Category: Monetary Policy

The Reserve Bank, not before time, has changed its tone. It has suggested that the interest rate cycle may have peaked. From the pause in the trend to higher rates we now have talk of a longer pause in interest rate settings. If the exchange rate holds up better than R14 to the US dollar by the next time the Monetary Policy Committee (MPC) meets in November, interest rates may well be on their way down. The Bank’s inflation forecast (if not the year on year change in the CPI, headline inflation itself) will have had time to adjust lower and food price inflation will be in retreat from its extraordinarily elevated 12% plus base. How rapidly this occurs will depend on the rain. Prayers for rain are in order.

If all goes better on the inflation front, the Reserve Bank will be able to focus on something very important to the SA economy over which it does have considerable influence and that is domestic spending and lending. Its interest rate settings do predictably affect the willingness of households and firms to spend more; and the SA economy urgently needs the stimulus of more demand and lower interest rates.

These interest rates however have no predictable influence on the exchange rate, rainfall or on excise and other taxes, including fuel and sugar taxes. Nor do they affect the price of electricity except, perversely, should Eskom persuade Nersa, the regulator, that its higher borrowing and other costs are a good (actually bad) excuse for a higher tariff. Nor, as I would argue, though the MPC would disagree, do higher interest rates influence inflationary expectations for the better and/or wage demands for the better.

Inflation expected (which has remained remarkably stable and consistent around the 6% – the upper band of the inflation target level will follow inflation – not the other way round. Inflation leads and inflation expected follows, as will be further demonstrated should inflation come down because the rand has strengthened and long term interest rates decline relative to US interest rates, meaning less rand weakness expected and hence less inflation expected. This narrowing of the spread between RSA and US benchmark interest rates has been under over the past few days. It is a very helpful development.

With some help from global capital flows, the weather and the politicians (and also the rating agencies) we will see the rand hold up inflation and the inflation forecasts continue to recede. The question then will be how low can interest rates in SA go. I would suggest as low as it takes to get the growth in spending running at a sustainable 3- 4% per annum. The sustainability of such growth will depend upon support from capital inflows and so a stable rand itself. Faster growth itself will be very encouraging not only to capital expenditure by firms and the government – but to global suppliers of capital. Can we dare hope for a virtuous cycle of faster growth with less inflation? A reprise perhaps of 2003-2008, accompanied by much better control of money supply and bank credit?

Tim Harford of the Financial Times in an article carried in Business Day 18th May (Big data power up inflation figures) writes of the attempts under way to predict inflation ahead of the official data releases using ‘big data” – in this case observing continuously thousands even billions of prices reported online “by hundreds of retailers in more than 60 countries”

There is however more to this very welcome exercise made possible by modern technology than improving our measures of inflation –or being better able to adjust prices for changes in the quality of the goods and service being priced in the market place- a truly formidable task as Harford suggests. Or for that matter in the practice of in using high frequency data to predict the next GDP announcement, which also comes with something of a time lag. Helping to anticipate the next GDP announcement in the US is an exercise undertaken by one of the branches of the Fed. The Federal Reserve Bank of Atlanta publishes its GDPNow forecasts of GDP that are attracting understandable attention in financial markets.

The primary purpose in being able to more accurately predicting inflation or growth announcements to come is that it helps the forecaster to anticipate central bank policy changes – in the form of interest rate adjustments or doses of money creation- now called Quantitative Easing- that may follow the news about inflation or growth. Past performance tells us that central banks will react in predictable ways to the unexpected, to the surprisingly good or bad economic news to which inflation and GDP announcements make a large contribution. The economic news is important because the central bank regards the news as important. They are mandated to meet targets for price stability and to help the economy realise its growth potential. Knowing what the central bank will do can be very valuable information. Valuable because what central banks can do is move markets. And beating the market- being ahead of the market moves – can be extraordinarily valuable. Just as being behind the new direction of a market can be as damaging to participants in markets who miss-read the signals.

Central banks however can only move the markets in what they may regard as the right directions if they can take the market place by surprise. As is well recognized in the market place- only surprising news matters- the expected is captured in current prices and valuations. And so there is every reason for participants in the financial markets not to be surprised so that they can take evasive action in good time and position themselves for what central banks and the market may do to them. Better forecasting models of inflation or growth – or even of the next inflation or GDP announcements, using new technology- big data- helps market participants to realize profits or avoid losses.

Yet by anticipating central bank action the market place helps void the intended influence of central bank actions on the economy. This makes central banks much less influential over the economy than the still generally accepted conventions allow central bankers about the role they can and should play in managing the business cycle. Robert Lucas of Chicago in 1995 was awarded a Nobel Prize in economics (as were other rational expectation theorists, for this “policy invariance” critique of central banks, including Finn Kydland and Edward Prescott (2004) And one could add to this list of path breaking Nobel Prize winning economists, Edmund Phelps (2006) and even Milton Friedman (1976) honoured for demonstrating that economic growth could not be stimulated by inflation. They showed that any favourable trade-offs of inflation (bad) for more growth (good) were between unexpected inflation (not inflation) and GDP growth- something very difficult to achieve in any consistent way because of inflation avoiding behaviour market participants would be bound to take. The case for more inflation had been made by the famous Phillips curve- a theory that at one stage enjoyed wide support in the economics profession as a justification for engineering more inflation. Inflation (higher prices) it was thought could help overcome price and wage rigidities that were presumed to prevent an economy finding its own path to full employment. It became the essence of Keynesian economics.

