kaleidic monetary 1410 a

The Kaleidic Guide to UK Monetary Policy

Kaleidic Economics http://www.kaleidic.org/

Edited by Anthony J. Evans This version: October 2014

2

•  The Kaleidic Guide to UK Monetary Policy intends to provide a practical, applied overview of the contemporary conduct of central banks, with a specific emphasis on the UK

•  It remains a work in progress

Welcome

Photo credit: unknown

This guide is part of a series

•  For an introduction to macroeconomic policy see my textbook on Managerial Economics –  http://www.marketsformanagers.com

•  For a detailed and critical discussion of monetary theory and policy see my book (in progress) on an Austrian approach to the quantity theory –  http://econ.anthonyjevans.com/books/mvpy/

3

Contents

1.  Macroeconomic forecasts 2.  Natural rate of interest 3.  Transmission mechanism of

monetary policy 4.  Quantity theory 5.  Conventional monetary policy

a.  McCloskey-Fama challenge b.  Interest on reserves c.  Zero lower bound

6.  Emergency monetary policy a.  Low interest rates b.  Quantitative Easing c.  QE-a culpa d.  Forward guidance e.  Negative interest rates

7.  Federal Reserve 8.  Rule of Law 9.  European Central Bank 10. Topics

a.  Balance sheet recession b.  Savings and forced savings

11.  Indicators a.  Money and financial markets b.  Output and the labour

market c.  Costs and prices d.  International economy

4

1. Macroeconomic forecasts

5

Forecasts are difficult

•  The “Great Moderation” lulled many into a false sense of security

•  Economists don’t have a good track record at making forecasts

•  This guide is intended to help you understand the economy, and make sense of competing forecasts

6

Great Moderation

•  “From the time Britain abandoned the ERM in September 1992 to 2004 monetary policy in Britain was highly successful both in terms of achieving stable economy growth and in terms of maintaining low inflation. On the output side, real GDP growth averages 2.8 per cent per annum and recorded positive growth in every single quarter between 1992 quarter three and 2008 quarter two”

•  Greenwood, “The successes and failures of UK monetary policy, 2000-08”, in Verdict on the Crash, Booth (Ed.), 2009, IEA

7

The U.S.

•  We now know that Q1 2008 real GDP growth was negative, but at the time the estimates of growth were “modest but positive” and “as of July 10, 2008, forecasts for the second half of 2008 were for continued modest growth”*

8 * Bullard, J., “The Notorious Summer of 2008” University of Arkansas, Quarterly Analysis Luncheon, November 21st 2013

Forecasts for the UK economy, 2008

9

Published June 2008

Actual value: -0.6%

(March 28th 2014)

Forecasts for the UK economy, 2009

10

Published June 2008

Actual value: -5.4%

(March 28th 2014)

2. Natural rate of interest

11

Background

•  The natural rate is the rate at which GDP is growing at potential and inflation is stable

•  It can be used to make a judgment about the stance of monetary policy

•  “[Knut Wicksell] made the distinction between the “natural” rate of interest, which equalised saving and investment plans, and the “financial” rate of interest, set by the banking sector”*

•  It is the rate at which money supply is neutral: –  No distortions to the capital structure –  No (demand side) inflation

•  If market interest rates are below the natural rate: –  Unsustainable credit boom –  Inflation

12 * White, William, “Ultra Easy Monetary Policy and the Law of Unintended Consequences”, Federal Reserve Bank of Dallas, August 2012

How to measure: Rule of thumb

•  Andrew Lilico*:

•  Mario Rizzo and Andreas Hoffman** use the long term trend rate of real GDP growth as their estimate of R*. (Perhaps this is because of an assumption that when at the natural rate inflation is 0)

•  William White suggests using the IMF’s estimate of the potential growth rate for the global economy***

13

Where R* = (Nominal) natural interest rate P* = inflation target Y* = sustainable real GDP growth

€

R*= P *+Y *

* http://blogs.telegraph.co.uk/finance/andrewlilico/100015883/the-bank-of-england-should-raise-interest-rates-next-week/ ** http://thinkmarkets.wordpress.com/2011/04/09/are-market-rates-below-the-natural-rate-again/ *** White, William, “Ultra Easy Monetary Policy and the Law of Unintended Consequences”, Federal Reserve Bank of Dallas, August 2012

How to measure: Long term interest rates

14 http://blogs.ft.com/money-supply/2012/04/26/the-feds-rate-forecast-mess/

≈ 4%

Aside: the market doesn’t believe the FOMC

15 From JP Koning, https://twitter.com/jp_koning/status/519939742419656705/photo/1

Falling

How to measure: Trend real Fed Funds rate

16 http://www.frbsf.org/economic-research/publications/economic-letter/2005/october/estimating-the-neutral-real-interest-rate-in-real-time/

How to measure: Structural model

17 http://www.frbsf.org/economic-research/publications/economic-letter/2005/october/estimating-the-neutral-real-interest-rate-in-real-time/

How to measure: productivity

18 http://econfaculty.gmu.edu/pboettke/workshop/Spring2010/Beckworth2.pdf

How to measure: productivity

19 http://econfaculty.gmu.edu/pboettke/workshop/Spring2010/Beckworth2.pdf

Beckworth and Selgin (2010)

•  We can’t observe the real neutral interest rate •  But:

–  Long run average ≈ long run actual rate –  We understand the determinants

•  Ramsey growth model:

•  g = productivity growth •  n = population growth •  d = household rate of time preference

20 Beckworth and Selgin 2010 “Where the Fed Goes Wrong: Where the Fed Goes Wrong: The “Productivity Gap” and Monetary Policy”

€

rn = g+ n+ d

Beckworth and Selgin (2010) (contd)

•  The neutral rate today is equal to the long run steady real interest rate, plus the difference between expected Total Factor Productivity Growth, and the long run average TFP growth rate:

•  Where:

•  Let rn = 2% and λ=0.7

21

22

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1999 Q1

1999 Q4

2000 Q3

2001 Q2

2002 Q1

2002 Q4

2003 Q3

2004 Q2

2005 Q1

2005 Q4

2006 Q3

2007 Q2

2008 Q1

2008 Q4

2009 Q3

2010 Q2

2011 Q1

2011 Q4

2012 Q3

2013 Q2

Neutral real interest rate

Source: Kaleidic Economics

Estimates of the natural rate

23

Author Period R* Source

Laubach and Williams 2003 3.2%

Fels and Pradhan Feb 2006 2.25% http://www.ft.com/cms/s/1/6d8e4cfa-a3d8-11da-83cc-0000779e2340.html?siteedition=uk#axzz1aslBJ4sA

Morgan Stanley Jan 2010 2.5% http://www.telegraph.co.uk/finance/economics/7021000/Neutral-interest-rate-may-be-2.5pc.html

Andrew Lilico Mar 2012 3-3.5%

David Blanchflower Jun 2012 -3%

Perhaps R* is consistently below NGDP because NGDP is too high!

3. Transmission mechanism of monetary policy

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What is the transmission mechanism?

•  The manner in which monetary policy affects the real economy is complicated and controversial

•  As a starting point, we can follow a framework put forward by Frederic Mishkin in 1996

25

Transmission mechanisms

Monetary policy transmission

channels

Money channel MV=PY Expectations

Interest rate channel

Exchange rate channel

Asset price channel

Tobin’s Q

Wealth effects

Credit channel

Balance sheet channel Credit rationing

Bank lending channel

26

Traditional

Mishkin, Frederic. 1996. "The Channels of Monetary Transmission: Lessons for Monetary Policy." NBER Working Paper Series w5464. 1996. http://myweb.fcu.edu.tw/~T82106/MTP/Ch26-supplement.pdf


•  Based on IS-LM model •  Affects cost of capital and thus investment

–  Here, investment includes consumer durables •  Emphasis on real, long-term interest rates •  Sticky prices mean a reduction in short term nominal

interest rates (i.e. policy rate) will reduce short term real interest rates

•  Long-term interest rates are an average of expected future short term rates

27 Mishkin, Frederic. 1996. "The Channels of Monetary Transmission: Lessons for Monetary Policy." NBER Working Paper Series w5464. 1996. http://myweb.fcu.edu.tw/~T82106/MTP/Ch26-supplement.pdf


•  Can think of this as an offshoot to the interest rate channel


Tobin’s q

•  Monetarists –  If M rises people have excess cash balances and reduce

their money holdings by increasing their spending –  This increases the demand for equities, and also their

price •  Keynesians

–  Expansionary monetary policy makes bonds less attractive than equities causing price of equities to rise

•  Higher equity prices will increase q and boost investment spending

•  There is also a Tobin q for housing –  We can treat “equities” quite broadly

29

€

q =market valueof firm

replacement cos t of capital


Wealth effects

•  Based on Modigliani’s life cycle model •  Consumption is a function of lifetime resources

–  Human capital, real capital, financial wealth


Credit channel

•  Focus on the role of asymmetric information in financial markets

•  Interest rate changes are amplified by endogenous change in external finance premium

•  “where monetary policy is seen to have its effect through interest rate effects on balance sheets, and through the decision to supply and demand external finance.”

•  Duncan Brown •  http://wonkery.co.uk/blog/2013/10/4/money-beats-credit


Credit channel (2)

•  “The 'credit channel' theory of monetary policy transmission holds that informational frictions in credit markets worsen during tight- money periods. The resulting increase in the external finance premium--the difference in cost between internal and external funds-- enhances the effects of monetary policy on the real economy. We document the responses of GDP and its components to monetary policy shocks and describe how the credit channel helps explain the facts. We discuss two main components of this mechanism, the balance-sheet channel and the bank lending channel. We argue that forecasting exercises using credit aggregates are not valid tests of this theory.”

•  Bernanke, B.S., & Gertler, M., 1995 “Inside the black box: the credit channel of monetary policy transmission” Journal of Economic Perspectives, 9(4):27-48

32

Balance sheet channel(s)

•  Cost of raising external funds is lower for high net worth enterprises –  Adverse selection - low net worth firms have less

collateral –  Moral hazard – owners have lower equity stake

•  (1) To the extent that monetary policy raises the net worth of firms, it reduces these asymmetric information problems:

•  (2) Also, a lower nominal interest rate will improve cash

flow

–  Unlike the interest rate channel it’s the nominal short term interest rate that is having the impact


Balance sheet channel(s) (contd.)

•  Credit rationing –  Related to balance sheet channel, credit rationing

occurs when borrowers are denied loans even though they are willing to pay higher interest rates

•  Stiglitz & Weiss (1981) –  Higher interest rates can increase the adverse

selection problem because agents taking the biggest risks are most anxious to borrow

–  Cutting rates means that a greater proportion of prospective borrowers are low risk

•  (3) Debt payments are fixed in nominal terms •  Therefore unanticipated increases in the price level will

lower the liabilities (i.e. debt) of firms in real terms, without affecting real value of assets and hence increase their net worth


Household balance sheets

35

•  Expansionary monetary policy: –  (1) Increases net worth of households –  (2) Increases cash flow –  (3) Increase net worth (unanticipated debt reprieve)

–  Households don’t have alternative access to finance –  Looser monetary policy reduces distress and makes

them more willing to invest in durables/housing



•  Larger firms have better access to stock and bond markets •  Some borrowers can only access credit markets through

banks •  Increases in bank reserves and bank deposits will increase

quantity of loans available •  Change in supply of intermediated credit

•  If the bank lending channel is strong, monetary policy will have a relatively bigger impact on smaller firms


Reasons to take credit channel seriously

1.  Evidence that credit market imperfections affect firms’ employment and spending decisions

2.  Small firms (likely to be more credit constrained) are hurt more by tight monetary policy

3.  Asymmetric information view can be applied to explain why financial institutions exist in the first place

•  Mishkin 1996


Commentary

•  Can view credit channels as “amplifying and propagating conventional interest rate effects” (Mishkin 1996)

•  Important feature is emphasis on variables other than interest rates

•  The strength of the credit channel depends on the source of the monetary injection. Austrians and Creditists agree that the banking system is important –  Austrians: Cantillon effects – market for loanable funds

disrupts relative price signals and alters structure of production

–  Creditists: information asymmetries are why its important


Mishkin’s lessons for monetary policy

1.  Don’t equate the monetary stance with nominal short term interest rates –  Movements in nominal rates ≠ movements in real rates –  Often the real rate is the more important part of the transmission

mechanism 2.  Other asset prices contain important information

–  E.g. stock prices, forex, housing –  They are also part of the transmission mechanism

3.  Monetary policy can still be effective when nominal short term rates are near zero –  Can still use OMO (and not just in government securities) –  Can still affect inflation expectations

4.  Price stability should be the primary long run goal for monetary stability –  Unanticipated changes in the price level can cause unanticipated

changes in output, and threat of financial crises make deflation dangerous


Transmission mechanisms

Monetary policy transmission

channels

Money channel MV=PY Expectations



Asset price channel

Tobin’s Q

Wealth effects

Credit channel

Balance sheet channel Credit rationing



Creditists

Austrians Austrians

Old Monetarists

Keynesians Old Keynesians

Austrians Austrians

Market monetarists

New Keynesians

How about a “risk taking channel”?

•  “There are a number of ways in which low interest rates can influence bank risk-taking”:

1.  Impact on valuations, incomes and cash flows and measured risk •  Lower rates will boost asset and collateral values and improve

estimates of probability of default •  “This is close in spirit to the familiar financial accelerator, in

which increases in collateral values reduce borrowing constraints (Bernanke et al, 1996)”

2.  Search for yield •  Money illusion (“investors may ignore the fact that nominal

interest rates may decline to compensate for lower inflation”) •  Target savers: “liabilities are linked to a minimum guaranteed

nominal rate of return or returns reflecting long-term actuarial assumptions rather than the current level of yields. In a period of declining interest rates, they may exceed the yields available on highly-rated government bonds. The resulting gap can lead institutions to invest in higher-yielding, higher-risk instruments”

3.  Habit formation •  Consumption rises, increased economic activity may reduce risk

aversion 4.  Central bank communication

•  More predictability can encourage greater risk •  “Good” central banking creates moral hazard (Greenspan put)

41 Altunbas, et al “Does monetary policy affect risk-taking?” BIS Working Paper No.298, March 2010 http://www.bis.org/publ/work298.pdf

The monetary transmission mechanism (according to the Bank of England)

42

Key question: How does monetary

policy affect real wealth?

