One of the fundamental tenets of effective central banking is independence from meddling politicians. While in most countries, a nominated head of the central bank must be given confirmed by the national legislature, it is generally regarded as detrimental for the government to be meddling in the decision making process of the central bank. That being said, high-level political oversight of central bank operations is a necessity.
After yesterday's shock and awe announcement from Europe's leadership which includes: 60B euros in government bond purchases by the ECB; 440B euros in loans or guarantees; as well as potentially 250B euros from the IMF (read America), I have yet to read any reaction to the apparent loss of ECB independence from Europe's politicians. Just last Thursday, Trichet stated unequivocally in a Q&A period that ECB purchases of government bonds had not been discussed at the most recent rate decision. Then in a complete 180 on the issue, on Sunday evening the ECB announced that they will be buying government bonds (along with the reintroduction of a number of liquidity facilities).
Admittedly, market volatility was very high Thursday and Friday, and the liquidity facilities existed during the earlier financial crisis. That being said, I am having an awfully hard time believing that the ECB did a complete 180 on the topic of QE over the course of one and a half trading days without enormous pressure from Euro zone politicians. If my convictions turn out to be rooted in fact, such overt political meddling does not bode well for the future of effective central banking.
Showing posts with label Monetary Policy. Show all posts
Showing posts with label Monetary Policy. Show all posts
Monday, May 10, 2010
Monday, March 29, 2010
Jeremy Grantham Weighs In on Where We Stand and What is to Come
I recognize Jeremy Grantham as a very intelligent person, and always take time to ruminate on his opinions at considerable length. Although not quite headline news any more, as it was released in January, GMO's Quarterly Letter is definitely worth a read. Mr. Grantham speaks highly of the re-emergence of Volcker in the regulation debate, and very lowly of the Supreme Court ruling to remove caps on corporate political donations (ironically, in defense of free speech - who are they kidding?). But I digress.
Given that his publication marked the turn of the decade, Mr. Grantham offered his opinions on what the coming decade had in store, as well as reviewing his firm's predictions over the last decade. Looking forward, Mr. Grantham is not particularly optimistic:
"I still believe that after the initial kick of the stimulus, we will move into a multi-year headwind as we sort out our extreme imbalances. This is likely to give us below-average GDP growth over seven years and more than our share of below-average profit margins and P/E ratios, so that it would feel more like the bumpy (bumpy, but not so disastrous) 1970s than the economically lucky 1990s and early 2000s."
Broadly, I agree with this forecast, which is quite similar to that of Mr. El-Erian of PIMCO (more on Mr. El-Erian in some other post). Admittedly, the conclusions of his analysis are not particularly novel. However, I consider the following observations particularly astute.
"Now, though, after our massive stimulus efforts, the Fed’s balance sheet is unrecognizably bad, and the government debt literally looks as if we have had a replay of World War II. The consumer, meanwhile, is approximately as badly leveraged as ever, which is to say the worst in history. Given this, we would be well advised to avoid a third goaround in the bubble forming and breaking business. Up until the last few months, I was counting on the Fed and the Administration to begin to get the point that low rates held too long promote asset bubbles, which are extremely dangerous to the economy and financial system. Now, however, the penny is dropping, and I realize the Fed is unwittingly willing to risk a third speculative phase, which
is supremely dangerous this time because its arsenal now is almost empty." (Grantham's emphasis)
As far as I am concerned, it is this insight which should be the crux of any policy debate moving forward. There really is no room for error moving forward. In "This Time is Different", Reinhart and Rogoff calculated that government debt expands 86% in the 3 years following a domestic banking crisis. Assuming history is any guide (a classic folly, but current deficit figures are mind-numbing, lending support to Reinhart and Rogoff's findings) this implies that there won't be any more room on the government balance sheets to bear the costs of any further crises. The Fed's balance sheet stands at $2.4 trillion. How much larger can it realistically get without threatening the government's financial integrity? While there are strong arguments for extreme monetary stimulus, every meeting the Fed decides to hold off on raising rates, they increase the probability of inflating another asset bubble. This has the effect of inching the global economy (back) towards the precipice through the heightened risk of future asset bubbles, while simultaneously hauling it from the brink via extremely accommodative monetary policy. Are the benefits of loose monetary policy worth the risk of catastrophe in the form of another ugly asset bubble? I cannot claim to have this grand calculus mastered, but I sure would like to hear this question being asked a little more often.
