Tag Archive for 'Interest rates'

Get set for more negative interest rates

Published on 1 February 2012 at 7:30 pm in Economics, Finance and USA. Tags: FT Alphaville, Interest rates, US Treasury.

Via FT Alphaville, I see that the US Treasury Borrowing Advisory Committee wants to allow bids for US treasury issuances that have negative interest rates:

The question was asked if it made sense for Treasury to permit bids and awards at negative interest rates in marketable Treasury bill auctions. DAS Rutherford noted that there were operational issues associated with such a rule change, but that the hurdles were not insurmountable. It was the unanimous view of the committee that Treasury should modify auction regulations to permit negative rate bidding and awards in Treasury bill auctions as soon as feasible. Rutherford noted that any decision on this policy change would likely be made at the May refunding.

Fun times.

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Policy options for the Euro area [Updated]

Published on 30 November 2011 at 1:38 pm in Economics, Europe, Finance and Politics. Tags: Credit crisis, Credit crunch, ECB, Europe, Germany, Greece, Interest rates, Ireland, Italy, Portugal, Spain.

I here list a few policy options for the Euro area that I support, broadly in descending order of my perception of their importance. Everything here is predicated on an assumption that the Euro itself is to survive and that no member nation of the Euro area is to exit the union. I don’t claim that this would solve the crisis — who would make such a claim? — but they would all be positive steps that increase the probability of an ultimate solution being found.

Immediately establish a single, Euro area-wide bank deposit guarantee scheme. A single currency must absolutely ensure that a Euro held as money in Greece be the same as a Euro held as money in Germany. That means that retail and commercial deposits in each should be backed by the same guarantee. I have no firm opinion on how it should be funded. The classic manner is through a fee on banks proportional to their deposits, but if Euro area countries ultimately prefer to use a Tobin-style tax on transactions, that’s up to them. Just get the thing up and running. Of course, a unified deposit guarantee also requires a unified resolution authority in the event of an insolvent bank collapsing. There are many and varied forms that fiscal union can take; this is the most urgent of them all. I am shocked that this does not already exist.

The ECB should switch from targetting current inflation to expected future inflation. The Bank of England already does this. Accepting that any effect of monetary policy on inflation will come through with a lag (or at least acknowledging that current inflation is backward looking), they “look through” current inflation to what they expect it to be over the coming few years. This is important. Current inflation in the Euro area — i.e. the rate of change over the last 12 months — is at 3%. On the face of it, that might make an ECB policymaker nervous, but looking ahead, market forecasts for average inflation over the coming five years are as low as 0.85% per year in Germany. They will be much lower for the rest of the Euro area. Monetary policy in the Euro area is much, much too tight at the moment. At the very least, (a) interest rates should be lowered; and (b) the ECB should announce their shift in focus toward forward inflation.

The ECB should start to speak more, publicly, about forms of current inflation that most affect future inflation. This follows on from my previous point, but is still logically distinct. The Fed likes to focus on “core” inflation, stripped of items with particularly volatile price movements. I don’t much care whether it is non-volatile prices or nominal wages, or even nominal GDP. I just want the ECB to be speaking more about something other than headline CPI, because it is those other things that feed into future headlines.

The ECB’s provision of liquidity to the banking system, while currently large, is not nearly large enough. The fact that “German Bunds trade below the deposit facility rate at the ECB and well below the Overnight Rate” is clear evidence of this. I currently have no opinion on whether this ought to be in the form of increasing the duration of loans to Euro area banks, relaxing the collateral requirements for loans or working with member countries’ treasuries to increase the provision of collateral. I certainly believe (see my second point above) that interest rates should be lowered. The point, as far as is possible, is to make replacing lost market funding with ECB funding more attractive to banks than deleveraging.

A great deal of Euro area sovereign debt is unsustainable; hair-cuts are inevitable and they should be imposed as soon as possible (but, really, this requires that a unified bank resolution authority be established first). The argument for delaying relies on banks’ ability to first build up a cushion of capital through ongoing profitability. When banks are instead deleveraging, the problem is made worse by waiting.

Credit Default Swaps must be permitted to trigger. The crisis may have its origins in the the profligacy of wayward sovereigns (frankly, I think the origins lie in the Euro framers not appreciating the power of incentives), but the fundamental aspect of the crisis itself is that various financial assets, previously regarded as safe, are coming to be thought of as risky. By denying market participants the opportunity to obtain insurance, Euro area policymakers are making the problem worse, not better. Market willingness to lend to Greece in 2025 will in no way depend on how we label the decisions made in 2011 and 2012.

Every member of the Euro periphery should be in an IMF programme. Yes, I’m looking at you, Italy. If the IMF does not have sufficient funds to work with, the ECB should lend to it. All politicians in Euro periphery countries should be speaking to their electorates about multi-decade efforts to improve productivity. These things cannot be fixed in two or three years. They can, at best, be put on the right path.

For every country in an IMF programme, all sovereign debt held by the ECB should be written down to the price at which they purchase it. If the ECB buys a Greek government bond at, say, a 20% discount to face value, then that bond should be written down by 20%. The ECB should not be in a position to make a profit from their trading if Europe finds its way through the overall crisis. Similarly, the ECB should not be in a position to take a loss, either — they should not be required to take a hair-cut below the price they pay for Euro area sovereign debt.

