Author Archives: Tomoya Sekita

Hong Kong dollar as a mirror image of the Swiss franc

After the SNB dropped its minimum exchange rate, an interesting comparison between the Swiss franc and Hong Kong dollar is discussed. Paul Krugman introduced this comparison in his recent blog post, mainly to depict how similar Swiss minimum exchange rate policy and Hong Kong’s currency board are, except for institutional setups and history of the system. If this is the case, it might be a good reason to worry about stability of Hong Kong dollar since these two countries used very similar mechanism. Krugman, however, further argues that “no chorus demanding the peg that the peg be abandoned” in Honk Kong because of “hard-money ideologues” which Hong Kong has and Switzerland did not.

On the other hand, the recent article by the WSJ focuses on difference between two countries, as the title of the article “Hong Kong Dollar Peg Doesn’t Fit in Swiss Hole” suggests. While the article also pointed out institutional difference just as Krugman does, it further says that Switzerland and Hong Kong are facing opposite pressure in terms of capital flow, which should lead the opposite implications for the currency management. Specifically, while the SNB probably worried about huge capital inflow comes in the country given widely expected the ECB’s QE and Greek election, Hong Kong would face pressure of capital outflow (thus devaluation pressure on the currency), since the Fed is widely expected to raise its interest rate later this year. And in terms of whether Hong Kong could drop its currency peg, the article insists it’s unlikely since Hong Kong has a long history of defending its currency board system even when other Asian currencies collapsed during the Asian financial crisis in 1998.

On similarity vs. difference discussion, I would rather agree with the WSJ’s argument especially because “the direction of capital flow” matters under their policy mechanism. In theory, while central bank can depreciate its own currency indefinitely by printing money to buy foreign currency, the opposite is not true if central bank used up all foreign reserves. In this sense, we could say Hong Kong dollar is a mirror image of what the Swiss franc was used to be, with severer restriction in maintaining currency peg.

So what about potential instability of the Hong Kong dollar? I’m not confident enough to say it won’t happen. In terms of institutional setup and history of currency peg in Hong Kong, we have to remind how the Gold Standard was abandoned after the Great Depression happened. Although the Gold Standard had been believed as the best policy to maintain currency stability, all major countries eventually gave up their currency peg to restore domestic economy. Thus, we cannot exclude possibility that Hong Kong will follow this case. What’s more, although the WSJ article argues that Hong Kong is unlikely to abandon the policy that has anchored the financial system for decades given the recent political instability, I would say the political instability might be an incentive for policymakers to give up its currency board, since people might not accept sharp economic slump driven by currency defending policy which was implemented during the Asian financial crisis.

How to evaluate investors in the era of government intervention

It’s becoming increasingly normal that government intervenes financial markets. On the last Thursday, the ECB finally joined the “QE club” and this announcement led higher stock price, lower interest rates and lower Euro, which is probably what the European policymakers wanted. While it’s tempting to just focus on macroeconomic impact of these intervention policy, one should not forget about an impact on investors’ behavior. In the ECB example, most of the discussions are about how QE policy works to get European countries out of economic stagnation, and only a few people seem interested in how the policy affects investors’ incentive.

Let’s say government intervenes particular market and the price of intervened asset keeps raising. While many investors think it’s might be a bubble, it’s not always the case that they sell that asset expecting their investment decision will be finally paid off when a bubble bursts. Why isn’t? One reason might be the fact that many investors are evaluated based on “excess return (alpha)”, not absolute return. In other words, they have to earn more than their benchmark (e.g. market indices of the asset class they invest) earns. This means that as long as the asset price keep raising, investors who go against the market keep making “loss” relative to their benchmark. And since their performance is often evaluated in short period of time, their best strategy to maximize their clients’ benefit could be just following the bull market, even if they know it’s a bubble.

