in the bilateral deficit with China accounts for 70% of the deterioration in the eurozone’s trade balance since end-2001 (when China joined the WTO) and for one third of the deterioration since mid-2005 (when China began to appreciate its currency).

Both these examples show that the “need for higher savings” argument is bogus. No, I’m not saying that the US does not need to save more. The point here is that despite the recent rise in US savings, China has yet to bear the brunt of this adjustment, instead displacing other exporting countries, many of which are as poor or poorer. Yes, China is “importing more”. But clearly not *enough*. And a prompt and meaningful real exchange rate appreciation is a critical policy tool to make “enough” happen.

Then you have those who say that a renminbi appreciation won’t be of much help in reducing the bilateral deficit with the US. To support this, they point to the currency’s 21% appreciation vs. the US dollar since July 2005, which, seemingly, had no impact on the US deficit with China (the deficit kept increasing in dollar terms until the crisis escalated at the end of 2008).

This argument is equally bogus for at least two reasons: First, it ignores the role of domestic demand growth as a driver of imports. But more importantly, even a 20% change in the exchange rate means very little when the price and wage levels start from an extremely low base.

Chinese wages remain a tiny fraction of wages in the advanced world when measured in US dollar terms. They are also much lower than many of China’s developing-country competitors in global markets for, say, textiles or manufactures (e.g. see Peru, Turkey, Mexico, Romania). Meaning that even a further 20% or 30% appreciation may not be enough to bring wages to par with competitors.

Incidentally, for a country with a stated objective to reorient growth towards domestic demand, raising real wages would be an obvious starting point.

But it goes beyond that. Recent press reports cite that stress tests by China to assess the resilience of its exporters to renminbi appreciation found that some firms would be very sensitive and probably go out of business. In other words, many Chinese exporters only exist because of, effectively, a subsidized exchange rate level. Apart from being unfair in the context of a global competitive landscape, it’s also detrimental for China’s own efforts to move up the value-added chain, by fomenting complacency among its firms.

Finally, it’s amazing to suggest the renminbi is not overvalued when China has continued to accumulate FX reserves at a rate of $50 million an hour throughout the crisis! And don’t tell me it’s insurance!

After correcting for (an estimate of) valuation effects, almost half of that accumulation in 2009 was accounted for by the trade surplus—no need for insurance there. Another 20% can be accounted for by foreign direct investment flows—the most stable form of foreign investment with little need for precautionary reserves. Even if all the remaining flows were “hot money”, insurance does not involve covering 300% of those flows with reserves, esp. when you already have another $2 trillion in your coffers!

China’s exchange rate policy is a major distortionary force in global trade and also a key impediment for the smooth functioning of global capital markets and the conduct of monetary policy everywhere (including in China itself). As we speak, there are emerging market countries whose stage in the business cycle demands a tighter monetary policy. And yet, they don’t move because of fears of an exchange rate appreciation that would ruin their competitive edge in major markets.

China, along with every major economy interested in participating in, and profiting from, an increasingly globalized world, has a duty to take policies that foster stability in trade and capital markets. In China’s case, exchange rate policy is the number one issue. It's irresponsible for anyone calling him/herself an economist to claim the contrary.

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.

Vola-geddon

With monetary authorities around the world preparing for their exit, there are fears in some circles that a new Armageddon is in sight. Volatility could shoot up, it is argued, as investors try to figure out the impact of a synchronous global tightening on their respective asset classes—let alone the difference between, say, the effective fed funds rate and the interest on excess reserves!

The fears are not unjustified, so I thought of going back to see whether history, can inform us about the chances of an impending “Vola-geddon”!

I’ll focus on the behavior of volatility during three “exit” precedents: (a) The Bank of Japan (BoJ)’s exit in 2006, which is the only available precedent of a central bank’s exit from quantitative easing (QE); (b) the Fed’s exit in 2004, which followed a stated commitment to a “low for long” rates policy and therefore bears similarities to the current situation; and (c) the Fed’s exit in 1994, a year that saw volatility in capital markets go up.

Earlier exit episodes are not as relevant, mainly because central bank communications were much more opaque than today—e.g. prior to February 1994, the Fed did not even announce its target policy rate, while changes in the target rate were often made outside scheduled FOMC meetings, leaving markets guessing.

So what does experience tell us?

First “lesson” is that, under normal circumstances (and I’ll define “abnormal” below), central banks will begin their exit only after the recovery seems to be well entrenched. This moment is usually associated by a preceding period of steadily declining volatility/risk aversion.

For example, by the time the Fed hiked in Feb 1994, the VIX (volatility implied from options on the S&P500) had been on a declining path for more than two years, reflecting the improving risk environment. Ditto for the Fed’s 2004 exit and the BoJ’s in March 2006. In other words, by the time the hikes begin, markets are pretty well equipped to withstand a rise in volatility, were this to occur.

