Fed raising the stakes

On my blog, I have tended to focus on monetary policy issues. Indeed the previous post from February 2014 was ominously titled “The sum of all tightenings” (now that I just read it, it turned out not to be a completely bonkers story). Today, too, I will focus on monetary policy, albeit from a more theoretical standpoint.

A few years after the crisis, some economists were pondering the idea of raising the inflation target. Most famously, a paper by Olivier Blanchard from 2010 suggests that the CPI target should be moved from 2 to 4% (short summary here). There was also an interesting paper from Laurence Ball four years later advocating the same thing. I remember at the time that the idea was ridiculed by “street” economists and strategists with the reasoning going along the lines of “yeah right, you can’t even meet your current target so good luck with a higher one”. Even the policy heavyweights like Ben Bernanke dismissed the idea back then and we simply moved on.

Those of you who follow the markets will be aware that last week Janet Yellen somewhat surprisingly said that the question of raising the inflation target is critical (a nice FT story here). Again, the idea was quickly dismissed, eg by Martin Wolf. In fact, I chuckled to see this familiar argument from the FT View, which entirely misses the point. Again.

But the Fed should not be distracted from the theoretical benefits of changing the goal while it has consistently failed to reach the current one.

In fact, before going into the crux of my argument let’s sort out this flawed observation of missing the inflation target. Below is the chart of the core CPI and PCE in the US in the last five years:

fredgraph (1)

The core PCE has fluctuated around 1.5% and core CPI, while more volatile, has been around 2% for most of the time (except 2015). If someone thinks that from the economic agents’ point of view this is sufficiently far from the target to warrant making fun of the monetary authority then they are mistaken (and that would hold even if we weren’t exiting from the biggest forced deleveraging of a generation). For the purposes of this post, I will therefore assume that the Fed has been fairly close to its inflation target and it has certainly not been a failure of the policy. If you disagree with this, you might as well stop reading. Also, please bear in mind that this argument is about the Fed and the Fed only (not the ECB or the BoJ, whose inflation credentials are considerably worse).

Back to the main story, though. Former Governor of the National Bank of Poland Marek Belka was asked several years ago during a meeting with investors in London whether he thought it made sense to lower the inflation target in order to adjust to ever-low inflation prints. He seemed shocked at the suggestion and replied asking why anyone would want a tighter monetary policy at this juncture? Most people in the room didn’t get his point so he went on explaining that lowering inflation target by 1pp is tantamount to a promise that real rates would be durably higher by this amount. In other words, the central bank would have to hike interest rates faster than otherwise. Seems simple but for many this still isn’t straightforward. For some reason, the discussion didn’t move to raising inflation target back then.

Assuming the Fed is a credible central bank (and if it isn’t then I am not sure which one is…), there is a possibility that the inflation target gets moved to 4%. In the short to medium term it would be similar to letting inflation run a little bit hot after years of low growth, which the Fed wants to allow anyway but in the long run it would be a significant change. This would mean that the Fed commits to not tightening monetary policy as aggressively as it otherwise would. Would people believe it? Sure they would!

Now, the problem these days is reflexivity of markets. For example, Fed hikes interest rates, dollar strengthens, Fed needs to refrain from hiking. All this sometimes happens at a breath-taking pace. Also, we must not forget the Fed’s dual mandate, given that we seem to be at full employment. Therefore, it is safe to assume at the moment that the Fed will continue chugging along with rate hikes for the foreseeable future. Slowly but surely.

There is a significant problem here, which the Fed seems to have identified (judging by recent comments from Dudley) – so far the slow and predictable pace of hiking interest rates has not led to any significant tightening of monetary conditions as stocks continued rallying, spreads tightened and the curve flattened. This very much resembles the pre-crisis Greenspan’s conundrum era. The Fed hikes but the market eases thus leading to significant build-up in leverage until things go really ugly. So hiking rates, while appropriate, may prove deathly in the long run given how vast the financial markets have become.