Modern central bankers now take inflationary expectations very seriously. So labelled Expected inflation augmented Phillips curves are at the heart of their inflation modelling. (Inappropriately given the history of a failed theory) They attempt through their policy interventions to “anchor” inflationary expectations- as the phrase goes. By anchoring inflationary expectations they hope to avoid inflationary surprises that are well understood to be damaging to the real economy.

Unexpectedly high or low inflation makes it harder for firms and trade unions, with price and wage setting power to make the right output and employment optimizing decisions about wages and prices. Unexpectedly high or low inflation can temporarily confuse them about the true state of the economy and so exaggerate the direction of the business cycle that will in time be reversed as inflation expected adjusts to actual inflation.

But this sensible understanding of the need to avoid inflation surprises does not seem to inhibit the larger ambitions of central banks to manage the business cycle. They still seem to believe that they able to helpfully “fine tune” the economy- manage the business cycle – through appropriate changes in interest rates and QE so that the economy can realizes its full growth potential. But logically or rather illogically this must mean being able to surprise the market place with their policy reactions – a market that is very determined not to be surprised.

In pursuing such grand ambitions to manage more than inflationary expectations, central bankers are perhaps promising more than they can hope to deliver- and so attaching too much attention to themselves. The market place has become increasingly skeptical about central bank delivering on its promises to manage aggregate global spending, demand that remains deficient despite the best efforts of central bankers world-wide. More central bank modesty – as well as more realism in the market place – about what central bankers can and cannot do – is called for.

The Fed made one thing very clear on Thursday after it decided to leave its interest rates unchanged: short term interest rates in the US will stay lower for longer than previously forecast. The equity markets responded favourably to the news for about an hour and then changed their collective mind. A sense that the Fed explanation – of its lack of action implied lower rates of economic growth – soon overcame what might have been a favourable influence on share prices. Other things equal, lower interest rates mean higher share prices. But other things are seldom equal when central banks react, as the market has again revealed.

While equity indexes fell away, the responses in the other sectors of the capital markets were very obviously consistent with a shallower expected rising path for short term interest rates in the US. Longer term interest rates declined quite sharply almost everywhere, including in South Africa, and the dollar lost ground against almost all other currencies, including most emerging market currencies like the rand.

Interest rates have causes as well as effects. If the cause is lower than previously forecast growth rates, the expected impact on the top line of any present value calculation – a lesser expected flow of revenue and operating profits – can outweigh the influence of a lower rate at which such profits are to be discounted. This seems to characterise recent global equity market reactions. Could the market change this initially negative interpretation of Fed policy for equity values?

We think it could – because the Fed has (surprisingly) explicitly accepted its responsibilities to the global and not only the US economy. That the Fed has recognised that the strong US economy, leading to a mighty US dollar, has left strains in its wake. The Fed reacting to these strains seems to us to improve the prospects for global economic growth by moderating some of the risks to the global economy linked to the strong dollar. Furthermore, from now on any failure of the Fed to raise rates does not imply any unexpected weakness in the US economy – rather it will be the global economy that will be the focus of attention.

The disturbances to global equity and currency markets in late August emanated from China. What the Chinese were thought to be doing and intended to do to the still undeveloped market in the renminbi rattled the markets. The threat of a competitive devaluation of the yuan, whose rate of exchange was firmly linked to the very strong dollar, would be a clear danger to the global economy.

The Japanese yen and the euro, the most important competitors and customers for China, had both devalued significantly versus the dollar and the yuan without any obvious push back from the US or China. Competitive devaluations and beggar-thy-neighbour policies did grave damage to the global economy in the 1930s by decimating the volume of international trade. All economies gain from trade, buying more from and selling more to other economies and raising their efficiencies accordingly. Any threat to global trade is a threat to growth. China was perceived to be such a threat even as the Chinese authorities were doing all they could to convince the markets that they could and would support the yuan against weakness.

The weaker dollar and a globally sensitive Fed surely diminish the risks that the Chinese will make policy errors that the rest of the world will suffer from. It takes off some of the deflationary pressure on commodities and commodity currencies. It also reduces some of the burden of dollar denominated debts incurred by emerging market companies and governments. A weaker dollar is also helpful for the reported earnings of US business with global operations. The willingness of the Fed to react to global and not only US economic developments. This enhanced sensitivity of the Fed to the state of the global economy should therefore be welcomed by shareholders everywhere.

It should also help to relax central bankers outside of the US, not least those in Pretoria, who have seemed particularly agitated by the prospect of rising rates in the US. The case for lowering short term rates in SA to promote much needed additional spending has improved – as it has improved everywhere. This is good news for shareholders

Should we be frightened of our banks and their shadows or should we rather learn how to deal with banking failure?

