Central Bank Communication and Financial Stability

Central Banks across the world are racing to go transparent. In United States, the Federal Reserve has raised transparency to new levels by publishing the long-term policy rate forecast and the next rate hike expectations of the individual members of the Federal Open Market Committee (FOMC). The Reserve Bank of India too has not remained unaffected by this trend as its minutes now reveal the individual opinions of its Monetary Policy Committee members.

The argument behind this transparency is that it minimizes information asymmetry and helps shape policy expectations among all market participants more effectively. However, it is far from certain that such transparency is beneficial in the long-term or any more efficient than the current strategy of relative opacity.

For example, in the instant case of the Fed, the longer-term forecasts of the individual members, albeit appropriately qualified, helps bake in expectations of longer-term policy direction among market participants. Though qualified with assumptions and conditions, this fine print is most likely to be overlooked, especially when there is a sustained period of upswing in various growth indicators. As the actions of Alan Greenspan and Co. over the first half of the past decade shows, the members are themselves likely to be blinded to the various cognitive biases that influence their decisions when the economy is either doing well or badly.

The resultant "irrational exuberance" is certain to bias the decisions of a large number of market participants. In these circumstances, the longer-term forecasts act as pro-cyclical amplifiers. In the absence of such forecasts, the market participants would atleast have been that less certain about the economic trends. And given the formidable reputation that central banks have assiduously built-up over the past few years, these forecasts are likely to carry much greater punch than other sources of information.

Therefore, such transparency enhancing forecast publications, tend to make the market participants lean more towards the wind than would have been the case in their absence. Perversely enough, a dose of uncertainty may have diminished the "irrational exuberance" and herd mentality and made market participants more guarded in their economic decisions. In simple terms, instead of improving market efficiency, the reduction of information asymmetry has the potential to lower market stability.

Update 1 (24/2/2012)

It appears that the Fed's push to reduce frictions in one area is complemented by increased frictions in other areas. Simon Johnson detects a very clear bias in the meetings held by the Fed officials on the Dodd Frank legislation,

Just on the Volcker Rule — the provision in Dodd-Frank to limit proprietary trading and other high-risk activities by megabanks — Fed board members and staff members apparently met with JPMorgan Chase 16 times, Bank of America 10 times, Goldman Sachs nine times, Barclays seven times and Morgan Stanley seven times...

Based on what is in the public domain on the Fed’s Web site, my assessment is that people opposed to sensible financial reform — including but not limited to the Volcker Rule — have had much more access to top Federal Reserve officials than people who support such reforms. More generally, it looks to me as though, even by the most generous (to the Fed) account, meetings with opponents of reform outnumber meetings with supporters of reform about 10 to 1.

Central Banks hold sway, where are the governments?

There is a common feature in the respective policy responses to the current domestic economic situations in United States and India. In both countries Central Banks are at the frontline fighting the battle, while governments appear missing in action. In many respects, both the Fed and the RBI are, in different ways and degrees, fighting not only the monetary policy but also the fiscal policy battles. This over-reach in both areas is unsustainable and is generating distortions that could set the stage for even bigger crises.

More worryingly, not only do the central banks themselves appear convinced of their leadership role, but everyone else too believes that they should keep doing more. In the process, governments are getting away lightly. Nothing can take away from the fundamental fact that only governments can sustainably bring a closure to the ongoing economic crisis and set the stage for a more sustained economic recovery.

In the US, since late 2008, the Fed has unveiled a series of policies, ranging from classic monetary policy to outright fiscal policy, to not only keep the credit market open but also to backstop aggregate demand from falling and stimulate economic growth itself. It has lowered rates to near zero and has committed to keep there till end-2014 (a period of over 6 years of extraordinary monetary accommodation), multiplied its balance sheet many-fold to over $3 trillion by purchasing a large category of assets and injecting massive quantities of liquidity, and is now experimenting with greater transparency in communicating the Fed's monetary policy processes so as to mould market expectations.

In contrast, apart from the initial stimulus plan, ARRA, the US government has largely remained at the sidelines. All this, while averting a financial meltdown and deep deflationary economic recession, has created several incentive distortions, besides postponing important adjustments. Mohamed El-Erian summed it up nicely in a recent FT op-ed,

"Despite its repeated pleas for fiscal and housing engagement, the Fed has inadvertently provided cover for other government agencies to continue avoiding difficult, but necessary, decisions. Notwithstanding these shortfalls, the Fed still feels compelled to do even more. For both moral and political reasons, it believes that it cannot be seen to stand on the sideline as the economy struggles with a deeply-entrenched unemployment crisis and political dysfunctionality – even if this means having to use even more imperfect, indirect and, increasingly, unpredictable policy measures."

Unlike in the US where economic growth and financial market stability have been the central themes, inflation and burgeoning public deficits have been the biggest concerns. RBI has been pitchforked into the frontline of the inflation battle. In turn, since the onset of the initial signs of economic strains and inflationary pressures in early 2010, the RBI has increased interest rates 13 consecutive times. In the process, it has tempered the over-heating economy and appears to have brought inflation down to more tolerable limits.

It was evident to anyone who cared to go beyong stage one that India's inflation problem was fundamentally a supply side problem and could be sustainably managed only by easing supply constraints, especially by removing infrastructure bottlenecks and increasing foodgrain production. RBI's inflation fighting policies only managed to cool the over-heating economy and bring it down to its constrained production possibility frontier.

This long-period of inflation-fighting by monetary tightening was an ideal opportunity for the government to undertake policy measures and reforms that would initiate the process of declogging the supply-side and pushing up the production possibility frontier. But nothing of that sort was forthcoming. Worse still, the government added to the problem with a series of fiscal largesse, unconcerned about the severe fiscal strains that were clearly evident.

This in turn increased government borrowings and boosted aggregate demand at a time when supply was severely constrained, therefore adding to the inflationary pressures. With interest rates rising, inflationary expectations anchored upwards and policy parlysis gripping government, investment climate weakened. Instead of expanding aggressively in a growing economy, cash rich businesses turned off their investment taps and have preferred to wait and watch.

Now, with the inflationary pressures easing, the onus is again back on the RBI to take the centerstage. Everyone calls on the RBI to lower interest rates to encourage investment. Critics accuse it of being "behind the curve" in lowering rates, just as it was accused of being similarly slow to raise rates in the first place as the recession struck.