Now, does volatility rise during exits? Clearly my sample is minute but there is a useful qualitative comparison between the 2004 and 2006 episodes (when the VIX did not rise); and the 1994 one (when, on the day of the Feb 1994 announcement, the VIX jumped 50% and hovered around those levels throughout the year).

In the case of the former two, the exit was largely anticipated by the market. You can see that by looking at the 3-month Libor expected three months forward (3m/3m). In the US, this had already begun to move up in early April, even though the first hike actually occurred end-June. In Japan, it moved as early as October 2005, around the time when the BoJ published its economic outlook, which hinted that the exit from QE was near.

In contrast, in 1994, 3m/3m rates suggest that the Fed’s February hike was largely unanticipated. News items at the time also point to ongoing market uncertainty about the impact of successive rate increases on the growth outlook (Mexico’s tequila crisis also contributed to higher vol later that year).

These examples provide support to the hypothesis that the improvement in the market’s understanding of central banks’ modus operandi—itself the result of enhanced central bank transparency over the years—has helped reduce policy-related uncertainty and financial market volatility. (Empirical research in the academic literature is consistent with this view).

Against this backdrop, both the Fed and the ECB are going at great lengths to explain the sequencing of their exit to the markets. This tells me that investors should take their words at face value when forming rates forecasts, rather than bracing for a nasty surprise.

Turning specifically to bond market volatility… Monetary policy can help contain it in (at least) two ways: First, with a credible commitment to low inflation, which anchors expectations and reduces the volatility of inflation forecasts; and second, by reducing uncertainty about the path of monetary policy itself.

The former calls for a strong emphasis on the path of inflation expectations as a guide to policy (an emphasis the Fed has explicitly affirmed in its FOMC statements); the latter calls (once again) for clear communication on the rationale and sequencing of the exit process.

So let’s what happened during the three exit episodes. In what follows, I’ll proxy uncertainty about the monetary policy path by the volatility in money markets, in line with a 1996 BIS paper by Borio and McCauley (volatility measured as the standard deviation in the daily change of the 3m/3m rate, over a 3-month period). The “test” then is to see whether money market volatility was “passed-through” to volatility in bonds of long-term maturities.

Turns out Japan is not a very informative case: Volatility in money markets was elevated during 2006 but remained within the bounds seen in late '04 and throughout '05. Importantly, the pass-through from money markets to long-term bond volatility was limited, especially for longer tenors (e.g. 10-year). I should mention that the BoJ did a good job explaining its exit plan ahead of time, in late-2005/early 2006. It’s just that the data do not seem to provide a conclusive link between monetary policy uncertainty (so defined) and bond market volatility.

In the US, volatility increased in both tightening episodes, though in 2004 the rise was shorter-lived—a brief interruption to a downward path in the context of a benign global risk environment. What differs from the Japanese case is that there is a clearer pass-through from money market to bond market volatility. In other words, *assuming* money market volatility can be interpreted as uncertainty about monetary policy, central bank communication may have more influence on bond market volatility in the US than in Japan.

So when could things go really wrong? I mentioned earlier I would define “abnormal” so here we go—a few “tail” events with Vola-geddon potential:

One has to do with the impact on long-term rates of the Fed’s downsizing of its balance sheet. Part of the reason is uncertainty about (a) how much impact the Fed’s MBS/Treasury purchases have had on long-term rates in the first place; and (b) whether it was the stock or the flow of Fed purchases that mattered (the Fed’s current thinking seems to be leaning towards the stock theory).

I personally expect a limited impact here, simply because the Fed is taking a very cautious approach—indicating it will opt for a passive downsizing in the short run (ie allowing its assets to mature), with active purchases only much later in the exit process. Note that the ECB did not really enter the asset purchase game (except for covered bonds) so that’s not an issue for them (but it’s a big issue for the Brits).

Another “tail” risk is a sudden shift in investor perceptions of sovereigns’ ability to service their debt (including the US). Unfortunately, triggers for such shifts are often “exogenous”: Sovereigns can be vulnerable for years (see Greece) before markets decide it’s time to pull the plug. So I have little to contribute in trying to predict the timing of this.

Finally, you could have a scenario where goldbugs and monetarist nutheads gain vogue, prompting a spike in inflation expectations that would force the Fed to act earlier and more forcefully on the rates front. Given the chatter in some circles, I can’t say that’s impossible, but in light of the dynamics in the real economy I’ll say just this: The probability I assign to this risk is exactly equal to the probability of Ben topping the charts with a song titled “I’m a printing machine”… you pick the number!