What if we raise the inflation target simultaneously then? As mentioned above, this gives the signal to people that the Fed won’t be hiking rates as fast as it otherwise would. That said, given where monetary conditions are, some additional rate hikes would still be likely. So far it sounds similar to what we have had to date. But the important distinction is that – taking Fed’s credibility for granted – markets would need to start pricing in more inflation premium to the long end of the curve. This would offset the dreaded flattening pressure, which has made people so worried lately. Note that if the curve isn’t flattening then (among others):

  • the appreciating pressure on the USD is smaller than otherwise;
  • investors are not pushed out of fixed income assets into riskier investments (see insurance companies);
  • the banking sector stays buoyant.

Finally, imagine that these two forces, ie rate hikes and an increased inflation target get supplemented by offloading of the balance sheet. What the Fed would then achieve would be bearish steepening of the curve, which in my opinion is the necessary condition for us to finally move on from the aftermath of the 2008 Global Financial Crisis. And if that happens, discussions about the US fiscal stimulus and tax cuts would probably be met by questions like “Donald who?!?” or “Who cares?”. This is because the economic impact of gradual bear steepening of the curve driven by a higher inflation target would trump (sic!) everything else.

*It’s been more than three years since I last posted. I don’t suppose it will take me another three years to write the next one but one should not assume that hereby the regular service resumes.

**I do realise that I made some short-cuts in reasoning above but this is a blog post from an anonymous bloke who sits in Warsaw and comments on the Fed policy, rather than a peer-reviewed paper in Journal of Applied Economics 🙂

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It’s not me, it’s you

This week one of the German banks (starts with “D” and ends with “eutsche Bank”) decided to enlighten us with their insight into Fed’s communication policy and transparency. One of their “analysts” has plotted the size of the Fed’s balance sheet against the number of words in FOMC statements. This person has also decided it would be useful to do a regression and inform us that R^2 is very high. There also was an arrow to show joint direction. Reluctantly, I will paste this chart below.

deutsche

 

And before anyone starts saying I don’t have a sense of humour, let me assure you I get the wit here. Additionally, I will not spend time explaining how absolutely retarded from the econometric point of view this is (on at least five levels).

When I moaned about it on twitter I got a few replies including one that says that the chart is “provocative”. Presumably because it points out the fact that the communication policy of the FOMC has been somewhat imperfect. In fact, this sort of criticism is often used against many other central banks, particularly after they’ve depleted traditional monetary policy tools.

I profoundly disagree with such opinions and here’s why.

The world is not exactly a carbon copy of any Macroeconomics 101 course. In fact, it is a pretty screwed up place with tons of opinions and research floating around simultaneously wrestling with burgeoning financial markets which themselves have become increasingly more random. Sure, occasionally there are chaps who make careers on calling some things right but then it quickly emerges they were one trick ponies (Roubini, Paulson, Taleb, Schiff, Whitney to name a few). And the private sector does reward being right so you can bet that many MANY people in banks, asset managers or hedge funds (including yours truly) are throwing a lot of resources at the problem of forecasting. With average results at best. So if the private sector has significant issues despite using an enormous amount of resources then why wouldn’t the public sector suffer from the same problem?

Pretty much no policy maker has never lived through anything resembling what we’re dealing with at the moment. Comparisons to the Great Depression and Japan have their significant shortcomings too. The system is extremely complicated and I am beginning to think that the whole economic analysis has hit a stumbling block similar to the Heisenberg uncertainty principle in physics. Perhaps we could calculate the trajectory of the global economy going forward but we would pretty much have to rebuild the whole world in some other place and watch it. Or, if that comparison doesn’t speak to you then maybe let’s use the Bitcoin example – the cost of mining (electricity) has now exceeded the benefits. So we end up with a combination of intuition and luck, unfortunately.

What has been the response of the central banks? Well, they’ve opened up. They started revealing all sorts of (dirty) secrets. It started even before the crisis with all sorts of fan charts. I remember very well when Poland was introducing its own Inflation Projection. The NBP spent considerable amount of time to inform people that this wasn’t a forecast but a projection. In other words, it was a work of a (pretty crappy) econometric model, which the central bank was filling with all the data it found relevant. And obviously, as the data changed, so did the outcomes of the model.

