Monetary policy and asset prices

A narrow path

Central banks around the world are struggling to promote growth without fomenting worrisome risk-taking

Jun 21st 2014
Washington, DC


UNTIL the global financial crisis, central banks treated bubbles with benign neglect: they were hard to detect and harder to deflate, so best left alone; the mess could be mopped up after they burst. No self-respecting central bank admits to benign neglect any longer. “No one wants to live through another financial crisis,” Janet Yellen, then a candidate to head the Federal Reserve, said last year. “I would not rule out using monetary policy as a tool to address asset-price misalignments.”

After six years of interest rates near zero the tension between central banks’ responsibility for output and inflation on one hand and financial stability on the other is growing. On June 12th the Bank of England hinted it would pursue new measures to curb ever-climbing property prices. Shortly afterwards Ms Yellen fretted about the “reach for yield” and subdued volatility, a sign of investors’ complacency.

For Britain and America, the prospect of using interest rates to tackle financial imbalances remains hypothetical. Not so in Norway and Sweden, where central banks have been stingy with rate cuts for fear of inflating home prices and household debt. That has come at a cost: inflation is below target in both countries; in Sweden it is negative. This could become entrenched: Andy Levin, an economist at the IMF, recently noted that long-run inflation expectations in both countries have also dropped below target.

In Sweden, the Riksbank’s stance has been deeply divisive. Two of the six members of its executive board voted in April to cut the repo rate, which is now 0.75%

Lars Svensson, an academic economist who left the board last year, calculates that unnecessarily tight monetary policy since 1997 has raised unemployment by 0.8 percentage points. He believes it has also worsened Sweden’s imbalances by slowing the growth of incomes more than the growth of debt, thereby raising the household-debt ratio, now 174%.

Sweden’s parliament recently instigated an independent review of the Riksbank’s policy. The central bank’s defenders argue that the consequences of a household-debt bust require pre-emptive action, and that tightening rules, such as tougher underwriting standards for mortgages, while essential, is not enough. A Riksbank staff study contradicts Mr Svensson’s findings, concluding that it is lower rates, if perceived to be long-lasting, that would in fact raise debt ratios. Nonetheless, a rate cut is widely expected next month.

Sweden’s experience is a cautionary tale for other central banks. In Britain, house prices have risen by 10% in the past year, and household debt, though down relative to income since the recession, still exceeds 140% of income. Mark Carney, the governor of the Bank of England, complains this has “unbalancedBritain’s recovery. He has hinted at countermeasures such as higher capital charges for mortgages and limits on high loan-to-value or debt-to-income ratios. He also warned that interest rates could rise sooner than markets expect, although this was motivated more by the surprising pace of recovery than by fears of financial instability.

Ms Yellen’s challenge is different. America’s economy, in contrast to Britain’s, continues to disappoint: on June 18th policymakers lowered their projection for economic growth this year, to 2.2% from 2.9% in March, the latest in a series of downgrades. They also reaffirmed their expectation that rates would stay near zero through the middle of next year, though the projected pace of tightening thereafter rose slightly.

Two things could prompt an earlier move. One is prices. The trend of falling inflation that had alarmed Fed officials is now over: consumer prices were up by 2.1% in May, the fastest in 20 months. But that is hardly unnerving; according to the Fed’s preferred index inflation is closer to 1.6%, well below the 2% target, and it is expected to stay below target through 2016. Moreover, Fed officials have recently hinted that they would prefer to let inflation rise above 2% briefly than strangle the recovery with premature tightening.

Before the meeting the IMF, in an unusually public and explicit fashion, urged the Fed to keep rates near zero for even longer than now planned and to let inflation exceed its target. But the dilemma this creates is well illustrated by the IMF’s indecision on the issue. In April it cautioned that “undue delay” in raising interest rates “could lead to a further build-up of financial stability risks”.

American homes are reasonably valued and household debt is just 109% of income, and falling. But fixed-income markets exhibit euphoria reminiscent of 2007. A record $94 billion of junk bonds was issued in the second quarter, and leveraged loans are on track to match last year’s record $1.1 trillion, according to Thomson Reuters. A third of those loans lack the standard covenants that limit how much debt the borrower can carry.