There are two important implications drown by the example above. First, since some governments intentionally create market distortion based on their belief on how intervention can help to achieve their policy goal, we cannot just say “bubble is bad” in this era of government intervention. Second, when asset boom is going on, either buyer or seller of that asset is betting on their investment strategy, purely to maximize their profit just as they usually do. This also means that the investment strategy should be evaluated based on the investment performance, not from the “social welfare perspective”. Based on those arguments, I would disagree with the idea of “Betting against subprime mortgage loan was a good thing” in the recent blog post by Dean Baker.

As the recent episode of the Great Recession and aggressive policy response by the Fed and other US policymakers clearly depict, government intervention policy can help to achieve policy goals. However, it’s policymakers’ job to prevent excessive asset bubble driven by their policy. And we should evaluate investors by how much they earn, not by what they do for the society.

Oil price drop and the central bankers’ dilemma

The recent drastic drop in the oil price started from the last year has huge impact on various economic agents around the globe. Among them, central bankers have to deal with difficult problem about how they incorporate oil price factor into their policy decisions, particularly in country with low inflation environment like the US. To understand their dilemma, we have to know two major lines of argument how lower oil price affects economy and price.

First argument is that lower oil price should be boon to the economy, since oil consumers can benefit from it. This is particularly true for the country like the US, since relatively large fraction of aggregate demand comes from household consumption compared to other countries, and households would greatly benefit from lower oil price because many Americans drive cars as their main way of transportation. Then, higher disposable income created by this would be expected to be spent on other goods, which will drive whole economy.

Another argument is that lower oil price could lead lower price level in general, which increases the risk of deflation. This argument sounds too obvious since general price level must be lower if oil price is included in the definition of “general price level (e.g. Consumer Price Index)”, but from the monetary policy perspective, central bankers usually focus more on inflation expectations rather than current price movement. This is because while lower inflation rate due to lower oil price will be tapered off unless oil price keep decreasing (remember price level matters for calculating inflation rate), lower inflation expectations (e.g. 3 percent to 1 percent) can have permanent effect on inflation rate. But in either case, it is clear that lower oil price creates deflationary pressure on economy.

A careful reader might see my point on how lower oil price puzzles central bankers. If central bankers believe that the impact based on the first argument is stronger, then they should not keep accommodative monetary policy anymore since inflation is expected to be higher than they desire in this case. On the other hand, if they think second argument is stronger, tightening monetary policy too soon would result in deflation. The recent survey of economic forecasters held by the WSJ reflects that there are indeed two camps of opinions on lower oil price introduced here.

One clue to see which position the Fed will take might be how they assess the risk of deflation in the US economy. For example, Paul Krugman strongly believes that the Fed should not tighten monetary policy because cost of deflation is too high to bear. We should watch the next couple of FOMC meetings carefully to see how the Fed reacts to the lower oil price, since it can be a game changer for the US economy as well as global financial markets.

Why does black opportunity matter for the future of the US economy?

For Martin Luther King Jr. day, I want to introduce the recent blog post by Richard V. Reeves as one evidence shows why black opportunity really matters for the US economy. He gives five facts depict how far we still have to go in terms of black opportunity (with some excerpts from his blog post):

  1. Half of Black Americans Born Poor Stay Poor

“Upward mobility from the bottom of the income distribution is much less likely for black than white Americans”

  1. Most Black Middle Class Kids Are Downwardly Mobile

“Seven out of ten black Americans born into the middle quintile fall into one of the two quintiles below as adults.”

  1. Black Wealth Barely Exists

“The median wealth of white households is now 13 times greater than for black households –the largest gap in a quarter century, according to analysis by the Pew Research Center.”

  1. Most Black Families Headed by Single Parent

“Black children are much more likely to be raised in a single-parent household, and as our own research suggests”

  1. Black Students Attend Worse Schools

“black students make up 16 percent of the public school population, but the average black student attends a school that’s 50 percent black.”