Same kind of thing happened to the forward guidance. Flawed concept as it is, it was misinterpreted from the very beginning. Yes, there were pretty silly thresholds but they were merely a reflection of what the central bank thought at the time. Plus they were always accompanied by phrases like “at least until” orunless” to demonstrate they were very soft. Anyway, the clue is in the name (“forward guidance“). Here’s a short clip to that effect:

And guess what? It turned out things have changed and central banks reacted as they saw fit. The classic example was the decision not to start tapering in September. But for some reason, people started screaming that this means the Fed has lost the credibility. Sure, the Fed has lost the credibility rather than those who came up with the cretenic #septaper hashtag in the first place. The same kind of thing happened with #dectaper and again, the Fed’s communication policy was to blame. Ok, feel free to argue that the FOMC made a series of mistakes in their assessment of the economy but for crying out loud do not say their communication policy was incorrect because that just goes against any logic.

I have this rule when analysing central bankers’ comments. When they talk about current month’s decision, I listen no matter what – after all, they are the ones pulling the trigger. When they talk about what they think they will do in the next 1-3 months, I take that into consideration when doing forecasts. And if they talk about anything beyond the next three months I just go to make myself a coffee. Sure, it might be interesting to read what they say but the disclaimer here is simple: They.Don’t.Know.

Central banks’ credibility

There is no such thing as doing something you don’t believe in to gain credibility.

The blogosphere is full of articles about why Larry Summers is worse than Janet Yellen (or was it all the way around?) and I don’t intend to add to that discussion. However, it seems to me that there is a bigger question that needs answering, i.e. central banks’ credibility.

I read today a very good summary of the arguments in favour of Larry Summers, put together by Ezra Klein (who makes it painfully clear these are NOT his views). The full article is here and I’d like to quote one paragraph:

Summers is a better dove because he’s a better hawk. (…) There are two versions of this argument. One is that Yellen will tighten prematurely, because her reputation as a dove will make it harder for her to convince the market that she really will begin tightening when the time comes, and so she’ll need to move from promising future tightening to actually tightening sooner than Summers would. Another is that investors won’t trust Yellen’s promises to tighten, and so the market will lose some confidence in the Fed and a risk premium will begin building — which would be even worse than an actual tightening.

I am very sorry to say but this is ludicrous from whatever angle you look at it. Firstly, to assume that the Governor of the mightiest central bank on the planet has to do something to convince the market she means business is a joke. Secondly, to assume that Fed Chair would at some point arrive at a conclusion that policy probably needs to be tightened in, say, 6 months’ time and then go on and tighten immediately is offensive to any sort of intelligence. And thirdly, after all these years of seemingly dollar-debasing / hyperinflationary / zerohedgey policies, can anyone argue that the market would lose confidence in the Fed?

Credibility is composed of two factors: trustworthiness and expertise.

Let’s start with the expertise. I think the cornerstone of economic analysis is the data. The Federal Reserve is the central bank that brought to you FRED and is home to some of the brightest economists out there. Working papers produced by Fed staff are of sensational quality (at least the ones I’ve read) and it’s the central bank that is embracing the modern technology in full (and I don’t mean only tweeting). True, not all of the Fed’s forecasts are spot on but they are probably accurate reflection of the prevailing state of affairs and include all available and relevant information. Additionally, the Fed has been around for almost a century. In other words, the institutional memory of the Fed really should not be questioned. And again, this does not mean they’re infallible.