Note that I have not yet used the phrase “Euro bond” anywhere. Note, too, that a central bank is only meant to be a lender of last resort to banks. The lender of last resort to governments is the IMF.

If Euro area policymakers really want to engage in a fiscal union (a.k.a. transfers) beyond the absolutely essential creation of a unified bank deposit guarantee scheme, it is perfectly possible to do so in a minimal fashion that does not lessen the sovereignty of any member nation: Have a newly created European Fiscal Authority (with voluntary membership) provide the minimum universally agreed-on level of unemployment benefits across the entire area, funded with a flat VAT. Any member country would retain the ability to provide benefits above and beyond the minimum. This will have several benefits:

Since its membership would be voluntary and it would provide only the minimum universally agreed level, it cannot, by definition, constitute a practical infraction on sovereignty;
It will help provide pan-European automatic stabilisers in fiscal policy;
It will provide crucial intra-European stabilisation;
It will increase the supply of long-dated AAA-rated securities at a time when demand for them is incredibly high; and
It will decrease the ability of Euro member countries to argue that they should be able to violate the terms of the Maastricht Treaty at times of economic hardship as at least some of the heavy lifting in counter-cyclical policy will be done for them.

———————-

Update 30 Nov 2011, 13:05 (25 minutes after first publishing the post):

It would appear that the world’s major central banks have announced a coordinated improvement in the provision of liquidity to banks. This is a good thing. Press releases:

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The ECB starts raising interest rates (updated)

Published on 7 April 2011 at 2:59 pm in Economics, Europe, Finance and UK. Tags: ECB, Eurostat, France, Germany, Greece, Interest rates, Ireland, Portugal, Spain, UK.

[Updated to include labour cost inflation too]

Here are the stories at the FT, the WSJ, the Economist (in their blogs) and for a won’t-somebody-think-of-the-children perspective, the Guardian [1].

There are plenty of arguments against the increase. You could argue that there’s a sizeable output gap, so any inflation now is unlikely to be persistent. You could argue that core inflation is low and that it’s only the headline rate that’s high. You could argue that with the periphery countries facing fiscal crises, they need desperately to grow in order to avoid a default or, worse, a breakup of the Euro area. You could argue that a period of above-average inflation in Europe’s core economies and below-average inflation in the periphery would allow the latter to (slowly) achieve what a currency devaluation would normally do: make them more competitive, attract business and allow them to grow in the long run (above and beyond the short-run stimulus of low interest rates).

On that last point, though, it’s worth looking at the data. It’s a great idea, in principle, but unfortunately and despite all the austerity packages, the data show exactly the opposite picture at present. Here’s the current year-over-year inflation rate broken down by country, from Eurostat (HICP and Labour Costs):

Economy	HICP	Labour Cost Index
Euro area as a whole	2.4%	2.0%
Germany	2.2%	0.1%
France	1.8%	1.5%
Greece	4.2%	11.7%
Ireland	0.9%	n/a
Portugal	3.5%	1.0%
Spain	3.4%	4.1%

For some reason Ireland doesn’t seem to be included in the Labour Cost data. Look at Greece and Spain. They’re getting more expensive to do business in relative to Germany and France. Portugal is in the right area, but with Germany’s growth rate in Labour Costs so low, they’re still coming out worse. The same story is painted in consumer inflation. It looks like Ireland is doing what it needs to, but Greece, Portugal and Spain are all getting even less competitive.

Here’s my theory: The ECB hates the fact that they’re temporarily funding these governments, but can’t avoid that fact. Furthermore, they reckon that Greece, Ireland and Portugal are eventually going to restructure their debt. Given that they cannot shove the temporary funding off onto some other European institution, the ECB either doesn’t care whether it’s in 2013 or today (they’ve already got the emergency liquidity out there and it can just stay there until the mess is cleaned up) or quietly wants them to do it now and get it over with. Either way, the ECB is going to conduct policy conditional on the assumption that it’s as good as done.

[1] Just kidding, Guardian readers. You know I love you. Mind you, the writing in that article could have been better — it says that inflation has gone above the ECB’s target of 2% and never mentions what it actually is, but later mentions the current British inflation rate (4.4%) without explaining that it is for Britain and not the Euro area.

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Some brief thoughts on QE2

Published on 4 November 2010 at 1:03 pm in Economics, Finance and USA. Tags: Brad DeLong, Federal Reserve, Interest rates, James Hamilton, Liquidity, Menzie Chinn, Risk Aversion, Scott Sumner, USA.

Instead of speaking about “the interest rate” or even “the yield curve”, I wish people would speak more frequently about the yield surface: put duration on the x-axis, per-period default risk on the y-axis and the yield on the z-axis. Banks do not just borrow short and lend long; they also borrow safe and lend risky.

Liquidity is not uniform over the duration-instantaneous-default-risk space. Liquidity is not even monotonic over the duration-instantaneous-default-risk space.

There is still a trade-off for the Fed in wanting lower interest rates for long-duration, medium-to-high-risk borrowers to spur the economy and wanting a steep yield surface to help banks with weak balance sheets improve their standing.

I would have preferred that the interest paid on excess reserves (IOR) be lowered.

By keeping IOR above the overnight rate, the Fed is sterilising their own QE (the newly-injected cash will stay parked in reserve accounts) and the sole remaining effect, as pointed out by Brad DeLong, is through a “correction” for any premiums demanded for duration risk.

