Is inflation targeting still a macroprudential goal for central banks? What does a large foreign exchange reserve means?

Concerns about recent Fed hiking was also about the years of undershooting inflation targets set by the Fed, and the Fed behind the curve with respect to rising inflationAccordingly, policy should be set with a view to achieving modestly above-target inflation, perhaps 2.3 or even 2.5 per cent, during a boom with the expectation that it will decline during the next recession. A higher inflation target would entail easier policy in the future. Given below 2% inflation as norm now given changing demographics to an aging population and smaller workforce with more reliance on technology integration, setting FFTR to 2% in the long term seems more of managing the market’s inflation expectations as it is equally important to managing inflation, though market don’t seem to have the same market expectations as seen from TIPS or breakeven rates, and neither did core CPI overshoot 2%. Besides, when the market is in disbelief of the Fed target, would heightening the inflation target expectations in the long term changed business expectations and caused the economy to overshoot to close the nominal slack? Or, given the must earlier hike despite before the economy have yet to overshoot, is the Fed implicitly saying 1% inflation is their new target, the new norm? Image.png

A major factor behind the need for a potential rethink on flexible inflation targets: the low level of the neutral interest rate, the short-term rate which neither stokes nor slows economic growth. A below 2% inflation might be here to stay if we continue to see slow productivity growth and high global saving. A low neutral inflation rate constrains how high the Fed can lift rates without harming the economy and thus gives it less room to cut them in a downturn. 

That said, some argue that the Fed should adopt a goal for the growth of nominal gross domestic product, rather than focusing on a price index. A switch in strategy would promote a stronger economic expansion by encouraging consumers and companies to spend more. That would allow the Fed to eventually raise interest rates to higher levels. While targeting nominal levels to follow some path, some doubt it works in practise. Assumptions for nominal level targeting to work are: forward looking private sector where expectations about future economic conditions are factored into today’s economic decisions, and central banks must convince the private sector to believe that they will be credible in meeting its price level target, despite some deviations from other goals like stable inflation from time to time. Fortunately, these challenges have been experienced real hand by the Swedish Riksbank in 1930s after Sweden was forced to abandon the gold standard.

Some also argued that bygones should be bygones and past undershooting should not be compensated by today’s overshooting. Similar to targeting inflation rate, its targeting nominal GDP growth. Its also known as the “speed limit policy” because central bank tightens policy whenever nominal GDP growth is above their target and loosens when it is below. But its advantages and disadvantages are much like inflation rate targeting. It performs well in stable times but its scope is limited when policy rates are near effective ZLB. Following recession, they imply a much earlier tightening of policy rates than inflation targeting. Only difference is that, growth rather than unemployment or inflation becomes the central bank goal.

However, if a 1% inflation rate is a good buffer that can absorb periodic business disruption and keep the economy away from deflation (falling CPI price index), it is good enough for now. It points to a fact that, without deflationary pressures, banks are hoarding more cash in a tighter regulatory framework (Basel III) and consumers are putting off purchases by saving more of their income, given a secular stagnation as hypothesis by Larry Summers and a volatile labour market thats disrupted by technology and displacing workers to retraining. Perhaps, we could do more than just inflation targeting and go beyond the toolbox of monetary policies, to improving labour productivity and mobility. 

Besides short term policy interest rates and inflation expectations, the Fed plans to start shrinking its balance sheet “relatively soon” (expecting to start Sep/Oct 2017), by not reinvesting “a series of caps” at most (not exactly) $50bil of near retiring C/P-STRIPS each month following its monthly cycle of weekly Treasury auctions of various maturities, despite looking through weaker inflation expectations. But the treasuries are lumpy. Some months the cap will be binding, then the next month there will be tens of billions of room under the cap. Say the cap is met every month, it takes (4244-789)/50 = 69 months or 6 years to normalise the balance sheet. Is this too long? No, as it has deflationary pressure on prices as treasuries and MBS are sold to markets, similar to a interest rate hike. The last thing the Fed wants is a stock market that more than corrects, into a bear market. Liquidity will be tight when margins available are low, when equities as collateral loss value and financing cost increases.