Shadow banks rather than non-bank financial intermediaries

A new description – shadow banks – has entered the financial lexicon. The term is, as we may infer, is not used in a positive context. Rather it is to alert the public to the potential dangers in shadow banks, as opposed to the presumably better regulated banks proper.

This is a use of language consistent with one of the dictionary definitions of the word:

A dominant or pervasive threat, influence, or atmosphere, especially one causing gloom, fear, doubt, or the like: They lived under the shadow of war.

Or perhaps alluding to shadowy, defined as:

An older, less pejorative description of this class of financial institution or lender would have been non-bank financial intermediary or perhaps near-bank financial intermediary to describe those firms that closely resembled banks in their lending activities. Examples are mortgage lenders (once called building societies), insurance companies, pension funds, money market funds and unit trusts, all of which would have fall under the modern description, shadow banks.

As we show below, drawing on the March 2014 Financial Stability Report of the SA Reserve Bank, the share of SA banks in the total business of Financial Intermediation in SA has declined over the past few years while the share of other financial intermediaries (including money market funds and unit trusts) has risen consistently, also in part at the expense of pension and retirement funds

Source; SA Reserve Bank Financial Stability Report, March 2014

The role of financial intermediaries is to facilitate the capital providing and raising activities of economic actors, domestic and foreign. They stand between (intermediate) the providers of capital in the economic system, be they households or firms, and those raising funds, to cover (temporary) financial deficits, that is, other households and firms and government agencies needing finance. They also compete for financial custom with those providers and users of finance who might bypass the financial intermediaries completely and deal directly with each other.

Such activities may be described as disintermediation when, for example, a firm previously dependent on bank finance bypasses the banks and issues its own debt or equity in the financial markets. The subscribers to such issues may however well be other financial intermediaries, for example pension funds, in which case  it is the banks that will have been disintermediated.

Why banks are different from all other financial intermediaries

What then makes banks different in principle from other financial intermediaries? It may be in the detailed manner in which they are regulated, as we indicate above. But pension and retirement funds are also subject to particular regulations and regulators designed to protect providers of capital to them as are the managers of money market funds or unit trusts.

Banks are different not because they borrow and lend (or, more generally, raise and provide capital); they are different fundamentally because an important part of their function is to provide, via some of the deposit liabilities they raise, an alternative to the cash provided by the central bank that can be used for transactions, in the older terminology, as a much more convenient medium of exchange . In so doing, they provide an essential service to the economy, providing a payment system without which the modern economy would founder.

The danger with banks, narrowly confined to those few institutions that provide the payments mechanism, is that a large bank failure would bring down the payments mechanism with it. This is a danger to the broader economy almost too ghastly to contemplate. It is a danger that makes a large transaction clearing bank, on which all other financial institutions depend, not only to hold their cash, but more importantly, to help make payments, too big to fail. If such a bank were in danger of failing and unable to recapitalise itself in the market place, it would be obliged to call on the taxpayer for additional capital and the central bank for cash as a lender of last resort. A call that the central bank and the government could not, in good sense, resist. Shareholders given such a rescue should then lose all they have invested in the bank while depositors might be saved while bank creditors generally may or may not be obliged to accept a haircut. A possible haircut would help bank creditors exercise essential disciplines over banks as borrowers. The moral hazard of too big to fail and therefore too big to have to worry about default could be overcome without jeopardising the payments system with a predictable well recognised set of bankruptcy procedures for banks.

Clearly, facilitating payments by transferring deposits on demand of their depositors, is not all that banks do. Not all their funding is by way of deposits that may be transferred or withdrawn on demand. Term deposits as well as ordinary debt may be more important on their balance sheets than current accounts or transaction balances.

Banks, narrowly defined as the providers of a payments system, largely originated by offering an alternative medium of exchange to that of transferring gold or silver and the notes issued by a central banks to settle obligations. The owners of banks came to realise that they did not have to maintain anything like a 100% backing in gold or notes or deposits with the central banks for the deposits that could be withdrawn without notice, to survive profitably.

Fractional reserve banking was seen to be possible and profitable. In other words, the interest spread between the cost of raising deposits, with demand deposits paying the lowest interest or no interest at all, helped the banks make profits on the spread between their borrowing costs and interest income and so helped pay for the costs of maintaining the payments mechanism – a form of cross subsidy. It may be surmised that had the banks had to levy fees to cover all the costs, including a return on capital, of providing the payments mechanism, bank deposits might have proved less attractive and the growth of retail banks accordingly more inhibited than it was.

Banks in SA have become more dependent on net interest income in recent years, rising from about 5% to 10% of net income, while operating expenses have grown by about the same percentage. Return on equity has declined but remains a respectable 15% p.a.