Ms Yellen said such trends are not troubling enough to affect the course of monetary policy for now; she prefers that they be dealt with throughmacroprudentialpolicy, meaning regulations designed to address specific imbalances in the financial system. The Fed has already urged tougher underwriting standards on leveraged loans. But some of her colleagues want higher interest rates to play a part as well

Esther George, president of the Federal Reserve Bank of Kansas City, recently warned that the Fed’s commitment to keep interest rates low has encouraged small banks to raise the share of their bondholdings and loans that mature in more than three years to 53%, up from 37% in 2005. That exposes them to “heavy lossesif rates rise suddenly. Jeremy Stein, a Fed governor until last month, has noted that moneymen can find ways around macroprudential controls, whereas tighter monetary policygets in all of the cracks”.

Most officials at the Fed, however, worry more about an aborted recovery than financial instability. Three Fed economists helpfully quantified this trade-off last year by simulating two responses to a financial crisis

In one, rates fall to zero, and another crisis, 60% as bad as the first, erupts ten years later. In the other, rates are not allowed to fall below 1.5%, and the second crisis is avoided. Their conclusion: even with the second crisis, the cumulative loss of income and employment is far smaller in the first scenario. The ironic and unsettling upshot is that, sometimes, chancing another crisis is the optimal policy.

June 19, 2014 12:39 pm

The perils of returning a central bank balance sheet to ‘normal’

Asset holdings enable policy makers to regulate the economy, writes Benjamin Friedman

(FILES) File photo dated August 09, 2011 shows the US Federal Reserve building in Washington, DC. The Federal Open Market Committee's (FOMC) regular policy-setting meeting starts September 20, 2011 in Washington. The threat of inflation is expected to temper any decisions on new pro-growth measures when Federal Reserve policy-makers meet Tuesday on the US economy's poor health. With growth stagnating and unemployment stubbornly above nine percent, analysts say they expect the Federal Open Market Committee to take some action to stimulate the US economy. AFP PHOTO/KAREN BLEIER (Photo credit should read KAREN BLEIER/AFP/Getty Images)©AFP

With the US Federal Reserve on its way to bringing its bond-buying programme to an end, many are asking how to return the central bank’s balance sheet to “normal” – that is, to its pre-crisis size and composition. The same debate is under way at other central banks. Should they sell their bonds, or hold on to them until they mature? And if they are going to sell, which securities should go first? Yet there is another question that is equally important but seldom asked: is it sensible to return central banks’ balance sheets to “normal”? There are good reasons not to.

At the beginning of 2007, the Federal Reserve System’s assets totalled $880bn. Today, the balance sheet stands at $4.3tn, including $2.4tn of Treasuries and $1.7tn of mortgage-backed securities. The reason for buying these assets was not to reduce the federal funds rate, which had reached zero by late 2008, but to lower the interest rates at which loans are extended to people and businesses, stimulating demand.

The evidence shows that these bond purchases indeed lowered long-term rates relative to short-term rates, and lowered rates on more-risky compared with less-risky obligations. A conservative estimate is that a $600bn bond purchase (the size of the Fed’s second round of bond buying) lowered long-term interest rates by about 25 basis points: not enormous, but a worthwhile contribution to the US economic recovery. And the effect of lower long-term rates was probably reinforced by higher equity prices and a cheaper dollar.

The composition of the assets that the central bank buys matters too. Buying mortgage-backed securities narrowed the difference between the interest rate American homeowners paid on their mortgages and the rate at which the US government could borrow. This helped stop house prices from falling and spurred residential construction. Buying or selling bonds gives the Fed a way of influencing longer-term interest rates in general, and mortgage rates in particular. This lever will remain useful long after short-term rates begin to rise. But it will be out of reach if the central bank returns its balance sheet to its pre-crisis state.

Before the crisis, many people urged the Fed to tighten policy to arrest the developing bubble in the mortgage and housing markets. An increase in short-term interest rates would have helped cool asset markets, but it also risked impeding growth in other sectors. If the Fed’s balance sheet had included mortgage-backed securities, it could have sold them, scooping froth out of those particular markets without depressing the rest of the economy.

What are the potential drawbacks of maintaining a balance sheet significantly larger than the pre-crisisnormal”? First, the central bank may suffer losses if it buys securities that fall in value. So far, this has not happened; central banks’ bond buying programmes have made them – and, therefore, taxpayers record profits. Moreover, while such losses might ultimately impose costs on taxpayers, there is no risk from insolvency of the central bank itself. Unlike at private banks, which must keep cash on hand to meet withdrawals, central bank liabilities are not redeemable for anything else.