Nevertheless, packaging the new QE as a collection of monthly purchases grants the Fed future policy flexibility, as they can always declare that it will be cut off after only X months or will be extended to Y months.

It seems fairly clear to me that the announcement was by-and-large expected and so “priced in” (e.g. James Hamilton), but there was still something of a surprise (it was somewhat greater easing than was expected) (e.g. Scott Sumner).

Menzie Chinn thinks there is a bit of a puzzle in that while bond markets had almost entirely priced it in, fx-rate markets (particularly USD-EUR) seemed to move a lot. I’m not entirely sure that I buy his argument, as I’m not entirely sure why we should expect the size of the response to a monetary surprise to be the same in each market.

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Paying interest on (excess) reserves (Updated)

Published on 28 July 2010 at 11:47 am in Economics, Finance and USA. Tags: Abate, Altig, Barclays Capital, Bruce Bartlett, Federal Reserve, Interest rates, James Hamilton, Sumner, Sweden, USA.

The U.S. Federal Reserve is currently paying 0.25% interest on the reserve accounts of depository institutions. This is therefore, at present, the primary rate of policy concern (as opposed to the Fed Funds rate): if a bank can’t get a rate of return that, when adjusted for risk, is greater than 0.25%, they will stick their money in their reserve account at the Fed. Among others, Scott Sumner [blog] has called this policy a mistake.

There is an economic cost to the policy. 0.25% isn’t much, but it’s the risk-free aspect that complicates things. If banks’ risk aversion or their perception of the risks associated with investments are high, then a truely risk-free 0.25% could look quite attractive. With the interest rates on US treasuries so low, there’s certainly reason to believe that risk aversion is still abnormally high at the moment. Whether the demand for loans is coming from particularly risky projects, or is perceived to be, I don’t know (is there any way of knowing?).

So why have it at all? I suppose I support the paying of interest on required reserves. The banks don’t get a choice with them, so it seems only fair that they be compensated. But for excess reserves, there would need to be an offsetting benefit to justify the policy. One benefit will be that the interest is paid with new money, so it’s a way of quietly helping banks improve their balance sheets. There’s currently about US$1 trillion in excess reserves, so that’s about US$2.5 billion per year. That may be a lot of money to you and me, but it’s not much more than a rounding error to the US banking system as a whole. Still, it’s something. Another benefit, depending on your point of view, is that by attracting all that money into excess reserves, the Fed sterilised the QE they engaged in last year. If you feel that the sterilised QE has caused lower long-term interest rates and hold that those rates are the ones that most significantly drive the economy and distinctly dislike inflation, then you’d probably judge the affair to have been a success [I include the weasel words because I am no longer certain]. A third benefit, which is really a further justification of the second, is that there is evidence that the Fed’s QE appears to have lowered not just US rates, but foreign rates as well. In that case, then you probably want to sterilise the fraction going to other countries (bad enough, one might think, that America is fixing the rest of the world; it would be unthinkable if America also had to suffer inflation by doing so).

Anyway, all of that is by way of getting around to this point: via Bruce Bartlett, I’ve just discovered that Sweden also pays interest on reserve deposits, normally 0.75 percentage points lower than their repo rate. But, crucially, their repo rate is currently only 0.50%, which means that their deposit rate is negative, at -0.25%.

For myself, I tend to think that the interest rate on excess reserves should be lowered. My argument is similar to what I imagine Scott Sumner would say, so I should also explain his view a little, to the extent that I understand him. With nominal GDP at US$14 trillion, the US$1 trillion sitting in excess reserves is a very, very large amount of money. If it were released into the economy, it would be a huge stimulus (even if the money multiplier/velocity of money is temporarily low). By choosing to sterilise their QE (presumably out of fear of inflation), the Fed has turned what could have been a tremendously effective stimulus into a mediocre one at best. Scott is rather more sanguine about inflation in general than I am (he favours targeting NGDP; I suspect that this graph would make him want to tear his hair out), but even if the Fed wishes to target inflation of, say, the near-universally accepted benchmark of 2%, then with actual current inflation down at 0.5% and expected future inflation below 1.5% for most of the next 10 years and falling, the sterilisation has been excessive.

Update 6 Aug 2010:

The FT’s Alphaville has gathered the arguments for and against. Here are three arguments (and their counter-arguments) for keeping the Interest on Reserves (IoR) unchanged:

First, from Ben Bernanke himself, made in recent congressional testimony:

The rationale for not going all the way to zero has been that we want the short-term money markets like the federal funds market to continue to function in a reasonable way because if rates go to zero there will be no incentive for buying and selling federal funds, overnight money in the banking system, and if that market shuts down … it’ll be more difficult to manage short-term interest rates, for the Federal Reserve to tighten policy sometime in the future. So there’s really a technical reason having to do with market function that motivated the 25 basis points interest on reserves.

I think this is silly. It’ll be more difficult to manage short-term interest rates in the future only if, following an effective shut-down of the federal funds market, it becomes costly to start it back up again. I seriously doubt that the banks are going to take their existing staff, processes and infrastructure dedicated to this and throw them out the window. Heck, in a Q&A session after his testimony, Mr Bernanke stated that lowering the interest rate on reserves is a (serious) option in the event that the FMOC decides that further stimulus is warranted:

But broadly speaking, there are a number of things we could consider and look at; one would be further changes or modifications of our language or our framework describing how we intend to change interest rates over time — giving more information about that, that’s certainly one approach. We could lower the interest rate we pay on reserves, which is currently one-fourth of 1%.