Source; SA Reserve Bank Financial Stability Report, March 2014

The inevitable risks in fractional reserve banking and leveraged banks

Such fractional reserves however do pose a risk to the shareholders of banks as well as to their depositors. There might be a run on the bank that could cause the bank to fail, making the shares they owned in the bank valueless. Clearly, the interest earning assets it typically held could not be cashed in as easily as its deposit liabilities. Banking failures led to responses by regulators – firstly in the form of a compulsory cash to deposit ratio demanded of banks and in the form of deposit insurance designed to protect the smaller depositor. This was introduced in the US in the 1930s in response to the Great Depression and the banking failures associated with it.

Compared to most other financial institutions, including the so-called shadow banks, banks proper have always been among the most highly leveraged of business enterprises.. Their debts include all deposits, current and time deposits, equivalent to 90% or more of their assets, leaving little room for errors in the loans made.

The protection provided to depositors in the form of required cash or liquid asset reserves could not insure any bank or financial institution against the bad loans that could wipe out shareholders equity and cause a bank to go out of business.  Hence the regulatory focus in recent years, not so much on cash adequacy, but on equity capital adequacy. The Basel rules promoted by the central bankers’ central bank, the Bank for International Settlements located in Basel, Switzerland, have imposed higher equity capital ratios of banks.

Understandably, the SA Reserve Bank as the regulator of the SA banks has given attention in its Financial Stability Report to the capital adequacy as well as the operating character of the banks under their supervision. The results of this analysis indicate that by international standards, the four large SA banks are well capitalised and well managed. As the table below shows, a capital to asset ratio of nearly 15% provides a return on banking shareholders’ equity of close to 15%, even though the return on total assets held by the banks is only 1.1%. Without high degrees of leverage SA banks might not be profitable enough to be willing to cross-subsidise the payments mechanism. If so other providers of a payments mechanism would then have to be found.

Funding such alternative providers with fees charged might not seem an attractive alternative to the current banking system that facilitates payments, partly through the interest spread, but with the danger than banks can fail. Dealing with the possibility of failure may well prove a better approach than imposing capital and cash requirements of banks that make them unable to easily stay in business.

There are no guarantees against banking failure

There is no guarantee that regulated bank capital, adequate for normal times and not so demanding as to threaten the profitability of banks and their survival as business enterprises, would be sufficient to support the banks in abnormal times. The global financial crisis of 2008 took place in most unusual circumstances, that is when the an average house price in the US declined by as much as 30% from peak to trough. Such declines meant that much of the mortgage lending of US banks had to be written off. Even a capital adequacy ratio of 15% might not protect a banking system, with a typically large dependence on mortgage lending, against failure, should the security in house prices collapse as they did in the US. SA banks have held up to 50% of all their assets in the form of nominally secure mortgage loans. They too would not have survived a collapse in house prices of similar magnitude.

Is it possible to insulate the payments mechanism from other banking activity? And what would it cost the holders of transaction balances?

It may be possible, given modern technology, to separate the payments system from  bank lending and borrowing. The payments system could be conceivably managed by the specialised equivalents of a credit card company that would compete for non interest bearing transactions balances on a fee only basis. The transfer mechanism could well be a smart phone or some equivalent device.

The proviso would have to be 100% reserve backing for these balances held for clients to transfer. These reserves that would fully cover the liability would have to take the form of a cash deposit with the central bank or notes held in the ATMs.  A deposit with a private bank would not be sufficient to the purpose- the other private bank, unlike a central bank can also fail and so bring down the payments system. If such a separation of banking from payments was enforced by regulation, large banks might not then be too big to fail any more than any other financial intermediary or indeed any other business enterprise might be regarded as too big to fail. But the unsubsidised transaction fees that would have to be levied to cover the costs of such an independent  payments system, fully protected against failure, that would include an appropriate return on shareholders capital invested in such payment companies, might prove more onerous than the costs of maintaining transaction balances with the banks today that provide a bundle of services, including facilitating transactions.

It is striking how expensive it is to transfer cash through the specialised agencies that provide a pure money transfer service. A fee of 5% or more of the value of such a transaction is not unusual. The case for bundling banking services, even should banks need to be recapitalised should they fail in unusual circumstances, may well be a price worth paying. In other words what is required for financial stability and a low cost payments service is a predictable rescue service for the few large banks that manage the payments system.

The MPC voted to keep interest rates on hold. Without a recovery in growth rates, interest rates will stay on hold – absent the dangerous mind games of January 2014 that led to an ill-timed rise in the repo rate.

The Monetary Policy Committee (MPC) of the Reserve Bank yesterday indicated that its outlook for SA inflation over the next few years has improved marginally. To quote the statement:

“The Bank’s forecast of headline inflation changed marginally since the previous meeting. Inflation is expected to average 6,2 per cent in 2014, compared with 6,3 per cent previously, with the peak of 6,5 per cent (previously 6,6 per cent) expected in the fourth quarter. The forecast average inflation for 2015 remained unchanged at 5,8 per cent. The forecast horizon has been extended and inflation is expected to average 5,5 per cent in 2016, and 5,4 per cent in the final quarter of that year. Inflation is still expected to remain outside the target band from the second quarter of 2014 until the second quarter of 2015.”