Second, because asset purchases have to be paid for, the huge increase in central banks’ holdings has required a corresponding increase in their outstanding liabilities. Those economists who think of prices and wages as determined by the liabilities of the central bank expected hyperinflation to follow

Yet no increase in inflationnot even a few percentage points – has yet appeared in any economy that has pursued this course. That is because the central banks in question have made it advantageous for banks to redeposit the additional reserves instead of lending against them. This has prevented these asset purchases from triggering what might otherwise be an inflationary flood of credit.

For decades, it has been commonly understood that the central bank’s policy interest rate is the only independent instrument of monetary policy. We now see that there are two: the policy interest rate and asset purchases or sales.

But the central bank cannot sell what it does not own. To keep this additional policy tool available, the Fed and other central banks should hold on to an ample supply of assets. They should not shrink their balance sheets to the pre-crisis size.

The writer is a professor of political economy at Harvard University 

Copyright The Financial Times Limited 2014

Heard on the Street

Wall Street's Reason to Fear the Repo

By John Carney

June 22, 2014 2:09 p.m. ET

A handful of Wall Street firms are much more vulnerable than their peers to a type of bank run seen during the financial crisis. Unfortunately for investors, the identity of these firms is a mystery.

One lesson from the financial crisis was that a little known but important source of funding, the repo market, can freeze up in times of stress. That is because cash investors, such as money-market funds, can suddenly stop making the short-term loans collateralized by securities, known as repurchase agreements, or repos, that help finance Wall Street's securities portfolios. The shorter the maturity of a firm's repo financing arrangements, the quicker they can come due and the more vulnerable it is to a repo run.

That is why the repo market, and reducing firms' reliance on it, has come into focus with regulators. Officials such as Federal Reserve governor Daniel Tarullo, the central bank's point person on regulation, have repeatedly spoken of the need for overhauls of this market, along with that of money-market funds.

Against that backdrop, a new study by the Federal Reserve Bank of New York of repo financing for riskier, less-liquid assets, such as corporate bonds, offers some potentially encouraging news. It found that Wall Street as a whole appears less vulnerable to repo runs. The average maturity of these trades, weighted by the value of collateral, was nearly 80 days in the first quarter, up from just 40 days in 2011.

But not all firms are so well placed. At a quarter of the 15 firms with the largest positions in this market, the weighted-average maturity was 26 days or less, according to the Fed researchers.

So which firms are the weakest in this regard? That's the rub: The New York Fed study used confidential information that investors can't access. And because most firms don't disclose the maturity of their repo trades, there is no way to tell which is most vulnerable to a repo run.

Citigroup, and Goldman Sachs Group are the exceptions: Each discloses that its risk assets have secured financing with a weighted average maturity of more than 100 days. For the rest of Wall Street, the weakness detected by the Fed is cloaked in opacity.

It isn't as if this is a trivial matter: Repo runs played a role in the demise of Bear Stearns and Lehman Brothers. So the extent of a firm's vulnerability to such a scenario shouldn't be kept hidden. What's more, these known unknowns can become dangerous if markets come under stress. Another lesson from the crisis is that when markets suspect that some financial institutions are critically weak but can't identify which ones, liquidity dries up for everyone.

Hopefully, this study is a sign that regulators, who have made clear that the repo market can contribute to systemic risk, are moving toward requiring greater transparency. An added benefit: Banks made to disclose repo vulnerability would likely move to reduce it. It is time to shed light on the repo market's darkness.

lunes, junio 23, 2014



Place of gold in a perilous world

With numerous conflict flashpoints around the world and the possibility of market collapses there has never been a better time to hold some gold as insurance.

Author: Lawrence Williams

Posted: Wednesday , 18 Jun 2014

London (Mineweb) - The world is a dangerous place. One only has to look at the rise in extremism, rogue regimes, overthrown governments attempting to regain power, ethnic and religious factions fanatically opposed to one another, and other violent conflicts to see this. Indeed one could say that the populace of Western democracies are perhaps more in peril now than at the peak of the Cold War when the threat of mutually assured nuclear destruction kept most serious conflicts from ever starting.

Back then there would have been a state to target should conflict arise. Nowadays the threat tends to come from small disparate fanatical groups which have no easily identifiable physical power base and with leadership by individuals who may be located almost anywhere. But the weapons available to these groups and rogue states are often the most sophisticated money can buy, and the illegal arms trade can supply, and their awareness of the high tech means by which their leaders might be located makes them increasingly difficult to track down and sanction. Even if the leadership is destroyed in say a drone strike, it tends to be like the Hydra’s headcut them off and more grow in its place and often these are more extreme than the originals. Should some of these more extreme groups gain access to nuclear and biological weapons we could be closer to at least partial Armageddon than at any time in global history.

