Tag Archives: Monetary policy

The power of the European Central Bank

With inadequate fiscal policy, monetary policy labors to compensate, creating damaging economic distortions in the eurozone market.
By Bercan Begley – The pandemic has left millions of Europeans out of work and many underemployed, their businesses partly closed. Yet some are flourishing as never before. For European bourses, it has been marvelous. As the price of stocks has climbed, so has the wealth of those who own them.

Never have we seen such a disconnect between the real economy, the home of democracy, and the financial markets, the domicile for capitalists. And one institution has been at the centre of it all—the European Central Bank.

The ECB is perhaps the most powerful yet least understood institution in the eurozone. It has the power to engender economic, social and political change. Following the global financial crisis, the bank embarked on an epic experiment in monetary economics.

Two levers

There are two macroeconomic levers: fiscal and monetary policies. Before the introduction of the euro, both largely belonged to European Union member states. With monetary union, monetary policy moved to Frankfurt, centralized in the headquarters of the new ECB. Fiscal policy, such as tax-rate formulation, belonged to member states, but under the Maastricht treaty’s Stability and Growth Pact the European Commission supervised.

The lead-up to the crash saw profound capital misallocation in the eurozone. Pre-euro, ‘currency risk’ tempered financial venture-taking. A Munich-based bank would undertake due deliberation before converting Deutschmarks into Irish punts, due to the variability of exchange rates. Currency volatility played a risk-mitigating role, moderating investment allocation. Foolhardy owners of financial assets bore their losses and had no compensating recourse to the political domain. more>

Updates from Chicago Booth

The cycle behind sovereign debt disasters
By Michael Maiello – In theory, sovereign debt can be a healthy part of a growing economy. Governments can borrow from creditors to fund trade deficits, importing goods from other countries so their citizens can buy the products and enjoy the benefits.

While that may be the idea, the results of such borrowing are generally disastrous, warns research by Stanford’s Peter M. DeMarzo, Chicago Booth’s Zhiguo He, and Copenhagen Business School’s Fabrice Tourre. There is no default plan for a sovereign borrower the way there is for, say, a corporate one—and borrower countries have proven unable or unwilling to commit to anything like one. Without the disciplining force of covenants, which are common in private-sector borrowing, the system doesn’t wholly account for the risks associated with economic booms and busts, which works against strategic, responsible borrowing.

The trio’s work on sovereign debt risks rests on a foundation of work by DeMarzo and He on private-sector debt, in which they describe the tendencies of corporations to borrow without restraint when they do not pledge collateral to specific lenders. As uncollateralized borrowers tend to issue debt in good times and bad, lenders demand ever-higher borrowing costs over time, erasing the benefits to the borrower company and increasing default risk. Collateral adds discipline to the process. In another study, DeMarzo argues that sovereign borrowers should pledge assets to creditors as collateral in the event of default. This latest research, with He and Tourre, suggests that such collateralization could crystallize the consequences of default and break the debt cycle that is so costly to so many citizens. more>

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2021 Bond Market Outlook: Finding Yield in a Recovery

As global economic growth strengthens this year, bonds investors may find opportunities in high quality bonds, higher-yielding debt and assets that hedge against a declining U.S. dollar.
By Jim Caron – As fixed income investors, we expect 2021 to be a year of recovery. Many economic forecasts show U.S. GDP increasing by as much as 5%, or even 6%, and it begs the question: Won’t bond market yields rise in this environment? Rising yields of course mean falling bond prices—at least on paper for investors who own the debt. But yields will be rising for good reasons, based on economic growth and cash flow returning to markets.

Bond market movements will act as key indicators of the health of the recovery, as well as corporate performance and consumer confidence in 2021 and beyond. Compared to 2020, when global monetary and fiscal policies were focused on supporting solvency and bond investors benefited from flocking to safe-haven assets, such as U.S. Treasuries, this year may entail a more idiosyncratic environment for credit, which will make active portfolio management paramount.

As economic growth strengthens (most likely in inverse proportion to the severity of the pandemic this year) and variation in the fixed-income market broadens, so will the opportunities for bond allocators. For investors searching for higher yields and portfolio diversification to hedge against equities and U.S. dollar weakness, we see fixed income opportunities in five key areas.