Back to Grantham's piece. From this discussion, he ruminates on where investors may find value in the coming decade, as well as reviewing his calls from the end of 1999, which are amazingly accurate. For those who don't have time to read it, he considers the S&P 500 to be worth something around 850 (keep in mind that this was published in January and therefore this figure may have changed). Definitely worth the half hour it will take to read the report in its entirety.
Given that his publication marked the turn of the decade, Mr. Grantham offered his opinions on what the coming decade had in store, as well as reviewing his firm's predictions over the last decade. Looking forward, Mr. Grantham is not particularly optimistic:
"I still believe that after the initial kick of the stimulus, we will move into a multi-year headwind as we sort out our extreme imbalances. This is likely to give us below-average GDP growth over seven years and more than our share of below-average profit margins and P/E ratios, so that it would feel more like the bumpy (bumpy, but not so disastrous) 1970s than the economically lucky 1990s and early 2000s."
Broadly, I agree with this forecast, which is quite similar to that of Mr. El-Erian of PIMCO (more on Mr. El-Erian in some other post). Admittedly, the conclusions of his analysis are not particularly novel. However, I consider the following observations particularly astute.
"Now, though, after our massive stimulus efforts, the Fed’s balance sheet is unrecognizably bad, and the government debt literally looks as if we have had a replay of World War II. The consumer, meanwhile, is approximately as badly leveraged as ever, which is to say the worst in history. Given this, we would be well advised to avoid a third goaround in the bubble forming and breaking business. Up until the last few months, I was counting on the Fed and the Administration to begin to get the point that low rates held too long promote asset bubbles, which are extremely dangerous to the economy and financial system. Now, however, the penny is dropping, and I realize the Fed is unwittingly willing to risk a third speculative phase, which
is supremely dangerous this time because its arsenal now is almost empty." (Grantham's emphasis)
As far as I am concerned, it is this insight which should be the crux of any policy debate moving forward. There really is no room for error moving forward. In "This Time is Different", Reinhart and Rogoff calculated that government debt expands 86% in the 3 years following a domestic banking crisis. Assuming history is any guide (a classic folly, but current deficit figures are mind-numbing, lending support to Reinhart and Rogoff's findings) this implies that there won't be any more room on the government balance sheets to bear the costs of any further crises. The Fed's balance sheet stands at $2.4 trillion. How much larger can it realistically get without threatening the government's financial integrity? While there are strong arguments for extreme monetary stimulus, every meeting the Fed decides to hold off on raising rates, they increase the probability of inflating another asset bubble. This has the effect of inching the global economy (back) towards the precipice through the heightened risk of future asset bubbles, while simultaneously hauling it from the brink via extremely accommodative monetary policy. Are the benefits of loose monetary policy worth the risk of catastrophe in the form of another ugly asset bubble? I cannot claim to have this grand calculus mastered, but I sure would like to hear this question being asked a little more often.
Back to Grantham's piece. From this discussion, he ruminates on where investors may find value in the coming decade, as well as reviewing his calls from the end of 1999, which are amazingly accurate. For those who don't have time to read it, he considers the S&P 500 to be worth something around 850 (keep in mind that this was published in January and therefore this figure may have changed). Definitely worth the half hour it will take to read the report in its entirety.
Wednesday, March 24, 2010
Fed Paper on Asset Purchases
The Federal Reserve recently published a noteworthy paper on the Large Scale Asset Purchase (LSAP) programs. A little background: when the Federal Reserve reach the effective lower bound of traditional monetary policy in December 2008 (Fed Funds rate between 0 and 25 basis points), they had a strong conviction that the economy was in need of more stimulus than the ultra-low Fed Funds rate was providing. Specifically, Fed staffers were looking to lower long term borrowing rates, a goal which cannot be achieved by manipulating the short end of the yield curve. This forced the Fed to resort to unconventional monetary policy. The desired effects were ultimately obtained through 3 LSAPs which, combined, totaled over $1.7 trillion. The purchases were divided as follows: (1) $300 billion worth of Treasuries concentrated in the 2-10 year term (2) $175 billion in agency debt and (3) $1.25 trillion in agency mortgage backed securities. As the latter two of these facilities are scheduled to wind down at the end of the month (the Treasury purchase program ended in October) the Fed published a timely paper discussing the execution and cumulative impact of the LSAPs on long term interest rates.