While people would agree that all five facts are important from many different perspectives, I have one specific reason that solving these problems can be a key for the US economic success in the future: potential growth rate. In “The Demise of U.S. Economic Growth: Restatement, Rebuttal, and Reflections”, Robert J. Gordon expects US potential growth rate is going to be far lower in the future, compared to a 2.0 percent average annual growth rate of real GDP per capita between 1891 and 2007. Specifically, he introduces “four headwinds” which are primary causes of his pessimistic forecast of the US economy: demographic shifts, educational attainment, inequality and national debts.

One may notice that those headwinds introduced by Gordon are closely related to the five facts given by Reeves. For example, if black people’s mobility would be improved and their wealth would grow fast enough to reduce inequality, that will achieve a higher income growth for bottom 99 percent of the income distribution in the US. Similarly, if black students will attend better school, that will surely take average educational attainment of American higher, thus productivity growth will also become higher than otherwise. Thus, more black opportunities could make the US potential growth higher.

Conclusion: if the both facts and arguments introduced above are correct, bringing more opportunities to black people should become a real interest of all Americans. Martin Luther King Jr. would be glad to see the US economic prosperity achieved by more opportunities brought to black people.

The SNB’s decision and power of expectations in monetary policy

After the Great Recession hits, it’s becoming increasingly popular that central banks employ “expectations” as a part of their monetary policy. The Federal Reserve has been actively using communication policies (the most famous one is called “forward guidance”), which essentially means the Fed makes some promises regarding its future policy path to make the policy more effective. The Federal Reserve explains how this kind of policy works as follows:

By providing information about how long the Committee expects to keep the target for the federal funds rate exceptionally low, the forward guidance language can put downward pressure on longer-term interest rates and thereby lower the cost of credit for households and businesses, and also help improve broader financial conditions.

This is a very clever idea as it sounds, since central banks could strengthen their policy without using “official” policy variable in their toolkit. Only they have to do is to put “language” into their communication with general public (such as monetary policy statement and press conference). And this is the part of reasons why many central banks employ the similar strategy. For example, in the middle of the euro crisis in 2012, the ECB president Mario Draghi said that “the ECB is ready to do whatever it takes to preserve the euro”, which became very popular phrase both among policymakers and financial markets. In response to this statement made in the press conference, yields on sovereign debts in troubled countries immediately went down. Yes, the policy (just one sentence!) to control “expectations” worked perfectly.

Then here comes the SNB. In the most recent policy meeting, the Swiss National Bank decided to give up its cap on the Swiss franc exchange rate. In other words, the SNB suddenly “broke a promise” that it does “whatever it takes” to stabilize its currency. The price of betraying expectations seems very high, since the Swiss franc exchange rate surged and Swiss stock market tumbled right after the decision. Although the SNB also decided to lower its policy interest rate further into deeper negative territory, it did little to offset the shock in financial markets.

Here is a lesson that other central banks have to learn: policymakers should be very careful when they incorporate expectations into part of their policy, and abandoning this kind of policy could result in huge turmoil in financial markets. And since different policy settings have different policy implications, central bankers have to be sure that how they keep consistency among the policy to control expectations and other economic policies.

On currency manipulation: some questions need to be answered

In the recent Op-ed column of the New York Times, Jared Bernstein argues the Trans-Pacific Partnership (TPP) should include a chapter on currency manipulation. He names some Asian countries including China and Japan as “currency managers”, insisting attempts made by these countries are subsidizing their exports and taxing their imports, which results in persistent trade deficits in the United States. In response to this situation, he suggests first to define what currency management looks like, then to agree on specific retaliation measures for currency managers including tax on the imports of offending countries, fines, and the temporary canceling of certain trade privileges.

Needless to say, there are plenty of examples of “currency management” he refers to, ranging from some developed economies like Japan and Euro area (although they haven’t embarked on quantitative easing policy yet, their intension of depreciating the Euro is clear), and many developing economies including China, Singapore and Malaysia. Still, I think there are at least three questions Bernstein and the US policymakers have to answer before they include a chapter on currency manipulation.