We see value in taking a tactical barbell investing approach, which involves owning high quality and interest-rate sensitive fixed income to balance more risky credit. During the first half of 2021, investors can consider adding U.S. Treasuries and Australian and New Zealand government bonds amid an expected increase in yields. When it comes to investment grade corporate credit, we have some aversion to highly-rated bonds, including A-rated corporates with high cash balances because there’s risk that M&A activity in this cohort could weigh on valuations. We prefer a combination of triple-B corporate bonds with solid company fundamentals and U.S. Treasuries as a preferred risk allocation, as an example. more>

Updates from Chicago Booth

How central bankers misjudge forward guidance
By Rose Jacobs – One of the best ways to spur an economy is to get people spending, and policy makers have a number of tools to do that. Yet growing evidence suggests a favored approach of late—forward guidance by central banks—doesn’t work. Such guidance, usually focusing on the outlook for interest rates, is meant to make clear to consumers that prices are likely to rise soon, so buying big items now would be smart.

While people may agree with the buy-now logic, they still may not react as economists and policy makers expect, according to Boston College’s Francesco D’Acunto, Karlsruhe Institute of Technology’s Daniel Hoang, and Chicago Booth’s Michael Weber. That’s because they don’t understand the signal, the researchers find.

“If you’re an economist too much stuck in your model world, this is very surprising to you,” Weber says. On the other hand, he acknowledges that not everyone can follow the logic chain that leads from a central banker predicting depressed interest rates, to lower borrowing costs, to higher inflation, to the urgency of buying now. “If you’re not too detached from reality, it’s not surprising,” Weber says.

The researchers analyzed two events in which governments or central banks signaled that prices were set to rise. One was a 2005 announcement by the German government that the country’s value-added tax (similar to the US sales tax) would increase from 16 percent to 19 percent in 2007. The second was a 2013 statement by then European Central Bank president Mario Draghi that interest rates would stay low or decline further for some time. To economists, this statement was a clear signal that price inflation would soon follow. more>

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Introducing Cybersecurity Insights: Director’s Corner

By Matthew Scholl – The Director’s Corner will highlight how NIST’s cybersecurity, privacy, and information security-related projects are making a difference in the field and leading the charge to make positive changes.

I believe the greatest accomplishment for the division, and what I am most proud of, is how we work globally — and the way we work in an open, transparent, and inclusive process. This is especially true in the development and standardization of cryptography. This process, coupled with NISTs technical excellence in crypto, results in NIST encryption used by commercial IT products across the world. This underlying encryption enables billions of dollars of electronic commerce to function­; such as swiping credit cards at the grocery store — to online purchases — to major financial exchanges.

As we look at 2020 and beyond, NIST will update our encryption standards and ensure that encryption will continue to enable the economy and protect our livelihood. The biggest thing coming in the future (that you will hear more and more about), is in the area of quantum resistant cryptography. NIST is building open, transparent, and inclusive encryption methods with our global partners for new sets of encryption that are needed when quantum computing becomes a reality.

Quantum computing is a completely new method and architecture of conducting computational activity (or way to generate information). When a quantum computer finally is strong enough, some of our current encryption will become vulnerable. Therefore, NIST is proactively working to create new encryption standards. more>

Green money without inflation

Funding an ecological transition in Europe via ‘green money’ bonds would be economically justifiable.
By Paul De Grauwe – To what extent can the money created by the central bank be used to finance investments in the environment?

This is a question often asked today. The green activists respond with enthusiasm that the central bank—and, in particular, the European Central Bank (ECB)—should stimulate the financing of environmental investments through the printing of money.

The ECB has created €2,600 billion of new money since 2015 in the context of its quantitative easing (QE) program. All that money has gone to financial institutions which have done very little with it. Why can’t the ECB inject the money into environmental investments instead of pouring it into the financial sector?

Most traditional economists react with horror.

Who is right? It is good to recall the basics of money creation by the ECB (or any modern central bank). Money is created when that institution buys financial assets in the market. The suppliers of these assets are financial institutions. These then obtain a deposit in euro at the ECB, in exchange for relinquishing these financial assets. That is the moment when money is created. This money (deposits) can then be used as their reserve base by the financial institutions to extend loans to companies and households.

There is no limit to the amount of financial assets the ECB can buy.