For sure, in the coming months, the RBI will lower rates and cost of capital will come down. Businesses will start investing and economic growth will recover somewhat. But all that will be pyrrhic victories if interest rate cuts are not accompanied with policy reforms to ease supply constraints. In its absence, we will witness another short-cycle of boom followed by over-heating and slowdown. The RBI will again be forced to step in an re-enact its current role.

Markets and central banks alone cannot set the foundations for economic growth. Governments have a critical role to play in laying the policy framework for expanding the economy's production possibility frontier. Markets thrive on the enabling policy environment established by public policy actions. Paralysed governments, which cede responsibility to technocratic institutions like central banks, are merely kicking the can down the road.

Satyajit das has an excellent article in FT which outlines the distortions caused by a prolonged period of ultra-low interest rates.

Update 1 (30/4/2012)

An excellent FT op-ed on how leveraging central bank balance sheet has come to be seen as the least costless route out of a financial crisis induced recession. The unprecedented liquidity injections have undoubtedly helped backstop the lurch into full-blow depressions. By early 2009, the Fed, the ECB and the BoE had all cut their main policy rates to all-time lows, and it has remained there since. However, the challenge for central banks is not to manage the retreat from these accommodatory policies before stoking inflationary pressures and without suffering massive losses.

The use of the balance sheet as a policy tool is no longer likely to be considered unconventional. The crisis has moved it to the centre.

 

Monetary accommodation in a graphic

As historians look back on the sub-prime mortgage meltdown and the Great Recession, one of the things sure to receive considerable attention is the dramatic expansion of central bank balance sheets in their aftermath. As the credit markets froze, central banks emerged as lenders, insurers, and even buyers of last resort in an effort to backstop the slide and maintain financial market stability.

The graphic below captures the true magnitude of the balance sheet expansion by central banks acros developed economies. It is four years old and there are no signs of any exit.



Fortunately, fears of inflationary expectations being unhinged and bond-market vigilantes wreaking havoc have so far proven unfounded.

Update 1 (16/1/2012)

Economist has an excellent graphic and article on the extraordinary monetary accommodation being carried out by central banks across advanced economies.


Update 2 (2/5/2012)

Martin Wolf has this graphic that highlights the dramatic changes that have swept central banking in recent past.

Update 3 (8/5/2012)

Gavyn Davies on the difference between monetary base and monetary aggregates and why the expansion in monetary base does not always lead to inflation,

These are very different types of “money”. The monetary base is mostly the reserves of the commercial banks held at the central bank. M1-M4 are mainly deposits of varying maturity held by the public at the commercial banks. The monetary base can behave very differently from the wider aggregates, and with very different consequences for the economy at large.
 
The recent rise in the monetary base has occurred because the central banks have purchased sovereign debt from the commercial banks, and have credited the banks with reserve balances at the central banks to settle these transactions. Since the commercial banks have simultaneously wanted to increase their holdings of liquid balances in the safest possible form, in order to secure their future funding requirements, these balances have simply remained at the central bank doing nothing...

Monetarist models of the economy generally assume that there is a fixed ratio between the monetary base and M1-M4...The fixed relationship between base money and M1-M4 applies when bank lending is constrained by reserve requirements and banks are eager to increase their lending. In those circumstances, a rise in the monetary base or banks’ reserve assets leads to an automatic “multiplier” rise in bank lending, and then in the bank deposits which comprise the M1-M4 monetary aggregates. None of this is happening now, since bank lending is not constrained by reserve requirements and banks do not want to lend.

Counter-cyclical Fed communication strategy

When the history of central banking is written, historians will surely devote a substantial part of the book to the aftermath of the bursting of the sub-prime mortgage bubble. As financial markets veered at the edge of precipice and the Great Recession took hold, and fiscally constrained and politically paralyzed governments largely abdicated the policy making space, central banks were left with the onerous task of stabilizing financial markets and restoring economic growth.

Central banks, led by the American Federal Reserve and the Bank of England, have deployed a wide range of monetary policy tools to stabilize markets and boost aggregate demand. These unconventional monetary easing approaches like quantitative easing policies have contributed to a dramatic ballooning of the balance sheets of central banks across the developed world.

In keeping with such changes, central banks have also sought to make more effective use of their communication strategies to anchor market expectations. One of the most important instruments of central bank communication has been the publicly announced commitment to keep interest rates low for extended periods of time. The Federal Reserve in the US had very early in the crisis announced its commitment to keep interest rates low for "and extended period of time". Subsequently, it went further in providing greater clarity to this phrase by announcing in August that it planned to keep rates near the zero bound till atleast the summer of 2013. The objective is to firm expectations among various market participants and reduce uncertainties about consumption and investment decisions.

Now, the NYT reports that the Fed is planning to make publication of interest rate forecasts a permanent feature of its monetary policy communication strategy. The Times writes,

"Forecasting policy is part of a broader set of changes that the Fed is considering to improve public understanding of its methods and goals. The Fed’s chairman, Ben S. Bernanke, and other officials say that improved communications could deliver a modest boost to the economy with relatively little risk. None of their other options for additional action are nearly so appealing...

Such a forecast likely would cover the expected path of policy over the next three years, including information about the range of predictions. The Fed already publishes similar predictions about economic growth, inflation and unemployment four times a year."

While the attempt to shape longer-term expectations to revive the "animal spirits" is understandable during such recessionary times, there will be questions raised about the wisdom of such upfront commitment during upturns in the business cycle. For example, during an economic recovery when financial markets are booming and inflationary pressures are rising, such upfront commitment to keep interest rates low would, instead of leaning against the wind, be amplifying the market exuberance. It would run contrary to the conventional wisdom on central banking - "take the punch bowl away when the party gets going".

Such upfront commitment could also restrict the central banks' freedom to manoeuvre. Economic headwinds can change unexpectedly. A commitment to follow a particular policy stance would limit the central bank's ability to change track in response to emergent trends. Any such abrupt deviation from its pre-announced policy stance would erode the credibility of future announcements by the central bank.

In other words, while anchoring expectations by announcing a commitment to maintaining interest rates during recessionary and uncertain times may be desirable, it may not be wise to institutionalize such medium to long-term commitments into the monetary policy framework of central banks.

Is monetary accommodation becoming a dogma?

When history of the tumultous period of the Great Recession will be written, central bankers will be among its dominant characters. All along the crisis, across the world, monetary policy has been the predominant and preferred choice to fight both financial market instability and boost aggregate demand.