A second viewpoint, put forward by Dave Altig (of the Atlanta Fed) and Joseph Abate (of Barclays Capital), is that

If banks didn’t get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn’t see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum.

I think that Jim Hamilton’s response to this is excellent, so let me just quote it in full:

But Dave doesn’t quite finish the story. If I as an individual bank decide that a repo or T-bill looks better than zero, and use my excess reserves to buy one of these instruments, I simply instruct the Fed to transfer my deposits to the bank of whoever sold it to me. But now, if that bank does nothing, it would be left with those reserve balances at the end of the day on which it earns nothing, whereas it, too, could instead get some interest by going with repos or T-bills. The reserves never get “shifted into short-term, low-risk markets”– instead, by definition, they are always sitting there, at the end of the day, on the balance sheet of some bank somewhere in the system.

The implicit bottom line in the Abate story is that the yields on repos and T-bills adjust until they, too, look essentially to be zero, so that banks in fact don’t care whether they leave a trillion dollars earning no interest every day.

The essence of this world view is that there are two completely distinct categories of assets– cash-type assets which pay no interest whatever, and risky investments like car loans that banks don’t want to make no matter how much cash they hold.

But I really have trouble thinking in terms of such a two-asset world. I instead see a continuum of assets out there. As a bank, I could keep my funds overnight with the Fed, I could lend them in an overnight repo, I could buy a 1-week Treasury, a 3-month Treasury, a 10-year Treasury, or whatever. Wherever you want to draw a line between available assets and claim those on the left are “cash” and those on the right are “risky”, I’m quite convinced I could give you an example of an asset that is an arbitrarily small epsilon to the right or the left of your line. Viewed this way, I have a hard time understanding how pushing a trillion dollars at the shortest end of the continuum by 25 basis points would have no consequences whatever for the yield on any other assets.

Finally, back with Dave Altig, there is the argument that:

the IOR policy has long been promoted on efficiency grounds. There is this argument for example, from a New York Fed article published just as the IOR policy was introduced:

“… reserve balances are used to make interbank payments; thus, they serve as the final form of settlement for a vast array of transactions. The quantity of reserves needed for payment purposes typically far exceeds the quantity consistent with the central bank’s desired interest rate. As a result, central banks must perform a balancing act, drastically increasing the supply of reserves during the day for payment purposes through the provision of daylight reserves (also called daylight credit) and then shrinking the supply back at the end of the day to be consistent with the desired market interest rate.

“… it is important to understand the tension between the daylight and overnight need for reserves and the potential problems that may arise. One concern is that central banks typically provide daylight reserves by lending directly to banks, which may expose the central bank to substantial credit risk. Such lending may also generate moral hazard problems and exacerbate the too-big-to-fail problem, whereby regulators would be reluctant to close a financially troubled bank.”

Put more simply, one broad justification for an IOR policy is precisely that it induces banks to hold quantities of excess reserves that are large enough to mitigate the need for central banks to extend the credit necessary to keep the payments system running efficiently. And, of course, mitigating those needs also means mitigating the attendant risks.

But, to me, this really sounds like an argument for having higher reserve requirements, not an argument for encouraging excess reserves. I’m all for paying interest on required reserves and setting the fraction required at whatever level you judge necessary to ensure the operation of the payments system. But don’t try to shoe-horn that argument into keeping interest payments on excess reserves.

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On interest rates

Published on 23 November 2009 at 12:05 pm in Economics, Finance and USA. Tags: Brad DeLong, Interest rates, Paul Krugman, Recession, Tyler Cowen, USA.

In what Tyler Cowen calls “Critically important stuff and two of the best recent economics blog posts, in some time,” Paul Krugman and Brad DeLong have got some interesting thoughts on US interest rates. First Krugman:

On the face of it, there’s no reason to be worried about interest rates on US debt. Despite large deficits, the Federal government is able to borrow cheaply, at rates that are up from the early post-Lehman period … but well below the pre-crisis levels:

Underlying these low rates is, in turn, the fact that overall borrowing by the nonfinancial sector hasn’t risen: the surge in government borrowing has in fact, less than offset a plunge in private borrowing.

So what’s the problem?

Well, what I hear is that officials don’t trust the demand for long-term government debt, because they see it as driven by a “carry trade”: financial players borrowing cheap money short-term, and using it to buy long-term bonds. They fear that the whole thing could evaporate if long-term rates start to rise, imposing capital losses on the people doing the carry trade; this could, they believe, drive rates way up, even though this possibility doesn’t seem to be priced in by the market.

What’s wrong with this picture?

First of all, what would things look like if the debt situation were perfectly OK? The answer, it seems to me, is that it would look just like what we’re seeing.

Bear in mind that the whole problem right now is that the private sector is hurting, it’s spooked, and it’s looking for safety. So it’s piling into “cash”, which really means short-term debt. (Treasury bill rates briefly went negative yesterday). Meanwhile, the public sector is sustaining demand with deficit spending, financed by long-term debt. So someone has to be bridging the gap between the short-term assets the public wants to hold and the long-term debt the government wants to issue; call it a carry trade if you like, but it’s a normal and necessary thing.