It used to be that monetary policies were used hand in hand with fiscal policy, with the monetary committee being autonomous and independent from government politics, focusing only on policies. Price stability with modest growth, low unemployment, exchange rate stability, money supply in the domestic and international economy (printing cash and issuing bonds), as well as a lender of last resort in times of crisis, were the central bank goals. But since 2008, the Federal Reserve have been the superstar, doing all the heavy lifting to stimulate the anemic growth. When did economic growth became a central banks’s goal?

Yellen said “Future policy makers might choose to consider some additional tools that have been employed by other central banks, though adding them to our toolkit would require a very careful weighing of costs and benefits and, in some cases, could require legislation”. She suggested that a future rethink of economic policy should not be confined to just the Fed. Fiscal policy makers, for instance, could beef up so-called automatic stabilizers in the budget that provide support to the economy when it weakens. 

A bit of history to understand how we got here…

Back to the Gold standard period before 1973, a fixed exchange rate regime, the goals of central banks were to preserve the stability of the international monetary system by injecting liquidity when gold convertibility came into question i.e. print cash. The Federal Reserve came into live in 1907 in response to a plaguing deep recession to promote a global currency that is “elastic” in meeting the needs of a growing economy. The flexible currency would help absorb the forces that causes periodic financial panics. A lack of understanding of the consequences of deflation on the real value of collateral and a rise in secured loan debts, an insidious downward adjustment / haircut behind money illusion, deepened the Great Depression in 1930s. Banks collapses led to bank runs, bankruptcies, unemployment, inability to purchase and a deflationary spiral. That haunting episode taught central banks a great lesson: they could have used their balance sheets to sufficiently lower long-term rates and counter the cascading sequence of bankruptcies. 

Post World War II, countries seek only to rebuild their country and economy. International committees were formed, countries joined the alliance, followed the international rules and coordinated a stable economic growth together. It was a time of “Great Moderation“, where cooperative structural reforms, exports and imports of technology and human capital, integration of values, ideas and religion, developments of the financial instruments and integration of financial markets, led to a reduction in the volatility of the business cycle fluctuations. So did a central bank balance sheet became more stable. In times of stability, peace and prosperity, central banks interest in balance sheet wane. Balance sheet took a back seat, while focus of monetary policy was exclusively on short term policy interest rate. 

Then came the Asian financial crisis in 1997/8. Countries, especially those in an export oriented growth economy, saw the need to build up foreign exchange reserves so that they can intervene and defend speculative attacks on their currencies and protect the price competitiveness of their export industry. As increasing adoption of a floating exchange rate regime in the trilemma led to trade balance contributing more to the change in foreign reserve, export oriented economies such as Taiwan, HK, India, China, Korea, Malaysia, Philippines, Thailand and Indonesia naturally had a accumulation of foreign reserve. But the sizable build up in the asset side of the balance sheet required a comparable increase in domestic liabilities which, on the other hand, are assets side of the balance sheet of financial intermediaries such as banks and insurance. By fractional banking system, these reserve are disseminated as loans not matched with a deposits and ends up as cash in circulation. Money supply grew, so centrals used liquidity absorbing instruments such as reserve requirements and issuance of sterilised bonds to neutralise the liquidity. 

Current Account + Financial Account +  Δ(foreign reserve) = 0

if <0, there is capital outflow that’s not recorded by the government 

Spending on import, reduce trade balance, increase reserve… always (-) sign on foreign reserve, since more foreign reserve means more money is park offshore