In a recent blog post, Brad DeLong echoed this view when he advocated further massive expansion of the Fed's balance sheet and committing to a target nominal GDP growth. He writes,

"The Federal Reserve might be able to spark a real economic recovery by... announcing that it is going to keep short-term Treasury interest rates low not just as long as the economy is depressed but even afterwards when the economy has recovered and when it would normally be raising interest rates: that it is going to keep short-term Treasury interest rates low until it generates an inflationary boom, and that you had better start building capacity now to serve your customers during that inflationary boom or your competitors will do so and take your profits...

If I were in the hot seat, I would follow the Jan Hatzius plan: (a) take the Fed's balance sheet up to $5T over the next two months, and (b) say that if that turned out not to be enough to get nominal GDP growth to a path that will return it to its pre-2007 trend within three years, that I would then keep interest rates low and take the Fed's balance sheet even higher until it did."

A similar debate is being played out across the Atlantic in Europe. With the Eurozone economies grappling an existential crisis, there have been calls for the ECB to emulate the Federal Reserve and indulge in aggressive monetary policy to stabilize financial markets. A leading advocate of such measures, Wolfgang Munchau wrote,

"The European Central Bank must agree a backstop of some kind, either an unlimited guarantee of a maximum bond spread, a backstop to the EFSF, in addition to dramatic measures to increase short-term liquidity for the banking sector. That would take care of the immediate bankruptcy threat."

More specifically, in addition to advocating a fiscal union, he favors unconventional quantitative easing and issuance of large enough joint-and-several liability eurozone bonds. On same lines, James Surowiecki has called for the ECB becoming the lender of last resort for the embattled European economies,

"If the European Central Bank were to commit publicly to backstopping Italian and Spanish debt, by buying as many of their bonds as needed, the worries about default would recede and interest rates would fall. This wouldn’t cure the weakness of the Italian economy or eliminate the hangover from the housing bubble in Spain, but it would avert a Lehman-style meltdown, buy time for economic reforms to work, and let these countries avoid the kind of over-the-top austerity measures that will worsen the debt crisis by killing any prospect of economic growth."

The suggestions of DeLong, Munchau, and Surowiecki are representative of policy prescriptions on both sides of the Atlantic calling for aggressive measures to restore economies to their pre-crisis normal. The monetary policy bias is very distinct.

As I have blogged earlier, advocates of such policies suggest them more out of desperation than from any strong conviction. There is a strong urge to throw everything and the kitchen sink at the intractable problem and hope that something will click. Brad DeLong himself writes,

"How well would it work? We don't know. Are they worth trying? I certainly think so..."

While all such accommodatory policies will surely contribute towards backstopping losses and stabilizing the markets, there are two important questions. One, given the circumstances, how effective will be such policies? Two, what are the costs - direct and secondary market distortions - associated with this?

A honest assessment of both these questions will raise disconcerting answers. The severity of the crisis, on both sides of the Atlantic, means that the magnitude of monetary accommodation - liquidity injections and indirect debt guarantees - required to meaningfully and sustainably stabilize the financial markets is beyond the abilities of most central banks and governments.

Further, the secondary market distortions that are certain to be set off by such sustained and extra-ordinarily large monetary accommodation will certainly challenge global financial market stability. It will perpetuate many of the bad practices that contributed towards the sub-prime era financial market excesses - regulatory arbitrage, TBTF, mis-pricing of risk etc. This monetary accommodation and flood of liquidity has the strong likelihood of generating another round of resource misallocation in the financial markets. It will also expose the emerging economies to the vagaries of massive cross-border capital flows, with all its attendant adverse consequences.

Much of the academic debate that feeds into policy making has been on exploring alternatives to get the economy back to its pre-crisis normality at any cost. This line of thinking glosses over questions about whether the old normal is itself desirable. There is a strong case that the quarter century of Great Moderation, with its low unemployment rate and inflation coupled with high growth rates, was the result of a fortunate confluence of favorable factors. The dynamics generated by China and the emerging economies, a big wave of trade and financial market liberalization, and dramatic productivity improvements generated by advances in information technology contributed to the Great Moderation.

The past 15 years, atleast since the late nineties, has been an era of unprecedented complementarities. The emerging economies saved to cheaply finance consumption and deficits in many parts of the developed world. Cheap exports of consumer durables and non-durables served to keep inflation low across the world. The consumption boom in developed economies also kept up the demand for commodities from many developing countries. It was over-optimistic to imagine that these forces would maintain their momentum forever.

In the process of this era of extraordinary stability and growth, several distortions and imbalances had become institutionalized into the world economy. The monetary-pump-prime-your-way-out of recession fails to acknowledge that the efforts to restore normalcy would serve to perpetuate many of the same distortionary trends and policies that fuelled the crisis. For example, there is enough evidence that the ultra-low rates have benefitted the remaining big financial institutions, who have used the opportunity to grow even bigger and pose even greater systemic risks.

Apart from resolving the extant problem, every crisis is also an important opportunity to wring out the excesses of the bygone era that was in the first place responsible for the crisis. In this case, the later can be done both by letting those responsible pay for their recklessness and greed (after all this is the primary incentive formation and disciplining mechanism of capitalism) and by refining regulatory policies to pre-empt such future failures. Unfortunately, influential opinion makers across the world have been focussed more on exploring options to get the economy back to its pre-crisis normal instead of doing the hard problem solving to get things back to a more efficient and desirable "new normal".

Update 1 (3/12/2011)

In a move to ease Eurozone's debt squeeze, the Federal Reserve, ECB, BoE, BoJ, SNB, and Bank of Canada announced that they would reduce by about half the cost of a program under which banks in foreign countries could borrow dollars from their own central banks, which in turn get those dollars from the Fed. The banks also said that loans would be available until February 2013, extending a previous deadline of August 2012. This move effectively makes the Fed emerge as the global lender of last resort, lending dollars to foreign central banks so as to ease credit markets there. The move is intended to free up liquidity and ensure that European banks have funds during the sovereign debt crisis and keep borrowing costs down for consumers and firms.

These are loans between central banks rather than loans to individual foreign banks, there is very little risk to US taxpayers. However, in the face of ECB's reluctance to buy debt of the most beleaguered Eurozone economies and work as the risk absorber of last resort, this is the closest that the Fed can get to effectively doing ECB's job and purchasing foreign government debt itself.