Bank of England http://www.bankofengland.co.uk/publications/Documents/other/monetary/montrans.pdf

Their emphasis is on

inflation

Bank of England’s view

•  Bank of England’s “How Monetary Policy Works” •  Interest rates affect the overall level of expenditure •  Bank rate affects:

–  Interest rates set by commercial banks •  Which affects cash flow (borrowers tend to spend

more of any extra money they have then lenders, so lower interest rates boosts spending)

–  Price of financial assets (e.g. bonds, shares and houses) •  Easier to extend mortgages •  Raise wealth

–  Exchange rate •  Sterling assets become less attractive

43 http://www.bankofengland.co.uk/monetarypolicy/Pages/how.aspx

Is there a unique transmission mechanism?

•  “If the structure of the economy through which policy effects are transmitted does vary with the goals of policy, and the means adopted to achieve them, then the notion of of a unique ‘transmission mechanism’ for monetary policy is chimera and it is small wonder that we have had so little success in tracking it down.”

•  David Laidler “Monetarist Perspectives” p.150

44

4. Quantity theory

45

The equation of exchange

•  M Money supply growth •  V Velocity •  P Inflation •  Y Real GDP growth

46

M +V = P +Y

Three options for monetary policy

•  Monetary aggregates (M) •  Inflation targeting (P) •  Nominal income (P+Y)

47

It’s a matter of language

School Term

Keynesian Aggregate demand

Monetarist Nominal income

Austrian Total income stream

48

5. Conventional monetary policy

49

Sterling Monetary Framework

50

51 http://www.bankofengland.co.uk/education/Documents/resources/postcards/mpc2.pdf

Use actual P rather than Pe

Better to be consistently late to the right party than consistently

early to the wrong one

A rudimentary transmission mechanism

Risk free benchmark

Short term market rates

Gilt rates Asset prices

52

Bank rate

3 month LIBOR

10 yr govt. bond

FTSE 100 share index

“In the United Kingdom, the Monetary Policy Committee (MPC) sets an interest rate for the Bank of England’s own market transactions with financial institutions – the rate at which the Bank will make short-term loans to banks and other financial institutions. This rate is known as the official Bank Rate.” Bank of England, Target 2.0 Resource Manual 2013

Note: Bank rate is also paid on some reserve balances

What is the target?

•  Bank of England often willing to allow inflation to stray from 2% –  Target was really 3% +/- 1% –  ECB for example was 2%-2.5% despite the original

target being “under 2%” •  Alternatively, it could be viewed as an average inflation

target –  There’s no real difference between average inflation

targeting and price level targeting if the period over which the average is calculated is sufficiently long

•  Some argue that the focus should be on “core inflation” –  This excludes especially volatile prices –  Better gauge of long term trends

•  But how do you decide what to keep in? The policy regime is “Target 2.0”. Communication strategy is focused on headline inflation

53

Taylor rule

•  The Taylor Rule is a general guideline that allows policymakers to ascertain an appropriate interest rate for various growth rates of inflation and output. We can use a simple version of the rule:

•  See Nechio, F., “Monetary policy when one size does not fit all” FRBSF Economic Letter, June 13th 2011

54

Taylor rule =1+ 1.5× inf lation( )− 1×unemployment gap( )

Example: ECB in January 2013

55

Mankiw rule

•  Simpler than the Taylor rule: it only looks at core inflation and unemployment

•  Similar to the Evans rule: Fed should ease monetary policy until unemployment < 7% OR core inflation >3%

•  This version was published in the 1990s, an updated one is:*

56 See http://gregmankiw.blogspot.dk/2006/06/what-would-alan-do.html * See http://marketmonetarist.com/2014/09/16/mankiw-rule-tells-the-fed-to-tighten/

r = 8.5+1.4(CIR−U)

r = 9.9+ 2.1(CIR−U)

Data source

57

FEDFUNDS

Effective Federal Funds Rate, Percent, Monthly, Not Seasonally Adjusted

UNRATE

Civilian Unemployment Rate, Percent, Monthly, Seasonally Adjusted

CPILFESL_PC1

Consumer Price Index for All Urban Consumers: All Items Less Food & Energy, Percent Change from Year Ago, Monthly, Seasonally Adjusted

58

-6

-4

-2

0

2

4

6

8 20

00-0

1-01

20

00-0

5-01

20

00-0

9-01

20

01-0

1-01

20

01-0

5-01

20

01-0

9-01

20

02-0

1-01

20

02-0

5-01

20

02-0

9-01

20

03-0

1-01

20

03-0

5-01

20

03-0

9-01

20

04-0

1-01

20

04-0

5-01

20

04-0

9-01

20

05-0

1-01

20

05-0

5-01

20

05-0

9-01

20

06-0

1-01

20

06-0

5-01

20

06-0

9-01

20

07-0

1-01

20

07-0

5-01

20

07-0

9-01

20

08-0

1-01

20

08-0

5-01

20

08-0

9-01

20

09-0

1-01

20

09-0

5-01

20

09-0

9-01

20

10-0

1-01

20

10-0

5-01

20

10-0

9-01

20

11-0

1-01

20

11-0

5-01

20

11-0

9-01

20

12-0

1-01

20

12-0

5-01

20

12-0

9-01

20

13-0

1-01

20

13-0

5-01

20

13-0

9-01

20

14-0

1-01

20

14-0

5-01

FEDFUNDS MANKIW

2.4%

59

-12

-10

-8

-6

-4

-2

0

2

4

6

8

10 20

00-0

1-01

20

00-0

5-01

20

00-0

9-01

20

01-0

1-01

20

01-0

5-01

20

01-0

9-01

20

02-0

1-01

20

02-0

5-01

20

02-0

9-01

20

03-0

1-01

20

03-0

5-01

20

03-0

9-01

20

04-0

1-01

20

04-0

5-01

20

04-0

9-01

20

05-0

1-01

20

05-0

5-01

20

05-0

9-01

20

06-0

1-01

20

06-0

5-01

20

06-0

9-01

20

07-0

1-01

20

07-0

5-01

20

07-0

9-01

20

08-0

1-01

20

08-0

5-01

20

08-0

9-01

20

09-0

1-01

20

09-0

5-01

20

09-0

9-01

20

10-0

1-01

20

10-0

5-01

20

10-0

9-01

20

11-0

1-01

20

11-0

5-01

20

11-0

9-01

20

12-0

1-01

20

12-0

5-01

20

12-0

9-01

20

13-0

1-01

20

13-0

5-01

20

13-0

9-01

20

14-0

1-01

20

14-0

5-01

FEDFUNDS MANKIW MANKIW'

2.4%

0.7%

Problems

•  Natural rate of unemployment isn’t stable –  Raw unemployment is an imperfect measure of slack –  Ignores rise in people leaving labour market

•  There’s been a drift downwards in core inflation since 2008 •  May be an argument for catch up growth, having allowed

such excessively tight policy from 2009 onwards –  i.e. should operate a level target

•  But Mankiw Rule isn’t intended to be an optimal policy rule, but an indication of when and why the Fed may begin to tighten policy

60 See http://marketmonetarist.com/2014/09/16/mankiw-rule-tells-the-fed-to-tighten/

Darda-Mankiw rule

•  Michael Darda suggests –  Prime age employment rate –  Core CPI

61 See http://marketmonetarist.com/2014/09/18/the-mankiw-darda-rule-tells-the-fed-to-wait-a-bit-with-hikes/

Productivity gap rule

•  “If, for example, policymakers aim for a 2 percent inflation target, then to avoid aggravating the business cycle they must set the federal funds target at a rate equal to the real neutral rate plus 200 basis points”

•  “In general, departures from optimal monetary policy can be understood as being measured by the spread between the real federal funds rate at any moment and the neutral real federal funds rate at that moment”

•  Hence “productivity gap”:

•  If Pt > 0 target real rate is too high and policy is too tight •  If Pt > 0 target real rate is too low and policy is too loose

62

€

Pt = rt − rtn

Beckworth and Selgin 2010 “Where the Fed Goes Wrong: Where the Fed Goes Wrong: The “Productivity Gap” and Monetary Policy”

63

Productivity gap rule

Tight

Easy

Easy

Neutral

Beckworth and Selgin 2010 “Where the Fed Goes Wrong: Where the Fed Goes Wrong: The “Productivity Gap” and Monetary Policy”

Deviation of interest rates to their natural rate is the stance

•  “By doing so Ferguson, instead of adhering to the original understanding, dating back to Wicksell, of conformity of the actual with neutral or “equilibrium” federal funds rate as a summary criterion for the correctness of monetary policy, treated it as if it were merely one of several desirable policy objectives that might profitably be traded against one another”

64 Beckworth and Selgin 2010 “Where the Fed Goes Wrong: Where the Fed Goes Wrong: The “Productivity Gap” and Monetary Policy”

UK estimates based on Beckworth & Selgin

65

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

8.0

1999 Q1

1999 Q4

2000 Q3

2001 Q2

2002 Q1

2002 Q4

2003 Q3

2004 Q2

2005 Q1

2005 Q4

2006 Q3

2007 Q2

2008 Q1

2008 Q4

2009 Q3

2010 Q2

2011 Q1

2011 Q4

2012 Q3

2013 Q2

REAL NOMINAL

Source: Kaleidic Economics

5a. The McCloskey-Fama challenge

66

Does the Fed control interest rates?

•  Liquidity effect hypothesis: –  “Changes in short term interest rates are caused by

exogenous actions of the Fed” (Thornton, 2002)

•  According to Jeff Hummel, the Fed can’t control real interest rates

•  It affects nominal interest rates, a lot, but only through it’s control of expected inflation

•  The market, not the central bank, determines real interest rates

67

The McCloskey-Fama challenge

•  “In the end, there is no conclusive evidence (here or elsewhere) on the role of the Fed versus market forces in the long-term path of interest rates.” –  Fama, E.F., “Does the Fed control interest rates”, June

2013 (forthcoming in The Review of Asset Pricing Studies)

•  According to Fama: –  US credit market $50 trillion –  Fed assets pre 2008 < $1 trillion (<2% of the market) –  Fed assets 2010 $2.5 trillion (<5% of the market)

•  The Fed is a price taker and ultimately “a little person in a

large market cannot move the price very much” –  McCloskey, D., “Other Things Equal, Alan Greenspan

Doesn't Influence Interest Rates”

68

The McCloskey-Fama challenge

•  “To the extent that the various parts of the loan market are segmented, and the longer it takes for interest-rate changes to be transmitted across maturities and financial sectors, the more powerful the central bank's impact on particular interest rates, but the weaker its effect on the economy overall, will be.”

•  Hummel, 2013

69

Monetary stance

•  According to Hummel/Reitz what the Fed does is more important than what it says –  So called “open mouth operations” only matter if they

are backed up by open market operations, and if they are not, they reduce credibility for any future open mouth operations

–  Scott Sumner to Justin Reitz: •  "You are right that the Fed follows the market far

more than most people understand" •  An alternative measure of the monetary stance is changes

in the central banks share of the market for domestic government bonds

70

The Reitz position

1.  From 2000-2007 the monetary base rose by 4% per year –  The domestic monetary base (i.e. stripping away

currency that went overseas) rose by just 1.9% per year

2.  The Fed’s holdings of US Treasuries rose by $250bn –  The daily trading volume in the US Treasuries market is

$450bn 3.  The Fed’s gross daily average trading volume was 2% of the

market –  In terms of outright purchases (i.e. not repos, which

tend to net out) the Fed’s role was 0.05% of the market 4.  The Fed’s share of the US Treasury market fell from 20% to

18% –  During the same period foreign governments holdings

rose from 25% to 33%

71 http://thinkmarkets.wordpress.com/2011/04/09/are-market-rates-below-the-natural-rate-again/#comment-9851

What is driving ARM? Fed Funds rate or 10 yr Treasury rate?

72 Source: Justin Reitz

Further evidence

73 Source: David Beckworth, http://macromarketmusings.blogspot.co.uk/2013/05/a-failure-to-act-fed-policy-and.html

The Fed’s share of Treasuries rose in 2011, pushing down

treasury yields

But that makes it hard to blame the Fed for falling

interest rates from 2000-2007!

Net acquisitions as a share of net issuance

74 Source: Peter Warbuton, Economic Perspectives

Also need to know how much is being retired

75 h/t Ben Southwood, Adam Smith Institute

Open markets, open mouths, or interest rate smoothing?

•  Daniel Thornton finds “no evidence that either open market operations or open mouth operations can account for the close relationship between the funds rate and the funds rate target”

•  Alternative hypothesis: interest rate smoothing –  “the Fed does not move rates per se but, rather,

smooths the transition of rates to a the new equilibrium required by economic shocks.”

–  "changes in the Fed’s funds rate target are an endogenous response to economic events...”

•  Daniel Thornton, (2002) “The Fed and Short-Term Interest Rates: Is It Open Market Operations, Open Mouth Operations, or Interest Rate Smoothing?”

76 http://research.stlouisfed.org/econ/thornton/openmouth.pdf

5b. Interest on reserves

77

Interest on excess reserves

•  The Fed started to pay interest on excess reserves in October 2008 •  Authorisation was granted in 2006 and intended to commence in October

2011. Concerns about inflation (!) led the Fed to bring it in earlier •  The aim is to make it easier to conduct monetary policy

–  More control over Fed Funds rate –  Previously concerns they were “unable to prevent the federal funds

rate from falling to very low levels” New York Fed* –  Provides the floor in a “corridor” system

•  An increase in interest rate on reserves will make banks less willing to lend on the open market, and push up the interbank (i.e. Fed Funds) rate

•  “Raising the rate of interest paid on reserve balances will give us substantial leverage over the federal funds rate and other short-term market interest rates, because banks generally will not supply funds to the market at an interest rate significantly lower than they can earn risk free by holding balances at the Federal Reserve” Ben Bernanke*

78 http://blogs.wsj.com/economics/2009/09/16/fed-paying-interest-on-reserves-a-primer/

Interest on excess reserves

•  But what a bad time to implement it! •  It incentivises commercial banks to hold higher reserves,

rather than buy Treasuries (or other assets) •  This constitutes contractionary monetary policy •  Fed claimed that IoR also helps with exit strategy

79 http://blogs.wsj.com/economics/2009/09/16/fed-paying-interest-on-reserves-a-primer/

What interest rate is paid on reserve balances?

