Monetary Regime Transition in the Emerging World

Andres Velasco

Jan. 7, 2013.

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SANTIAGOIs inflation targeting – the rule that most of the world’s major central banks (though not the United States Federal Reserve) use to set interest rates – in its death throes? Many analysts seem to think so.

Mark Carney, currently Governor of the Bank of Canada, has not even taken over his new job at the helm of the Bank of England, yet he has already announced that he might change the BoE’s policy anchor. In Japan, the Liberal Democrats won December’s general election after having promised a more expansionary monetary policy. And in the US, the Fed has announced that it will keep interest rates low until unemployment reaches 6.5%.


None of this is as new as it seems. Among rich countries, inflation targeting has been on its way out since the 2008-2009 financial crisis. The large-scale asset purchases carried out by the European Central Bank, for example, have little to do with any definition of inflation targeting.

But inflation targeting has also been losing its hold on policymakers in emerging-market economies. Starting in the 1990’s, central banks in Brazil, Chile, Mexico, Colombia, Peru, South Africa, South Korea, Indonesia, Thailand, and Turkey adopted varieties of the scheme. But things changed with the global financial crisis.

In joint research with Roberto Chang and Luis Felipe Céspedes, we show that all inflation-targeting central banks in Latin America have used a range of non-conventional policy tools, including currency-market interventions and changes in reserve requirements. Again, this is a far cry from the textbook version of inflation targeting.


What comes next? In the developed world, the leading contender to replace inflation targeting is nominal-GDP targeting. This seems to be what Carney has in store for Britain. Under the proposed new system, if the BoE would like to keep inflation around, say, 2%, and expects the trend rate of GDP growth to be 3%, it should announce a target for nominal GDP growth of 5%.

This new regime might help rich-country central banks to keep their economies suitably stimulated. But, from the point of view of emerging countries, changing the monetary-policy regime in this way makes little sense. Central banks in Asia and Latin America have had three problems with inflation targeting from the outset, but moving to nominal-GDP targeting solves none of them.

The first problem concerns capital inflows and exchange-rate appreciation. When rich-country central banks cut interest rates, capital moves south and east. Some inflows are always welcome. But when the flow becomes a flood, the currency strengthens sharply. Commodity exports typically continue to grow, but industrial and non-traditional exports suffer.

Increasing interest rates only attracts more capital, while cutting rates can cause the economy, already stimulated by the foreign inflows, to overheat. Faced with this dilemma, many emerging-market countries have turned to exchange-rate intervention, and then to raising banks’ reserve requirements, in order to make foreign borrowing less attractive.

This is a problem that concerns the composition of output (traditional versus non-traditional exports), not just its level. Moving to nominal-GDP targeting would not make a difference.


The second problem is shared by rich and middle-income countries’ central banks: how to ensure that monetary policy addresses the need to maintain financial stability.

Inflation targeting concerns itself with the prices of goods and services, not the prices of financial assets. If “irrational exuberanceset in and a bubble developed in real-estate or equities markets, well, so be it, the standard theory maintains.

After the devastation wrought by the boom-and-bust cycle of recent years, not many economists are comfortable with the “so be itattitude anymore. Nor are many emerging-market countries’ central banks, which are adopting changes in reserve requirements and loan-to-value ratios, among other measures, to prick asset-price bubbles in their early stages.

Advocates of nominal-GDP targeting claim that these prudential measures could be added to create an extended version of their preferred regime. Perhaps, but they could be added to the standard inflation-targeting regime as well. Moving from one system to the other helps little in this regard.
The final problem concerns central banks’ role as lenders of last resort in a crisis. This job is especially important – and difficult – in emerging markets, because a significant share of debt, both public and private, is typically in foreign currency. As a result, lending in crisis situations implies using international reserves and providing foreign-currency liquidity. This, too, is alien to the standard target-inflation-and-float-the-currency regime. But it would be just as alien to a system in which the central bank targeted nominal GDP and the currency floated.
These considerations suggest that the way out does not lie in moving from one simple, one-size-fits-all rule to another. Emerging markets need a monetary-policy regime that takes explicit account of capital-flow volatility, asset-price misalignments (including the exchange rate, which is the price of foreign currency), and the resulting financial instability.
The feedback from these factors to interest rates probably should not be the same in tranquil and turbulent times. A comprehensive regime should encompass two rules one for crisis situations and one for “the rest of the time” – plus explicit guidelines for moving from one to the other and back.
We are far away from being able to formulate and apply such a rule. But at least the debate has now begun. The floor is open.