So then what about trustworthiness? Do I trust Janet Yellen and Larry Summers? Not particularly, no. But it is completely irrelevant. Trustworthiness in the Federal Reserve Chairman or Chairwoman extends from the trustworthiness of the institution. That’s why markets learned to trust Alan Greenspan even if he turned out to be a true maestro of destruction. Interestingly, almost two decades of his reign, which ended in peril, did not dent the Fed’s credibility. You could think that after the mess that Alan made, the frantic printing of money would have been compounded by the disillusion with the Fed’s handling of the economy… Instead, inflation remains in check (perhaps even too much) and I don’t think people have a sense of the Fed losing control. So all in all, I think the fairy tale about the market being worried about trustworthiness of either Yellen or Summers is just that – a fairy tale. Investors will trust them both because both have their own credentials and they will be running one of the best (in terms of human capital) central banks in the world.

But as I said, I don’t want to make it all about the U.S. Do you remember November 2011? The previously modestly (or would it be moderately?) known Governor of Bank of Italy Mario Draghi became the ECB Governor. At that time it was painfully obvious that the ECB had to cut interest rates and yet for some reason people thought it wouldn’t happen during the first meeting. They were saying that it would be damaging for the ECB credibility if an Italian started his tenure in Frankfurt by cutting rates thus infuriating the Germans. Silvia Wadhwa (why does she even have the right to express her own opinions?) said on the day of the meeting she would eat her hat if Draghi cut rates. And what happened? Draghi cut interest rates and… nothing. The EUR did not fall apart, inflation did not soar, the Germans didn’t go on strike. Why is that? Firstly, because the ECB is an important player in the market that makes things happen and secondly because Draghi did the right thing. Imagine how his credibility would look like if he waited a few months just to appease the Wadhwas of the world. Would he be able to play his ace of spades several months later by saying “whatever it takes”? Perhaps but credibility is not built on appeasing investors but by doing what you think is right with support of the institution behind you.

Again, I would like to stress that what I’m discussing here is the issue of credibility rather than making no mistakes. Importantly, sometimes the market goes the other way and assumes that some institutions have limitless credibility (I addressed it in my previous post “Just do as I say, don’t do as I do“) but that’s beside the point.

I only ask you this. Don’t tell me that differentiating candidates should be based on what they may or may not do if and when the need to hike rates arises. Rest assured that they will do whatever they think is right and that it has more to do with the incoming data and the analysis coming from within the Fed. There is no such thing as doing something you don’t believe in to gain credibility (In fact, I like this sentence a lot so I will put it on the top)

What the central bank giveth, only the central bank taketh away

When I first started working at a bank they told me to do liquidity forecasts for the money market desk. It was a relatively simple, yet educational exercise. I would look at a given month and put together a table of cash inflows to and outflows from the system. For example, when there would be a bond redemption or a coupon payment, it would mean an increase in liquidity. Conversely, if the finance ministry were to issue bonds, it would drain some money from the system. These were just daily moves in liquidity but they were absolutely key for the money market rates. Believe me, you don’t want to make a mistake when doing that…

But the thing is that this was just forecasting of changes in maturity of money in the system. After all, the mere fact that the finance ministry pays out a coupon doesn’t mean that there is more money in the system. The finance ministry cannot print money so they would simply move it from their account to the accounts of bond holders. On that day overnight rates would normally drop but the system would balance itself quite quickly.

Fast forward to more interesting (aka post-Lehman) times. The central banks around the world have been printing money at a spectacular pace and many agree (myself included) that quite a few of developed economies are in the liquidity trap. Naturally, the increase in central banks’ balance sheets has led to a significant build up in excess liquidity, which – as we know all too well – usually ends up back at the central bank’s deposit facility. This is beginning to raise concerns in both developed and emerging economies. Let me give you three examples from recent weeks in the European Union (in order of appearance):

  • Hungary’s central bank is planning to limit banks’ access to the two-week NBH bills (open market operations). More details can be found here. NBH Governor Matolcsy is quite angry that the central bank needs to pay banks for the liquidity they park in this facility. He is pointing in the direction of foreign banks (I explained the mechanism in the post entitled The Invisible Carry), but we can assume this will eventually be extended.
  • Last week, Mario Draghi said the central bank was open to negative rates on the deposit facility.
  • This week, Nationa Bank of Poland’s Governor Marek Belka said that banks had too easy lives because they were parking PLN140bn using weekly open market operations and earning the repo rate without any problems.