"Twisting" on debt maturities as QE3?

The latest dimension to the US Federal Reserve's attempts to lower long-term interest rates through its quantitative easing (QE) program is "Operation Twist". It involves selling short-dated Treasuries (1-3 years) and buying longer-term securities (mostly 7-10 years) in an attempt to push down longer-term yields. These yields affect corporate borrowing and mortgage rates far more than short-term rates.

Hitherto, in the two rounds of QE (QE1 in 2009 was for $750bn, measured in 10-year Treasury equivalents, and QE2 in 2010 was for $412bn), lowering of long-term rates was sought to be achieved through massive purchases of long-term securities. This has involved a huge expansion of the Fed's balance sheet, though the resultant increased monetary base has been mostly confined to banks' reserves. This expansion of monetary base has generated criticism about stoking inflationary fears, weakening the dollar, and spawning other systemic distortions. It has also come in the way of another round of QE.

The new strategy avoids expanding the Fed's balance sheet and seeks to lower long-term rates by swapping short-term debt for longer-term ones. This would not involve any additional balance sheet expansion and would only cause maturity transformation of existing debt portfolio towards the longer-term. In simple terms, it would be merely re-balancing the Fed's portfolio.

It is estimated that by merely "recycling maturing bonds into longer-dated ones", $110bn would be added, and by "actively selling its portfolio of 1-3-year bonds and buying as much long paper as permitted", the Fed could achieve another $390bn. The former involving about $20 bn a month may not enthuse the markets as much as the later which could involve more than $65 bn a month. The Fed at present owns $632bn in Treasuries with a maturity of less than four years. See this Goldman estimate of Fed's possible Operation Twist strategy.



Twisting of the yield curve is not without precedents, though its impact has not been encouraging. It was first used, unsuccessfully, by the US in 1961 and then by Japan, again unsuccessfully, in the nineties. It carries with it certain clear risks. As the FT writes, it "could disrupt trading flows in the bond market, while reducing earnings for banks that borrow cheaply and invest in long-term Treasury debt". It would adversely affect the returns of institutions like insurance companies and pension funds that have large exposure to long-term debt instruments and also the net-interest margins of banks (who invest in long-term bonds).

Finally, it also increases the long-term interest rate risk in the Fed's portfolio, which could, at certain point, constrain the Fed's policy making freedom. Fed would then effectively become a player in the bond markets. And there also exists the probability of making considerable losses when the Fed exits from its current accommodatary stance. It is also being argued that speculation of Operation Twist has already been priced into long-term yields and not much will be achieved with the actual operations.

Update 1 (22/9/2011)

The Fed announces that it would invest $400 billion in long-term Treasury securities over the next nine months, using money raised by selling its holdings of short-term federal debt, in an attempt to drive down interest rates on mortgage loans, corporate bonds and other forms of credit. With this, the Fed hopes to drive down rates not by expanding its portfolio, as it has done twice in recent years, but by shifting its money into riskier long-term investments.

The Fed has amassed more than $1.6 trillion of federal debt. It said that by June 2012 it would sell $400 billion in securities with remaining maturities of less than three years and buy roughly the same amount in securities with maturities longer than six years. It said the result would shift the average maturity of its holdings to 100 months, or more than eight years, from the current average of 75 months, or just over six years.

Lower interest rates so far had not produced the full measure of predicted benefits because lending standards remained unusually strict. Most outstanding mortgages still carry interest rates above 5 percent, despite the availability of lower rates, because it remains difficult to refinance. Tough lending standards are likely to limit the benefits from lowering interest rates. Loans already are cheap, but they are also hard to get.

Negative interest rates in Switzerland

Amidst all the turmoil in Europe and the global financial markets, a less reported but remarkable event happened when the Swiss interest rates, including medium-term rates, in the LIBOR market plunged into negative territory. In other words, instead of being paid by their borrowers, lenders would now have to pay for the privilege of getting borrowers to accept their money!



As the Eurozone economies plunged into crisis, Swiss Franc emerged as a possible safe haven. The resultant capital inflows boosted the Franc by over 20% against the Euro, hurting Swiss exports and economic growth. In fact, as Gillian Tett writes, the Goldman Sachs has described it as "the most overvalued currency" in recent history, 71% stronger than fundamentals justified.



In response, early this month, the Swiss National Bank (SNB) acted aggressively to lower interest rates to virtually zero (from 0.25%), inject unsterilized cash, build up sight deposits (cash withdrawable on demand from the central bank) with the SNB, and repurchase outstanding SNB bills and use the proceeds to buy Euros in the forex market. The SNB press release said,

"Effective immediately, the SNB is aiming for a three-month Libor as close to zero as possible, narrowing the target range for the three-month Libor from 0.00-0.75% to 0.00- 0.25%. At the same time, it will very significantly increase the supply of liquidity to the Swiss franc money market over the next few days. It intends to expand banks' sight deposits at the SNB from currently around CHF 30 billion to CHF 80 billion. Consequently, with immediate effect, the SNB will no longer renew repos and SNB Bills that fall due and will repurchase outstanding SNB Bills, until the desired level of sight deposits has been reached."

The results of this aggressive response has been spectacularly successful, with interest rates on Swiss two and three-year government bonds falling into negative territory and spreads with German bund widening on the negative side. The Swiss ten year bonds have fallen off precipitiously in the last two months. The futures markets are currently predicting negative rates until 2013 and minus 8 basis points next summer.











This effectively means that "if you want to lend Swiss francs or make a deposit in the next year, you must pay for that privilege", an anomaly that has led to Gillian Tett of FT to describe it as "Alice in Wonderland" economics! Alternatively, anyone holding two-year or three-year Swiss bonds is now demanding that the price exceeds the coupon-included return in order to be tempted to sell.



Apparently, this is not the first instance of negative interest rates. In the 1970s the SNB imposed negative interest rates on foreign accounts to deter inflows; and in 2008 some short-term Swiss market rates briefly turned negative. That also happened in Japan in the late 1990s and recently some dollar short-term rates have touched negative territory. However, in all these cases, the negative rates covered only ultra-short rates, whereas the present Swiss situation is for medium-term rates covering the next two years. In simple terms, borrowers could take out a two-year loan with the assurance that they would need to be paid by the lenders for the next two years.