In principle, it could purchase all existing financial assets (all bonds and shares, for example), but that would increase the money supply in such a way that inflation would increase dramatically. In other words, the value of the money issued by the ECB would fall sharply. To avoid this, the bank has set a limit: it promises not to let inflation rise above 2 per cent. That imposes a constraint on the amount of money which the ECB can create. So far, it has been successful in remaining within the 2 per cent inflation target. more>

Updates from Chicago Booth

The safest bank the Fed won’t sanction – A ‘narrow bank’ offers security against financial crises
By John H. Cochrane – One might expect that those in charge of banking policy in the United States would celebrate the concept of a “narrow bank.” A narrow bank takes deposits and invests only in interest-paying reserves at the Fed. A narrow bank cannot fail unless the US Treasury or Federal Reserve fails. A narrow bank cannot lose money on its assets. It cannot suffer a run. If people want their money back, they can all have it, instantly. A narrow bank needs essentially no asset risk regulation, stress tests, or anything else.

A narrow bank would fill an important niche. Right now, individuals can have federally insured bank accounts, but large businesses need to handle amounts of cash far above deposit insurance limits. For that reason, large businesses invest in repurchase agreements, short-term commercial paper, and all the other forms of short-term debt that blew up in the 2008 financial crisis. These assets are safer than bank accounts, but, as we saw, not completely safe.

A narrow bank is completely safe without deposit insurance. And with the option of a narrow bank, the only reason for companies to invest in these other arrangements is to try to harvest a little more interest. Regulators can feel a lot more confident shutting down run-prone alternatives if narrow bank deposits are widely available. more>

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Updates from Chicago Booth

How to make money on Fed announcements—with less risk
By Dee Gill – Andreas Neuhierl and Michael Weber find gains of about 4.5 percent when investors bought or shorted markets in the roughly 40 days before and after Federal Open Market Committee (FOMC) announcements that ran counter to market expectations. Investors can make money on these “surprises,” even if they did not take positions before the announcements, the findings suggest.

Markets routinely forecast the content of FOMC announcements, which reveal the Fed’s new target interest rates, and usually react when the Fed does not act as expected. An FOMC announcement is an expansionary surprise when its new target rate is lower than the market forecasts and contractionary when it’s higher than expectations.

Share prices moved predictably ahead of and following both types of surprises, the study notes. Prices began to rise about 25 days ahead of an expansionary surprise, for about a 2.5 percent gain during that time. Before a contractionary surprise, prices generally fell. The researchers find that the movements occured in all industries except mining, where contractionary surprises tended to push share prices higher. more>

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Fiscal Policy Remains In The Stone Age

By Simon Wren-Lewis – Or maybe the middle ages, but certainly not anything more recent than the 1920s. Keynes advocated using fiscal expansion in what he called a liquidity trap in the 1930s. Nowadays we use a different terminology, and talk about the need for fiscal expansion when nominal interest rates are stuck at the Zero Lower Bound or Effective Lower Bound.

When monetary policy loses its reliable and effective instrument to manage the economy, you need to bring in the next best reliable and effective instrument: fiscal policy.

The Eurozone as a whole is currently at the effective lower bound. Rates are just below zero and the ECB is creating money for large scale purchases of assets: a monetary policy instrument whose impact is much more uncertain than interest rate changes or fiscal policy changes (but certainly better than nothing). The reason monetary policy is at maximum stimulus setting is that Eurozone core inflation seems stuck at 1% or below. Time, clearly, for fiscal policy to start lending a hand with some fiscal stimulus.

You would think that causing a second recession after the one following the GFC would have been a wake up call for European finance ministers to learn some macroeconomics. Yet what little learning there has been is not to make huge mistakes but only large ones: we should balance the budget when there is no crisis. more>

Three Cheers for Financial Repression

By Tom Streithorst – “Financial repression.” It sounds terrifying, right? It smacks of authoritarian bureaucrats sucking the life-blood out of hard-working, innovative makers and doers.

Umm, no. That’s not even close. It’s about bondholders. Economists started using the term in the 1970s when bondholders were losing money because inflation exceeded the interest rate.

These days, it’s market forces more than government policy that push real interest rates below zero. Whether you call it a savings glut or secular stagnation, our collective desire to save far exceeds our collective desire to invest. Savers want safe assets more than borrowers want to invest in productive capacity.

Don’t cry for the rentier class. For the past forty years (ever since Federal Reserve Chairman Paul Volcker manufactured a brutal recession in order to eliminate 1970s inflation) economic policymakers have concentrated on ensuring the profitability of the bond market more than just about anything else. They focused their attention on financial stability and low inflation rather than the traditional goal of promoting full employment.

Consequently, the financial sector has quadrupled in size relative to the rest of the economy, the rich absorb most of the benefits of growth, and workers’ real wages have stagnated or even declined. Financialization has made wealthholders richer than ever, but it hasn’t done much for the rest of us.

What is good for the bankers has not been good for the economy as a whole. more>