The past week has seen worrying activity almost globally – with ISIS making huge unexpected incursions into the heart of Iraq, more terrorist activity claiming lives and hostages in Africa and the Ukraine insurgency continuing to escalate – and, as a result, the gold price has been picking up again as safe haven investment starts to return. But whether this is enough on its own to kickstart a really significant gold price rise remains to be seen. In particular the American populace as a whole will likely remain unconcerned about activities on the other side of the world, but it should be aware that Al Qaeda and the even more extreme ISIS could perhaps pose even more of a major threat to people on the American continent than Russia has in the past or could in the future. And in Europe, which is closer geographically to most of the really serious global flashpoints, people are beginning to feel more vulnerable.

Consider the successful ISIS move on Mosul, Iraq’s second largest city with a population of around 1.8 million. There some 500,000 are reported to have fled the city mostly to Kurdish territory to the east, while many more have been killed by the insurgents

Those who fled have had to leave their houses and possessions behind, escaping with what they can carry with them. Those who own gold will at least have a portion of their wealth with them which may stand them in good stead in the months, perhaps years, of tribulation ahead and help them establish a new life.

Such is the nature of conflict. And when extremists like the ISIS groups – or Al Shahab in East Africa and Boko Haram in West Africa attack, people would rather leave their homes and major possessions than stay and face a dangerous futurenot only from the insurgent groups, but from potential city destroying conflict as the supposedly ruling government tries to take back the territory lost. Syria comes to mind as well, with a huge flood of refugees into neighbouring Turkey and Lebanon. Those who have put their trust in gold at least have something with which they can at least start a semblance of a new life. Those who survived such conflicts in Bosnia and Croatia through flight during the sectarian civil war which engulfed those countries in the 1990s will be well aware of this and one suspects many will nowadays be retaining an emergency reserve of easily transportable wealth – of which gold is the most easily tradeable in an emergency – in case conflict should spring up again, however unlikely.

In Eastern Ukraine, much of the population in the apparently insurgent controlled Donbass region will be fearful of a heavy handed, and possibly indiscriminate, response by the Ukrainian army, particularly following the downing of one of its transport planes with heavy loss of life. People may choose to join the flood of refugees into Russia which they see at least as a way of preserving their lives, if not their property and if they have gold they have something they can trade to re-establish themselves in the event they are unable to return for whatever reason.

Small wonder therefore that gold buying is making something of a comeback in many parts of the world. The Middle East, for example, is seeing major gold purchasing while in the perhaps more politically stable, but traditional gold buying areas like India, where gold has stood the test of time in terms of an inflation hedge, demand remains strong despite the government’s attempts to rein it in to protect the nation’s balance of payments. 

So too across virtually all of Southeast Asia, some areas of which have a recent history of conflict, but virtually all of which have seen periods of out of control inflation. Even Chinanow the biggest gold buying nation of all - has seen citizens flooding to protect their wealth largely through inflation fears, but also for historical reasons.

But it is the U.S. which seems currently to control the gold price, perhaps through the machinations of the major bullion banks who can make vast profits through manipulating the price up and down by utilising the futures markets, and these historic reasons for owning gold are not really present.

Conflict is unlikely, bar some horrendous terrorist atrocity, which cannot be ruled out given the fanatical nature of some of the anti-U.S. political groups elsewhere in the world. Meantime inflation has been kept under reasonable control for many years. The Wall Street crash of 1929 is mostly outside living memory, but a repeat cannot be dismissed and some savvy investors will be holding gold just in case. A terrorist attack on the scale of 9/11 could well bring markets crashing down. It may be as well at least to hold some proportion of one’s wealth in gold as insurance.

In Europe, the rise of far right and far left leaning political parties is a cause for concern in terms of political stability, while Ukraine is close geographically to the continent’s centre. Russia under Putin seems to be seeking to regain some of its past powers and no-one knows how this may pan out. It will leave those in some of the former Soviet controlled Eastern European nations worried that the Bear may be flexing its claws in order to regain its influenceperhaps as much by destabilisation as by actual conflict.

The global banking system too remains stretched and bank collapses could leave people heavily exposedjust ask Greek Cypriots!

It is indeed an uncertain and perilous world we live in and holding gold as a wealth protector seems as important now as it ever has been not necessarily for making huge gains as a result of a rising price, but as a protector against heavy losses should banks collapse and markets crash. It is a prudent policy to hedge one’s bets.