Andrés Velasco, a former finance minister of Chile, is a visiting professor at Columbia University's School of International and Public Affairs. He has consulted for the International Monetary Fund, the World Bank, and the Inter-American Development Bank, as well as for several Latin American governments.

Personal finance

Ghastly gurus

The best advice is to keep your wallet closed

Jan 12th 2013

Pound Foolish: Exposing the Dark Side of the Personal Finance Industry. By Helaine Olen. Portfolio; 292 pages; $27.95 and £17.99.
Market Sense and Nonsense: How the Markets Really Work (and How They Don’t). By Jack Schwager. Wiley; 343 pages; $40 and £26.99.

HAVE you ever met anyone who has grown rich just by saving? Probably not. But you may well have met someone who has grown rich looking after other people’s savings. That dark secret lies at the heart of “Pound Foolish”, Helaine Olen’s excellent book, a contemptuous exposé of the American personal-finance industry.

With icy logic, Ms Olen, a journalist, demonstrates that much of the advice given by moneymaking gurus on television or in print is either fatuous or based on ridiculously optimistic assumptions about future investment returns. Take the idea that saving the cost of a daily latte and investing the proceeds in the stockmarket would make you rich. Saving $3 a day, or $1,100 a year, might be a sensible economy measure but it won’t build a fortune.

Such faddish ideas are the financial equivalent of miracle diets. A belief in instant riches lured millions into buying internet stocks in the late 1990s or overpriced houses in the middle of the past decade, when any personal-finance adviser worth his salt should have been advising clients to run in the opposite direction. But optimism sells, and realism tends not to.

As well as bad advice, the gurus have plenty of expensive products to flog—from courses that teach people how to become better real-estate investors to branded goods like a $49.99 canvas laptop bag or a $34.98 silver leather wallet. By the time clients have bought all the books, attended the courses and stocked up on the accessories, someone has definitely become rich, though probably not the saver.

Savers make all sorts of rookie mistakes—from following the stock tips touted on television to paying through the nose for complex financial products when simple low-cost alternatives (like index-tracking funds) are available. And debtors are similarly foolish, running up big bills on high-charging credit cards. Perhaps such lessons could be rammed home by financial-literacy courses but Ms Olen is cynical, noting that many courses are sponsored by financial-services companies, creating an obvious conflict of interest.

Indeed, this is one of the central problems of personal financehow to get advice to apathetic consumers. The unwillingness of consumers to pay for advice has led to hard-selling, high-charging salesmen taking over the industry.

Britain has just reformed its payment system for financial advice and if Ms Olen’s book has a fault, it is the lack of an international perspective offering such examples. The personal-finance pages of British newspapers are doughty champions of consumer rights. While she rightly attacks the high-cost annuities sold to American consumers, she might have reflected that the kind of low-cost annuities sold in Britain ensure that retirees do not outlive their savings.

But Ms Olen is right to home in on the biggest problem that personal-finance gurus neglect; people earning $20,000 a year will struggle to pay for the basics in life and will simply not be able to save their way to a life of comfort, let alone riches. As Ms Olen concludes, “We do not live in an economic environment that will permit mass personal-financial progress, no matter how well meant the guidance or advice.”

Like Ms Olen, the latest book from Jack Schwager, best known for his “Market Wizardsbooks based on interviews with traders and fund managers, takes a potshot at TV stockmarket tipsters. A four-year analysis of the share recommendations by Jim Cramer, star of CNBC’sMad Money”, shows that while the stocks rose on the day he mentioned them, they underperformed the market over longer periods. The experts polled by Louis Rukeyser on “Wall Street Week” (a programme on public television) proved to be almost perfect contrarian indicators; they were most bullish in December 1999, at the peak of the dotcom bubble.

Mr Schwager’s book starts off with plenty of sound, basic advicebeware of assuming that past high returns can be maintained, for example—before expertly demonstrating that a leveraged exchange- traded fund (a fund that promises to deliver an enhanced market return) is a dreadful investment because of its structure, being almost bound to disappoint.