However, given the depth of the financial crisis, as FT Aplphaville says, even this situation is fraught with dangers. Technically, the build up of sight deposits (which would be used as reserves by banks) should "cause Swiss rates to fall sharply since the more reserves banks hold, the less they require to borrow from each other and the lower the rate falls". FT Alphaville writes about the distortionary possibilities,

"Since the SNB pays zero on its sight deposits, there is a very real risk banks might be encouraged to hoard cash on deposit rather than to lend it out for a negative rate. This would be the exact opposite of expanding the money supply. It might even be contractionary.



Now, the SNB is probably hoping that the extreme unattractiveness of having to pay an additional rate to hold Swiss francs will be enough to encourage holders of the currency (especially those abroad) to sell the franc and move elsewhere. This, theoretically, should flood the market with Swiss francs, lowering exchange rates and easing liquidity. But there is still the danger that the move could drive Swiss francs straight into the coffers of Swiss-based banks, who would then be unwilling to lend them out at a negative rate.



In that circumstance, a deflationary spiral motivated by 'capital preservation' could begin. Once that starts, no matter how much 'QE' money is printed, it becomes completely ineffective at boosting the money supply. In fact, if anything, it arguably becomes a deflationary force because the money is being pumped directly into a liquidity trap, in which capital preservation (rather than yield) is the chief priority of banks and depositors. Which, by the way, happens to be exactly what happened during the Great Depression."

This has echoes of the Great Depression (see this Ben Bernanke paper), when "the market for unsecured lending died a death because counterparties no longer trusted each other",

"Everyone turned towards a collaterised lending regime, one in which only the very best collateral (Treasuries and gold) would do. This had the effect of causing a run towards Treasury securities. No matter how much money was printed by the Fed to ease liquidity concerns it only intensified the obsession with capital preservation. Largely by eliminating the number of Treasury securities in the market. Since, there was no one the banks could lend money to in the wider market due to credit concerns, Treasuries became a bit of a Giffen good. The money had to be parked somewhere... With capital preservation becoming the top priority for banks, institutions were willing to pay more than the face value of Treasury securities, because investing elsewhere would come with too great a risk of default."

In the uncertain environment, as the prices of Treasuries went up (and the yields fell down), banks purchased more of the same. The same story is being repeated today with Swiss Government Bonds, pushing yields into negative territory.



As an update, it does now appear that the SNB's aggressive actions have not been as successful as initially thought in curbing the Franc's rise.

The "framing effect" and monetary policy

In its quarterly monetary policy review, the Reserve Bank of India (RBI) has raised its benchmark repo rate (the rate at which it lends money to commercial banks) by 50 basis points to 8%, its 11th successive increase since October 2009.

In the accompanying statement, the RBI expressed heightened concerns at inflationary expectations getting unleashed. It argued that inflation was a far bigger concern than any slowdown in economic growth. In simple terms, as the RBI Governor's press statement indicates, the main thrust of the interest rate decision was to "moderate inflation and anchor inflation expectations".

Given this "inflation targeting" based paradigm in central bank communication, the rate hike has expectedly raised concerns about its adverse impact on economic growth. It is argued that the increased cost of borrowing would discourage investments and slow down growth. Further, they also claim that since the inflation is driven by supply-side causes, monetary policy actions will have little impact on the final outcomes. This view is based on the valid assumption of an inflation-growth trade-off.

However, a different, "over-heating economy" paradigm based central bank communication could give a different spin to this interest rate decision. It is common knowledge, and the RBI statement reiterates this, that inflation in India is caused by supply constraints. The growth on the supply-side of the economy is simply unable to keep pace with demand growth. These constraints include infrastructure bottlenecks, slow growth in manufacturing production capacity and agriculture production etc.

In the circumstances, there are only two options - ease supply-side constraints and/or slow down demand growth. Since the former is a medium to long-term challenge, the only alternative is to cool-down the economic growth. In this context, the objective of the RBI's rate hike decision becomes one of deliberately cooling down an over-heating economy. The interest rate hike has the desired contractionary effect on the economy. In this monetary policy communication paradigm, lowering growth, and not inflation, is the direct objective. If this is the objective, then the inflation-growth trade-off loses its relevance, with the balance tipping decisively in one direction.

This debate is a classic case of what behavioural economists call "framing effect". Substantively, both "inflation targeting" and "cooling the overheating economy" based monetary policy decisions amount to the same. However, when framed in terms of the former, concerns about growth come to the fore, forcing governments into criticising the central bank. In contrast, when framed in terms of the latter, where slowing down growth is the explicit objective, the criticism of the central bank is likely to be more muted.

Automatic fiscal stabilizers and counter-cyclical fiscal policy

I have blogged extensively about the utility of fiscal policy in combating aggregate demand slumps, especially when the economy is facing the zero-bound in nominal interest rates.

However, unlike the more rules-based monetary policy, fiscal policy is subjective and deeply political. The classic fiscal policy alternatives like direct government spending on infrastructure face the problem of implementation lags. In contrast, automatic stabilizers kick-in immediately, being targeted on those most likely to spend any money provided to them. It no surprise that automatic stabilizers - unemployment insurance, food stamps etc - have among the highest fiscal multipliers.

The WSJ points to the apparent success of Sweden in managing its recovery from the Great Recession and attributes it to successful expansionary policies by both the government and the Riksbank. The Swedish economy grew 5.5% in 2010 and unemployment rate has fallen from its peak of 9% to 7%. Instead of high-profile direct spending and tax cuts, the Swedish government responded swiftly with automatic stabilizers to provide income, health care and other services to people who are unemployed. The Riksbank, initially lowered rates aggressively to zero, even taking it to minus 0.25% (savers had to pay 0.25% for the privilege of keeping deposits). Its quantitative easing program was more expansionary than even the Fed - the Riksbank's balance sheet was more than 25% of GDP in the summer of 2009, compared to 15% for the Fed.

Further, unlike many other developed economies, Sweden entered the recession in excellent fiscal health - its budget had a 3.6% of GDP surplus in 2007, to 3% deficit in the US. This gave the government enough cushion to indulge in extended fiscal expansion when recession struck. This was a result of a strong commitment, borne out of the bitter experience of its banking and economic crisis in early 1990s, to maintain a counter-cyclical fiscal policy.