It also reported that inflation expectations are unchanged:

“The Reuters survey of inflation expectations of economic analysts conducted in May is more or less unchanged since the previous survey. Inflation is expected to average 6,3 per cent in the second quarter, and 6,2 per cent in the final two quarters of this year, before returning to within the target at an average of 5,8 per cent in the first quarter of 2015. Annual inflation is expected to average 6,2 per cent in 2014, and 5,6 per cent and 5,4 per cent in the subsequent two years respectively, somewhat lower than the Bank’s forecast.”

The growth outlook for the economy, according to the MPC by strong contrast has “deteriorated markedly” :

“The domestic economic growth outlook has deteriorated markedly, with the reversal of a number of the tentative positive signs observed at the beginning of the year. The Bank’s forecast for economic growth for 2014 has been revised down from 2,6 per cent at the previous meeting to 2,1 per cent, implying a further widening of the negative output gap. The forecast for 2015 remains unchanged at 3,1 per cent, and growth in 2016 is expected to average 3,4 per cent. However, the risks to these forecasts are increasingly to the downside against the renewed possibility of electricity load-shedding, among other factors.”

With this backdrop one might have thought that the decision not to raise short term interest rates would have been a formality. But not so for two members of the MPC – compared to the three at the meeting before – who actually voted for a further increase in rates. What can be on their minds?

It can’t be a belief that higher interest rates can do much to slow down inflation. The Investec Securities simulation for the Reserve Bank model of inflation and growth indicates that an increase of 25bps in the repo rate will only reduce its expected inflation by roughly 8bps and this would take seven quarters to take full effect. In other words, not much help on the inflation front at considerable further risk to the state of the economy – and moreover in the knowledge that an unpredictable exchange rate (that the model treats as an independent influence, about which assumptions rather than predictions are made when running the model).

The hard pressed SA economy had some good luck in the form of a stronger rand and a bumper maize harvest, which will help to hold down inflation in the months ahead. One gains an impression that had the rains not come when they did, the case for raising rates might have had more support.

That monetary policy is hostage to such obvious supply side shocks as drought and global risk aversion is not a comfortable thought. The reality is that inflation n SA has very little to do with the demand side of the economy (as the Reserve Bank acknowledges fully) and everything to do with factors over which interest rates have little influence: exchange rates and the harvest as well as the pace of administered price increases, which is the province of the regulators and the tax collectors.

At least this time round, at the media briefing and Q&A, the Governor was asked some leading questions about supply side effects and the influence of interest rates. She was even asked if the hike in rates in January (with hindsight surely a mistake) did any harm to the economy. There was little mea culpa in the response and a resort in the response to the non-testable theory that had the Bank not raised rates then second round effects – higher inflationary expectations – would have taken inflation higher. In fact there is no evidence that inflation expectations lead inflation rather than the other way round. And, as the MPC indicated, inflation expectations remain unchanged and the great constant in the economic environment.

This Q&A unfortunately indicates the danger in monetary policy: that members of the MPC come to believe that in order to preserve their inflation fighting credentials, and because the markets may expect them to raise interest rates, then that is what they have to do. This is regardless of the predicted outcomes for inflation and, more importantly, for growth.

The trouble with such monetary policy reactions is that they can never be tested or refuted. The economic caravan always moves on even as the dogs bark. Who can say with certainy what might have happened if the Bank had acted differently? Such mind games do not serve the SA economy well. Interest rates in SA should have been lower, not higher, given the state of the economy over the past 12 months The time for a cyclical upswing in interest rates is when the economy can justify it – not before. And there is clearly no justification for higher interest rates given the growth outlook.

Ben Bernanke has now retired as Fed chairman, having rewritten the book on central banking.

He has done this not so much by what he and his fellow governors (including his successor Janet Yellen) did to address the Global Financial Crisis (GFC) that erupted in 2008, but by the enormous scale to which he supplied cash to the US and global financial system as well as in injecting new capital to shore up financial institutions whose failure would pose a risk to the financial system.

The scale of Fed interventions in the financial markets is indicated in the figure below which highlights the explosive growth in the asset side of its balance sheet. The initial actions taken after the collapse of Lehman Brothers in September 2008, what may be regarded as classical central bank assistance for a financial system in a crisis of liquidity, was superseded by further massive injections of cash into the US and global financial system as the figure makes clear. The cash made available by the central bank in exchange for securities supplied (discounted) by hard pressed banks, when only cash would satisfy depositors and other lenders to banks, alleviated the panic and allowed normally sound financial institutions to escape the run for cash. But Quantitiative Easing (QE) thereafter became much more than a temporary help to the financial system.

Chairman Bernanke recently took the opportunity to explain his actions and the reasoning behind them in a valedictory address to his own tribe (that of professional economists) gathered at the annual meeting of the American Economic Association (AEA) in early January 2014¹. On the role of a central bank in a financial crisis, he said:

“For the U.S. and global economies, the most important event of the past eight years was, of course, the global financial crisis and the deep recession that it triggered. As I have observed on other occasions, the crisis bore a strong family resemblance to a classic financial panic, except that it took place in the complex environment of the 21st century global financial system. Likewise, the tools used to fight the panic, though adapted to the modern context, were analogous to those that would have been used a century ago, including liquidity provision by the central bank, liability guarantees, recapitalization, and the provision of assurances and information to the public.”