Stopping the leakages in China

I’m increasingly convinced that there’s a bunch of algorithms out there with instructions to trade as soon as the word “hike” appears on a Bloomberg headline. Doesn’t matter who hikes or what they hike—milliseconds later, the market reaction is all but predictable: Stocks down, dollar up, commodities down, Treasuries sell off.

Take the Fed’s move to hike the discount rate: No matter that the Fed had warned about this; no matter that it made crystal clear this was neither meant to, nor expected to, affect financial conditions; the kneejerk reaction was all of the above (though, thankfully, actual people with brains stepped in subsequently to restore some sense).

Anyway, the lack of significance in the Fed’s move is too obvious to be worth discussing. What I want to dwell on here is another hike—that by China—where the implications (or lack thereof) are a touch less obvious.

So, you may recall that, at the end of last week, and right before the Chinese New Year holiday, China hiked banks’ reserve requirement ratio (RRR) for the second time this year. Both times, we got the all-predictable market reaction above—the rationale being that China is stepping on the brakes, prompting a slowdown in domestic investment (especially in infrastructure and real estate), commodity imports and global growth.

But as it happens, China’s RRR hikes have virtually zero impact on the country’s financial conditions. Indeed, as I’ll argue below, China has yet to show any signs that it is serious about avoiding overheating and asset bubbles in its economy in an effective and sustainable way.

I’ll start from the (non-)impact of the RRR hike first. In theory, a higher RRR can work to curtail credit growth in two ways: First (and most importantly), by affecting the price of lending—by reducing the average interest banks earn on their assets, it effectively forces them to raise lending rates to maintain their profitability. And second, by putting a ceiling on the quantity of funds/deposits available for lending.

However, in the case of China, both these channels are broken. Starting from the price, with interest rates prescribed "from above", lending rates have not budged since the end of 2008, when they were cut sharply to forestall an impending downturn. So no tightening there.

When it comes to the quantity of new loans, the authorities have set a target for new loans in 2010, at CNY 7.5 trillion. This is the second biggest ever (after last year’s CNY 9.6 trillion) and at least twice as high as in 2005-07, when GDP growth rates stood at double-digits. So, again, not exactly tightening.

Importantly, given the quantitative target for new loans, the hike in the RRR is in theory redundant: Once you have put a ceiling on new loan creation, what’s the point of trying to control quantities through hikes in the RRR?

In practice there may be a “point”... First, the authorities’ track record of enforcing their quantitative targets is less than stellar. For example, last year, new loans exceeded the target by almost 100%!

This year they’re trying harder: According to local press reports, regulators are closely monitoring new loan creation with a 30/40 rule, under which new loan creation in each quarter cannot exceed 30% of the whole year’s quota; and new loan creation in each month cannot exceed 40% of each quarter’s quota. Arguably, the hike in the RRR can provide an additional source of restraint in banks’ ability to lend…. But does it?

No. And here is why: What the RRR does is place an upper bound to the times a given amount of new deposits can be “multiplied” into new loans—all else equal, including interest rates, project riskiness, banks’ liquidity preferences, etc. In the case of a RRR of 15.5% (that’s the simple average of China’s 14.5% for small banks and 16.5% for large ones), this “multiplier” is equal to 5.5 times (=(1-RRR)/RRR).

That’s not really binding. Consider this: With the current RRR, it just takes a deposit “base” of CNY 1.3 trillion (or US$200 billion) to create new loans of CNY 7.5 trillion, China’s quantitative target for 2010. But the annual flow of new deposits is much higher than this, due to China’s commitment to a fixed exchange rate regime: Indeed, PBoC data show that some US$200 billion of (largely unsterilized) flows have entered the system in the six months to November 2009 alone (perhaps a little less, if one takes into account valuation effects).

Unless the inflows are either sterilized (which would require higher interest rates) or meaningfully reduced (via a CNY appreciation), “leakages” in new loan creation seem all but inevitable. Mind you, not just new loan creation.. excess liquidity can also be directed to the stock market or real estate assets at home or in Hong Kong, fuelling bubbles—already a concern for many investors and policymakers in Asia and elsewhere.

Bottom line, China’s recent measures fall way short of sending a signal that it’s serious about preventing overheating and asset bubbles. Quantitative and administrative measures can go only as far. The real McCoy would be a hike (or multiple hikes) in interest rates, and soon… much sooner than the Fed, which, in my humble opinion, is not moving on the rates front till next year, barring major surprises in inflation expectations or employment.

In turn, this means the exchange rate will have to give: Controls on capital inflows will fail to stop hot money from coming in, right as the tightening cycle is about to begin.

Is that the course of action the authorities envisage? Nobody knows. But in the meantime, the one advice I can give to all those algorithmic traders out there is that it may be time to expand your "vocabulary".