Now, you could and should be worried if this thing looked like a great bubble — if long-term rates looked unreasonably low given the fundamentals. But do they? Long rates fluctuated between 4.5 and 5 percent in the mid-2000s, when the economy was driven by an unsustainable housing boom. Now we face the prospect of a prolonged period of near-zero short-term rates — I don’t see any reason for the Fed funds rate to rise for at least a year, and probably two — which should mean substantially lower long rates even if you expect yields eventually to rise back to 2005 levels. And if we’re facing a Japanese-type lost decade, which seems all too possible, long rates are in fact still unreasonably high.

Still, what about the possibility of a squeeze, in which rising rates for whatever reason produce a vicious circle of collapsing balance sheets among the carry traders, higher rates, and so on? Well, we’ve seen enough of that sort of thing not to dismiss the possibility. But if it does happen, it’s a financial system problem — not a deficit problem. It would basically be saying not that the government is borrowing too much, but that the people conveying funds from savers, who want short-term assets, to the government, which borrows long, are undercapitalized.

And the remedy should be financial, not fiscal. Have the Fed buy more long-term debt; or let the government issue more short-term debt. Whatever you do, don’t undermine recovery by calling off jobs creation.

The point is that it’s crazy to let the rescue of the economy be held hostage to what is, if it’s an issue at all, a technical matter of maturity mismatch. And again, it’s not clear that it even is an issue. What the worriers seem to regard as a danger sign — that supposedly awful carry trade — is exactly what you would expect to see even if fiscal policy were on a perfectly sustainable trajectory.

Then DeLong:

I am not sure Paul is correct when he says that the possible underlying problem is merely “a technical matter of maturity mismatch.” The long Treasury market is thinner than many people think: it is not completely implausible to argue that it is giving us the wrong read on what market expectations really are because long Treasuries right now are held by (a) price-insensitive actors like the PBoC and (b) highly-leveraged risk lovers borrowing at close to zero and collecting coupons as they try to pick up nickles in front of the steamroller. And to the extent that the prices at which businesses can borrow are set by a market that keys off the Treasury market, an unwinding of this “carry trade”–if it really exists–could produce bizarre outcomes.

Bear in mind that this whole story requires that the demand curve slope the wrong way for a while–that if the prices for Treasury bonds fall carry traders lose their shirts and exit the market, and so a small fall in Treasury bond prices turns into a crash until someone else steps in to hold the stock…

For reference, here are the time paths of interest rates for a variety of term lengths and risk profiles (all taken from FRED):

To my own mind, I’m somewhat inclined to agree with Krugman. While I do believe that the carry trade is occurring, I suspect that it’s effects are mostly elsewhere, or at least that the carry trade is not being played particularly heavily in long-dated US government debt relative to other asset markets.

Notice that the AAA and BAA 30-year corporate rates are basically back to pre-crisis levels and that the premium they pay over 30-year government debt is also back to typical levels. If the long-dated rates are being pushed down to pre-crisis levels solely by increased supply thanks to the carry trade, then we would surely expect the quantity of credit to also be at pre-crisis levels. But new credit issuance is down relative to the pre-crisis period. Since the price is largely unchanged, that means that both demand and supply of credit have shrunk – the supply from fear in the financial market pushing money to the short end of the curve and the demand from the fact that there’s been a recession.

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The contradictory joys of being the US Treasury Secretary (part 2)

Published on 16 November 2009 at 4:28 pm in Economics, Finance, Politics, Trade and USA. Tags: Bloomberg, Brazil, Exchange rates, Federal Reserve, Geithner, Inflation, Interest rates, Korea, Roubini, Russia, Trade, US Dollar, USA.

In my last post, I highlighted the apparent contradictions between the USA having both a “strong dollar” policy and a desire to correct their trade deficit (“re-balancing”). Tim Geithner, speaking recently in Tokyo, declared that there was no contradiction:

Geithner said U.S. efforts to boost exports aren’t in conflict with the “strong-dollar” policy. “I don’t think there’s any contradiction between the policies,” he said.

I then said:

The only way to reconcile what Geithner’s saying with the laws of mathematics is to suppose that his “strong dollar” statements are political and relate only to the nominal exchange rate and observe that trade is driven by the real exchange rate. But that then means that he’s calling for a stable nominal exchange rate combined with either deflation in the USA or inflation in other countries.

Which, together with Nouriel Roubini’s recent observation that the US holding their interest rates at zero is fueling “the mother of all carry trades” [Financial Times, RGE Monitor], provides for a delicious (but probably untrue) sort-of-conspiracy theory:

Suppose that Tim Geithner firmly believes in the need for re-balancing. He’d ideally like US exports to rise while imports stayed flat (since that would imply strong global growth and new jobs for his boss’s constituents), but he’d settle for US imports falling. Either way, he needs the US real exchange rate to fall, but he doesn’t care how. Well, not quite. His friend Ben Bernanke tells him that he doesn’t want deflation in America, but he doesn’t really care between the nominal exchange rate falling and foreign prices rising (foreign inflation).

The recession-induced interest rates of (effectively) zero in America are now his friend, because he’s going to get what he wants no matter what, thanks to the carry trade. Private investors are borrowing money at 0% interest in America and then going to foreign countries to invest it at interest rates that are significantly higher than zero. If the foreign central banks did nothing, that would push the US dollar lower and their own currencies higher and Tim gets what he wants.