Furthermore:

“The Federal Reserve responded forcefully to the liquidity pressures during the crisis in a manner consistent with the lessons that central banks had learned from financial panics over more than 150 years and summarized in the writings of the 19th century British journalist Walter Bagehot: Lend early and freely to solvent institutions. However, the institutional context had changed substantially since Bagehot wrote. The panics of the 19th and early 20th centuries typically involved runs on commercial banks and other depository institutions. Prior to the recent crisis, in contrast, credit extension …….. Accordingly, to help calm the panic, the Federal Reserve provided liquidity not only to commercial banks, but also to other types of financial institutions such as investment banks and money market funds, as well as to key financial markets such as those for commercial paper and asset-backed securities. .Because funding markets are global in scope and U.S. borrowers depend importantly on foreign lenders, the Federal Reserve also approved currency swap agreements with 14 foreign central banks.

“Providing liquidity represented only the first step in stabilizing the financial system. Subsequent efforts focused on rebuilding the public’s confidence, notably including public guarantees of bank debt by the Federal Deposit Insurance Corporation and of money market funds by the Treasury Department, as well as the injection of public capital into banking institutions. The bank stress test that the Federal Reserve led in the spring of 2009, which included detailed public disclosure of information regarding the solvency of our largest banks, further buttressed confidence in the banking system.”

In the accompanying notes to his speech, the following explanations of shadow banking as well as the special arrangements made to boost liquidity were specified as follows:

“Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions–but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions. Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper conduits, money market funds, markets for repurchase agreements, investment banks, and nonbank mortgage companies.

“ Liquidity tools employed by the Federal Reserve that were closely tied to the central bank’s traditional role as lender of last resort involved the provision of short-term liquidity to depository and other financial institutions and included the traditional discount window, the Term Auction Facility (TAF), the Primary Dealer Credit Facility (PDCF), and the Term Securities Lending Facility (TSLF). A second set of tools involved the provision of liquidity directly to borrowers and investors in those credit markets key to households and businesses where the expanding crisis threatened to materially impede the availability of financing. The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CPFF), the Money Market Investor Funding Facility (MMIFF), and the Term Asset-Backed Securities Loan Facility (TALF) fall into this category.”

The initial injections of liquidity by the Fed to deal with the crisis was followed by actions that did write a further new page to the central bankers’ play book. That is, in the form of very large and regular additional injections of additional cash into the financial system, made on the Fed’s own initiative, in the form of a massive bond and security buying programme, which accelerated in late 2011 and early 2013 (QE2 and QE3) that was undertaken not so much to shore up the financial system that had stabilized, but undertaken as conventional monetary policy to influence the state of the economy by managing key interest rates and especially mortgage rates.

Usually, monetary policy focuses on changes in short term interest rates, leaving long term interest rates and the slope of the yield curve to the market place. But in the US, the mortgage rate, so important for the US housing market, is a long term fixed rate of interest linked to long term interest rates and US Treasury Bond Yields. These long term fixed mortgage rates (30 year loans) available to homeowners are made possible only with the aid of government, in the form of the government sponsored mortgage lending bodies Fannie Mae and Freddy Mac, whose lending practices did so much to precipitate the housing boom and bust and were particularly in need of rescuing by the US Treasury. Their roles in the crisis do not feature in the Bernanke speech made to the AEA.

The state of the US housing market is a crucial ingredient for improving the state of US household balance sheets that are so necessary if households are to spend more in order that  that the US economy can recover from recession. Households account for over 70% of all final demands in the US and only when households lead can firms be expected to follow with their own spending plans. These household balance sheets had been devastated by the collapse in house prices, by 30% on average from the peak in 2006 to the trough in average house prices in 2011. It was this boom in house prices followed by a collapse in them that was the proximate cause of the financial crisis itself.

This bubble and bust, after all, happened on Bernanke’s watch as a governor and then as chairman of the Fed, for which the Fed does not take responsibility. A fuller explanation of the deeper causes of the GFC was offered by Bernanke in his speech to the AEA:

“The immediate trigger of the crisis, as you know, was a sharp decline in house prices, which reversed a previous run-up that had been fueled by irresponsible mortgage lending and securitization practices. Policymakers at the time, including myself, certainly appreciated that house prices might decline, although we disagreed about how much decline was likely; indeed, prices were already moving down when I took office in 2006. However, to a significant extent, our expectations about the possible macroeconomic effects of house price declines were shaped by the apparent analogy to the bursting of the dot-com bubble a few years earlier. That earlier bust also involved a large reduction in paper wealth but was followed by only a mild recession. In the event, of course, the bursting of the housing bubble helped trigger the most severe financial crisis since the Great Depression. It did so because, unlike the earlier decline in equity prices, it interacted with critical vulnerabilities in the financial system and in government regulation that allowed what were initially moderate aggregate losses to subprime mortgage holders to cascade through the financial system. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, deficiencies in risk measurement and management, and the use of exotic financial instruments that redistributed risk in nontransparent ways. In the public sector, vulnerabilities included gaps in the regulatory structure that allowed some systemically important firms and markets to escape comprehensive supervision, failures of supervisors to effectively use their existing powers, and insufficient attention to threats to the stability of the system as a whole.”