•  It’s changed –  Oct 2008: the rate on required reserves was greater

than the rate on excess reserves •  Required reserves were paid the average of the

Fed Funds target range (-0.10%) •  Excess reserves were paid the lowest Fed Funds

target rate (-0.75%) –  22/10: Excess reserves down to -0.35% –  5/11: No spread –  16/12: monthly average interest rate on both is 0.25%

–  http://www.federalreserve.gov/monetarypolicy/20081216d.htm

80

81 http://www.frbsf.org/education/publications/doctor-econ/2013/march/federal-reserve-interest-balances-reserves

2007 (averages) Required reserves: $43bn Excess reserves: $1.9bn

Payment systems and market failure

•  Deferred Net Settlement (DNS) wholesale payment system –  Gathers orders throughout the day and then transfers

reserves from net senders to net recipients •  Real-Time Gross Settlement (RTGS) wholesale payment

system –  Sends payments as they arrive

•  Central banks have been moving from DNS (which originated with private clearing houses) to RTGS on market failure grounds

•  Selgin (2004) contests this rationale

82 Selgin, G., 2004 “Questioning the Market Failure Hypothesis” International Review of Law and Economics 24, no. 2, pp.333-350

5c. The zero lower bound

83

Loanable funds market

•  If some people want to save more, interest rates will fall such that people substitute saving with spending and AD remains constant

•  At the extreme this could result in a negative real interest rate

•  Since central banks can’t cut nominal rates below zero this creates a floor –  Non cash assets can be sold for cash, and cash has a

nominal interest rate of 0. If nominal rates go below this people will switch to cash

–  The fear is a deflationary spiral •  Postponing consumption because of concerns of a

recession becomes self-fulfilling •  Real value of debt rises (r=i-p and I can’t fall

below 0. Hence deflation, i.e. a –ve p will mean that r rises)

•  But is this a policy floor? It only exists in as much as it’s a “merely” apolicy instrument.

84

Liquidity trap

•  “A situation in which prevailing interest rates are low and savings rates are high, making monetary policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings because of the prevailing belief that interest rates will soon rise. Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline”

•  http://www.investopedia.com/terms/l/liquiditytrap.asp

85

ZLB is not a liquidity trap

•  Keynes was talking about the i/r on bonds. The liquidity trap occurs in a different part of the transmission mechanism to the zero lower bound (i.e. on policy rates).

•  Tim Congdon contrasts the original liquidity trap with what contemporary Keynesians (e.g. Krugman) are invoking today) –  Keynes’ trap: broad money can’t push nominal bond yields below

zero •  i.e. When yields are low the interest elasticity of the demand

for money is infinite –  Krugman’s trap: the central bank cannot use OMO to get short

term interest rates below zero •  Hence threat of deflation leads to high real interest rates

•  According to Congdon Keynes’s trap is possible but implausible and not apparent today. Krugman’s trap is nonsense because there’s plenty of other monetary policy tools

86 * See Congdon, T., “Krugman’s liquidity trap claptrap” IEA Blog, February 29th 2012

Interest rate channel and ZLB

•  Even if nominal rates are at zero policy makers can still

affect the expected price level which will reduce real interest rates


Zero lower bound policy

“The central bank uses open market operations to buy and sell government bonds1 from commercial banks2 with newly created money to influence the interbank market and hit a target short-term3 interest rate4”

88

4. Quantitative

easing

1. Qualitative

easing

2. Credit easing

3. Operation twist

This increases narrow money directly (the monetary base increases), and increases broad money if commercial banks choose to expand deposit lending against their higher cash reserve.

Operation twist

•  San Francisco Fed: original operation twist (Kennedy in 1961) lowered yields by 15 basis points

•  But if altering maturity structure of government debt has an effect can’t debt management office conduct QE?

•  “What that implies is that finance ministries could conduct their own QE by issuing less long-term debt, reducing its supply and driving up prices. In fact, governments have done exactly the opposite. Since mid-November America's Treasury has issued some $589 billion in extra long-term debt, of which the Fed has bought $514 billion. From early 2009 through to March 2010 Britain's Treasury issued £247 billion ($396 billion) of extra long-term gilts, of which the Bank of England bought £199 billion. In effect, QE in both countries has been undermined by debt-management policy.”*

•  To the extent that operation twist works QE has been offset by governments desire to issue longer term debt (and reduce their exposure to a short term financing problem)

89 * “Twisted thinking” The Economist, April 2nd 2011

Central banks can expose themselves to various forms of risk

• Asset classes of lower quality

Capital risk

• Assets that are harder to trade

Liquidity risk

• Assets of longer maturity

Duration risk

90

6. Emergency monetary policy

91

Financial crises

•  Mishkin (1994) lists 5 factors: 1.  Increases in interest rates 2.  Stock market declines 3.  Unanticipated decline in price level 4.  Increases in uncertainty 5.  Bank panics

92 * Mishkin, F.S., 1994, “Preventing financial crises: An international perspective” Manchester School, 62:1-40

Monetary policy is like a goalkeeper

•  Goalkeepers can’t win you a football match because they don’t score goals. However their errors can lead to heavy defeats.

•  Aim: get the basics right and avoid calamity

93

“Bad monetary policy is disastrous – but good

monetary policy is neutral” Allister Heath

“Why QE is not the answer to Britain’s economic problems” City AM, July 6th 2012

The origins of central banking

•  NO! •  The original role of the central bank was to prevent bank runs spreading

throughout the entire system by doing one of two things: –  (i) offering lines of credit to sound banks that cannot find credit by other

means (i.e. lender of last resort); –  (ii) closing down unsound banks in an orderly manner

94

ER Hospice

Fed Lots The opposite!

BoE Haphazard Not really

ECB Yes None of this

“The central bank should be an ER, not a hospice”

“Good news bears” The Economist, November 30th 2010

How LOLR operates: Fed loans to Morgan Stanley

95 http://blogs.reuters.com/felix-salmon/2011/11/28/chart-of-the-day-morgan-stanley-bailout-edition/

Sep. 16th 2008 $21.5bn Sep. 17th 2008

$40.5bn

Sep. 29th 2008 $107bn

“The Fed didn’t blink: it kept on lending, as much as it could, to any bank which needed the money, because, in a crisis, that’s its job” Felix Salmon

Bagehot’s rule

•  Bagehot’s rule: –  “Lend without limit, to solvent firms, against good

collateral, at ‘high rates’”

•  Fed/ECB practice: –  “Lend freely even on junk collateral at ‘low rates’”*

•  “There is a material difference between the central bank passively sitting on the bid (or low end) of this bid ask spread, which is what Bagehot advocated, and the central bank aggressively transacting near the upper end of a bid ask spread, which is what Bernanke's QE1 and QE2 are”

•  JP Koning**

96 *Ashwin Parameswaran,http://www.macroresilience.com/2011/09/12/bagehots-rule-central-bank-incentives-and-macroeconomic-resilience/ ** http://www.coordinationproblem.org/2011/01/qe1-and-monetary-disequilibrium.html

Initial response from the Bank of England

•  8th October 2008:

•  (Extension of) Special Liquidity Scheme (SLS) –  £200bn in short term loans –  Set up in April 2008 for 6 months –  Operated from April 2008 – Jan 2009

•  Bank Recapitalisation Plan –  Government buys shares in troubled banks –  £25bn (+ further £25bn if needed) –  Major recipients

•  Lloyds TSB, RBS –  Notable non participants

•  HSBC, Standard Chartered, Barclays •  Loan guarantees

97

Policies adopted: “credit easing”

•  Peter Warburton (Economic Perspectives) claims that the sudden withdrawal of the Special Liquidity Scheme caused the recovery to stall in 2010

•  March 2012: National Loan Guarantee Scheme (NLGS) –  Government guarantees on unsecured borrowing by banks –  Total value of loans = £5.2bn –  Replaced by Funding for Lending

•  June – Sep 2012: Extended Collateral Term Repo (ECTR) facility –  Banks can pledge wide range of loans/securities for cash

•  August 2012: Funding for Lending –  Bank of England (and ultimately government) support on the condition

of lending to businesses/households is maintained or (preferably) increased

–  In June 2012 King only gave a patchy overview saying cost of funds would be “below current market rates”*

98 * “Chained to trouble” The Economist, June 23rd 2012

Funding for Lending critique: Frances Coppola

•  First results: only Barclays actually increased lending! •  Rationale for FLS: the liquidity provided by QE wasn’t finding its way to homebuyers

and small business •  Lends 9 month gilts rather than cash (therefore more like the Discount Window

Facility than the ECTR) •  Banks can use these as collateral and reduce their funding costs •  Main difference though is the obligation on the borrower

–  “FLS borrowing incurs a fee, which increases if borrowers reduce their lending to non-banks (corporates and households)”

–  But the fee isn’t very big –  “Assuming the high-quality collateral allowed them to borrow from the funding

markets at 0.5%, the initial cost of FLS funding on the base stock of lending was 0.75%. That is a very considerable reduction on the prevailing funding spreads at the time”

•  Since then, Eurozone worries have calmed, and “There is now little difference between market funding costs for well-regarded banks and the FLS scheme”

•  Coppola: bank lending will rise at some point but not because of FLS because it isn’t fixing the underlying problem of over indebtedness

99 http://coppolacomment.blogspot.co.uk/2013/03/the-fatally-flawed-fls.html

The moment of crisis

•  Secrecy: External Members of the MPC weren’t even told about emergency loans to HBOS or RBS*

•  Mervyn King was conservative and academic: –  Very worried about moral hazard –  “the Bank has no democratic mandate to put

taxpayer’s money at risk”**

100 * See Blanchflower, D., “Mervyn King is a tyrant, but who will succeed him at the Bank” New Statesman, April 12th 2012 ** “Chained to trouble” The Economist, June 23rd 2012

Lack of transparency

•  “it’s frankly ridiculous that it’s taken this long for this information to be made public. We’re now fully ten months past the point at which the Financial Crisis Inquiry Commission’s final report was published; this data would have been extremely useful to them and to all of the rest of us trying to get a grip on what was going on at the height of the crisis. The Fed’s argument against publishing the data was that it “would create a stigma”, and make it less likely that banks would tap similar facilities in future. But I can assure you that at the height of the crisis, the last thing on Morgan Stanley’s mind was the worry that its borrowings might be made public three years later…

If the Fed wants to get Americans back on its side — and it needs to get Americans back on its side — then it will have to stop fighting these silly battles against transparency”

•  Felix Salmon

101 http://blogs.reuters.com/felix-salmon/2011/11/28/chart-of-the-day-morgan-stanley-bailout-edition/

Easy monetary policy

•  The benefits of easy monetary policy is that it buys time, but if you don’t make use of that time to fix the underlying problem then it’s a waste

•  This problem is compounded by the possibility of creating serial bubbles: –  1987 stock market crash –  Late 1980s property boom –  1998 Asian financial crisis (LTCM) –  2000 Tech bubble –  2007 Housing bubble

•  “By mitigating the purging of malinvestments in successive cycles, monetary

easing thus raised the likelihood of an eventual downturn that would be much more severe than a normal one”

•  “In short, monetary policy has itself, over time, generated the set of circumstances in which aggressive monetary easing would be both more needed and also less effective”

102 See White, William, “Ultra Easy Monetary Policy and the Law of Unintended Consequences”, Federal Reserve Bank of Dallas, August 2012

Ultra easy money

•  “It is also the case that ultra easy monetary policies can eventually threaten the health of financial institutions and the functioning of financial markets, threaten the “independence” of central banks, and can encourage imprudent behavior on the part of governments.”

•  William White

103 White, William, “Ultra Easy Monetary Policy and the Law of Unintended Consequences”, Federal Reserve Bank of Dallas, August 2012

Dynamics of intervention

•  June 2012: •  “Mr Posen not only calls for more money printing, but also

for the Bank to spend the cash on assets other than gilts – an idea that the governor and other Bank staffers have fiercely objected to on the grounds that it would hinder Threadneedle Street’s independence.”*

•  Key issues: –  Thin end of the wedge (and dynamics of intervention) –  Independence

104 Claire Jones, “Posen resumes his role as MPC dove” Financial Times, June 11th 2012

Emergency policy becomes a new regime

•  “I think the December 2008 FOMC decision [to target a Fed Funds Rate of 0%-0.25%] unwittingly committed the U.S. to an extremely long period at the zero lower bound similar to the situation in Japan, with unknown consequences for the macroeconomy.”

•  James Bullard, President and CEO of the Federal Reserve Bank of St Louis


The inflationary tightrope

106

Tightrope

•  Stephanie Flanders mocked me for suggesting that CB policy can make both deflation and hyperinflation (i..e extreme outcomes) more likely

•  For the ECB cuts to interest rates affects LTROs (banks are charged the average rate over 3 years)

•  “The fundamental problem that Mr Draghi faces is the acute divergence within the euro zone as capital flight sucks funds out of the periphery and into the core, making monetary conditions simultaneously tight and loose. In Germany, despite recent gloom, businesses and households can borrow readily at cheap rates. In southern Europe, banks are restricting the supply of credit; those loans that are available are expensive”*

107 * “When the chips are down” The Economist, June 23rd 2012

Tightrope (2)

•  “It's not that QE per se creates regime uncertainty. It's that it foster a situation where the future price level becomes less clear because of doubts over the central banks intentions and the political and technical problems of withdrawing the base afterwards. It places the central bank on that tightrope you discussed.”

•  Robert Thorpe, comments on The Filter^ •  http://thefilter.blogs.com/thefilter/2010/11/the-threat-

of-qe2.html

108

Tightrope (3)

•  “Leijonhufvud (2012) contends that the end results of such credit driven processes could be either hyperinflation or deflation, with the outcome being essentially indeterminate prior to its realization”

•  “In earlier publications, Leijonhufvud referred to the “corridor of stability” in macroeconomies. Outside this corridor, he suggests that forces prevail which encourage an ever widening divergence from equilibrium”

•  Citation (?): Leijonhufvud A (2009) “Out of the Corridor: Keynes and the Crisis” – Cambridge Journal of Economics 33, PP. 741-757


6a. Low interest rates

110

Dangers of low i/r (and especially negative real i/r)

•  Capital misallocations –  Financial speculation (i.e. excessive risk taking) –  “a skeptic would have to be blind not to see bubbles inflating in junk-

bond issuance, credit quality and yields… here we are again mired in a euphoric environment in which some securities have risen in price beyond all reason… and where caution seems radical and risk-taking the prudent course”**

–  Distortions in the ratio of capital to labour •  Zombie capital

–  Entrepreneurs postpone the liquidation of unproductive capital –  “by definition, the investment that is deterred (by being crowded out by

malinvestment kept in place by low rates) is more productive than the investment that is maintained (by not being liquidated)”*

–  “the perceived need to support the weak could also lead to higher interest charges for those strong enough to afford it”***

•  Lower medium term growth rate (due to zombie capital) •  Masks underlying problems and makes future rate rises more painful

111 * Lilico, A., “Malinvestment can coexist with low investment” Daily Telegraph, March 30th 2012 ** Seth Klarman, Baupost Group, see “The big issue” The Economist, March 15th 2014 *** White, William, “Ultra Easy Monetary Policy and the Law of Unintended Consequences”, Federal Reserve Bank of Dallas, August 2012


•  Destabilising capital flows –  “Ultra-low interest rates appear to have prompted additional capital

flows to emerging markets, particularly into their bond markets. Purchases of emerging-market bonds by foreign investors totaled just $92 billion in 2007 but had jumped to $264 billion by 2012”

–  McKinsey* –  Kazakh currency fell by 19% in February 2014

•  “Mr Kelimbetov said that Kazakhstan could no longer afford to spend billions propping up the tenge (which is pegged to a basket of the dollar, the euro and the Russian rouble) and needed to make exports more competitive. He cited fallout from the “tapering” of quantitative easing in America, capital flight from emerging markets and a falling rouble (whose trajectory the tenge tends to mirror, since Russia is a close trading partner)”.