Many commentators and indeed the central bankers themselves have been mentioning that the idea behind those measures is to make the banks lend more. It is often claimed that the liquidity in the banking system should be helping the economy recover, instead of making banks money. But this is a very simplistic approach to how banks operate.

Let’s say that a banking system has excess liquidity of 1,000bn (never mind how it got to that state). This money is kept at the central bank in weekly open market operations and earns 0.05%. Let’s then assume that the central bank slashes this rate to -1%. What happens?

Some banks may conclude that using the central bank is not a very smart thing to do anymore and will go and buy, say, 3-month TBills. But who will they buy them from? Finance ministry? Ok, but then what will the finance ministry do with the money it gets from the bank? It will pay teachers’ salaries (among others, of course). What will the teachers do? They will keep it on their bank accounts, which means the money will have returned to the system and we’re back at square one, but with one happy finance minister who just sold some TBills.

Other banks will conclude that maybe they will take the money they’d normally put at the central bank, swap it into another currency, eg the USD and buy some USD-denominated assets with it. The price of USD in the swap market will increase (and the price of the local currency will decline) but ultimately the money won’t disappear and will return to the central bank. The process will, however, lower fx swap rates.

Perhaps there will be one bank whose CEO will feel patriotic and will want to lend money to “hard-working entrepreneurs up and down the country”. Why the decline of deposit rate by 105bp would persuade her to do that is beyond me, but we can make such an assumption. So if this bank lends some money for the new investment project, then the company in question will spend the money and the money will… come back to the system! At the end of the day, there will still be 1,000bn sitting with the central bank. Just at a different price.

I don’t question the fact that such a move will persuade banks to search for higher-yielding assets, ie loans but what I’m trying to explain is that the liquidity in the banking system is like a hot potato. The central bank controls how much money there is in the system (using various ways, eg printing money, changing the reserve requirement etc) and the market only needs to decide the price of this money. The only way that lowering rates to the negative territory impacts the amount of cash in the system is because the central bank will be returning 99% of the money placed in it back to banks. But then which of the major central banks could even contemplate shrinking its balance sheet at the time when the global economy remains exceptionally fragile?

What I think discussions like the ones taking place in Europe will lead to is significant re-pricing of interbank rates (BOR-OIS spreads could decline massively as banks start passing on the potato) and an increased demand for government or quasi-government bonds by banks’ assets and liabilities management desks (ALMs). Perhaps this is the point of the whole exercise. Then again, isn’t it yet another version of crowding out and actually forcing banks to play the carry in government bond markets? Hard to see how that should please politicians but perhaps this is the only path to rejuvenate the credit action. I really don’t like growth implications of such a process. Unless of course the ultimate beneficiaries, ie the governments, use the extra demand for their papers to increase public spending… But I will spare you, Dear Reader, yet another discussion about consequences of austerity. There’s this chap in the US who does that several times a day.

 

Baron Münchhausen and spreads in Europe

Hieronymus Carl Friedrich von Münchhausen is known for telling the story that he pulled himself (and the horse he was sitting on) out of the swamp by his own hair.

This reference was the first thing that came to my mind after seeing this and this post on Paul Krugman’s blog. After the whole bunch of swearwords, that is.

In the first one he argues that France has finally joined the club of ultra-sovereign countries, i.e. countries who can do whatever they please and yet get away with it because bond yields remain remarkably low. The second one uses “research” material from VoxEU entitled Panic-driven austerity in the Eurozone and its implications. There are five charts in it which I would like to discuss before circling back to Krugman’s thesis about French bonds.

Chart 1. Austerity measures and spreads in 2011.

 

degrauwe_fig1

 

In this chart the author argues that the higher the spread, the bigger the austerity that was subsequently applied. Well if it isn’t remarkable – so they’re telling us the higher the increase in credit spread in 2011, the bigger the adjustment had to be? Brilliant. But let’s say it’s an introductory statement just to warm us up.