The obvious question for critics of Bernanke is why the Fed itself did not do more to slow down the increases in the supply of credit from banks and the so called shadow banks? Perhaps the Fed could not do more, given its lack of adherence to money and credit supply targets and its heavy reliance on interest rates as its principal instrument of policy.

Given what happened in the housing price boom, it seems clear that policy determined interest rates should have been much higher to slow down the growth in credit. But it may also be argued that interest rates themselves are insufficient to moderate a credit cycle. This is an essentially monetarist point not addressed by Bernanke. In other words, to say there is more to monetary policy than interest rates. The supply of money and bank credit is deserving of control according to the monetarist critique. The Bernanke remedy for protecting the system against the prospect of a future financial crisis is predictably familiar: better regulation and more equity on the books of banks and other lenders. It may be argued that there will always be enough capital, regulated or not, in normal times, and too little in any financial crisis regardless of generally well funded financial institutions. Prevention of a financial crisis may prove impossible and the attempt to do so may be costly in terms of too little, rather than too much, lending and leverage in normal conditions (when lenders are appropriately default risk-conscious and do not make bad loans on a scale that makes for a credit and asset price bubble that ends in tears). The cure for a crisis should always be on hand and the Bernanke recipe will hopefully not be forgotten in the good times.

Any current concern about monetary aggregates would have to be on the liabilities side of the Fed balance sheet, conspicuous not so much for the volume of deposits held by the member commercial banks with the Fed, but with the historically unprecedented volume or ratio of deposits (cash) held by these banks with the Fed, in excess of their regulated cash reserve requirements. Also conspicuous is the lack of growth in bank lending to businesses – despite the abundance of cash on hand (see figures 2 and 3).

As Bernanke explained:

“To provide additional monetary policy accommodation despite the constraint imposed by the effective lower bound on interest rates, the Federal Reserve turned to two alternative tools: enhanced forward guidance regarding the likely path of the federal funds rate and large-scale purchases of longer-term securities for the Federal Reserve’s portfolio. Other major central banks have responded to developments since 2008 in roughly similar ways. For example, the Bank of England and the Bank of Japan have employed detailed forward guidance and conducted large-scale asset purchases, while the European Central Bank has moved to reduce the perceived risk of sovereign debt, provided banks with substantial liquidity, and offered qualitative guidance regarding the future path of interest rates.”

The use of forward guidance to help the market place forecast the path of interest rates more accurately, so reducing uncertainties in the market place leading hopefully to better financial decisions, predates the Bernanke chairmanship of the Fed. However, he should be credited with taking the Fed to new levels of transparency and much improved communication with both the marketplace and the politicians. In Bernanke’s words:

“The crisis and its aftermath, however, raised the need for communication and explanation by the Federal Reserve to a new level. We took extraordinary measures to meet extraordinary economic challenges, and we had to explain those measures to earn the public’s support and confidence. Talking only to the Congress and to market participants would not have been enough. The effort to inform the public engaged the whole institution, including both Board members and the staff. As Chairman, I did my part, by appearing on television programs, holding town halls, taking student questions at universities, and visiting a military base to talk to soldiers and their families. The Federal Reserve Banks also played key roles in providing public information in their Districts, through programs, publications, speeches, and other media.

The crisis has passed, but I think the Fed’s need to educate and explain will only grow.”

Historically US banks held minimum excess cash reserves, meeting any demand for cash by borrowing reserves in the Federal Funds market (the interbank market for cash), so making the Fed Funds rate the key money market rate and the instrument of Fed monetary policy. Holding idle cash is not usually profitable banking – but it has become so to an extraordinary degree. Furthermore, the large volume of excess reserves means that short term interest rates fall to zero from which they cannot fall any further. The reason they have remained above zero is that the Fed has been willing to reward the banks for their excess reserves by offering 0.25% p.a on their deposits with the Fed.

Every purchase of bonds or mortgage backed securities made by the Fed in its asset purchase programme must end up on the books of a bank as a deposit with the Fed. But before the extra phases of QE, the banks would make every effort to put their cash to work earning interest rather than holding them largely idle (as they are now doing). But it would appear that the Fed expects the demand for excess cash to remain a permanent feature of the financial landscape and can cope accordingly.