•  The Economist**

112 * “QE and ultra-low interest rates: Distributional effects and risks” McKinsey Global Institute Discussion Paper, November 2013 ** http://www.economist.com/news/asia/21597005-anger-devaluation-hints-broader-malaise-tenge-fever


•  Destabilising capital flows –  Foreign currency denominated debt in emerging markets companies

•  “In the aftermath of the global financial crisis, rich-world central banks unleashed a flood of liquidity to support their own sickly economies.”

•  “Emerging-market companies have begun issuing foreign-currency-denominated debt with gusto: $1.3 trillion of it was outstanding in 2013, up from $597 billion in 2009, according to Nomura, a Japanese bank. As a result, foreign borrowing as a share of all emerging-economy borrowing has been climbing. Banks are leading the way. Since late 2008 the share of debt issued by financial firms abroad has risen steeply, from 15% to 22%, the IMF says.”

–  This is bad because •  “Foreign-currency borrowing damns them, in times of trouble, to a

vicious downward spiral: a loss of faith in a country’s currency makes its debts harder to repay. That in turn further reinforces doubts about its currency.”

113 http://www.economist.com/news/finance-and-economics/21600150-cheap-credit-tempting-emerging-markets-towards-risky-borrowing-financial


•  Pension deficits –  Lower bond yields increase the costs of providing pensions –  “You need a much larger pension pot to buy a given level of income…

since less of the work is performed by investment returns, more of the work has to be done by the saver”***

–  Combined deficit of FTSE 350 increased by £17bn “in the year to March 31st”*

–  According to the Pension Protection Fund, from June 2011 – June 2012 the deficit of UK pension funds rose from £24.5bn to £312bn*

–  “That requires firms to divert more money into their schemes – money that might otherwise have been available to finance business expansion”**

•  “In 2013 fixed-income mutual funds suffered their first annual outflow since 2004” ****

114 * “Stuck in the middle” The Economist, May 5th 2012 ** “Keeping it real” The Economist, June 20th 2012 *** “Another paradox of thrift” The Economist, September 18th 2010 **** “Solving the puzzle” The Economist, Jan 4th 2014

Unintended consequence of low interest rates

•  One of the reasons for the spike in commodity prices that occurred in late 2007/early 2008 was the fact that the Fed were cutting interest rates making it easier for firms to borrow for speculative reasons

•  Higher commodity (and oil) prices may have contributed to reduced growth –  “This oil price shock contributed to the slowdown in

the U.S. economy in the second half of 2008”*


Commodity Research Bureau (CRB) foodstuffs index

116 See here: http://www.crbtrader.com/crbindex/crbdata.asp * http://www.mindfulmoney.co.uk/wp/shaun-richards/inflation-at-breakfast-time-and-in-food-prices-but-disinflation-elsewhere/

Commodity foodstuffs index "up by just under 16% in the year so far.” Shaun Richards, March 2014*

Target savers

•  Artificially low interest rates can increase savings if people are attempting to meet a fixed financial commitment

•  “But in China, unlike other countries, this repression does not discourage saving. In fact, it appears to do the opposite. The country’s households are “target savers”: they squirrel away money to meet a fixed financial goal, such as the down-payment on a home. If their thrift is poorly rewarded, they simply do more to reach their target.”

•  The Economist •  http://www.economist.com/news/china/21599806-our-

asia-economics-editor-takes-his-leave-less-worried-many-his-peers-about-frailties

117

Sucks to be a saver in 2014

•  Mortgage rates rising (5 yr fix from 1.03% in 2013 to 1.7% in 2014

•  Time deposits falling as well! (5 year loan is 1.58%)

118 Tim Wallace, http://www.cityam.com/blog/1391093734/savers-are-getting-crushed-despite-rising-mortgage-rates

Low real i/r aren’t necessarily bad for savers

•  “ISA savers with £100,000 have lost £18,500 since 2008 and pensioners buying annuities have been rewarded for their thrift with lower income for the rest of their lives. But, one must ask, what was the alternative?”*

•  “What is absolutely clear is the alternative to cut-price interest rates and QE – a depression on the lines of the US in the 1930s – would likely have wiped out almost all the capital and left savers destitute.”*

•  “without bargain basement mortgage rates, cheap mortgage loans and the ability of weak companies to have rights issues to rebuild balance sheets – the four to five million unemployed once predicted by Blanchflower might actually have happened.”*

•  Rises in asset prices can increase house prices by more than the loss of income due to low rates on savings –  “those most hurt were people able to take the pain with high levels of

savings, good pensions (despite the great annuity robbery) and decent equity in their homes”*

•  “The loss of savings returns has been a price worth paying for stability and recovery.”*

119 * Alex Brummer, “Low rates saved your savings when the global economy fell off a cliff” This is Money, http://www.thisismoney.co.uk/money/saving/article-2573367/ALEX-BRUMMER-Low-rates-saved-savings.html

Low real i/r aren’t necessarily bad for savers (2)

•  A McKinsey Global Institute discussion paper pointes out that the increase in house prices and bond prices probably outweigh the reductions in fixed incomes.

•  “If one accepts that house prices and bond prices are higher today than they otherwise would have been as a result of ultra-low interest rates, the increase in household wealth and possible additional consumption it has enabled would far outweigh the income lost to households.”

•  Most “savers” probably benefit: –  Lower income –  Higher wealth

•  But –  Worse cash flow –  Bigger stake in (any) bubble activity –  It’s non voluntary

•  Also –  Reduced fiscal pressure on government

•  “By the end of 2012, governments in the United States, the United Kingdom, and the Eurozone had collectively benefited by $1.6 trillion, through both reduced debt service costs and increased profits remitted from central banks”

120 “QE and ultra-low interest rates: Distributional effects and risks” McKinsey Global Institute Discussion Paper, November 2013

Downsides of low interest rates

1.  Confidence channel is (potentially) self defeating – 

“Indeed, the greater the respect held by the public for the central bank in question, the more likely this outcome might be. Higher respect would increase the likelihood that the public would believe that the central bank had identified problems that they themselves had not foreseen”*

2.  Target savers “if in fact the accumulation rate becomes so low that it th

reatens the minimum accumulation goal, the only recourse (other than postponing retirement) will be to save more in the first place”

– “Strictly speaking this conclusion follows only if the rate of growth of productivity (and economic potential) has also fallen. Thus there must be an increase in saving to reconstitute lost wealth”


Downsides of low interest rates

3.  Distributional effects –  “Very low rates imply less

household disposable income for creditors and more disposable income for debtors. Should the marginal propensity to consume of creditors (say older, credit constrained people living off accumulated assets) exceed that of debtors, the net effect of redistribution could be to lower household spending rather than raise it”

4.  Is it wealth? –  “From this perspective, higher equity prices constitute wealth only if based on

higher expected productivity and higher future earnings. This could be a byproduct of lower interest rates stimulating spending, but this is simply to assume the hypothesis meant to be under test.”

5.  Pensions – 

“that lower interest rates reduce the asset revenues of pension funds and raise the present value of future liabilities. Funding shortfalls eventually have to be made up by the sponsoring company, reducing profits and funds available for investment”


Dangers of rapid reversal

•  Like all bubbles, these exaggerated increases can rapidly reverse when interest rates return to normal levels

•  The lower US interest rates are causing a substantial capital flow to those economies, creating currency volatility. The economies hurt by the increasing value of their currencies are responding with measures to protect their exports and limit their imports, measures that could lead to trade conflict

•  the increased cash on banks’ balance sheets will make the Fed’s exit strategy harder

•  Feldstein, M., “QE2 is risky and should be limited” Financial Times, November 2nd 2010

123

Malinvestment


Vertical Intertemporal – shift towards capital investment

Horizontal Investments in particular sectors

Housing (US, UK, Spain, Ireland) & Construction

Construction

Infrastructure (Channel Tunnel, “Big Dig”, Millenium Dome)

Financial sector

Export capacity (South East Asia heavily reliant on sales to over indebted consumers)

Automotive (e.g. China)

Drop in savings rates Renewable energy (solar panels & wind turbines)

Malinvestment: China

•  “Keynesians would argue that Beijing has the tools to stoke aggregate demand. It could, for example, adjust interest rates and bank reserve requirements, instruct state-owned banks to maintain lending, or deploy some of its $3 trillion in foreign exchange reserves. The government also appears to have many shovel-ready construction and infrastructure projects that could help the economy glide to a soft landing and then bounce back.

•  The Austrian perspective introduces some scarier considerations. China has been investing 40 percent to 50 percent of its national income. But it is hard to invest so much money wisely, particularly in an environment of economic favoritism. And this rate of investment is artificially high to begin with.

•  The Austrian approach raises the possibility that there is no way for China to make good on enough of its oversubsidized investments. At first, they create lots of jobs and revenue, but as the business cycle proceeds, new marginal investments become less valuable and more prone to allocation by corruption. The giddy booms of earlier times wear off, and suddenly not every decision seems wise. The combination can lead to an economic crackup — not because aggregate demand is too low, but because the economy has been producing the wrong mix of goods and services.”

125 Cowen, Tyler, “Two Prisms for Looking at China’s Problems” New York Times, August 11th 2012

6b. Quantitative easing

126

127 http://www.bankofengland.co.uk/education/Documents/resources/postcards/qe2.pdf

Goal of QE

Yield Liquidity

•  BoE buys assets •  This raises their price •  This reduces their yield •  This boosts AD

•  Sellers substitute into other assets with higher yields with new money (i.e. company shares, bonds)

•  This reduces borrowing costs therefore C and I increase

•  If shares are an important part of income then C rises

•  Banks have more money and they pass it on to their customers

•  This increases broad money

128

QE1 time scale Announcement Decision on QE Other

11th Feb 2009 February Inflation Report released and indicates QE asset purchases likely

5th March 2009 MPC announced it will purchase £75bn of assets (majority of which will likely be gilts) funded by central bank reserves. Gilts will be restricted to bonds with residual maturity of 5-25 years. Will take up to 3 months to complete

Bank rate reduced from 1% to 0.5%

7th May 2009 QE asset purchases will be extended by £50bn to £125bn. Will take a further 3 months to complete

6th August 2009 QE asset purchases will be extended by £50bn to £175bn. Buying range will be extended to gilts with residual maturity greater than 3 years. Will take a further 3 months to complete

Gilt lending programme to allow counterparties to borrow gilts from the APF’s portfolio for a fee (and alternative gilts as collateral)

5th November 2009 QE asset purchases will be extended by £25bn to £200bn. Will take a further 3 months to complete

4th February 2010 QE asset purchases will be maintained at £200bn

Note: these are mainly medium and long-dated amounting to 30% of outstanding gilts held by private sector and 14% of NGDP*

129 Taken from: http://www.bankofengland.co.uk/research/Documents/workingpapers/2012/wp466.pdf * http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb110301.pdf

Subsequent QE

130

Date QE

March 2009 - February 2010 £200bn

October 2011 – May 2011 + £125bn

July 2012 + £50bn

As of May 2014 £375bn

QE transmission mechanism

131 Taken from: http://www.bankofengland.co.uk/research/Documents/workingpapers/2012/wp442.pdf

Quantity of assets purchased by the creation of central bank reserves on a settled basis (in sterling millions)

132

£0

£50,000

£100,000

£150,000

£200,000

£250,000

£300,000

£350,000

£400,000

Update 9th May, 2014, series code: YWWB9R9

Components of the Asset Purchase Facility

•  Commercial paper •  Corporate bonds •  Gilts •  Secured commercial paper

133

Commercial paper

•  “The objective of private sector asset purchases under the Asset Purchase Facility is to improve the liquidity in, and increase the flow of, corporate credit by making purchases of high-quality private sector assets including commercial paper and corporate bonds.”

•  “The Bank's intention was that the Facility would operate for as long as the highly abnormal conditions in corporate credit markets that were impairing finance of real economic activity persisted. Given the improvements in market functioning since the Facility was introduced, the Bank provided 12 months' notice of its intention to withdraw the Commercial Paper Facility on 15 November 2010 and closed the Facility on 15 November 2011.”

134 http://www.bankofengland.co.uk/markets/Pages/apf/cp/default.aspx

Corporate bonds

•  “Through the Corporate Bond Secondary Market Scheme, the Bank will offer to make regular small purchases and sales of a wide range of high-quality corporate bonds. The focus of the Scheme is to facilitate secondary market activity, to help to reduce liquidity premia on high-quality corporate bonds, and so remove obstacles to corporate access to capital markets.”

135 http://www.bankofengland.co.uk/markets/Pages/apf/corporatebond/default.aspx

Gilts

•  “On 5 March 2009, the Chancellor authorised the MPC to use the APF for monetary policy purposes by financing asset purchases using central bank reserves. Therefore, in addition to setting Bank Rate each month, the MPC also sets a target for the level of assets to be financed by central bank reserves over a period of its choosing. In order to meet the MPC's objective for total asset purchases, the APF was authorised to purchase medium- and long-maturity conventional gilts in the secondary market..”

•  “In line with the MPC’s most recent decision in relation to the asset purchase programme, the APF has purchased £375 billion of assets by the creation of central bank reserves. The Bank and the Debt Management Office (DMO) have agreed that the Bank will make available to the DMO a significant amount of the gilts purchased via the Asset Purchase Facility (APF) for on-lending to the market through the DMO’s normal repo market activity. For further details, please see the joint”

136 http://www.bankofengland.co.uk/markets/Pages/apf/gilts/default.aspx

Secured commercial paper

•  “The Secured Commercial Paper Facility enables the purchase of investment grade sterling asset-backed commercial paper securities that support the financing of working capital. It can channel funds to a broad range of corporates whilst also underpinning secondary market activity and helping to enlarge the private issuance market, and so removing obstacles to corporate access to capital markets.”

•  “To achieve this, the Bank of England offers to purchase, at a minimum spread over risk-free rates, newly issued commercial paper in the primary market via dealers, and after issuance from other eligible counterparties by acting as a backstop for secondary market investors.”