Clice Crook points to the example of the US, where though the Obama administration came up with a large fiscal stimulus in 2009, mostly with tax cuts and direct spending, its impact was offset by the severe fiscal tightening by the local governments. He also writes about the relative lack of influence of fiscal stabilizers in the US,

"Two factors weaken automatic stabilizers in the US. First, the government is small, so economic fluctuations, other things being equal, move fiscal quantities less. Second, states are subject to balanced-budget rules. Much of the US government has to follow a pro-cyclical fiscal policy – cutting spending and raising taxes – during a recession."

The acrimonious debates surrounding fiscal expansion in the US underlines the need for a much greater role for automatic fiscal stabilizers. However, it is also important that these automatic stabilizers have automatic sunset clauses that ensure exit from fiscal expansion when the economy recovers. Mark Thoma makes an excellent case for greater use of automatic fiscal stabilizers during recessions.

In this context, Jeffrey Frankel, Carlos A. Vegh, and Guillermo Vuletin (pdf here) examined long-term fiscal policy in 94 countries (73 developing and 21 developed countries) over the 1960-2009 period and found that "the cyclicality of a country’s fiscal policy – a sign of its riskiness – is inversely correlated with the quality of the country’s institutions".

They examined the correlation between government spending and GDP for these countries over two periods, 1960-1999 and 1999-2009, and found a significant increase in countries with negative correlation (or counter-cyclical spending) over the two periods. In fact, among developing countries, those following counter-cyclical policies increased four-fold to 35% over the two periods. The graphic below indicates the correlation between spending and GDP for these countries in the 2000-09 period, with yellow and black bars representing developing and developed countries respectively.



The increase in counter-cyclicality in the conduct of fiscal policy by developing countries is evidence of greater maturity by policy makers and policy institutionalization in these countries. This maturity is corroborated by other indicators like reduced debt-to-GDP ratios in many developing countries. The authors "find that the cyclicality of a country’s fiscal policy is inversely correlated with the country’s institutional quality which includes measures of law and order, bureaucracy quality, corruption, and other risks to investment". They highlight the success of Chile with counter-cyclical fiscal policy and attributes it to institutional strengthening reforms since 1980s.

Bernanke's priorities mapped!

The first ever formal press conference by a Fed Chairman was thought as an excellent opportunity to find out where the Fed's priorities lay. Which of the two - inflation or unemployment - did the Fed consider to be a greater evil?

Conservatives have been whipping up fears of an inflationary spiral, pointing to the dangers of the huge amounts of money from the two rounds of quantitative easing sloshing around. This coupled with the burgeoning public debt, they argue, is reason enough to indulge in austerity and fiscal contraction. In contrast, liberals point to the persistenly high unemployment rates, low inflation and the weak aggregate demand and have been advocating more expansionary policy, including a third round of quantitative easing. They point to the dismal latest economic growth figures and weak labour market conditions and claim that further austerity will contract the economy, increase the debt-to-GDP ratio, and drag the economy deeper into a recession.

So where does the Fed's sympathies lie? The Reuters have an excellent word cloud which conclusively highlights which direction the Fed is leaning towards.



For the record, Bernanke said that inflation must take precedence over employment because inflation would result in job losses,

"While it is very, very important to help the economy create jobs and help to support the recovery, I think every central banker understands that keeping inflation low is absolutely essential to a successful economy, and we will do what we can to make sure that happens... The trade-offs are getting harder at this point. Inflation is getting higher. It’s not clear that we can get substantial improvements in payrolls without creating a considerable risk of a dangerous rise in inflation."

This, as Mark Thoma and others have pointed out, is baffling given that unemployment rate rules high and inflation is running below the Fed’s preferred range of 1.5 to 2.0 percent. It is all the more surprising since the Fed, by Bernanke's own admission, believes the expected rise in inflation, due to rising commodity prices, is only transitory. Mark Thoma is spot on in his assessment,

"The potential benefit of further policy moves by the Fed is higher growth and lower employment. The potential cost of more quantitative easing is inflation. So the decision on whether to provide more help to labor markets comes down to a comparison of the expected employment benefits to the expected inflation cost... none of the Fed’s forecasts show any long-run concern about inflation at all."

Update 1 (30/4/2011)

Three excellent graphics - bond yields, inflation, and unemployment - from Paul Krugman, that lays to rest all speculation about bond-vigilantes, spiralling inflation etc.

Update 2 (2/5/2011)

Chad Stone has an excellent graphic that captures the across the board drop in US economic growth in the first quarter of 2011 compared to the previous quarter.



Update 3 (3/5/2011)

NYT editorial questions the real meaning of the modest reduction of unemployment rate in the US from 10.1% in late 2009 to 8.8% now. Over the last year, the number of new hires has been outstripped by the masses who have either given up looking for work or who have not undertaken a consistent job search, say, after graduating from high school or college. Those missing millions are not counted in the official jobless rate; if they were, unemployment today would be 9.8 percent.

Mohamed A. El-Erian points to a few other uncomfortable unemployment facts - much of the improvement in recent months (from 9.8% in November last year) is due to workers exiting the labor force, thus driving workforce participation to a multi-year low of 64.2%; if part-time workers eager to work full time are included, almost one in six workers in America are either under- or unemployed; more than six million workers have been unemployed for more than six months, and four million for over a year; unemployment among 16-19 year olds is at a staggering 24%.

The competitiveness mismatch in Europe

Paul Mason (via Paul Krugman) has an excellent graphic that captures one of the fundamental problem facing many peripheral economies of Europe - lack of competitiveness.



He writes,

"There is a huge competitiveness mismatch and a resulting huge trade mismatch. The south became an export market for north-European manufactured goods, and a credit market for the north-European banks - which may have been technically constrained to be dour and presbyterian by domestic law but nevertheless piled into the Irish and Spanish property bonanza with gusto. Everybody benefited from the credit bubble; but Germany has above all benefited from the Eurozone's structural imbalance."

And The Economist is spot-on in its analysis of Portugal's problems,

"Portugal now joins Greece and Ireland in the euro zone’s intensive-care ward. Its public debts are nowhere near as monumental as Greece’s; its banks not as reckless as Ireland’s. It has succumbed because of a humdrum failure to rein in wage increases and to modernise a bureaucracy schooled in tallying the quiet remains of the first global empire, as well as an inability to coax upstanding family companies, which for centuries have crafted textiles, ceramics and shoes, into competing with the Chinese."