As a matter of fact, the securities held outright in the Federal Reserve balance sheet has grown from USD 789bil to USD 4,244bil, a cumulative result of 3 rounds of quantitative easing, which is not a new tool.Image.pngImage.png
  • Nov 2008 (QE1): Fed started buying 600bil of MBS. But banks was hoarding cash as their reserve requirement was tied down with toxic assets like MBS and are rebuild the shock absorber.
  • Dec 2008: set FFTR 0.25% effectively at ZLB (was 3.5% at Jan 2008). Effective FFR will maintain within FFTR (expectations) and a narrow band. If it deviates outside the band, open market operations to repurchase or issue treasuries using its balance sheet is done to keep the FFR within upper band and lower band. This transmission mechanism works as follows: rise in short‐term rates are quickly transmitted to other financial market prices, including longer‐term rates and lending rates which benchmark against policy rates. These hikes translate into higher real rates because prices tend to remain sticky in the short‐run. But its effect on the long end of the curve depends more on inflation expectations. If I expect inflation to be soaring high in the future, I woul not bother picking up a $20 bill on the sidewalk as it would be worth little in the future. FFR and band.png
  • Jun 2010: Asset peaked at 2.1tril, purchases halted as economy started improving. Debts matured and balance sheet shrink naturally.
  • Aug 2010: Fed’s goal was to keep asset holdings at 2 trillon to simulate a weak economy. To maintain that level, started monthly purchases of 30bil of T-note with maturities ranging 2 to 10 years, not MBS, since there are more counterparties holding treasuries as assets and transmission are more effective than MBS (issued by the bank channel only).
  • Nov 2010 (QE2): Bought 600bil of Treasury securities at end of Q2 2011
  • Sep 2011: “Operation Twist” (sell short maturities bills, use proceeds to buy long term T-bonds and MBS) Effectively increase long term asset prices, reduce their yield and hence long term borrowing cost. This reduce financing cost for those looking to buy cars, homes or start a business. Fed’s asset’s duration increase relative to liability’s duration, and balance sheet becomes more exposed to curve risk, losing in a curve steepening scenario. But transmission of lower yields was not effective as long end of curve only fell a few bp.
  • Sep 2012 (QE3): started monthly 40bil purchase of open-ended bonds (e.g. ABS) while maintaining FFTR near ZLB through 2015 until unemployment falls below 6.5% or core inflation rate above 2.5%. Monetary policy focus have seemed to change from using short term interest rates to target a stable inflation to using balance sheet to target a low unemployment. QE3 was effective in meeting its goals: it freed up the bank’s RRR constraint by removing toxic MBS from bank’s asset, allowed banks to have the capacity to lend without increasing retail deposits. It inject money supply by liquidifying treasuries and MBS into cash by temporarily taking them off bank’s balance sheet, which reduced the US dollar, increase US exports price competitiveness and the net worth of many counterparties holding US equities. The increase in money supply was used for financing buybacks and growth of fund management activities. Most importantly, the management of market expectations by setting a clear target “at least until 2015” gave investors the confidence that the short term floating rate they pay to finance their long term assets will be unchanged. This reduce propensity to save and carry debt, and increase propensity to spend and hold debt, and the expansion of balance sheet fills the missing gap for banks finding depositors for making loans to borrowers.
  • Dec 2013: Ended “Operation Twist“, instead of exchanging short-term Treasuries for long-term notes, it kept rolling over the short-term debt.
  • There is no more tools by the Fed, beyond balance sheet expansion, and structural reforms that require heavylifting from fiscal policy. The Bipartisan Budget Act of 2015, signed by President Obama, suspended the debt ceiling and the deadline 15 Mar 2017 has passed. treasury balance for fiscal policy.jpgfed surplus.pngNow, POTUS Trump needs a debt ceiling raise or default on its own debt to the Fed. Read here for more on debt ceiling. 

    The House Freedom Caucus, a group of about three dozen conservatives, issued a statement last week in support of raising the debt limit by August [2017]. But the caucus opposed doing so without conditions, and demanded any increase be paired with “cutting [the budget] where necessary, capping where able, and working to balance in the near future.”

  • While not solving the debt crisis, Trump cut top tax rate for all businesses from 35% to 15% without a detailed plan, leading to no serious discussion on tax reforms. POTUS Trump is bringing US to a higher fiscal cliff before a sharper fall, but curbing on fiscal spending to live within means will impede the economy in the short run. federal debt pub.pngfederal debt GDP.pngUnder Obama, the debt increased from $6.8trillion upon his inauguration in January 2009 to $14.4 trillion when he left office in January 2017. As May 2017, the Treasury Department measured the national debt at $19.8 trillion, right at the limit.President Donald Trump’s budget proposal estimated that the national debt will increase to $21 trillion by the end of 2018, and to $24.6 trillion by 2027. That said, its no wonder central bank became the only one doing the weightlifting to grow the economy. 
  • From the BOP, US is running a huge trade deficit but is able to do so because foreign investors have been contributing to capital inflow.bop net cap flow.png
  • Low interest only increases asset prices and create a money illusion, but does not create jobs. The reason business is not hiring might be less about rates, more about technology replacing jobs, a changing skillsets in labour market and an unbalanced demographic shifts to a smaller working population.
  • If we look at the components of the balance sheet, it is largely funded by foreign investors rather than by domestic market deposits, its duration is centred in 1-5y (weekly Thursday H41 report) and its MBS is largely >10y maturity and is 1.7tril compared to treasuries of 2.5tril.federal debt held by foreign.pngfed bs maturity.pngA higher debt ceiling might also question the autonomy of the Federal reserve in relation to the White House, given that the government has actually been running a “helicopter money” expansionary policy via government organisations as channels of transmission for a prolonged period since the time federal debt didn’t shrink and ceilings got higher.