The Fed figures that the impact of their purchases were twofold. Initially, most of the impact can be attributed to increased liquidity in the targeted markets, thereby reducing the enormous liquidity premiums present in these markets in early 2009. The second impact was what they termed the "portfolio effect", the mechanics of which are essentially as follows: by purchasing such an enormous volume of securities currently held on private balance sheets, the supply of said securities is meaningfully reduced, increasing their price and reducing their yields. The purchases also create more reserves in the system, and force investors to turn to other markets in the search for yield, thereby bringing down interests rates (and borrowing costs) in a wide cross-section of markets. The sheer size of these purchases is put in perspective as
"22 percent of the $7.7 trillion stock of longer-term agency debt, fixed-rate agency MBS and Treasury securities outstanding at the beginning of the LSAPs...We believe that no investor - public or private - has ever accumulated such a large amount of securities in such a short period of time"
I had not given it much consideration, but I was quite surprised by how large this proportion was. Armed with this knowledge, I am (even) more willing to accept the conclusions of the study. The qualitative discussion is brought to a close with the statement that, as a result of the portfolio effect, "the winding down of LSAPs need not cause a meaningful rise in market interest rates". In other words, the effects of these programs are seen as largely permanent (a point of much contention in the markets) by the Fed.
Also included are number of statistical analyses (primarily event studies) designed to determine the cumulative impact of the operations on long term yields. A number of classes of securities are examined. The results are as follows (for the baseline 8-event set): 2y Treasury, -34 basis points (bps); 10y Treasury, -91 bps; 10y agency debt, -156 bps; Agency MBS, -113 bps; 10y term premium, -71 bps; 10y swap, -101 bps; Baa index, -67 bps. I was not surprised by the conclusions of their study - in fact I fully agree - but proving it statistically is no enviable task. There is just too much noise. All told, the discussion preceding the statistical analysis, as well as the charts (two of which are below) are definitely worth a read. The statistical analysis, on the other hand, was a bit of a slog.
The Fed figures that the impact of their purchases were twofold. Initially, most of the impact can be attributed to increased liquidity in the targeted markets, thereby reducing the enormous liquidity premiums present in these markets in early 2009. The second impact was what they termed the "portfolio effect", the mechanics of which are essentially as follows: by purchasing such an enormous volume of securities currently held on private balance sheets, the supply of said securities is meaningfully reduced, increasing their price and reducing their yields. The purchases also create more reserves in the system, and force investors to turn to other markets in the search for yield, thereby bringing down interests rates (and borrowing costs) in a wide cross-section of markets. The sheer size of these purchases is put in perspective as
"22 percent of the $7.7 trillion stock of longer-term agency debt, fixed-rate agency MBS and Treasury securities outstanding at the beginning of the LSAPs...We believe that no investor - public or private - has ever accumulated such a large amount of securities in such a short period of time"
I had not given it much consideration, but I was quite surprised by how large this proportion was. Armed with this knowledge, I am (even) more willing to accept the conclusions of the study. The qualitative discussion is brought to a close with the statement that, as a result of the portfolio effect, "the winding down of LSAPs need not cause a meaningful rise in market interest rates". In other words, the effects of these programs are seen as largely permanent (a point of much contention in the markets) by the Fed.
Also included are number of statistical analyses (primarily event studies) designed to determine the cumulative impact of the operations on long term yields. A number of classes of securities are examined. The results are as follows (for the baseline 8-event set): 2y Treasury, -34 basis points (bps); 10y Treasury, -91 bps; 10y agency debt, -156 bps; Agency MBS, -113 bps; 10y term premium, -71 bps; 10y swap, -101 bps; Baa index, -67 bps. I was not surprised by the conclusions of their study - in fact I fully agree - but proving it statistically is no enviable task. There is just too much noise. All told, the discussion preceding the statistical analysis, as well as the charts (two of which are below) are definitely worth a read. The statistical analysis, on the other hand, was a bit of a slog.
Friday, March 19, 2010
Bank of Canada's Next Move?