Chart 2. Change in spreads vs. initial spreads

degrauwe_fig2

Now this is epic. The Baron Münchhausen argument. It basically says that the the higher the initial spread, the bigger the subsequent decline. A few things about that. Firstly, absent of a total collapse of the eurozone, how else should this chart look like? Secondly, using the same weight for the spread on tiny Portugal and Greece as Spain or Italy is just skewing the results. Thirdly, I don’t think that using the decline in percentage points as dependent variable is kosher because spreads can’t go negative and so 50bp for France is something completely different to 50bp for Portugal. Finally, I seriously wonder if the fit would be so bombastic if they removed Portugal and Greece – those dots at the beginning seem close to the best-fit line but I have a sneaky feeling that this is mostly because of the scale.

Chart 3. Change in debt-to-GDP ratio vs. spreads since 2012Q2

degrauwe_fig3

 

First of all, this is just plain wrong from the econometric point of view. What is this -0.6747 factor in the equation? It means that if there is no change in debt/GDP then spread will fall on average by 67bp. So 10 years of unchanged debt and spread falls by almost 700bp? No, friends, such results should be deemed “inconclusive” and there shouldn’t be any downward sloping line here. But if you want the line then have a look what it would imply if debt levels fell. Spreads would increase… Brilliant. Finally, assuming no lags or anything is just ridiculous.

Figure 4. Austerity and GDP growth 2011-2012  <– this one I actually have no problems with. Stating the obvious, but so be it.

Figure 5. Austerity and increases in debt-to-GDP ratios

degrauwe_fig5

 

This one says that austerity increases debt to GDP. A lot has been said on the subject and in the short run it is very difficult to argue with that. One could make an argument that without austerity debt/GDP would’ve increased even more because of super-high borrowing costs but let’s not go there here.

Wait a second though. So if austerity increases debt to GDP and we “know” from (ridiculous) Chart 3 that higher debt to GDP is associated with a decline in credit spread then isn’t austerity leading to lower spreads? Alternatively, if we interpret Chart 3 as the lack of relationship then shouldn’t we also conclude that austerity has no impact on credit spreads?

If the author’s only intention was to show that the ECB was instrumental in narrowing the spreads then fair enough. But the analysis provided is weak to say the least.

And this brings us back to Paul Krugman. Because if he believes in what De Grauwe wrote, i.e. that the reduction in spreads was the function of how high the spreads went in the first place then why has France rallied so much? Similarly, why would it rally if austerity worsens things so much?

Oh, I know why. Blame the markets (both ways).

First De Grauwe:

Since the start of the debt crisis financial markets have provided wrong signals; led by fear and panic, they pushed the spreads to artificially high levels and forced cash-strapped nations into intense austerity that produced great suffering.

Then Krugman:

Markets have concluded that the ECB will not, cannot, let France run out of money; without France there is no euro left. So for France the ECB is unambiguously willing to play a proper lender of last resort function, providing

If one wants to make an argument that OMT has led to significant tightening of credit spreads in the eurozone, we really don’t need working papers – a tweet will do. But for crying out loud do not mix austerity with that. Especially as austerity and OMT were completely coincidental. And if you do have to mix austerity into all this then make a little bit of effort to make a consistent and mathematically correct set of arguments. And make up your mind, Mr. Krugman. Either austerity is bad and ultimately keeps debt to GDP high and thus credit risk elevated in which case you need to rethink France. Or austerity sometimes makes sense in which case… well… you need to rethink a hell of a lot of things.

Otherwise your story is not far from what Baron Münchhausen – amusing and entertaining but ultimately ridiculous.

 

Central banks, exit strategies and space travels

Sometimes the best analysis of current conditions can be found in research written at a time when such conditions seemed only theoretical. This is because people writing about them have no hidden agenda and usually do it out of sheer intellectual curiosity. I have recently come across one such example when I was trying to figure out what the nature of the Fed/BoE/BoJ/ECB exit strategy will be. Whenever it may come, that is.