But the foreign central banks want a strong dollar because (a) they’re holding gazzilions of dollars worth of US treasuries and they don’t want their value to fall; and (b) they’re not fully independent of their political masters who want to want to keep exporting. So Tim regularly stands up in public and says that he supports a strong dollar. That makes him look innocent and excuses the foreign central banks for doing what they were all doing anyway: printing local money to give to the US-funded investors so as to keep their currencies down (and the US dollar up).

But that means that the money supply in foreign countries is climbing, fast, and while prices may be sticky in the short term, they will start rising soon enough. Foreign inflation will lower the US real exchange rate and Tim still gets what he wants.

The only hope for the foreign central banks is that the demand for their currencies is a short-lived temporary blip. In that case, defending their currencies won’t require the creation of too much local currency and they could probably reverse the situation fast enough afterward that they don’t get bad inflation. [This is one of the arguments in favour of central bank involvement in the exchange-rate market. Since price movements are sluggish, they can sterilise a temporary spike and gradually back out the action before local prices react too much.]

But as foreign central banks have been discovering [1], free money is free money and the carry trade won’t go away until the interest rate gap is sufficiently closed:

Nov. 13 (Bloomberg) — Brazil, South Korea and Russia are losing the battle among developing nations to reduce gains in their currencies and keep exports competitive as the demand for their financial assets, driven by the slumping dollar, is proving more than central banks can handle.

South Korea Deputy Finance Minister Shin Je Yoon said yesterday the country will leave the level of its currency to market forces after adding about $63 billion to its foreign exchange reserves this year to slow the appreciation of the won.
[...]
Brazil’s real is up 1.1 percent against the dollar this month, even after imposing a tax in October on foreign stock and bond investments and increasing foreign reserves by $9.5 billion in October in an effort to curb the currency’s appreciation. The real has risen 33 percent this year.
[...]
“I hear a lot of noise reflecting the government’s discomfort with the exchange rate, but it is hard to fight this,” said Rodrigo Azevedo, the monetary policy director of Brazil’s central bank from 2004 to 2007. “There is very little Brazil can do.”

The central banks are stuck. They can’t lower their own interest rates to zero (which would stop the carry trade) as that would stick a rocket under domestic production and cause inflation anyway. The only thing they can do is what Brazil did a little bit of: impose legal limits on capital inflows, either explicitly or by taxing foreign-owned investments. But doing that isn’t really an option, either, because they want to be able to keep attracting foreign investment after all this is over and there’s not much scarier to an investor than political uncertainty.

So they have to wait until America raises it’s own rates. But that won’t happen until America sees a turn-around in jobs and the fastest way for that to happen is for US exports to rise.

[1] Personally, I think the central bankers saw the writing on the wall the minute the Fed lowered US interest rates to (effectively) zero but their political masters were always going to take some time to cotton on.

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The contradictory joys of being the US Treasury Secretary

Published on 16 November 2009 at 11:45 am in Economics, Finance, Politics, Trade and USA. Tags: Bloomberg, Exchange rates, Federal Reserve, Geithner, Inflation, Interest rates, Korea, Roubini, Trade, US Dollar.

Tim Geithner, speaking at the start of the G-20 meeting in Pittsburgh:

Sept. 25 (Bloomberg) — Treasury Secretary Timothy Geithner said he sees a “strong consensus” among Group of 20 nations to reduce reliance on exports for growth and defended the dollar’s role as the world’s reserve currency.

“A strong dollar is very important in the United States,” Geithner said in response to a question at a press conference yesterday in Pittsburgh, where G-20 leaders began two days of talks.

Tim Geithner, speaking in Tokyo while joining the US President on a tour of Asian capitals:

Nov. 11 (Bloomberg) — U.S. Treasury Secretary Timothy Geithner said a strong dollar is in the nation’s interest and the government recognizes the importance it plays in the global financial system.

“I believe deeply that it’s very important to the United States, to the economic health of the United States, that we maintain a strong dollar,” Geithner told reporters in Tokyo today.
[...]
Geithner said U.S. efforts to boost exports aren’t in conflict with the “strong-dollar” policy. “I don’t think there’s any contradiction between the policies,” he said.

Which is hilarious.

There is no objective standard for currency strength [1]. A “strong (US) dollar” is a dollar strong relative to other currencies, so it’s equivalent to saying “weak non-US-dollar currencies”. But when the US dollar is up and other currencies are down, that means that the US will import more (and export less), while the other countries will export more (and import less), which is the exact opposite of the re-balancing efforts.

The only way to reconcile what Geithner’s saying with the laws of mathematics is to suppose that his “strong dollar” statements are political and relate only to the nominal exchange rate and observe that trade is driven by the real exchange rate. But that then means that he’s calling for a stable nominal exchange rate combined with either deflation in the USA or inflation in other countries.

Assuming my previous paragraph is true, 10 points to the person who can see the potential conspiracy theory [2] implication of Nouriel Roubini’s recent observation that the US holding their interest rates at zero is fueling “the mother of all carry trades” [Financial Times, RGE Monitor].

Hint: If you go for the conspiracy theory, this story would make you think it was working.