137 http://www.bankofengland.co.uk/markets/Pages/apf/securedcpf/default.aspx

Impact of QE

Study Findings

Kapetanios et al. Bank of England Working Paper No. 443

•  Reduced long term gilt yields by 100 points

•  Increased real GDP by 1.5%

•  Increases CPI by 1.25%

Bridges & Thomas Bank of England Working Paper No. 442

•  Increased M4 by 8%

Harrison Bank of England Working Paper No. 444

•  Boosted AD

138

Quantitative easing

•  QE is appropriate if the problem is nominal –  i.e. if the demand for money exceeds the supply of

money •  It won’t help if the problem is real

–  Excessive debt –  Skill mismatch –  Over regulation

•  Dangers: –  The bigger the balance sheet, the bigger the risks of

reducing it •  i.e. raises the stakes for exit strategy •  “once on such a path, “exit” becomes extremely

difficult”* –  Financial instability (i.e. bubbles)

139 * White, William, “Ultra Easy Monetary Policy and the Law of Unintended Consequences”, Federal Reserve Bank of Dallas, August 2012

QE needs to be timely

•  Does anyone believe that QE was responding to a liquidity crisis?

•  Central banks (and most commentators) were all behind the curve

140

Problems with implementation of QE

•  Expectations channel

•  “Being surprised why QE doesn’t work when you’re trying to keep inflation expectations at 2% is like being surprised why people don’t have party at a “free” bar if you make it clear that you will remove alcohol from anyone who starts to feel drunk”

But:

•  Even if you credibly commit to limitless alcohol there won’t be a party if everyone is already hungover!

141

Winners and losers

•  Winners: –  “Winners from QE include the City trading desks that

saw the value of their bond portfolios soar. Other beneficiaries include the sovereign bond dealers who passed bonds from the DMO to the Bank at almost no risk, and the commercial banks who gained a supportive source of free funding.”

•  Losers: –  “director general of Saga, Ros Altmann, says: “QE is

the worst thing that could happen to pensions, it is devaluing and destroying pensioners’ income.””

–  Faisal Islam, “The Great Money Mystery”, Prospect Magazine, October 2010

142

Concern about unintended consequences

143

“this enormous economic policy came with

enormous unintended consequences”

Ed Conway, March 5th 2014

http://www.edmundconway.com/2014/03/many-happy-returns-for-the-few-five-years-of-quantitative-easing/

Dynamics of intervention

•  “When QE was first announced, it was the equivalent of emergency surgery. Then, further rounds were needed to help the economic patient recover. The third step was for the Bank of England to hand back to the Treasury the interest it earned on government bonds, in the name of good accounting. And now what was originally a temporary arrangement has been turned into something more permanent.”

•  “The policy had the useful side-effect, as far as governments were concerned, of providing a willing buyer for their bonds at a low interest rate. To be fair, central banks did not buy in the primary market: that is, when the bonds were issued. But the fact that they were buying in the secondary market gave an incentive for private-sector buyers to stump up.”

•  “The British government has in effect ended up with an interest-free loan from its central bank, financed by money creation. The debt has not been formally cancelled, but it might as well have been.”

144 http://www.economist.com/news/finance-and-economics/21600142-central-banks-will-be-financing-governments-permanent-basis-now-you-see-them

Problems

1.  Makes democratic leaders less accountable –  Government financing through central bank rather than

taxation or bond markets 2.  Increases inequality

–  Boosts asset prices held mainly by the rich

•  “Perhaps in ten or 20 years’ time, recent events will be seen as the moment the world crossed a line.”

145 http://www.economist.com/news/finance-and-economics/21600142-central-banks-will-be-financing-governments-permanent-basis-now-you-see-them

Unknown risks

•  “there are nagging concerns that large-scale asset purchases carry with them particular risks to the economy or the health of the financial system that we still don’t understand well.”

•  John Williams, President of the Fed Reserve Bank of San Francisco

•  “Monetary Policy at the zero lower bound” January 16th 2014

146

Rules versus discretion

•  “Market Monetarists do not encourage ad hoc balance sheet expansions as per the practice of QE by the Fed or the BoE. Central banks should set clear and credible expectations for the path of nominal spending, backed up by the threat of an unlimited expansion of the balance sheet.”

•  Britmouse*

•  Ad hoc reductions will be damaging as well. A problem with QE is the implementation and also the extent to which this generates problems for an exit strategy.

147 Comment on Money Illusion, http://www.themoneyillusion.com/?p=12891

Inconsistent with inflation targeting

•  Problem is that BoE have been using QE “within the existing regime of inflation targeting.”*

•  “agents may reasonably believe that the central bank will largely undo the increase in the money stock as soon as it starts to have an important effect on aggregate demand. As a result, expected inflation may not rise, and the open-market purchase may have little effect”

•  David Romer, Advanced Macroeconomics

•  “We now have the odd situation where those warning of impending hyperinflation – the sternest critics of QE – provide the intellectual prerequisites for it to work. By contrast, in pandering to those concerns, its proponents ensure that it will not. I would not recommend it, but for QE to work the BoE needs to up anchor and credibly commit to reckless and rampant inflation.”*

148 * “Anchors aweigh: King has to let UK prices rip” City AM, November 2011 http://www.cityam.com/article/anchors-aweigh-king-has-let-uk-prices-rip

QE exit

•  The Bank of England earns interest on the gilts that it owns –  “After buying £325bn of debt from the market, the

public sector (the Treasury) is paying interest to itself (the BoE) on debt that it owes to itself”*

•  In November 2012 the Chancellor requested that £35bn of interest payments should be passed over to the Treasury

•  Technically, this is just a transfer from one public body to another –  The Bank of England is a public institution and the

Treasury receives half of any profits every 6 months •  Ultimately, when interest rates rise and gilt yields fall the

Bank of England will make a loss on its QE purchases •  This makes 2015 debt targets harder and massages the

figures

149 * Owen, J., “Bank of England should retire QE debt” Financial Times, March 11th 2012 See Lilico, A., “Inflation is too high and switching from QE to outright money-printing ain’t gonna help” Conservbative Home, November 2012

QE exit

•  “QE was supposed not to be money printing because it involved an automatic mechanism for withdrawing the liquidity – namely the coupons and bond redemptions. So over the long-run there was no net injection of money”

•  “it's only by including interest payments on QE gilts in the money withdrawn that QE isn't really money-printing.”

•  “But if the government takes the coupon payment to itself, that means the automatic withdrawal is less than the money injected and QE really does entail money printing – just plain old Weimar-type money printing disguised by an accounting trick. Essentially by taking the interest, the government is essentially forgiving a portion of the real value of its own loans. ”

150 Lilico, A., “Inflation is too high and switching from QE to outright money-printing ain’t gonna help” Conservbative Home, November 2012 [http://www.conservativehome.com/thecolumnists/2012/11/andrew-lilico-inflation-is-too-high-and-switching-from-qe-to-outright-money-printing-aint-gonna-help.html]

QE exit route

•  “After the binge of creating money and buying debt, the received wisdom is that the Bank of England will sell the debt it has purchased back into the market. But this will be deflationary and raise interest rates. It is an unnecessary hangover… Instead of selling the debt back into the market, the BoE can retire the debt.”

•  “The BoE can only embrace debt retirement when two conditions have been fulfilled 1.  The markets and credit rating agencies should

recognise that QE debt is not real debt 2.  The government needs to get its deficit under

control.”

151 * Owen, J., “Bank of England should retire QE debt” Financial Times, March 11th 2012

QE exit route

•  “in theory the Bank of England will eventually sell back to the markets the £350bn or so in gilts it will own as a result of quantitative easing (QE). Yet I doubt this quantitative tightening (QT) will ever happen”

•  “As M&G’s Jim Leaviss points out, the gilt cancellation could take place using the same process and precedent set with the cancellation of £9bn of UK of gilts acquired from the Post Office pension scheme in April 2012. No default would take place (so there would be no CDS trigger and no D from ratings agencies only interested in failures to pay private investors). Of course, the credibility of UK monetary and fiscal policy would be badly shaken – but that is at it should be. We have a major problem – pretending otherwise doesn’t help anybody.”

152 * Heath, A., “We need an open contest to decide who will run the Bank” City AM, April 12th 2012

Redemptions

•  “Investec analyst Philip Shaw commented on the Bank of England's decisions: 'The Monetary Policy Committee did not comment on whether it intends to reinvest the maturing gilts in its QE portfolio, or let the stock run down.

•  'Some £6.6billion of gilts (on a purchase paid basis, not par value) are due for redemption in March, with £8.5billion running off through the course of 2013 as a whole, so the committee needs to signal its intentions soon.

•  'The most logical time to do this would be at next month’s MPC meeting when it can frame the decision against the background of its new projections at February’s Inflation Report.'”

153 This is Money, “Bank of England leaves rates and QE unchanged despite fears of new downturn” January 2013

Why (credible) exit matters

•  Impact of QE: 1.  Increased demand for government bonds will increase

the price 2.  This reduces the yield

•  Therefore investors switch to other assets •  However if people expect further rounds of QE they may

expect that the increase in price (1) will provide a larger boost to the capital sum than they lose through lower yield (2).

•  “The upshot is that, as long as there might be more QE coming, far from money being chased out of bonds into real assets by QE, it might attracted into bonds.”*

•  Hence the end of QE will mean that there’s no capital gain to compensate for the lower yield, –  “Investors might then finally do what the policy might

have been intended to achieve in the first place – sell government bonds and buy real assets.”*

154 * Lilico, Andrew, “Quantitative easing may be most powerful when it ends” Daily Telegraph, June 17th 2013

Impact of QE

•  With expectation of future QE:

•  Once QE finishes:

155 * Lilico, Andrew, “Quantitative easing may be most powerful when it ends” Daily Telegraph, June 17th 2013

Lower bond yields

Higher bond prices

Lower bond yields

Higher bond prices

<

>

Exit strategy

•  Key questions: –  Should the Treasury take interest payments? –  Should you unwind QE (i.e. emergency monetary

policy) before raising interest rates (i.e. returning to conventional monetary policy)?

–  Should the gilts be sold off or written off?

•  The whole point is that we are still speculating about these questions 5 years on. That is why the use of QE has been muddled.

•  We are still asking whether or not QE represent a permanent increase in the monetary base!!

156

Retire the debt?

Favour Against

•  Government doesn’t need to sell debt back onto market

•  Reduced debt burden on taxpayers (from 63% of GDP to 41%)*

•  Explicit monetisation of debt

•  Reduce credit rating? •  Harms central bank

independence

157 * Heath, A., “We need an open contest to decide who will run the Bank” City AM, April 12th 2012

6c. QE-a culpa

158

QE-a culpa

•  My press coverage from 2009-2011 says more about the uncertainty of the period (and interest in heterodox economics) than it does my own expertise.

•  How does what I said at the time stand up?

159

Background

•  Firstly, my aim is to prompt debate. It is not to simulate policy.

•  Hence I’m very resistant to the “don’t just stand there” mentality of a crisis. If I were a policy maker my instinct would probably be closer to action. As an academic my instinct is more contemplative. –  Natural tendency to think of longer term and unseen

effects –  Even if these are outweighed but the short term

necessity for action I still feel I’m doing an important public duty by pointing them out

160

•  “my objective isn't to impress you by how clever I am. It's to participate in a conversation about economic theory and practice that all sides can learn something from. Therefore I don't see why I need to have provide an alternative plan before jumping into the debate - if I convince you that fiscal stimuli very rarely achieve their objectives, you'll need to decide for yourself what the implications are. This reminds me of students that want "an answer". I'm sorry, but that's not my job. It's to provide new information that allows you to provide your own answers. I'm not trying to convince people that my "worldview" is correct, and that you should share it. I'm merely offering fragments of wisdom to allow you to cultivate your own.”

•  February 17th 2010 •  http://thefilter.blogs.com/thefilter/2010/02/has-

quantitative-easing-paid-off-anthony-evans-comment-is-free-guardiancouk.html

161

A side note on data: broad money is growing through 2008!

162 “Liquidity in the age of independence: assessing money supply measures in light of the credit crunch”, Unpublished presentation, 8th November 2008

No warning in Notes and Coin (a measure of narrow money)

163

But UK Austrian Money Supply did contract

164 -4.00

-2.00

0.00

2.00

4.00

6.00

8.00

10.00

12.00

2006 Q1 2006 Q2 2006 Q3 2006 Q4 2007 Q1 2007 Q2 2007 Q3 2007 Q4 2008 Q1 2008 Q2

AMS YoY % Δ

Stealing thunder and lack of confidence

•  The method of constructing the UK Austrian Money Supply has changed since then so I was right to not draw too much emphasis to the warning signs

•  In addition, in January 2010 the Bank of England switched its conventional measure of broad money from M4 to M4ex

165

References

i.  “The semantics of printing money” The Guardian, March 2009

ii.  “The unpalatable financial truth” The Guardian, March 2009

iii.  “Has quantitative easing paid off?” The Guardian, February 2010

iv.  “The Threat of QE2”, Adam Smith Institute, November 2010

v.  “Monetarists’ blind spot on quantitative easing” Institute of Economic Affairs, March 2011

vi.  “To QE Or Not To QE? The Market Has Spoken” Management Today, January 2012

vii.  “Forward thinking”, Money Marketing, May 2011 viii. + The Filter^

166

[i]

•  “1) QE is printing money; and 2) the printing press is already turned on.” •  “the Bank's solution is a larger dose of what caused the original disease.” •  “We are now seeing the inevitable hangover and are faced with choice –

either to go through the painful but necessary recovery (a hangover) or simply to prolong the intoxication… QE is more hair of the dog.”

•  “despite the obfuscatory terminology, QE is nothing new. It is simply an exotic label for a discredited policy – one arm of government buying up the debt of another”

•  “Yes, the Bank of England is purchasing assets on the secondary market (not directly from the Treasury). Yes, the Bank has every intention to mop up this additional liquidity once the economy recovers, but "directness" and "intentions" are largely semantic.”

•  “The biggest danger of QE – one that no economist would deny – is the destructive inflation that it unleashes. We are asked to have confidence that our monetary authorities have both the omniscience to know when inflation will shoot upwards, and the benevolence to act in the public interest when this occurs”

•  “In February 2009 food price inflation rose to 9%, and factory gate inflation is at 3.1%, which might mitigate fears over deflation. We are in for another bout of inflation; another bubble is brewing. The party isn't over” 167

Fears over inflation vs. fears over deflation

168

0.0

1.0

2.0

3.0

4.0

5.0

6.0

CPI 2004-2014

Feb 2009 Inflation falls after my

warning

Mar 2009 - Feb 2010 This is when QE starts

Me: Here’s the inflation Monetarists: Hardly Zimbabwe – this is QE working!