One questions whether non-standard monetary policy tools besides policy rates such as balance sheet expansion for inflation targeting is here to stay. 

There are good arguments to preserve balance sheet expansion or shrinkage as a tool in the monetary toolbox. The increased role of secured money market transactions was a result of shadow banking. The long red tape in traditional banks which became longer after market blamed the “ninja loans” where people in need of emergency funds mortage their house that sparked the housing bubble for causing the GFC. Yield curve steepen so that NIM for banks remain in profit, but that took a toll on depositors who seek higher yields. The importance of secured loans channel is recognised by central banks around the world, which start to adopt reverse repos to inject liquidity through secured loans channel, vice versa for withdrawal of liquidity. The Fed’s balance sheet has 400bil worth of repo with less than 15 days to maturity, about one-sixth the size of its treasuries holding. The widespread use of repos because its cheaper financing for borrowers and secured for creditors increases the speed of transmission of a change in repo rates as more counterparties are affected. It also justifies as an effective floor for rates on most unsecured loans, besides the FFTR lower band. Repo rate is the best candidate to replace FFTR as a policy benchmark rate, in the light of low inflationary pressure or a strong growth that requires a need for upper band for repo rate. However, the effectivenes of using repo rate as a monetary policy depends on the discipline of enforcement from the central bank, whether will it stop refinancing borrowers, even if they are “too-large-too-fail” in the US economy.

A bit of history to understand how we got here…

The origins of this new credit system relate to the emergence of very sizeable cash pools that could not find safety in banks’ insured deposits (before FDIC coverage increased to $250k, it was $100k) and were in search of safer forms of placing that cash in the short‐term while earning higher yields. New forms of “safe” assets appear:

  • Securitisation, with tranches and enhanced “average” ratings from mixing good and bad apples
  • Repurchase agreements (repos) secures creditor with collaterals with some recovery value in the event of default

The crisis came when crashing housing prices raised doubts about securitisations and when chains of internal liquidity expanded by repos with re‐hypothecation and re‐use of the same securities (leveraging the borrowing) collapsed with rising haircuts and resulting illiquid markets. It was a “run on repo”. Quality of collateral became clear then when junks were rejected, while quality assets became special and bidded for. Its like a musical chair that stops moving when collaterals lose its value and debt spiral, freezing liquidity channels that are directly or indirectly counterparties to holders of these degraded collaterals. Image result for musical chair financial crisis

Actually, the shortage of safe asset can be seen from a high bid-to-cover ratio on treasuries auctions, low sovereign bond yields since nations cannot default on local currency debts, and a divergence in the path of interest rate and equities expected return since 2002.

Now, there is a broad set of market rates beyond the overnight interbanking lending rate, policy target rate, discount rate, repo rate and swap rate. The management of collateral is ever more important given the decline in unsecured loans and shortage of safe assets. More regulatory measures need to be in place to prevent institutions from overleveraging by re-using repos, and a more centralised repo desk can reduce such “run on repos” with a clearer picture of multilateral netting and knowing who are the parties with large one-sided exposures without freezing all intermediaries liquidity channels.