Nov. 13 (Bloomberg) — Brazil, South Korea and Russia are losing the battle among developing nations to reduce gains in their currencies and keep exports competitive as the demand for their financial assets, driven by the slumping dollar, is proving more than central banks can handle.
[...]
Governments are amassing record foreign-exchange reserves as they direct central banks to buy dollars in an attempt to stem the greenback’s slide and keep their currencies from appreciating too fast and making their exports too expensive.
[...]
“It looked for a while like the Bank of Korea was trying to defend 1,200, but it looks like they’ve given up and are just trying to slow the advance,” said Collin Crownover, head of currency management in London at State Street Global Advisors

The answer to follow …

Update: The answer is in my next post.

[1] There better not be any gold bugs in the audience. Don’t make me come over there and hurt you.

[2] Okay, not a conspiracy theory; just a behind-the-scenes-while-completely-in-the-open strategy of international power struggles.

[1] There better not be any gold bugs on this list. Don’t make me
come over there and hurt you.

[2] Okay, not a conspiracy theory; just a behind-the-scenes-while-
completely-in-the-open strategy of international power struggles.

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Money multipliers and financial globalisation

Published on 8 January 2009 at 1:44 am in Economics, Finance, UK and USA. Tags: Bank of England, Federal Reserve, Greg Mankiw, Interest rates, Monetary base, Money, Money multiplier, UK, USA.

Important: Much of this post is mistaken (i.e. wrong). It’s perfectly possible for America to have an M1 money multiplier of less than one even if they were an entirely closed economy. My apologies. I guess that’s what I get for clicking on “Publish” at one in the morning. A more sensible post should be forthcoming soon. I’m leaving this here, with all its mistakes, for the sake of completeness and so that people can compare it to my proper post whenever I get around to it.

Update: You can (finally) see the improved post here. You’ll probably still want to refer back to this one for the graphs.

Via Greg Mankiw, I see that in the USA the M1 money multiplier has just fallen below one:

M1 Money Multiplier (USA, Accessed: 7 Jan 2009)

At the time of writing, the latest figure (for 17 December 2008) was 0.954. That’s fascinating, because it should be impossible. As far as I can tell, it has been made possible by the wonders of financial globalisation and was triggered by a decision the US Federal Reserve made at the start of October 2008. More importantly, it means that America is paying to recapitalise some banks in other countries and while that will help them in the long run, it might be exacerbating the recessions in those countries in the short run.

Money is a strange thing. One might think it would be easy to define (and hence, to count), but there is substantial disagreement of what qualifies as money and every central bank has their own set of definitions. In America the definitions are (loosely):

M0 (the monetary base) = Physical currency in circulation + reserves held at the Federal Reserve
M1 = Physical currency in circulation + deposit (e.g. checking) accounts at regular banks
M2 = M1 + savings accounts

They aren’t entirely correct (e.g. M1 also includes travelers cheques, M2 also includes time/term deposits, etc.), but they’ll do for the moment [you can see a variety of countries' definitions on Wikipedia].

The M1 Money Multiplier is the ratio of M1 to M0. That is, M1 / M0.

In the normal course of events, regular banks’ reserves at the central bank are only a small fraction of the deposits they hold. The reason is simple: The central bank doesn’t pay interest on reserves, so they’d much rather invest (i.e. lend) the money elsewhere. As a result, they only keep in reserve the minimum that they’re required to by law.

We therefore often think of M1 as being defined as: M1 = M0 + deposits not held in reserve.

You can hopefully see why it should seem impossible for the M1 money multiplier to fall below 1. M1 / M0 = (M0 + non-reserve deposits) / M0 = 1 + (non-reserve deposits / M0). Since the non-reserve deposits are always positive, the ratio should always be greater than one. So why isn’t it?

Step 1 in understanding why is this press release from the Federal Reserve dated 6 October 2008. Effective from 1 October 2008, the Fed started paying interest on both required and excess reserves that regular banks (what the Fed calls “depository institutions”) held with it. The interest payments for required reserves do not matter here, since banks had to keep that money with the Fed anyway. But by also paying interest on excess reserves, the Fed put a floor under the rate of return that banks demanded from their regular investments (i.e. loans).

The interest rate paid on excess returns has been altered a number of times (see the press releases on 22 Oct, 5 Nov and 16 Dec), but the key point is this: Suppose that the Fed will pay x% on excess reserves. That is a risk-free x% available to banks if they want it, while normal investments all involve some degree of risk. US depository institutions suddenly had a direct incentive to back out of any investment that had a risk-adjusted rate of return less than x% and to put the money into reserve instead, and boy did they jump at the chance. Excess reserves have leapt tremendously:

Excess Reserves of Depository Institutions (USA, Accessed: 7 January 2009)

Excess Reserves of Depository Institutions (USA, Accessed: 7 Jan 2009)

Corresponding, the monetary base (M0) has soared:

Adjusted Monetary Base (USA, Accessed: 7 Jan 2009)

If we think of M1 as being M1 = M0 + non-reserve deposits, then we would have expected M1 to increase by similar amounts (a little under US$800 billion). In reality, it’s only risen by US$200 billion or so:

M1 Money Supply (USA, Accessed: 7 Jan 2009)

M1 Money Stock (USA, Accessed: 7 Jan 2009)

So where have the other US$600 billion come from? Other countries.

Remember that the real definition of M1 is M1 = Physical currency in circulation + deposit accounts. The Federal Reserve, when calculating M1, only looks at deposits in America.