Fiscal austerity is not going to solve the competitiveness deficit, as Greece is finding out, through its three-year €110 billion ($155 billion) EU/IMF combined emergency bailout of May 2010,

"The real source of gloom is the shorter-term impact of austerity. A year ago the plan forecast that GDP would shrink by 4% in 2010 and 2.5% in 2011. Instead it fell by 4.5% last year and IOBE predicts it will decline by 3.2% in 2011. The unemployment rate has risen from 9% in mid-2009 to 14.2% in the last quarter of 2010, and is expected to average 15.5% this year... progress in cutting the deficit in 2010 was slower than envisaged. Provisional estimates put it at an oppressively high 10.6% of GDP rather than the original target of 8.1%. Debt is now close to 145% of GDP... Ten-year government-bond yields have climbed to almost 13%. The credit-rating agencies have recently downgraded Greek sovereign debt still further, from junk to junkier."

The solution, as Paul Krugman writes, is a combination of German inflation and Spanish deflation,

"During the eurobubble years, there were huge capital flows to peripheral economies, leading to a sharp rise in their costs relative to Germany. Now the bubble has burst, and one way or another those relative costs need to be brought back in line. But should that take place via German inflation or Spanish deflation? From a pan-European view, the answer is surely some of both — and given that deflation is always and everywhere very costly, the bulk of the adjustment should in fact take the form of rising wages in Germany rather than falling wages in Spain."

And amidst this gloom, hiking interest rates to ward off inflationary pressures is only going to amplify the woes,

"But what the ECB is in effect signaling is that no inflation in Germany will be tolerated, placing all of the burden of adjustment on deflation in the periphery. From the beginning, euroskeptics worried about one-size-fits-all monetary policy; but what we’re getting is worse: one-size-fits-one, Germany first and only. That’s a recipe for a prolonged, painful slump in the periphery; large defaults, almost surely; a great deal of bitterness; and a significantly increased probability of a euro crackup."

The European policy makers are clearly missing the woods for the trees. They fail to see the competitiveness mismatch and see inflation and lack of market confidence as the problems. Accordingly, their prescription is to raise interest rates and implement austerity measures to regain market confidence. Unfortunately, the first will merely widen the competitiveness mismatch while the second, from evidence of Ireland, UK, and Greece so far, will do little to bring back the "confidence fairy".

Update 1 (12/4/2011)

Paul Krugman makes another interesting point about how the sudden convergence of interest rates in the aftermath of the introduction of the Euro has contributed to the crisis.



He writes that as the euro became a done deal, countries that had previously had to pay a large interest premium found themselves able to borrow on the same terms as Germany; this translated into a big fall in their cost of capital. The result was bubbles, inflation, and the crisis in the aftermath of the bubbles and inflation.

Update 1 (22/4/2011)

The graphic below captures the problems for the peripheral economies. Note the high external debt-GDP ratios and banking sector share of that debt.

Re-thinking macroeconomic policies - a graphical summary

The sub-prime mortgage crisis and the Great Recession have questioned several underlying assumptions of modern macroeconomics. Paul Krugman famously called it the "Dark Age of Macroeconomics" and many standard macroeconomics text books are currently undergoing wholesale revisions in the light to these experiences.

What should be the role of Central Banks, especially in ensuring financial stability? What are the policies and instruments that can be deployed by central banks? What should be the optimal inflation target? What are the exit routes available for central banks from extraordinary monetary accommodation? Do central banks have a role in stabilizing output, that goes beyond interest rate changes, especially when faced with deep recessions?

What regulations are required to ensure greater stability and improve the crisis-resilience of banks? What can be done to contain the build up of systemic risks and limit the contagion effects of deleveraging and resultant liquidity crisis? How do we mitigate the moral hazard concerns arising from financial bailouts? What type of financial market regulations are required to limit the possibility of asset bubbles?

What are the fiscal policy options for governments faced with an economic recession and zero-bound in interest rates? How should fiscal policy be organized during such recessions? Which policies deliver the greatest bang for the buck? How can we swiftly deploy stimulus measures in the face of political paralyses and gridlocks? Should governments restrain from stimulating the economy, when faced with zero-bound recessions, with short-term fiscal measures for fear of deficits and debts?

What is the role of global macoreconomic imbalances in causing and sustaining asset bubbles? What is required to prevent the build up of such imbalances? How should cross-border financial flows be regulated? What is the optimal capital account policy for emerging economies? What sort of international monetary system is required to satisfactorily resolve cross-national financial crises?

I have tried to consolidate the learnings from events of the last three years and the post-mortems and other research that has gone into more satisfactorily understanding and explaining macroeconomic policy making. The result is this graphic. While I must admit that it is highly simplified (all such beautiful flow-charts are meant to simplify complex policy eco-systems), it only seeks to broadly highlight all the different elements of a post-crisis macoreconomic policy framework.

It is clear that the mandate of central banks have to expand beyond inflation targeting and include financial market stability. And when faced with deep recessions, central banks have a credit policy role, whence it could become a lender, buyer, and insurer of last resort. Fiscal policy becomes critical when monetary policy loses traction and when interest rates are at the zero-bound. Its main instruments are automatic stabilizers and discretionary spending measures. The specific instruments of each policy, as indicated in the chart, are illustrative and is meant to merely guide discussion.



(Please click on the graphic to enlarge)

In fact, the IMF recently brought together some of the world's leading economists to a conference where the Fund and participants urged a wholesale re-examination of macroeconomic policy principles. See also this concise presentation by Olivier Blanchard.

More on redefining the role of central banking

This is carrying forward from my earlier blog post on the re-definition of the role of central bankers. The Economist has an interesting debate on the issue. Its Economists by invitation column recently discussed the changing role of central banks.

John Makin and Michael Bordo argue that central banks return to a focus on their primary goal of maintaining price stability. They also advocate a separation of price and financial stability functions.

Hyun Song Shin argues that the big failure of the pre-crisis monetary policy was a neglect of the macroeconomic importance of financial stability. He writes that the central banks either hived off the "unglamorous business of financial stability" to a separate microprudential regulator or neglected it. The central bankers sought to specialize in the technical details of core monetary policy.

Markus Brunnermeier advocates that central banks should use more of the available tools to maintain financial stability. He also suggests that "central banks should lean against imbalances preventively", instead of just cleaning up after crisis strikes. Takatoshi Ito impresses on the importance of central banks to coordinate closely with fiscal and regulatory authorities in managing the financial markets and during crisis management.