  1. How do they differentiate currency management from accumulating foreign reserves for other purposes?

As Bernstein himself noted, countries buy foreign currencies for various reasons. And other than currency management, one of those motivations is to have foreign reserves as an “insurance” for sudden capital outflows from country. One can immediately think of the recent currency collapse in Russia as an example of this kind of event and one can also imagine that having ample foreign reserve is really important when it happens. Since it is very difficult to predict how big an impact of capital outflow would be, countries (especially emerging economies with relatively volatile domestic currency fluctuations) have an incentive to purchase enough foreign currencies for a rainy day. Can any policymakers define reasonable level of foreign reserve which prevent future currency crisis? I’m rather skeptical about it.

  1. Is purchase of foreign currencies made by central bank a good definition of currency management?

Bernstein argues that weather the central bank is buying foreign currencies or not is a clear test of currency management. But there are other ways to lower domestic currency, again as Bernstein himself points out. Specifically, central bank can attempt to depreciate domestic currency by monetary easing (either by lowering short-term interest rate or implementing unconventional policies like quantitative easing). Since majority of people agree that either purchase of foreign currencies or monetary easing can achieve lowering domestic currency, I don’t really see why only the first one should be the “clear test” of currency management.

  1. Is the Chinese currency still undervalued?

When it comes to the Chinese currency, too many people just assume it is still way undervalued than it should be. Before criticizing China as a currency manipulator, it is important to show evidences for this. In fact, some researchers say that Chinese currency is not undervalued anymore by using the new purchasing power parity (PPP) calculation. While some other institutions like IMF reported that the yuan is “moderately” undervalued, it is almost clear that Chinese currency is heading to the right direction given that China’s current account surplus is now just 2 percent of its GDP (10.1 percent in 2007).

My conclusion is: unless at least those three questions are answered, other countries would think that Bernstein’s argument is rather one-sided even if both parties in the US congress agree with it.

Abenomics and the BOJ’s challenge of being a credible central bank

Abenomics — a bundle of economic policies designed to get Japan out of the long-lasting deflation and stagnation — has been a center of discussions regarding Japanese economy ever since the Prime Minister Shinzo Abe took his office. Among “three arrows” of policies (monetary policy, fiscal policy and structural reform), many observers should agree with the idea that the monetary policy has been playing the biggest role thus far. For instance, the surprise move by the BOJ last October made the yen exchange rate (against the US dollar) depreciated by roughly 1.4 percent in one day, which should help to raise inflation rates via higher importing prices. Since the limited fiscal resources is available given the huge national debts and little real progress has been observed from structural reform side, monetary policy will continue to play an important role in Abenomics this year.

Given this situation, Japan’s policymakers should worry about the survey result released last week. This survey, which is done by the BOJ, showed skepticism raised over the BOJ’s ability to stimulate the economy. Being asked the question “Do you think the BOJ is credible?” 10.7 percent (8.8 percent in six months ago) of the survey respondents answered “no”.

Why is this result so worrisome? A key to answer this question is the “Fisher equation” which basically says the real interest rate equals the nominal interest rate minus the inflation expectations. Since a central bank can stimulate economy by lowering the real interest rate, it can be achieved either lowering the nominal interest rate and/or raising the inflation expectations. However, one should remember the important fact that Japan is a “pioneer” of zero interest rate policy, which means the BOJ cannot lower the nominal interest rate any further unless it decides to implement negative interest rates policy. Therefore, at least the Fisher equation suggests, the only way that the BOJ can lower the real interest rate is through the inflation expectations channel which hinges on the credibility of the BOJ. In other words, it is really important for the BOJ (and of course PM Abe) to maintain their credibility that they continue to have a strong will to achieve 2 percent inflation to keep the real interest rate low enough to stimulate consumption and investment.

Yes, it is just a survey result. But Japan’s policymakers should take this seriously since they will have to rely on the monetary policy, and maintaining expectations is far difficult than maintaining the nominal interest rate.