By contrast, the definition of the monetary base is M0 = Physical currency in circulation + reserves held at Federal Reserve. The Fed knows that those reserves came from American depository institutions, but it has no idea where they got it from.

Consider Citibank. It collects deposits from all over the world, but for simplicity, imagine that it only collects them in America and Britain. Citibank-UK will naturally keep a fraction of British deposits in reserve with the Bank of England (the British central bank), but it is free to invest the remainder wherever it likes, including overseas. Since it also has an arm in America that is registered as a depository institution, putting that money in reserve at the Federal Reserve is an option.

That means that, once again, if Citibank-UK can’t get a risk-adjusted rate of return in Britain that is greater than the interest rate the Fed is paying on excess reserves, it will exchange the British pounds for US dollars and put the money in reserve at the Fed. The only difference is that the risk will now involve the possibility of exchange-rate fluctuations.

It’s not just US-based banks with a presence in other countries, though. Any non-American bank that has a branch registered as a depository institution in America (e.g. the British banking giant, HSBC) has the option of changing their money into US dollars and putting them in reserve at the Fed.

So what does all of that mean? I see two implications:

Large non-American banks that have American subsidiaries are enjoying the free money that the Federal Reserve is handing out. By contrast, smaller non-American banks that do not have American subsidiaries are not able to access the Federal Reserve system and so are forced to find other investments.
The US$600+ billion of foreign money currently parked in reserve at the Fed had to come out of the countries of origin, meaning that it is no longer there to stimulate their economies. By starting to pay interest on excess reserves, the US Federal Reserve effectively imposed an interest rate increase on other countries.

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Negative interest rates on US government debt and Brad DeLong (Updated)

Published on 10 December 2008 at 12:19 pm in Economics, Finance and USA. Tags: Brad DeLong, Cato, Credit crisis, Interest rates, Kling, Liquidity, Risk Aversion, Tyler Cowen.

The interest rates on US government debt has turned negative (again) as a result of the enormous flight to perceived safety. I guess they’ll be able to fund their gargantuan bailouts more easily, at least.

Brad DeLong has written a short and much celebrated essay (available on Cato and his own site) on the financial crisis and (consequently) why investors currently love government debt and hate everything else. I’ll add my voice to those suggesting that you read the whole thing. Here is the crux of it:

[T]he wealth of global capital fluctuates … for five reasons:

Savings and Investment: Savings that are transformed into investment add to the productive physical — and organizational, and technological, and intellectual — capital stock of the world. This is the first and in the long run the most important source of fluctuations — in this case, growth — in global capital wealth.

News: Good and bad news about resource constraints, technological opportunities, and political arrangements raise or lower expectations of the cash that is going to flow to those with property and contract rights to the fruits of capital in the future. Such news drives changes in expectations that are a second source of fluctuations in global capital wealth.

Default Discount: Not all the deeds and contracts will turn out to be worth what they promise or indeed even the paper that they are written on. Fluctuations in the degree to which future payments will fall short of present commitments are a third source of fluctuations in global capital wealth.

Liquidity Discount: The cash flowing to capital arrives in the present rather than the future, and people prefer — to varying degrees at different times — the bird in the hand to the one in the bush that will arrive in hand next year. Fluctuations in this liquidity discount are yet a fourth source of fluctuations in global capital wealth.

Risk Discount: Even holding constant the expected value and the date at which the cash will arrive, people prefer certainty to uncertainty. A risky cash flow with both upside and downside is worth less than a certain cash flow by an amount that depends on global risk tolerance. Fluctuations in global risk tolerance are the fifth and final source of fluctuations in global capital wealth.

In the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion. Savings has not fallen through the floor. We have had little or no bad news about resource constraints, technological opportunities, or political arrangements. Thus (1) and (2) have not been operating. The action has all been in (3), (4), and (5).

As far as (3) is concerned, the recognition that a lot of people are not going to pay their mortgages and thus that a lot of holders of CDOs, MBSs, and counterparties, creditors, and shareholders of financial institutions with mortgage-related assets has increased the default discount by $2 trillion. And the fact that the financial crisis has brought on a recession has further increased the default discount — bond coupons that won’t be paid and stock dividends that won’t live up to firm promises — by a further $4 trillion. So we have a $6 trillion increase in the magnitude of (3) the default discount. The problem is that we have a $20 trillion decline in market values.

Some people have criticised Brad for his characterisation of the liquidity discount, suggesting that he has confused it with the (pure) rate of time preference. I don’t think he is confused. Firstly because he’s a genuine expert in the field and if he’s confused, we’re in big trouble; and secondly because the two concepts are interlinked.

The liquidity discount is that an inability to readily buy or sell an asset – typically evidenced by low trading volumes and a large bid/ask spread – reduces it’s value.

The pure rate of time preference is a measure of impatience. $1 today is preferred over $1 tomorrow even if there is no inflation. [Update: see below]

The two are linked because if you want to sell assets in an illiquid market, you can either sell them at a huge discount immediately or sell them gradually over time. The liquidity discount is (presumably) therefore a monotonically increasing function of the pure rate of time preference for a given level of liquidity.

Minor update:

A more correct illustration of the pure rate of time preference would be to say:

Suppose that you could get a guaranteed (i.e. risk-free) annual rate of return of 4% and there is no inflation. A positive pure rate of time preference says that $1 today is preferred over $1.04 in a year’s time.

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