Here’s the link to the research entitled “The role of central bank capital revisited” published in September 2004 by the ECB. Interestingly, the paper was written by gentlemen with very German-sounding names (Ulrich Bindseil, Andres Manzanares and Benedict Weller). It reminds me of another ECB paper which in 2009 discussed “Withdrawal and expulsion from the EU and EMU” written by a Greek (Phoebus Athanassiou), but I digress.

I encourage you to take a minute and read at least the non-technical summary of this paper. Below are a few interesting quotes:

  • It is shown that a temporary shock creating negative capital and a loss-making situation is always reversed in the long run with the central bank returning to profitability and a positive level of capital.
  • However, a central bank with a loss-making balance sheet structure would in this context still able to conduct its monetary policy in a responsible way, even with a negative long-term profitability outlook.
  • Positive capital seems to remain a key tool to ensure that independent central bankers always concentrate on price stability in their monetary policy decisions.

The last one is a widely accepted notion but the former two can make you go “hmmmm”. Additionally, further in the paper the authors mention a key feature: “If there were no separation between the central bank and the government, the capital of the central bank is obviously irrelevant since one then has to consider only the aggregate capital of the State (including the central bank and the government).

The authors also mention that if a central bank has a negative capital then “The markets will have reasons to anticipate less stability-oriented behaviour of the central bank, which drives up inflationary expectations.” This catapults us straight to the current situation.

It would be remarkably difficult to argue that the BoE, BoJ or even the Fed are fully independent. Sure, they are not parts of their respective governments nor do they report to politicians (directly) but independence is illusion. This is particularly the case considering that they own the lion’s share of their local government bond markets, which many commentators perceive as a situation without an obvious exit. But let’s try and assume the unthinkable…

Imagine that efforts of the Federal Reserve eventually lead to some sort of stabilisation of growth, albeit at a low level. Assuming a fast growth rate is a bit too audacious even for me… Now surely this will raise the question of the Fed’s exit strategy. We can reasonably assume that the minute the market gets a sniff of selling of the Fed’s UST portfolio, things can get nasty. Granted, the Fed is wary of those risks and will try to minimise the impact but at the end of the day it will be a classical “more sellers than buyers” situation. As a side comment, it is entirely possible that the Fed starts with what one of my friends called Operation Untwist, i.e. selling the back end to buy short-maturity papers. This is bound to hit the central bank’s profitability. And so what?

Let’s say that the Fed adheres to the mark-to-market principles. Every bond that it sells makes the unsold portfolio look more and more under-water (all other things equal). Depending on how big the move in yields is, we can assume that the capital would be wiped out relatively quickly. The authors of the aforementioned article indicate that such a situation would “drive up inflationary expectations”. Now, hang on a minute – isn’t it what many central bankers are dreaming about? Wouldn’t that in the end increase velocity of money giving an additional boost to the economy?

The IMF analysed central banks’ losses too and concluded that if the central bank “goes bankrupt”, the risk of dollarisation of the economy increases sharply. I would agree with that when we talk about countries like Nicaragua or Egypt. But surely not in the US. It is remarkably difficult to imagine why would the Americans start preferring any other currency than the USD just because the Fed made some losses on its UST portfolio (and please don’t say “gold”). I admit that this is a slippery slope but a very important consideration at the moment is the liquidity trap and there are no easy ways out of it as many countries have painfully discovered lately (see my previous post “Has Britain finally cornered itself?“).

One of the models that the ECB study introduces spews out a nice chart:

inflation_cb_capital

This shows that a central bank’s capital does not have to turn negative to drive inflation a bit higher. Perhaps then we should not be too worried about what happens to the Fed when yields finally rise? Let me make an analogy to the momentum principle and space travels. When a rocket reaches outer space, a good way to boost velocity is to detach a part of the rocket which will essentially push the main chamber further and faster into space. This is pretty well explained here and can be summarised in the following diagram I have nicked:

rocket_propulsion

Sometimes it is good to take a step back to achieve the required effect. Perhaps a central bank incurring some losses while selling its government bond portfolios is a way to go after all…

Has Britain finally cornered itself?