The language issue

•  I’ve been keen to stress that QE is essentially just OMO •  The extent to which commentators label QE as something

distinct may reflect the additional powers being utilised by central banks, over and above merely expansionary OMO

•  Steve Horwitz: –  “To say I am a "staunch defender" of QE1 is to say that

I was in agreement with the size of that expansion, the securities that were purchased, and the dangerous powers the Fed unilaterally seized. And all of those would be false as the written and spoken record would clearly reveal. I have explicitly said that the Fed could have done what was necessary with its existing powers following its long-standing practices. And I have explicitly said that the size of QE1 was excessive as well. QE1 was a large mistake in all the ways noted above.”*

169 http://www.coordinationproblem.org/2011/01/qe1-and-monetary-disequilibrium.html

Orthodox monetary policy

•  In March 2009 I criticised a Financial Times video that attempted to explain QE because it:

•  “propogates the myth that this is fundamentally new policy - as if the Bank of England is only now being "inflationary", and "printing money".”

•  The Filter^ •  http://thefilter.blogs.com/thefilter/2009/03/quantitative-

easing-explained-by-the-ft.html

170

[ii]

•  “Over the last few years we have seen an unsustainable boom that has been financed through impoverishment. During this boom scarce capital has been squandered. Rather than use credit as a foundation for wealth-creation, it was erroneously treated as actual wealth, and consumed”

•  “a decline in output is an important step towards production that more closely matches consumer demand. If GDP growth has been driven by bubble activity, a fall in GDP is therefore an inevitable and necessary stage of recovery.”

•  “Genuine economic growth will only return if relative prices can adjust, malinvestment gets liquidated, and a correction is allowed to occur.”

171

[iii]

•  “To judge whether it worked depends on what would have happened without QE, and economists typically lack the toolkit to engage in rigorous counterfactual analysis.”

•  “Even if we understood better how the economy would look without the actual policy responses, determining whether they "worked" implies we understand the intentions of the primary decision-makers. Only then would we know if the actual outcomes match the intended consequences”

•  “my aim here is to list three things that we do know: 1.  banks have benefited. QE served as a bailout by the back door. By

enlarging the scope of assets it buys, and printing money to fund them, this creates (alas perhaps literally) a get-out-of-jail-free card for profligate bankers.

2.  the inflation risk appears to be lower than first feared. Inflation expectations are contained, and yields remain low. Whether this can be maintained is another matter. The decision to cease QE indicates a concern that the inflation tiger is about to bite. Today's figures show a sharp rise, and we should not ignore the possibility that UK gilts are merely a new bubble.

3.  the rules of the game have changed. The conditions under which QE would be rehabilitated aren't clear.” 172

Banker bashing? Moi?

•  “Whilst many businesses have benefited from being able to issue more commercial paper (as the second Giles video points out), the main beneficiaries have been the banks. For very good reasons the Bank of England is not supposed to directly finance UK government debt. This is the cause of most hyperinflations, and is "one arm of the state directly financing another". But they are able to buy them on the secondary market. This makes a massive arbitrage opportunity for banks that buy up gilts and sell them on to the Bank”

•  The Filter^, February 7th 2010 •  http://thefilter.blogs.com/thefilter/2010/02/qe-1-year-

on.html

173

[iv]

•  Muddled account of what QE was supposed to achiever (then: growth, now: prevent secondary deflation) –  “the perceived failure of quantitative easing to deliver economic growth has led to calls for even more quantitative easing”

•  Hyperinflation and public finance –  “the Bank of England buying assets on the secondary market is essentially a gradation of the policy that Mugabe’s government

has unleashed in Zimbabwe. One arm of government is buying up the debt of the other. We can pretend that those two arms are separate, but that illusion is becoming harder to maintain by the day.”

•  Liquidity vs. solvency –  “The original reason for having a lender of last resort was to provide emergency liquidity during a bank ‘panic’ and to help

unwind unsound banks so that they wouldn’t pose a systemic risk. As time has passed since the first round of QE1 we have realised that it wasn’t merely a short-term liquidity problem, but a fundamental one of solvency. This cannot be cured with a quick gush from the monetary spigot, and direct bailouts merely obscure the distinction between liquidity and solvency problems further.”

•  Inflation isn’t CPI –  “monetarists are right to mock scaremongering about hyperinflation… CPI is above target (3.1%), but not to the extent that I

(and others) feared… [But] We should also remember that inflation could manifest itself in asset price bubbles, for example in the gilt market or emerging markets”

•  Monetary stance –  “those who believe that low interest rates and a fast growing monetary base imply expansionary monetary policy make the same

mistake that economists made during the Great Depression. Then, as now, they were actually signs of an inept central bank failing to offset a fall in the broader money supply.”

•  Exit strategy –  “The excess liquidity that QE creates will find its way into the real economy at some point – possibly after the economy has

already begun to recover naturally – and this is why having an exit strategy is so important. Again, the more confidence markets have in the efficacy of such a strategy, the harder it is for QE to ‘work’, but doubts remain as to whether this can be navigated. Some argue that it’s simple to hike up interest paid on reserves, or possibly even confiscate such reserves when banks begin lending again. However, this overestimates the Bank of England’s ability to anticipate events.”

174

[iv]

•  Monetary disequilibrium –  “There is a plausible free market argument to say that under certain institutional conditions (such as

competitive banks and no moral hazard), increases in the money supply to offset changes in the demand for money would avoid adjustments having to take place through the notoriously ‘sticky’ real economy. In the same way that inflation creates real effects, so does a monetary deflation, and these effects are neither desirable nor necessary.”

•  “Policies like QE increase regime uncertainty and generate systemic instability. They have the potential to make matters worse, and ignore the fact that you cannot buy confidence. The Bank for International Settlements – one of the few organisations that foresaw large elements of the financial crisis – warns about the upside risk of continued low interest rates. Systemic misallocation of capital (including human capital) remains. Excessive risk-taking remains. Over-leveraged balance sheets remain. Volatile capital flows remain.”

•  Positive programme for laissez-faire 1.  “economic recovery will only come when we begin to rebuild the capital stock through investment. And

rather than recapitalise the banks through taxpayer bailouts, it can be done through an increase in voluntary savings”

2.  “the recession itself is a sign that markets are adjusting, and that entrepreneurs are engaging in the recalculation that is required to understand which plans were unprofitable and where capital should be reallocated. Allowing relative prices to adjust as quickly as possible, reducing labour market rigidities, and improving labour mobility will all help with this”

•  QE has run its course –  “There is an alternative to more QE.” –  Now: should have explained what it is good for

175

[v]

•  Orthodoxy of QE –  “He [Tim Congdon] challenges Gordon Brown's portrayal of his own role in the

financial crisis, arguing that instead of the response being his ‘brainchild’ the then Prime Minister required a layman's briefing and did not grasp the orthodoxy of the policy for situations when nominal income is falling”

•  “the best hope for monetary policy was that it prevented the ‘primary recession’ caused by the bubble unwinding turning into a "secondary recession" that sucked in the whole economy.”

•  “just as the monetarist view is too rosy, the Rothbardian view is too pessimistic.” •  Monetary disequilibrium

–  “Austrian economists are happy to acknowledge that under certain theoretical conditions QE can work as Congdon suggests – when the demand for money rises a corresponding increase in the supply can restore monetary equilibrium without forcing an adjustment to take place through prices and output”

•  LOLR (then: should use discount window, now: QE is better than discount window) –  “why can't the Bank of England simply fulfil its traditional role as being lender of

last resort” •  “In a world where central banks exist, this is the mechanism by which we distinguish

between the temporary illiquid to the fundamentally insolvent. And unlike QE it avoids a slew of unfavourable side effects, such as expanding the scope of the Bank of England (by redefining the types of assets and types of institutions they deal with); expanding their discretionary powers; generating regime uncertainty; increasing the upside risk of inflation; and placing epistemic burdens on policymakers that there is no hope they can shoulder.”

176

[vi]

•  'The Bank of England’s policy rate has been historically low for some time now and this cannot continue indefinitely. The aim of low interest rates is to boost the economy by creating incentives to borrow money and invest. But higher capital requirements and policy uncertainty create counter forces that restrict bank lending.

•  'In these circumstances the purported "benefits" of low interest rates fail to materialise, but the costs certainly do. These include the lack of an incentive to save (and actually rebuild banks' balance sheets through voluntary lending), distortions to the capital structure of the economy (making white elephants like the HS2 line appear profitable) and the erosion of people's savings.

•  'The fact that real interest rates (the difference between inflation and the return you get on your savings accounts) is negative is a harmful confiscation of wealth.

•  'When interest rates are close to zero policymakers look to alternatives, and quantitative easing has emerged as their favoured tool. However grateful banks and the financial community are in general to have an injection of freshly-printed money, it’s not clear how much this is helping the real economy. The aim shouldn’t be to preserve the status quo, but to find ways to allow banks to fail without exposing the general public to the fall-out.'

177

[vii]

•  Suspicion that QE will be utilised as a means to generate another boom –  “there can be a fine line between “stabilising MV

(money supply multiplied by velocity)” and “boosting AD (aggregate demand)”” [vii]

•  November 2010 my concerns with QE2 –  “the use of QE to boost aggregate demand (rather than

prevent a liquidity meltdown) is a precedent” –  http://thefilter.blogs.com/thefilter/2010/11/the-

threat-of-qe2.html

178

Anti deflationary vs. inflationary

•  “A further argument that Austrian's might be interested in, is the distinction between an expansion in the money supply to offset an increase in the demand for money, and an expansion in the money supply as a means to stimulate aggregate demand.” November 2010*

•  “QE1 wasn’t inflationary, it was antideflationary, but QE2

would be very dangerous, because there is no shortage of liquidity and the banking system is stronger.” Simon Ward**

179 • Evans, Anthony J., “The emerging view on QE2” The Filter^ http://thefilter.blogs.com/thefilter/2010/11/the-emerging-view-on-qe2.html ** See Faisal Islam, “The Great Money Mystery”, Prospect Magazine, October 2010

[viii]

•  “We are looking at a range of measures to support the economy, to support business and to help people. But nobody is talking about printing money.” Alistair Darling, 8th January 2009

–  “QE isn't a different policy tool, it's an alternative way of using current policy. Whereas OMO means targeting a particular interest rate (and altering the money supply to hit it) QE means targeting a particular quantity of money (and ignoring the interest rate).” Me, Jan 21st 2009*

–  “Any central banker who argues, as some do, that “we set the overnight rate on reserves and we simply accommodate the demand for reserves at that (official policy) rate; therefore, until the official policy rate hits the zero floor there is no quantitative easing as a separate policy instrument” is delirious. This is because the demand for reserves depends not just on the official policy rate, but also on other interest rates and spreads (on public and private assets of different maturitities), some of which can be influenced by the central bank even when the official policy rate is kept constant. This is especially true during times when financial markets are illiquid and disorderly.” Willem Buiter, Jan 11th 2009**

180 * http://thefilter.blogs.com/thefilter/2009/01/quantitative-easing.html ** http://blogs.ft.com/maverecon/2009/01/quantitative-and-qualitative-easing-again/

[viii]

•  Public finance –  “we can expect the Bank to buy a lot of gilts as part of this policy. Is that

"printing money"? The politicians will say no. But any economist would say yes...

–  ... When the Bank of England buys up gilts, one arm of the government is buying up debt owed by another arm of the government in exchange for money created by the central bank. Whether the gilt is brand new, or issued the day before, is quite simply irrelevant.”

–  “That said, there are big practical differences between this policy and Zimbabwe-style money financing. The most important is that the Bank is choosing to buy gilts as a means to an end. It is not being forced to buy them because the government has nowhere else to go.

–  Also - and crucially - the Bank has every intention of unmonetizing the debt when the storm is past”

–  Stephanie Flanders, 18th Feb 2009*

181 * http://www.bbc.co.uk/blogs/legacy/thereporters/stephanieflanders/2009/02/obtaining_the_right_to_print_m.html

Central banks and the gilt market

182 http://www.kaleidic.org/news/2012/12/5/the-unintended-consequences-of-extraordinary-policy.html

BoE have bought around half of all govt debt issued from 2009-2014

183 http://www.edmundconway.com/2014/03/many-happy-returns-for-the-few-five-years-of-quantitative-easing/

QE and public finance

•  Increasingly the Treasury is funding its spending through direct monetisation rather than taxation

•  Almost the entire budget deficit was monetised in October 2011 -  Bank of England bought £16.9bn of gilts -  Treasury needed £176bn

•  In November 2011 -  Bank bought £23.9bn -  DMO issues £11.9bn

184 Allister Heath, 9th February 2011

•  “On any given morning the debt management office (DMO), an arm of the treasury, sold billions of pounds worth of British gilts to the world. Then in the afternoon, barely 400 metres away, the Bank held a reverse auction where it, in effect, bought up billions of similar government debts. Under EU rules it would have been illegal for the DMO and the Bank to trade with one another. So instead the City stepped in, making profits on trading both sides of this bizarre monetary merry-go-round for over a year.”

•  Faisal Islam, “The Great Money Mystery”, Prospect Magazine, October 2010

185

Mea culpa

•  The justification for QE was to prevent a collapse in commercial banks balance sheets and reduction in broad money growth. But the main reason for this problem was an exogenous policy shock, namely an increase in capital requirements.

•  Mea culpa: –  I didn’t have a good grasp at to what was happening to

the money supply at the time - broad money growth data was flawed

–  I was treating the ceteris as paribus, believing that if the problem was regulatory intervention the solution is to remove that intervention, rather than introduce new ones

–  Quibbling about how QE was conducted (and not having a clear alternative) was less important than generating liquidity

–  I placed too much weight on the long term, unintended consequences of QE

186

Mea culpa

•  Then: implement Bagehot through discount window. Keep market liquidity separate

•  Now: the problem was OMO being too narrow. If you have a “small number of counterparties” and a “small subset of “good” securities”, there’s a ““Bagehotian” case can still be made for occasional direct Fed lending”

•  If OMO function well or reformed (i.e. diversify the participants and diversify the assets – then that’s how Bagehot should be implemented.

•  Just add water. Soak with liquidity and see where it goes

187 See Selgin (2012) “L Street Bagehotian Prescriptions for a 21st Century Money Market” Cato Journal 32(2):303-332

Perspectives

Monetarists Me

Wanting to influence policy action and therefore focus on the best way forward

Wanting to inform policy debate, therefore emphasize risks of emerging leitmotiv

Financial crisis was the result of central bank (and other regulatory) incompetence as of 2008

Financial crisis had been (broadly) anticipated and warned about but no one was listening!