That said, keeping a large balance sheet for central banks is not without its detractors. Some aruged that monetary financing can be more effective as it disguises the fact that there is an increase in government. So it pays to look at the corresponding fiscal debt when a central bank’s balance sheet grows. A country is better off if the central bank has the financial strength needed to carry out its functions. It is of course the macroeconomic and financial stability of the country that should determine policy decisions of the central bank, not profit or loss implications for the central bank’s balance sheet.Image result for central bank and government cartoon

While a large expansion of balance sheet did not had inflationary pressure on the economy, despite flooding the currency circulation in the domestic economy and monetary base relative to GDP, it might pose a issue if the central bank were to drain off the excess liquidity to new normal levels untimely or too intensively. Management of market expectations has to be clear so that market is ready, prepared and able to work with the Fed to absorb the shrinkage of reserve and deposits.

Central banks should monitor the credit growth in relation to the accumulation of foreign reserve. This happens especially in countries facing capital inflows and central banks have issued less than required central bank bonds to absorb the change in monetary base in the domestic economy. Reasons for this could be that the central bank can only issue short term maturities bonds and it constantly face refinancing risk if its bid-to-cover ratio is below one. It could also be that its domestic policy rate is higher than policy rates of the foreign currency it needs to sell to sterilised, resulting in a positive carry cost. Forcing domestic banks to accumulate a higher reserve of domestic currency with the central bank also got criticism as it crowds out private loans with “lazy assets” that seat in banks assets earnings yields without much effort (actually, higher RRR is like an indirect tax on domestic bank intermediation, because lazy assets reduces banks expected returns by forcing uptake of riskfree bonds with lower yields) That said, depending on the cause of capital inflow and the current inflationay pressures the economy is facing, central banks can tweaked the RRR to control the credit growth in private sector if the the portion of capital inflow that is incompletely sterilised is manageable by its domestic banks. However, evidence showed that build up of riskless “lazy assets” does encourage banks to take excessive risks, given the growth in international shadow banking and secured lending to liquidify these “lazy assets” into cash for lending. That said, countries with refinancing risk like Argentina would prefer issuing central bank bonds of very long term maturities to make sterilisation more effective.

TIC.pngFurthermore, foreign official investors account for a large percentage of agregate foreign holdings of US Treasury securities. While foreign central banks preference for US treasurities have downward pressure on US yield curve, boosting asset prices, quantitive easting from the Fed further the yield curve lower and had spillover effects on overseas markets too. When financial markets are subject to elevated uncertainty, central bank (actual and expected) actions on asset markets can play a disproportionate role in influencing financial market outcomes. This could create a potent cross-border feedback loop: large-scale asset purchases in the West depress the domestic yield curve, which tends to widen the interest rate gap with emerging Asia. Yield seeking private investors divert capital flows into emerging Asia, encouraging more foreign reserve accumulation. To counteract, foreign central banks will tag along the Fed with an accomodative stance. Easier monetary policy puts additional further downward pressure on US treasury yields as the demand in Asia for US treasury securities rises (though EM yields higher, but net of bond risk premium, private investors prefer better risk adjusted returns). Anticipating such a dynamic, investors can become overly sensitive to expected central bank policies.

Lastly, how are large changes in a central bank’s balance sheet coordinated with sovereign debt managers? The management of sovereign debt has taken on increased importance as government debt has risen and the Fed’s balance sheets have expanded. The much increased official holdings of financial assets from QE1,2,3 will have implications for the management of the corresponding liabilities. Increased issuance of short-term debt – either by the government or by the Fed – affects conditions in money markets, and this influences monetary transmission mechanisms. Central bank sales of balance sheet assets can conflict with government issuance. If a central bank is trying to take duration out of the market by buying longer-term sovereign debt (yield curve flattening), there may be a temptation for sovereign debt managers to take advantage of a temporary decline in the cost of issuing new bonds by increasing issuance of long-term paper. Vice versa, when central banks want to sell government bonds (reverse QE), what will be the reaction of sovereign debt managers who are anxious to place their own new issuance? They will face higher financing cost for fiscal projects! Strong coordination across institutions will be needed to make sure sovereign debt managers do not inadvertently work at cross-purposes to the monetary authorities both in crisis conditions and during the exit phase. That said, Fed “cap of series” only restricts it to near retiring treasuries which will not increase the financing cost for the government in the long run. Talks on the Fed issuing ultra long maturities treasuries could work in furthering that goal too!

While its good that the central bank is working more closely with the government, its best not to cross the line of politicians having autonomy over all monetary policies, not just policy rates.


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