Avinash Persaud feels that the effective divorce (in many countries) between central bank and regulatory agency, or monetary policy and regulatory policy, was a fatal mistake. He writes, "Monetary policy was deliberately oblivious to the asset price boom — that was somebody else’s problem. Regulatory policy was oblivious to macro risks — that was the central bankers job."

An excellent article in the same magazine chronicles the changing face of central banking and examines the dilemmas facing central bankers in the post-sub-prime crisis era. One of the concerns that was raised relate to the perception that, with quantitative easing, central bankers are treading into fiscal policy. In particular there are influential voices that claim that central bank purchases of government bonds, in the hope of lowering long-term interest rates, are tantamount to fiscal policy. They also argue that such policies were responsible for generating and sustainaing several macroeconomic imbalances in the global economy. Further, they also contend that such policies also end up bailing out greedy and irresponsible bankers.

In addition to the issues discussed in the earlier post, there are growing voices that central banks should take on more responsibility for the supervision of banks, especially with respect to the stability of financial systems. This effectively means more macro-prudential regulation, in addition to their existing responsibility for micro-prudential (bank-specific) regulation. This would involve assessing the systemic risk of the actions of individual institutions and different financial instruments.

The changing role of central banking

Standard economic models define the role of central bankers as managing price stability, as manifested by inflation rates, through the conventional interest rates-based monetary policy actions. Accordingly, inflation targeting has been the guiding monetary policy framework for a generation of central bankers.

The sub-prime crisis and the Great Recession has naturally raised questions about this strategy. On the one hand, it has brought to the fore the issue of financial stability, while on the other, it has also raised questions about the importance of economic growth itself. What can central banks do to promote these objectives?

Whatever the earlier reluctance, the dilemma about whether central banks should go beyond inflation targeting appears to have been settled. Some central banks, like the US Federal Reserve and the Reserve Bank of India, have always explicitly considered the promotion of economic growth as part of their objective (though others like the ECB have not been sure). However, the big change has been in the embrace of financial stability as an important objective of central banking policies.

Hitherto central banks have been concerned about the prices of goods and services. The prices of financial and other tradeable assets have remained outside their surveillance radar. The sub-prime mortgage bubble (and the financial market bubbles of the last two decades) with its several incentive distortions and its disastrous contagion effects on the real economy have highlighted the importance of monitoring the prices of financial assets. It is now clear that macroeconomic stability is a function of both price and financial stability.

This expansion in the scope of central banking has naturally raised questions about the instruments in their armoury to address the three-fold challenge of price stability, financial stability, and output stabilization. Financial stability is a much deeper issue than the other two, and requires that central banks go beyond their traditional micro-prudential regulation of individual banks. They have to assess the systemic risk impact of individual banks through macro-prudential regulation.

The current crisis has also seen central banks in the developed economies deploying a variety of often extraordinary measures to get their financial markets and economies back on the recovery path. The most important of these unconventional policies have been quantitative easing, which has been embraced by many central banks. Broadly, quantitative easing refers to the generic set of policies that involved direct credit injections, liberal credit access windows, near blanket credit guarantees, collateral standard expansions/dilutions, and outright asset purchases. The result of all this, coupled with the zero-bound in interest rates, has been dramatic credit expansions with explosive growth in the balance sheets of the central banks.



In the aftermath of the sub-prime meltdown, the US Federal Reserve and Treasury responded swiftly and pumped massive amounts to bailout Wall Street. Apart from lowering interest rates to the zero-bound, these measures also included credit guarantees and unconventional quantitative easing through direct credit injections and asset purchases. The Fed emerged as an effective lender, buyer and insurer of last resort.

It is difficult to estimate the exact impact of such policies. The counterfactual is one of the most difficult riddles. All the more so when the policy itself has not delivered its ultimate objective but merely prevented the situation from getting worse. How do we know what would have been the situation now without all these extraordinary policies? How do we know that these policies, tried out in desperation, have not prevented a repeat of the Great Depression? Or how do we know what could have been, as Paul Krugman and some others have claimed, with a stronger dose of quantitative easing?

There are other equally importat issues. For long time now, economic stability has meant targeting an inflation rate of around 2%. Accordingly, central banks across the developed world have successfully managed monetary policies over the past two decades and kept inflation expectations under control. In fact, it was even being suggested that central banking has slayed the inflation demon. All the major developed economies had low inflation rates and inflation expectations when the sub-prime bubble burst.

However, that in turn posed a problem of a different kind. The low inflation also mean that the interest rates were at already low levels. This also meant that the real interest rates were at ultra-low levels. Once the bubble burst and the Great Recession took hold, the central banks aggressively cut rates even further, and the interest rates touched the zero-bound. With inflation rates remaining low and even falling further, the real interest rates fell into the negative territory. All this meant that conventional monetary policy and its primary instrument, interest rate changes, had become blunt.

This naturally raised questions about the inflation and monetary policy decisions of the pre-crisis era. What is the optimal inflation rate? Should inflation rates be targeted a little higher, so as to enable governments and central banks to have some room to maneouvre with interest rates when downturns strike? What should be the ideal interest rates during the good times?

Almost exactly a year back, the IMF Chief Economist, Olivier Blanchard waded into this debate with a landmark paper. In a major U-turn from the standard IMF orthodoxy on inflation, he advocated a higher inflation target for economies during good times. He argued that economies should target a higher inflation rate, preferably 4% (against the standard 2%), so as to leave enough room for monetary policy actions to work when recessions and downturns strike.

At a 4% inflation rate, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.

However, the challenge with higher interest rates lies in balancing the central bank credibility associated with a rigid and well-communicated low inflation policy and the difficulty of anchoring inflationary expectations at a higher level of inflation. The Blanchard paper has several other important suggestions, some of which are of importance to central bankers. I have discussed them here.

More fundamentally, the recent crisis has certainly highlighted the importance of central banks, especially in crisis situations. The technical nature of their work and their ability to act immediately and without much lag, unlike their political counterparts, make them important institutions. In fact, given the centrality of the economy and the increasing importance of the central banks in macroeconomic management, it is important to re-assess the role of central banks.

Their over-sized role, even in developing economies, raises the inevitable questions about the type of over-sight that the political system should have on central banks. In the US itself there is a clear divide between those advocating much greater political control over the functioning of central banks and those demanding continuance of the central banks' autonomy.