Action! Doing something is better than doing nothing

The downsides of policy actions are not negligible and need to be weighed against the upsides

188

6d. Forward guidance

189

190 http://www.bankofengland.co.uk/education/Documents/resources/postcards/forwardcomp.PDF

Unemployment has fallen dramatically

191 http://www.tradingeconomics.com/united-kingdom/unemployment-rate

Does forward guidance solve the prisoner’s dilemma?

•  “The purpose of the guidance was to provide assurance to business that if they did invest, something which had not been happening, they would not be hit with higher interest rate costs for at least two years”*

192 * Alex Brummer, “Low rates saved your savings when the global economy fell off a cliff” This is Money, http://www.thisismoney.co.uk/money/saving/article-2573367/ALEX-BRUMMER-Low-rates-saved-savings.html

Forward guidance and uncertainty

•  “Forward guidance is intended to reduce uncertainty. The fact that it contains specified thresholds gives the appearance of a clear rule that binds the central bank. On the other hand, it also has the potential to increase uncertainty if it is deployed in a discretionary way. The UK growth rate continues to grow at an above-expected rate, with real GDP for Q3 being revised up from 1.5% to 1.9% (compared to the same quarter of the previous year). When the Bank of England chose 7% as the unemployment threshold that would need to be breached prior to interest rates being raised, they forecast that this would occur in 2016. In a matter of months this has been brought forward to 2014 with some commentators predicting it to be imminent. But instead of forward guidance being a way for markets to anticipate interest rate rises, the Bank seem more likely to simply shift the goalposts. Instead of being used to communicate the conditions under which a rate rise would be necessary, it is being used as a tool to convince markets that rates will be kept lower for longer than current expectations. ” January 2014q

•  “The utilisation of a 7% unemployment threshold was intended to show that monetary policy would stay looser for longer than markets had previously thought. In fact, it has shown that the necessity for loose monetary policy is lower than the MPC had thought” March 2014

193 Comments by Anthony J. Evans to Shadow Monetary Policy Committee

FOMC dissent

•  “I dissented from the new guidance for two reasons. The first reason is that the new guidance weakens the credibility of the Committee’s commitment to target 2 percent inflation. The second reason is that the new guidance fosters policy uncertainty and thereby suppresses economic activity. In what follows, I’ll elaborate on these reasons, discuss an alternative form of forward guidance, and conclude by strongly endorsing one aspect of the FOMC’s new forward guidance.”

•  Narayana Kocherlakota – President of the Minneapolis Fed

194

Has forward guidance worked?

•  “They set a threshold for unemployment and thanks to the success of policy – government policy and BoE policy – there is talk about what comes next.”*

•  George Osborne

195 * Giles, C. “BoE’s Mark Carney signals scrapping of forward guidance” Financial Times, January 24th 2014

Forward guidance reduced household confidence

196

Has forward guidance backfired?

197

6e. Negative interest rates

198

Negative interest rates

•  “I think it is a dreadful idea, especially dangerous at the tail end of the crisis” •  Yes, it would cause banks to increase their balance sheet and therefore increase

velocity –  Banks would increase lending –  The public would convert reserves to currency

•  To avoid banks switching from reserves to vault cash you’d need to charge interest on vault cash

•  This opens the door to charging interest on currency (would would allow central banks to create inflation without touching the money supply)

•  Banks would switch from holding reserves to holding Treasuries, pushing their returns down to zero (even negative?)

•  Would cripple the Discount window and Term Auction Facility (would generate double payment)

•  Increases the Feds ability to manipulate interest rates (and away from simply managing the money supply –  Moves from monetary policy to “federally subsidised financial

intermediation”

199 http://www.cato-unbound.org/2009/09/28/jeffrey-rogers-hummel/taxing-banks-holding-reserves

Switching from conventional to emergency policy requires learning

•  “the peak gilt market response to the Bank’s QE policy may not have occurred until the auction purchases began and the market learn about the effects of the policy”

•  Daines, Joyce and Tong 2012 “QE and the gilt market: a disaggregated analysis” Bank of England Working Paper No. 466

200

What role for the Fed?

•  “Call me an old-line Friedmanite, but if the economy must suffer under a central bank, it should be one that is circumscribed as much as possible. That means not giving the Fed additional powers, but stripping it of the powers to pay interest on reserves and to create subsidiary structured investment vehicles (like those with the label of Maiden Lane that made loans to Bear Stearns and AIG), as well as denying it the power to borrow money with its own securities, as Bernanke has advocated. Indeed, let’s go all the way with Friedman, and abolish the discount window, then eliminate all remaining reserve requirements (which the Fed is scheduled to gain the option to do in 2012), remove the Fed’s virtual monopoly on hand-to-hand currency, and while we are at it, prevent it from intervening in foreign exchange markets. Not one of these is essential for controlling the monetary base. Confine the Fed exclusively to open market operations using Treasury securities.”

•  Jeff Hummel

201 http://www.cato-unbound.org/2009/09/28/jeffrey-rogers-hummel/taxing-banks-holding-reserves

7. Federal Reserve

202

Bernanke claimed to be following Friedman

•  “Mr Bernanke’s argument for QE is based on the “portfolio balance” theory which stresses that, when the Fed buys bonds, investors increase their demand for other assets, particularly equities, raising their price and increasing household wealth and spending” Martin Feldstein, FT [http://www.ft.com/cms/s/0/9ba381d0-e6b5-11df-99b3-00144feab49a.html?siteedition=uk#axzz14mP7HBJn]

•  “Implicit in Friedman and Schwartz (1963b) and made explicit by Friedman (1974) and Friedman and Schwartz (1982) is the view that fluctuations in nominal income are the result of deviations between desired and actual money balances. In the short run, such fluctuations result in changes in both output and prices. According to this view, deviations between actual and desired money balances caused by changes in monetary policy are transmitted through the effects of household balance sheets … Ben Bernanke (2010:9) cites the portfolio balance channel as supportive of the Federal Reserve’s large scale asset purchases (LSAPs)” David Beckworth, “The Portfolio Balance Channel of Monetary Policy: Evidence from the Flow of Funds” [http://people.wku.edu/david.beckworth/portfolio.pdf]

203

Portfolio channel

•  Friedman, Milton and Anna Schwartz. 1963. A Monetary History of the United States, 1867 - 1960. Princeton, N.J.: Princeton University Press.

204

But he wasn’t!

205

Friedman Bernanke

Channel of emphasis

Monetary channel

Credit channel

Appropriate response

General liquidity

Targeted bailouts

Hummel, J.R., “Ben Bernanke vs. Milton Friedman” Real Clear Policy January 22nd 2013

Bernanke critique

•  “Mr. Bernanke credits targeted bailouts, starting in December 2007, with providing liquidity almost exclusively to solvent institutions with good collateral. Yet as his graphs demonstrate and his words fail to emphasize, for almost a year Fed sales of Treasury securities offset these injections. In doing so, the Fed was most definitely not acting like a traditional lender of last resort, which calms panics by increasing total liquidity, but was instead merely shifting savings into targeted institutions from other sectors of the economy”

•  Hummel, 2013, “The new central planning”, Wall Street Journal

206

Policy prescriptions

•  New Keynesian – monetary policy doesn’t work so we need fiscal policy

•  Creditists – need to fix the banking sector to repair transmission mechanism

•  Austrian – concerns about igniting a new boom/bust cycle

207

Do bank failures matter?

Yes • There is specific

knowledge that links customers with their banks that can’t easily be transferred to a new bank

• “The economy will tank if the banks go under”

No • Bank failures only

occurred due to branch restrictions

• Fall in NGDP expectations and supply side errors matter more

• Bank failures can be mitigated with (i) bankruptcy provisions; and (ii) encouragement of new entry

208

Or, rather, why do bank failures matter?

•  Friedman and Schwartz –  Resulting fall in broad money

•  Bernanke –  Interruption of intermediation

–  “banking panics contributed to the collapse of output and prices through nonmonetary mechanisms”

–  Bernanke, Ben, "Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression," American Economic Review, 1983, 257-76

209 * Hummel, J.R., “Ben Bernanke vs. Milton Friedman” Real Clear Policy January 22nd 2013

210 http://www.nber.org/papers/w19418.pdf

Most bank failures come after IP

plummets

Fed let market inflation expectations collapse through the floor in 2008


Real shock (housing market) only turned into a recession and then a financial crisis, after nominal income collapse


US response

•  Fed cut interest rates from >5% in September 2007 to 2% in June 2008 –  But Bernanke “was so afraid of inflation at a time of

rising commodity prices (particularly the price of oil) that he sterilized all those bailouts; for every dollar the Fed loaned to a specific institution it pulled a dollar out of the economy through the sale of government securities”*

•  The Fed Funds Rate approached 0% in September 2008 –  QE1 started but the increase in the monetary base was

being offset by the fact they they were paying interest on reserves

•  In December 2008 the FOMC set their target rate at 0%-0.25%

214 * Hummel, J.R., “Ben Bernanke vs. Milton Friedman” Real Clear Policy January 22nd 2013

US QE

Phase Date Amount

QE 1 November 2008 - June 2010 $2.1 trillion

June 2010 (?) £30bn per month

QE 2 November 2010 + $600bn (by Q2 2011)

QE 3 September 2012 $40bn per month

December 2012 $85bn per month

Exit June 2013

May reduce (“taper”) to $65bn per month in September

December 2013 $75bn from January 2014

January 2014 $65bn from February

March 2014 $55bn from April

April 2014 $45bn from May

215

Holdings began to fall as debt matured

In order for QE stock to remain at $2.054

trillion

Interest rates rise following QE

216 See http://www.adamsmith.org/blog/economics/central-banks-cause-low-interest-rates-but-not-by-lowering-interest-rates/

Monetary base fell prior to the 2008 recession

217

Bear Sterns

•  March 2008: the Fed helps J.P. Morgan to purchase Bear Sterns –  “Bear Sterns was the smallest of the five large investment banks”*

•  This is problematic 1.  It offered implicit insurance for the larger financial firms (there was no clarity on whether this was

a one off) 2.  It reduced market volatility, suggesting that this was seen as a successful policy


Lehman and AIG

•  Lehman was fourth largest investment bank •  “Expectations of a rescue had been established by the Bear

Sterns precedent”** •  “It looked like the U.S. economy had made it through the

first year of the crisis with slow growth but without a conventionally-defined recession.”*

•  Unlike Lehman, “AIG was not considered vulnerable by most observers until September 2008” – the revelation that a AAA rated firm was in “deep trouble” was “relatively surprising”*

•  The combined failure of Lehman and AIG “brought all financial firms under vastly increased suspicion and drove the financial crisis from mid-September 2008 onwards”*

219 * Bullard, J., “The Notorious Summer of 2008” University of Arkansas, Quarterly Analysis Luncheon, November 21st 2013 ** White L., 2010 “The rule of law or the rule of central bankers?” Cato Journal 30(3):451-463

8. Rule of Law

220

Central bank as central planner

Controlling interest rates

Controlling structure of

interest rates

Controlling allocation of

credit

221 See Hummel, J., 2011 “Ben Bernanke versus Milton Friedman: The Federal Reserve’s Emergence as the U.S. Economy’s Central Planner” The independent Review 15(4)

Rule of law

•  There’s a debate as to whether or not the Fed exceeded its legal remit –  “The Federal Reserve’s statutory authority is overly

broad, but even so may not be broad enough to cover all of the Fed’s nontraditional actions in the crisis”

–  “One has to read between the lines and off the edge of the page, however, to find authority for the Fed to purchase assets that are not “notes, drafts, and bills of exchange,” or authority to create special subsidiaries to do so”

•  Even if section 13(3) of the Federal Reserve Act does authorise Fed actions their repeated use of it violates the rule of law!

•  They can’t continue to invoke “unusual or exigent circumstances”

222 White, L., 2010 “The rule of law or the rule of central bankers?” Cato Journal 30(3):451-463

Rule of law

•  Examples of violations of the rule of law: 1.  Creation of new facilities to lend to nonbanks 2.  Creation of a subsidiary (Maiden Lane LLC) to protect

Bear Sterns bondholders (note they didn’t do this for Lehman, but did for AIG)

3.  Pressurized Bank of America to complete its acquisition of Merrill Lynch •  Bernanke and Paulson, “pressured [BOA CEO Ken]

Lewis into violating his own legal fiduciary duty to his shareholders, who had to approve the deal based on accurate information. Relying on no legal authority whatsoever, the Fed and the Treasury threatened to remove the board and management of Bank of America if they refused to go forward and demanded that Lewis no divulge the conversation” (Kuttner 2009)

223 White, L., 2010 “The rule of law or the rule of central bankers?” Cato Journal 30(3):451-463 Kuttner, 2009, “Betting the Fed” The American Prospect

Rule of law

•  Larry White’s translation of Ben Bernanke and Neel Kashkari (Treasury)

•  “When we in authority declare that it is time to be pragmatic, then we can do whatever we please. There are no durable principles, no constitutional or statutory constraints, limiting what we may do once we declare an emergency. Our hope of avoiding a deeper crisis authorizes us to make it up as we go along, to do whatever seems expedient at any given moment”

224 White, L., 2010 “The rule of law or the rule of central bankers?” Cato Journal 30(3):451-463

UK

•  Traditional central bank action –  “Asset purchases to boost cash in the banking system”* –  “Lender-of-last-resort assistance to institutions in particular difficulty”*

•  Penalty rates (reduce bank profits) •  Loans to be repaid, not new equity

•  Late 2008 saw direct capital injections •  Government is able to “dictate terms and override shareholder rights”, “a significant

threat to private property rights has emerged” •  October 2008 recapitalization exercise ordered banks (except HSBC) to raise £35bn

capital on the basis of a planning scenario (even if they didn’t feel they needed it). They were required to raise capital and also shrink risk assets (by up to 30%) –  This is a large, negative regulatory shock –  This can be considered a massive reduction in broad money

•  Existing shareholders had an option to subscribe to new equity but “many investors had been traumatised by the British government’s cavalier attitude towards shareholder tights in the recent nationalizations of Northern Rock and Bradford & Bingley. They were understandably nervous about the possible future appropriation of their assets”*

225 * Congdon, T., “Banking, regulation and the role of the central bank” in “Verdict on the Crash”, p.98-99

Regime uncertainty!!

