Tag Archives: monetary policy

Why I Hope European Bond Yields Rise

After the European central bank announced new bond purchases, bond prices for all major European sovereigns rose. This does not seem surprising. Fixed supply of bonds, central bank increases demand, it’s natural for prices to rise. However, if bond yields do not rise soon that would be bad news for the ECB’s goal of getting back to 2% inflation.

The U.S. experience with QE I and QE II were associated with higher bond yields. This is clear from the plot below produced by Michael Darda, chief market strategist at MKM partners.

Changes in US inflation expectations can explain the changes in the first two QE periods. Recall the long term nominal bond yield decomposition into expected future real interest rates, a term premium, and inflation expectations. Suppose we believe that real interest rates and the term premium are pinned down by productivity and preferences, and are therefore invariant to monetary policy. Then it must be that the reason the yields rose was because inflation expectations rose. Indeed, this is what inflation expectations as proxied by the 10 year TIPS breakeven suggest.

In my view, this is one of the most convincing arguments that QE “worked” in the US — the market very much believed that the asset purchases would drive up the price level. Therefore if bond yields in Europe don’t show any increase, that means the market does not expect the ECB to be successful in its crusade to raise inflation.

One might argue that this argument misses out on the liquidity effect — i.e. the fact that monetary expansions have short run effects on bond yields. Central bank cash translates into higher bids for bonds, and since there are now fewer bonds to go around, this pushes up the price. Indeed, we saw the inverse of this phenomenon during the “taper tantrum” two summers ago. After Bernanke announced the tapering off of bond purchases during the middle of the QE 3 period, 10 year bond yields had a dramatic 70 basis points rise from around 200 basis points to over 270. Contractionary policy clearly cannot raise inflation expectations, and so it’s clear that the rise in bond yields was the result of a liquidity effect.

Another argument to support the liquidity effect is that stock prices in Europe have also been rising. If the fall in bond yields reflect falling inflation expectations, that would have been very bearish for equities. The stock market rally thus contradicts the inflation expectations story.

However, the liquidity effect is a short run phenomenon. After smoothing out the market microstructure, in the end long term bond yields should still be determined by inflation expectations, expected real rates, and a term premium. So to see if the ECB’s purchases are having an effect, keep an eye out on long term bond yields and hope they go up.

Cross listed on medium.

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.

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.

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.

Will Europe Finally Join the QE Bandwagon?

Europe has struggled to rebound from the Great Recession.  A few years ago, it appeared that the EU and the United States were recovering at roughly the same pace, as shown by this graph of World Bank data on GDP growth rates.  In 2012, the EU dropped off of the path to recovery, posting a -0.4% growth rate, while the United States continued to chug on at around 2% growth per year.  This divergence was largely a product of the two different policy approaches taken by the central banks of each economy.  In the US, the Fed engaged in three separate rounds of large monthly bond purchases, or quantitative easing, with the goal of expanding the money supply and lowering interest rates.  In contrast, the European Central Bank responded with the European Financial Stability Facility to provide liquidity to EU members, and several European states undertook austerity policies.  It may be slightly naive to attribute all of the US economy’s recovery to quantitative easing, but it certainly appears to have been incredibly effective.

So why did the EU not even attempt quantitative easing while the Fed was rolling out several rounds of it?  One big obstacle that the ECB faces is the fact that it is composed of a multitude of national central banks, making it more difficult to coordinate asset purchases.  However, it appears that the time may have finally come for the European Central Bank to enlist the help of quantitative easing.  As reported in the Wall Street Journal, the ECB’s executive board has proposed a 12-month (at minimum) round of QE, composed of asset purchases of 50 billion euros per month.  The bank’s governing body will meet Thursday to discuss the proposal.  As noted by MIT professor Athanasios Orphanides in the Journal article, “the potentially open-ended nature of the program—the idea the ECB could continue beyond a year—is a bright spot that could give the program additional power”, since many economists believe one of the core strengths of quantitative easing is the effect on the market that expectations of aggressive future monetary policy can have.

As news of the potential ECB actions broke, the euro fell against the dollar – good news for the multitude of European states that rely heavily on exports to fuel their economy.  Italian prime minister Matteo Renzi was one of those who welcomed the news, who claimed that he dreams of parity between the Euro and the Dollar in an interview with the Wall Street Journal earlier today, believing that it would grant Europe greater economic flexibility.  However, it is not good news for everybody – German officials oppose the ECB plan, as noted in the first Journal article, since German taxpayers have concerns that they would be responsible for the more risky debt of other European countries.  Nevertheless, it appears to be the case that the ECB will carry out quantitative easing, having tried almost everything else, in an attempt to resuscitate the stagnant European economy.

What the SNB Teaches Us About Off Equilibrium Threats

One explanation for why the SNB went off the exchange rate peg was because its balance sheet was becoming too large. Even though balance sheet losses at central banks should have no theoretical effect on policy, Tyler Cowen argues that they do matter because balance sheet considerations serve as a political limit to how far central banks can go in their interventions.

The SNB’s failure to maintain their exchange rate peg can give us some insight into why unconventional monetary policy at the zero lower bound can be so difficult. In particular, it shows that the “off equilibrium threats” that are required to make monetary policy effective at the zero lower bound might be too large for central banks to stomach.

Apriori, it’s hard to imagine why central bank asset purchases can fail to push prices and output around. In Bernanke’s criticism of the Bank of Japan, he noted that if it were the case that domestic prices didn’t change in response to asset purchases, then the central bank could buy up the entire stock of domestic assets! In the limit, this would mean that the central bank could fund unlimited transfer payments. If that were really the case. This is patently absurd — supply side constraints realize themselves eventually—and so by contradiction it must be that at some point the central bank must be able to affect prices, and that in particular it can realize any arbitrarily high price level.

The international macro version of this argument is that a central bank must always be able to depreciate its own currency because otherwise, the central bank could buy up the entire global stock of assets.

But these results are only asymptotic. For any finite asset purchase, there’s no guarantee that the central bank will have an effect. And therein lies the problem. The frictions that balance sheet policies exploit are small, and the central bank needs to be able to commit to extremely large asset purchasesto have a large enough direct effect. To the extent that smaller purchases can have an effect, the only way they do so by operating on the expectations of future policies.

To formalize this, imagine that the central bank and foreign investors are playing a game. The central bank can choose between small interventions and large interventions, whereas the foreign investors can choose between going long the currency (and thus causing it to appreciate) or going short the currency (and thus causing it to depreciate).

If the central bank does a large intervention while foreign investors go long, the central bank can inflict infinite pain by buying up all of their real assets. In the end, all of the world’s assets would have been acquired while the foreign investors sit on piles of useless paper. However, this causes the central bank to suffer any political costs that come along with mass asset purchases.

So the central bank might want to do a small intervention. But if it’s not large enough, and expectations for inflation and exchange rates do not change, then foreign investors can continue going long the currency and thereby limiting the effect of monetary policy.

The central bank is in a dilemma. While it would prefer a small intervention, it needs to be willing to threaten a large intervention, or else foreign investors would not budge. But if political constraints are large enough, then the threat will not be credible and small interventions will have limited effect. For the central bank to ensure that the small intervention — short the currency world to be an equilibrium, it needs to have a credible “off equilibrium” threat that the central bank will buy up the world in the case that foreign investors do not short the currency as the central bank desires.

The conclusion is that when the SNB abandoned its peg, it lost its credibility to enforce these off equilibrium threats. This does not bode well for its future attempts at monetary policy at the zero lower bound.