He then moves on to more sophisticated measures of risk, rightly pointing out that “faulty risk measurement is worse than no risk measurement at all, because it may give investors an unwarranted sense of security.” As the book develops, beginners may start to struggle with mathematical concepts, such as Sortino and Calmar ratios, that regularly get trotted out.

Oddly, this curate’s egg of a book then veers off in a different direction—a lengthy description and defence of the hedge-fund industry. Mr Schwager demonstrates that hedge funds are less risky than many mutual funds, but he does not really deal with the central issue; that their fees are too high for the returns they deliver. One suspects that Ms Olen would respond to his conclusion that “hedge funds are a desirable investment even for unsophisticated, lower-net-worth individuals” with a loud, and well-deserved, raspberry.

The Age of Epigenetics

Timothy Spector

Jan. 10, 2013

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                   Illustration by Paul Lachine
LONDONFifty-one years ago, James Watson, Maurice Wilkins, and Francis Crick were awarded the Nobel Prize in Medicine for their discovery of DNA’s structure – a breakthrough that heralded the age of the gene. Since then, the field of genetics has advanced significantly, particularly as a result of the global Human Genome Project, which in 2003 identified all of the roughly 23,000 genes and three billion chemical base pairs in human DNA in order to screen for many rare diseases.

But, despite evidence that most diseases have a clear genetic component, only a fraction of the genes that explain them have been found. And scientists in the field remain puzzled by the fact that most identical twins (who share 100% of their genes) do not die from the same diseases. As a result, many in the scientific community are beginning to predict a decline in the role of the gene in pinpointing the root causes of diseases.
It is too soon to discount genetics, however, because the science of “epigenetics” – the study of mechanisms for turning genes on and off, thus changing the way a cell develops without altering the genetic code – is gaining traction. Indeed, the 2012 Nobel Prize in Medicine was awarded to John Gurdon and Shinya Yamanaka for revolutionizing scientists’ understanding of how cells develop by reprogramming DNA and cells without altering their genetic structure.
In 1962, Gurdon’s finding that almost any cell in the body contains the complete DNA code enabled him to create a tadpole by cloning an adult frog. More than four decades later, in 2006, Yamanaka discovered a way to trick complex adult cells in mice into regressing to their immature state, forming stem cells. Before this, stem cells – which can potentially be reprogrammed to develop into replacements for lost or damaged tissue – could be taken only from early-stage embryos, a practice that fueled ethical controversy.
The true promise of epigenetics has become apparent only in the last few years, as scientists’ ability to assess the epigenetic mechanisms in DNA – which can now be measured at roughly 30 million points across the human genome – has dramatically improved. Epigenetics can potentially be used to explain the root causes of many diseases that scientists have so far struggled to understand, from asthma to allergies to autism.
Consider lung cancer. Six decades ago, when most men smoked, British doctors linked smoking to lung cancer, making it the first disease to be causally linked to smoking. (In fact, lung cancer kills one in ten smokers.) But the incidence of certain kinds of lung cancer continues to rise – particularly in womenmaking it one of the most prolific killers worldwide, despite the general decline of smoking over the last 30 years.
Indeed, nowadays, many lung cancer patients have no history of smoking. These “blamelesspatients seem to develop a different kind of lung cancer from those who report a history of smokingone that is more responsive to new medications and has better, albeit still poor, outcomes.
Epigenetic processes that cause key anti-cancer genes, such as the tumor suppressor P16, to be switched off could explain the increased prevalence of lung cancer. A recent study showed that a few years of smoking can have this effect, making smokers more susceptible to a variety of cancers.
My team and I recently studied 36 pairs of identical twins, of which only one twin had breast cancer. These “genetic clones” had a few crucial differences. In the twin who developed the breast cancer, several hundred genes had been switched off. In a few genes, this had occurred five years before diagnosis. Such findings unlock the possibility of a diagnostic test well before the disease manifests itself, and of developing drugs that prevent – or even reverse – the cancer’s development.
Moreover, animal studies have shown that changes in stress or diet can alter the behavior and genes of future generations. As a result, it is likely that epigenetic changes can be inherited.
For example, smoking could have caused epigenetic changes in a grandparent’s DNA, effectively switching off certain anti-cancer genes. The genes would then be passed down to descendants in this switched-off state. Thus, the toxins that people ingest may not be the only relevant factor should cancer strike; the toxins that their parents or grandparents ingested could also be to blame.
Physical experiments revealing such trans-generational effects are impossible to conduct on humans, so historical or observational data must be used. One study of children in Bristol showed differences in growth depending on whether their grandfathers had smoked before the age of 11. Their bodies probably reacted defensively, adapting in the short term by changing the genes for the next few generations, or until the “danger” had passed, a so-calledsoft inheritancerunning in parallel to slower-acting evolutionary forces.
Fortunately, these epigenetic changes are potentially reversible. Four epigenetic leukemia drugs, which aim to switch the natural protective genes back on, are now on the market in the United States. More than 40 other epigenetic drugs are being developed, not only for cancer, but also for obesity and even dementia. In the future, regular epigenetic health check-ups could become standard practice.
More than 50 years on, genes remain crucial to understanding complex diseases – especially given scientists’ ever-improving ability to alter them. The age of the gene is far from over; it has simply progressed into the age of epigenetics.