Lately there has been a slew of good economic data out of Canada. Employment, retail sales, housing starts, you name it, they have all beat expectations this month.
This trend continued today with some surprising CPI data. Core CPI came in at 2.1% versus expectations of 1.7%. For those of you not fully in touch with what's going on up North, allow me to fill you in. On 21 April 2009 the Bank of Canada (BoC) reduced the overnight rate to the effective lower bound of .25% and pledged to keep it there until the end of Q2 2010, "conditional on the outlook for inflation". The BoC also effectively put their money where their mouth was by "rolling over a portion of its existing stock of one- and three-month term Purchase and Resale Agreements (PRAs) into six- and twelve-month terms at minimum and maximum bid rates that correspond to the target rate and the Bank Rate, respectively." Since then, at each Fixed Announcement Date (FAD), the same (now tiresome) message has been repeated. To paraphrase somewhat, it is as follows: 'the outloook for inflation remains steady, therefore we aren't going to hike until the end of Q2 2009, conditional on the outlook for inflation.'
Well, now the game has changed. In their quarterly Monetary Policy Report, published in January, the BoC forecast core inflation to average 1.6% in Q1 and 1.7% in Q2. If this were to materialize, it was implicit that rates would stay on hold. With core CPI in January coming in at 2% and now a 2.1% print in February, this forecast is beginning to look sanguine. The BoC shrugged off higher than expected inflation in their press release after the FAD on 2 March, stating that it was "the result of both transitory factors and the higher level of economic activity". With inflation being more sticky than expected and the next FAD scheduled for 21 April, there should be some vigorous debate behind closed doors at the BoC over the next few weeks. Governor Mark Carney (formerly of Goldman Sachs for all you conspiracy theorists out there) holds the veto at FADs. He is highly regarded in Canada for his handling of the crisis and is surely aware that a lot of the BoC's credibility rests on the right decision on 21 April.
Addendum:
The BoC has repeatedly fingered the strengthening Canadian dollar as a downside risk to inflation. Ironically, traders have been bidding up the Canadian dollar of late in expectation of a rate hike by the BoC. If this momentum trade continues, the feedback on inflation could provide Governor Carney the inflation data necessary to eschew the very rate hike that said traders are looking for.
This trend continued today with some surprising CPI data. Core CPI came in at 2.1% versus expectations of 1.7%. For those of you not fully in touch with what's going on up North, allow me to fill you in. On 21 April 2009 the Bank of Canada (BoC) reduced the overnight rate to the effective lower bound of .25% and pledged to keep it there until the end of Q2 2010, "conditional on the outlook for inflation". The BoC also effectively put their money where their mouth was by "rolling over a portion of its existing stock of one- and three-month term Purchase and Resale Agreements (PRAs) into six- and twelve-month terms at minimum and maximum bid rates that correspond to the target rate and the Bank Rate, respectively." Since then, at each Fixed Announcement Date (FAD), the same (now tiresome) message has been repeated. To paraphrase somewhat, it is as follows: 'the outloook for inflation remains steady, therefore we aren't going to hike until the end of Q2 2009, conditional on the outlook for inflation.'
Well, now the game has changed. In their quarterly Monetary Policy Report, published in January, the BoC forecast core inflation to average 1.6% in Q1 and 1.7% in Q2. If this were to materialize, it was implicit that rates would stay on hold. With core CPI in January coming in at 2% and now a 2.1% print in February, this forecast is beginning to look sanguine. The BoC shrugged off higher than expected inflation in their press release after the FAD on 2 March, stating that it was "the result of both transitory factors and the higher level of economic activity". With inflation being more sticky than expected and the next FAD scheduled for 21 April, there should be some vigorous debate behind closed doors at the BoC over the next few weeks. Governor Mark Carney (formerly of Goldman Sachs for all you conspiracy theorists out there) holds the veto at FADs. He is highly regarded in Canada for his handling of the crisis and is surely aware that a lot of the BoC's credibility rests on the right decision on 21 April.
Addendum:
The BoC has repeatedly fingered the strengthening Canadian dollar as a downside risk to inflation. Ironically, traders have been bidding up the Canadian dollar of late in expectation of a rate hike by the BoC. If this momentum trade continues, the feedback on inflation could provide Governor Carney the inflation data necessary to eschew the very rate hike that said traders are looking for.
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