After a week of travelling I came back to see that Moody’s has finally pulled the trigger on the country where I currently reside. This is such a non-story that it feels stupid to even mention but I suppose it will be making headlines for a little while longer. And this is a very good thing.

Before I start, however, I would like to thank the British government for conducting a massive social experiment, which will be used in decades to come as a proof that a tight fiscal/loose monetary policy mix does not work in an environment of a liquidity trap. We sort of knew that from the theory anyway but now we have plenty of data to base that on.

Secondly, I will be referring to my favourite IS/LM model. If you want to read more about it, a very good tutorial can be found here.

So… Let’s assume for a second that the Osborne/Cameron duo is capable of taking a stop-loss on their policy. I know it is a heroic assumption when discussing any politicians but why not…

When looking at record low cost of borrowing, a severely depressed economy and a central bank that does not even pretend anymore to be independent or targeting inflation the recipe should probably be to spend more. In the standard IS/LM model an increase in government spending over taxes (i.e. boosting the deficit) pushes the IS curve to the right. Thus, both the output level and the level of interest rate will increase. Consequently, the exchange rate should appreciate as capital flows to the country in question. This in turn leads to widening of the trade deficit. Ideally, the government would want the Bank of England to step in and limit the increase in interest rates (a.k.a. QE) so that the currency does not appreciate. And, as I mentioned before, the BoE is more than willing to do so.

Let’s now have a look at the situation from another angle. I have been going through he Bank of England’s quarterly reports in reference to trade (which can be found here) and I have found two interesting charts. The first one looks at episodes of rapid moves in the British pound and the impact on the trade balance:

gbp_trade

The relationship is pretty strong, which is why many people are calling for debasing of the sterling, particularly after G20 gave a pale-green light to such activities for countries, which are effectively in a liquidity trap.

The second chart shows why debasing of the sterling makes an awful lot of sense. It shows two measures of the International Investment Position – the standard one (i.e. with FDIs at book value) and what I would call a “market” one (i.e. with FDIs at market value).

uk_niip

You can see that the UK is looking quite a bit better if you take into account the actual values of FDIs. I would suggest that the recent rally in global equity prices has at least kept the blue line in the positive territory. This essentially means that GBP devaluation not only boosts the terms of trade but also makes the UK richer. Not very many countries are in such a pleasant situation (think of many emerging economies with significant external debt).

Again, weakening of the sterling does seem to be a very appealing strategy for the authorities. There is, however, one important problem – GBP devaluation is unlikely to bring extra revenues to the government and could actually make the fiscal position a bit worse. Here’s why – devaluing one’s currency and narrowing of a current account deficit means that the country’s savings are increasing in relative terms to investments. Granted, this may well have to happen considering a huge stock of private debt but this is not desirable from the growth point of view. On top of that, the J-curve effect dictates that the initial impact of currency devaluation will be actually adverse.

What I am trying to say is that while GBP devaluation has a lot of positive sides, it will probably not work on its own because it will further depress domestic demand thus putting a strain of public finances.

Therefore, I do believe that Britain has finally cornered itself into a situation where there is overwhelming evidence that Mr Osborne should really start spending. He should also assume that Mr Carney will not let that spending lead to appreciation of Real Effective Exchange Rate (a bit more on that mechanism in one of my previous posts entitled “Be careful what you target or am I in the right church?“). That is to say that the Bank of England will keep nominal and real rates very low. In my opinion this is the only rational way of the situation that we’re currently in. Then again, I am assuming the impossible here, i.e. that the politicians know what the stop-loss is.

How to trade this? I don’t normally trade anything related to the UK (except GBP/PLN) but I would assume that any sell-offs in Gilts should be used as an opportunity to buy. As far as the sterling is concerned, the fact that exports outside of the eurozone are now bigger than to the eurozone, EUR/GBP is a cross that doesn’t make that much sense. I would very much prefer the cable, or better yet selling the sterling against EM currencies as this is where the adjustment in trade balances will have to come from.