Tim Spector is Professor of Genetic Epidemiology at King’s College London, and the author of Identically Different: Why You Can Change Your Genes.

Last updated:January 11, 2013 4:17 pm

Billions pumped into global equities

Investors this week poured the most money into equity funds in more than five years, as global shares surged and a compromise deal on the US fiscal cliff boosted confidence.

Net inflows into equity funds monitored by EPFR, the the funds research company, hit $22.2bn in the week to January 9 – the highest since September 2007 and the second highest since comparable data began in 1996. Record inflows into emerging market and world funds drove much of the expansion.
The figures capped a week during which global equity indices hit multiyear highs, encouraging speculation about a “great rotation” this year out of safe, recession proof assets such as government bonds and into equity markets.
“It has certainly got something of that look about it,” said Cameron Brandt, EPFR research director.
“It is broadly based with strong flows into equities from retail investors and into actively managed funds. It has a different feel to it than other recent spikes in flows into equities.”
After a strong start to the year, the S&P 500 hit a five-year high this week, and erased modest losses to close unchanged, leaving it up 3.2 per cent so far this year.
In London, the FTSE 100 ended the week at 6121.58, taking it to levels last reached in May 2008. Its 3.8 per cent surge over the first full trading week marked the best start of any year since 1999. The FTSE All-World index finished at 230.67, its highest level since May 2011.
Scepticism remains, however, about whether the latest shift into equities will be sustained. “It’s a bull dream so far, not reality,” said Jim Stride, head of UK equities at Axa Investment Managers.
Adrian Cattley, European equity strategist at Citigroup, added: “Yes this is a good start to the year but we’ve seen this type of flow into equities before in January.”
In the US, investors are looking ahead to company earnings next week, while Washington has yet to raise the Federal debt ceiling and address planned spending cuts that could weigh on the economy this year. Investors are over-optimistic on earnings and we think the debt and fiscal issues could come back to bite the market hard,” said Michael Kastner, principal at Halyard Asset Management.
EPFR’s latest weekly figures showed a net $7.4bn inflow into emerging market equity funds and $3.4bn into world equity funds. Inflows into US equity funds, at $10.4bn, were at a six-week high. Europe equity inflows were more modest, at less than $1bn.
Separately, Thomson Reuters’ Lipper service reported US equity funds, including exchange traded funds, took in $18.3bn in the week to January 9 – the fourth-strongest figure since it began calculating weekly flows in 1992.
The strong figures from Lipper come in the wake of the compromise deal that avoided the so-called US fiscal cliffbillions of dollars’ worth of tax cuts and spending hikes that were due to automatically kick in at the start of the year. The new budget passed by Congress increased taxes for richer Americans and extended unemployment benefits, but delayed a decision on planned spending cuts for two months.
According to the UK’s Investment Management Association, net retail sales of equity funds hit £720m in November – the highest since April 2011making shares the most popular asset class for investors for the third month in a row. By contrast, fixed income funds sales were the lowest since October 2008.

Additional reporting by Michael Mackenzie in New York and Tanya Powley and Stefan Wagstyl in London

Copyright The Financial Times Limited 2013.