9. European Central Bank

226

ECB has been less aggressive than the Fed/BoE

227

ECB has focused on liquidity provisions

•  Longer Term Refinancing Operations (LTRO) –  Round 2: December 2011: Three year term

http://www.ecb.europa.eu/press/pr/date/2011/html/pr111208_1.en.html

–  Round 1 and 2 added up to €1tn •  Securities Markets Programme (SMP)

–  Purchase of €200bn worth of bonds from struggling countries

–  Limited to €500bn (with €100bn set aside for Spanish banks)*

–  Political issues: use of SMP is temporary and limited

228 “When the chips are down” The Economist, June 23rd 2012

Impact of LTRO

229 http://marketmonetarist.com/2012/02/21/googlenomics-and-how-ltro-might-have-ended-the-euro-crisis/

ECB deposit facility record highs

340

360

380

400

420

440

460

June '10 December '11

€bn

230

Receives 0.25%

interest

No lower bound!

Have the ECB done QE?

•  They’ve engaged in “unconventional” monetary policy –  3-year LTROs –  Reduced collateral standards –  Large increase in balance sheet (and monetary base) –  Bond buying programmes

•  When asked if the ECB was doing QE: –  “each jurisdiction has not only its own rules, but also

its own vocabulary” Mario Draghi*

•  Eurozone banks have only had around half the write downs that US/UK ones have

•  Plus: QE isn’t really “unconventional” anyway!

231 * “Crazy aunt on the loose” The Economist, January 7th 2012

How QE is conducted

•  Can narrow spread between:* –  Short-term and long-term rates

•  In which case buy govt debt –  Government and private rates

•  In which case buy private debt

•  “The Bank of England has stuck firmly to the first route, leaving it to the Treasury to extend credit to the private sector. The Fed has done a bit of both by purchasing federally-backed mortgage bonds as well as Treasuries, but avoided purchases of private assets because of legal and political constraints.

The ECB is in the opposite position to the Fed: circumscribed in its ability to fund governments but at liberty to buy private debt”*

232 * “Crazy aunt on the loose” The Economist, January 7th 2012

Communication

•  ECB’s communication strategy has increased uncertainty

•  “The ECB’s actions have not been communicated to the public ex-ante nor have they been linked to a targeted outcome. In short, the ECB is failing to manage expectations, the most important monetary policy transmission channel at its disposal”

•  David Beckworth

233 http://www.economonitor.com/blog/2012/01/how-to-fix-the-ecbs-communication-problem/

Communication

•  “The ECB offers little ex ante information about its outright asset purchases via the securities markets programme (SMP). The stock of outstanding purchases is only revealed ex post, and no information is published on the composition of that stock, either by maturity or by country of issuer. There is no preannounced schedule of purchases. Market participants thus face substantial uncertainty about when and where the ECB will intervene: this probably serves to reduce the liquidity of the underlying market and precludes the possibility that the market will anticipate the ECB’s actions, helping policy makers to achieve their policy objectives.”

•  Goldman Sachs research paper*

•  “the Goldman economists argue that the ECB is making a similar kind of mistake — not just with the SMP, but with its opaque and unenthusiastic public embrace of all of its unconventional policies. No doubt this is all politically motivated to maintain the pressure on national governments to keep moving towards a fiscal compact, but in the meantime it could be offsetting some of the intended effects of the policies themselves

•  Cardiff Garcia**

234 * See http://www.economonitor.com/blog/2012/01/how-to-fix-the-ecbs-communication-problem/ ** http://ftalphaville.ft.com/2012/01/17/837461/the-ecb-has-a-communications-problem/

Fed vs. ECB

William White: 1.  “The Fed seems to have treated its “non standard” measures

as a substitute for standard monetary policy at the ZLB. In contrast, the ECB treats them as measures to restore market functioning so that the normal channels of the transmission mechanism policy can work properly”

2.  “While the Fed made increasingly firm pre commitments (though still conditional) to keep the policy rate low for an extended period, the ECB consciously made no such pre commitment”

3.  “Whereas the Fed has purchased the liabilities of non financial corporations as well as those of Treasury and Federal agencies, the ECB has lent exclusively to banks and sovereigns”

4.  “While the ECB conducted only repos, in order to facilitate “exit” from non standard measures, the Fed made outright purchases”


10. Topics

236

10a. Balance sheet recession

237

Basic argument

•  Begins with a debt-fuelled asset price bubble –  Japan housing 1992 –  US housing 2007

•  When the bubble bursts the value of people’s assets collapses, but the value of their liabilities remain –  Balance sheets are “under water”

•  Balance sheet repair –  Private sector deleveraging (increase savings, pay off debt) –  Trying to reduce debt, rather than maximise profit

•  This reduces AD and generates a prolonged slump •  Central bank can’t do much:

–  People don’t want to borrow (therefore low interest rates aren’t enticing)

–  People draw down bank deposits to pay debt (money supply contracts and money multiplier becomes 0)

–  Lenders themselves (i.e. banks) have their own balance sheet problems

238 Koo, Richard, C., 2011, “The world in balance sheet recession: causes, cure and politics” Real-World Economics Review, Issue 58

How do we grow out of debt?

•  If and only if:

239

€

Δdebt = d(r − g)−ρ

Where d = existing stock of debt r = real interest rate i = nominal interest rate π = inflation rate g = real GDP growth rate ρ = primary budget balance

http://www.economist.com/blogs/dailychart/2011/11/debt-dynamics-0

€

d(i −π − g) < ρ

Debt reducers: Low i High π High g Positive ρ

Bank lending and recovery

•  Empirical support: –  Recoveries following financial crises are inherently

weaker (Reinhart and Rogoff)

•  However this has been challenged –  “We find that the regularity that recoveries are

systematically slower in the aftermath of financial crises does not hold for the postwar United States. The pace of the expansion after recessions seems to reflect deliberate aggregate demand policy. A weak lending outlook does not appear to pose an insurmountable obstacle to the functioning of stimulative aggregate demand policies”

–  Nelson and Lopez-Salido (2009)

240

Lending and spending

•  “changes in private nonresidential fixed investment precede changes in business sector credit market debt and bank lending, and changes in private residential fixed investment precede changes in bank lending.”

•  “U.S. household sector spending provides statistically significant information about future household sector lending, but not the other way around.”

•  “The ability and willingness to take on debt arguably is income constrained. Thus we might expect to see changes in income and spending precede changes in lending”

•  “increased lending is simply one possible consequence of an adequately expansionary monetary policy.”

•  Sadowski, M., “Does lending cause nominal spending, or does nominal spending cause lending?” Historinhas, June 14th 2014

•  http://thefaintofheart.wordpress.com/2014/06/14/does-lending-cause-nominal-spending-or-does-nominal-spending-cause-lending/

241

NGDP vs. balance sheet recession

•  Alternative explanation (Scott Sumner*): –  Recession caused by tight money –  Tight money reduces nominal income –  Bigger declines in spending in more highly indebted

areas (because most debts are nominal)

•  David Beckworth**: “the weak economic recovery is a failure of policy to fully restore aggregate demand, nothing more”

•  Vuk Vukovic***: “increase in government deficits may introduce the uncertainty that causes deleveraging to occur” –  We should factor in the structural problems at the

onset of the crisis (i.e. not simply an AD shock out of no where) and the regime uncertainty caused by big players (government and central bank)

242 * http://www.themoneyillusion.com/?p=11961 ** http://macromarketmusings.blogspot.co.uk/2011/12/weak-recovery-is-policy-failure.html *** http://im-an-economist.blogspot.co.uk/2013/04/richard-koos-balance-sheet-recession.html

10b. Savings and forced savings

243

The paradox of thrift

•  If everyone tries to increase their savings rate (as a proportion of income), this would reduce AD, and everyone’s income would fall

•  Hence an increase in savings rate can reduce economic activity

•  However: –  If the increase in savings is used to pay off debt lenders

will be able to increase their supply –  If the reduction in debt makes borrowers more solvent

the lenders will be more confident about lending –  If the current debt level is unsustainable an increase in

savings may reduce total consumption (in the short run) but increase sustainable consumption

–  See Lilico, Andrew, “Forget the paradox of thrift” Daily Telegraph, October 6th 2011

244

11. Indicators

245

Conference Board’s 7 leading indicators

1.  Order Book Volume (source: Confederation of British Industry)

2.  Volume of Expected Output (source: Confederation of British Industry)

3.  Consumer Confidence Indicator (source: European Commission)

4.  FTSE All-Share Index (source: FTSE Group) 5.  Yield Spread (source: Bank of England) 6.  Productivity, Whole Economy (Office for National Statistics) 7.  Total Gross Operating Surplus of Corporations (Office for

National Statistics)

246

OECD Composite Leading Indicators

•  Attempt to uncover trends •  Indicators that have ups and downs similar to the business

cycle – but anticipate turning points (by 6-9 months) •  Calculated monthly for 33 OECD and several non OECD

countries •  Comprised of

–  Orders and inventory changes –  Fin market indicators (share prices) –  Bus confident surveys –  Key sectors and trading partners

•  Downward CLI implies slow growth and possible recession •  Upward CLI implies impending recovery

247 See https://www.youtube.com/watch?v=UY8iPW0GVAo

CLI 2012-2014

248

97.5

98

98.5

99

99.5

100

100.5

101

101.5

United Kingdom United States Euro area (18 countries) China (People s Republic of)

LIBOR-OIS Spread

•  A measure of uncertainty •  See Sengupta, and Tam, “The LIBOR-OIS Spread as a

Summary Indicator” Federal Reserve Bank of St. Louis Economic Synopsis, 2008, No.25

249 Bullard, J., “The Notorious Summer of 2008” University of Arkansas, Quarterly Analysis Luncheon, November 21st 2013

LIBOR-OIS Spread

250 Bullard, J., “The Notorious Summer of 2008” University of Arkansas, Quarterly Analysis Luncheon, November 21st 2013

11a. Money and financial markets

251

11b. Output and the labour market

252

Purchasing Managers’ Index (PMI)

•  Published monthly by Markit Economics •  Available early •  Not revised •  Same methodology across different countries •  Covers all private sector activity •  Tracks variables such as:

–  Output –  New orders –  Stock levels –  Employment and prices across the manufacturing,

construction, retail and service sectors –  (i.e. not based on opinion)

253 http://www.markiteconomics.com/Public/Page.mvc/AboutPMIData

Unemployment

•  Unemployment rate is the number of people available and looking for work, as a proportion of the working population

•  Provides an indication of the amount of economic activity •  By showing the level of pressure on the supply of labour, it

gives an indication of pressure on wages, and thus prices •  Measured in two ways:

1.  Claimant count – the no. of people eligible for, and claiming, social security payments (i.e. Job Seekers Allowance)

2.  Labour Force Survey (LFS) – survey of households asking whether people are looking for, and available to start work

256

Nominal wage rigidities

257

“Here, it seems to me, is rather compelling evidence of wage stickiness, as indicated by the utter failure of hourly compensation to adjust downward in response to a massive collapse of spending” George Selgin

http://www.freebanking.org/2012/07/12/reply-to-salerno/

Nominal wage rigidity

•  “Nominal wages are very sticky and NGDP is very volatile. So when NGDP falls there is less money to pay workers, and rather than taking nominal wage cuts you get lots of workers sitting on the floor—unemployment. Britmouse has a couple graphs that show this pattern for Britain. (Read his post for a full explanation.) He used NGDP at basic prices net of taxes, which is the funds available to pay workers. Notice that when NGDP plunged in 2008-09, the real wage defined as W/NGDP per capita soared, and so did unemployment”

•  Scott Sumner •  http://www.themoneyillusion.com/?p=19072

258

Nominal hourly wages

•  Quarterly labour market statistics have an estimate of nominal hourly wages

–  IMPORTANT NOTE REGARDING LFS EARNINGS ESTIMATES

–  Gross weekly and hourly earnings data are known to be underestimated in the LFS. This is principally because of proxy responses.

–  Also, respondents whose hourly pay is £100 or over are excluded from the estimates.

259 http://uneconomical.wordpress.com/2013/01/28/on-uk-hourly-wages/

Average weekly earnings

260

261

-4

-2

0

2

4

6

8 Ja

n 07

Apr

07

Jul 0

7

Oct

07

Jan

08

Apr

08

Jul 0

8

Oct

08

Jan

09

Apr

09

Jul 0

9

Oct

09

Jan

10

Apr

10

Jul 1

0

Oct

10

Jan

11

Apr

11

Jul 1

1

Oct

11

Jan

12

Apr

12

Jul 1

2

Oct

12

Jan

13

Apr

13

Jul 1

3

Oct

13

Jan

14

Apr

14

Jul 1

4

Private sector Public sector

A measure of tight money

262

Too loose

Too tight

Britmouse: nominal GVA data from ONS series ABML [edit: note this is Nominal GVA at basic prices] and a population count from ONS series MGSL, which is 16+ population

http://uneconomical.wordpress.com/2013/01/28/on-uk-hourly-wages/

Apparently close relationship between firms' worries about sales & unemployment


Household liquidity demand (measured broadly) vs. U6 (i.e. broad) unemployment


11c. Costs and prices

265

The Economist house price index

•  The Economist looks at the following measures –  House price index –  Prices in real terms –  Prices against average incomes –  Prices against rents

•  All of them show massive gains in the 2000-2005 period, spiking in 2007/08, a sharp contraction and then levelling out to 2015

•  A similar pattern exists for many countries –  House prices were higher in the UK than US because

planning restrictions make the supply of housing more price inelastic

•  UK saw a fall in house prices •  US saw gluts of housing (especially capital

intensive ones like condominiums)*

266 See http://www.economist.com/blogs/dailychart/2011/11/global-house-prices * The Economist, “The great divide” April 28th 2012

Britain vs. US

268 http://www.economist.com/node/21553459

House Price Index (HPI) - ONS

269

HPI

270 http://www.ons.gov.uk/ons/infographics/housing-costs-in-inflation/index.html

Comparison

271 http://www.ons.gov.uk/ons/infographics/housing-costs-in-inflation/index.html

Nationwide

272 http://www.nationwide.co.uk/~/media/MainSite/documents/about/house-price-index/Jun_2014.pdf

Halifax

273 http://www.lloydsbankinggroup.com/Media/economic-insight/halifax-house-price-index/

Real average house price (Jan 1983)

274

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

1997 1998 2000 2001 2003 2004 2006 2007 2009 2010 2012 2013

http://www.lloydsbankinggroup.com/Media/economic-insight/halifax-house-price-index/

11d. International economy

275

About

•  Kaleidic Economics is a business roundtable that meets each quarter in London

•  We use "kaleidic" to mean two things. It reflects the eclectic approach we take to understanding economics, and the various traditions upon which we draw. More specifically, it is a metaphor for the economic system as a cascading pattern, rendering point predictions impossible

•  Director: Anthony J. Evans •  Email: [email protected]

276 (cc) Anthony J. Evans 2014 | http://creativecommons.org/licenses/by-nc-sa/3.0/

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Economy & Finance

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