According to Bernanke:

“Large-scale asset purchases have increased the size of our balance sheet and created substantial excess reserves in the banking system. Under the operating procedures used prior to the crisis, the presence of large quantities of excess reserves likely would have impeded the FOMC’s ability to raise short-term nominal interest rates when appropriate. However, the Federal Reserve now has effective tools to normalize the stance of policy when conditions warrant, without reliance on asset sales. The interest rate on excess reserves can be raised, which will put upward pressure on short-term rates; in addition, the Federal Reserve will be able to employ other tools, such as fixed-rate overnight reverse repurchase agreements, term deposits, or term repurchase agreements, to drain bank reserves and tighten its control over money market rates if this proves necessary. As a result, at the appropriate time, the FOMC will be able to return to conducting monetary policy primarily through adjustments in the short-term policy rate. It is possible, however, that some specific aspects of the Federal Reserve’s operating framework will change; the Committee will be considering this question in the future, taking into account what it learned from its experience with an expanded balance sheet and new tools for managing interest rates.”

It seems clear that the market is not frightened by the prospect that abundant supplies of cash will in turn lead to more inflation as the cash is lent and spent, as monetary history foretells. The market clearly believes in the capacity of the Fed to remove the proverbial punchbowl before the party gets going. Judged by the difference between yields on vanilla Treasury bonds and their inflation protected alternatives, inflation of no more than 2% a year is expected in the US over the next 20 years. According to Bernanke, who is much more concerned with the dangers of deflation, arguing that inflation of less than 2% should be regarded as deflation (given the hard to measure improvements in the quality of goods and services). Therefore if inflation is less than 2% this becomes an argument for more, rather than less, accommodative monetary policy by the Fed.

The market clearly finds the Bernanke arguments and guidance highly convincing. These expectations are a measure of Bernanke’s success as a central banker. He has surely helped save the financial system from a potential disaster and has done so without adding to fears of inflation.

The US economy has not however enjoyed the strong recovery that usually follows a recession. Bernanke has some explanation for this tepid growth:

“In retrospect, at least, many of the factors that held back the recovery can be identified. Some of these factors were difficult or impossible to anticipate, such as the resurgence in financial volatility associated with the European sovereign debt and banking crisis and the economic effects of natural disasters in Japan and elsewhere. Other factors were more predictable; in particular, we appreciated early on, though perhaps to a lesser extent than we might have, that the boom and bust left severe imbalances that would take time to work off. As Carmen Reinhart and Ken Rogoff noted in their prescient research, economic activity following financial crises tends to be anemic, especially when the preceding economic expansion was accompanied by rapid growth in credit and real estate prices.16 Weak recoveries from financial crises reflect, in part, the process of deleveraging and balance sheet repair: Households pull back on spending to recoup lost wealth and reduce debt burdens, while financial institutions restrict credit to restore capital ratios and reduce the riskiness of their portfolios. In addition to these financial factors, the weakness of the recovery reflects the overbuilding of housing (and, to some extent, commercial real estate) prior to the crisis, together with tight mortgage credit; indeed, recent activity in these areas is especially tepid in comparison to the rapid gains in construction more typically seen in recoveries.”

He also blames the slow recovery on the unintended consequence of unplanned government fiscal austerity:

“To this list of reasons for the slow recovery–the effects of the financial crisis, problems in the housing and mortgage markets, weaker-than-expected productivity growth, and events in Europe and elsewhere–I would add one more significant factor– – 18 – Since that time, however, federal fiscal policy has turned quite restrictive; according to the Congressional Budget Office, tax increases and spending cuts likely lowered output growth in 2013 by as much as 1-1/2 percentage points. In addition, throughout much of the recovery, state and local government budgets have been highly contractionary, reflecting their adjustment to sharply declining tax revenues. To illustrate the extent of fiscal tightness, at the current point in the recovery from the 2001 recession, employment at all levels of government had increased by nearly 600,000 workers; in contrast, in the current recovery, government employment has declined by more than 700,000 jobs, a net difference of more than 1.3 million jobs. There have been corresponding cuts in government investment, in infrastructure for example, as well as increases in taxes and reductions in transfers.

“Although long-term fiscal sustainability is a critical objective, excessively tight near-term fiscal policies have likely been counterproductive. Most importantly, with fiscal and monetary policy working in opposite directions, the recovery is weaker than it otherwise would be. But the current policy mix is particularly problematic when interest rates are very low, as is the case today. Monetary policy has less room to maneuver when interest rates are close to zero, while expansionary fiscal policy is likely both more effective and less costly in terms of increased debt burden when interest rates are pinned at low levels. A more balanced policy mix might also avoid some of the costs of very low interest rates, such as potential risks to financial stability, without sacrificing jobs and growth.”

Bernanke then went on to paint an optimistic picture of the US economy:

“I have discussed the factors that have held back the recovery, not only to better understand the recent past but also to think about the economy’s prospects. The encouraging news is that the headwinds I have mentioned may now be abating. Near-term fiscal policy at the federal level remains restrictive, but the degree of restraint on economic growth seems likely to lessen somewhat in 2014 and even more so in 2015; meanwhile, the budgetary situations of state and local governments have improved, reducing the need for further sharp cuts. The aftereffects of the housing bust also appear to have waned. For example, notwithstanding the effects of somewhat higher mortgage rates, house prices have rebounded, with one consequence being that the number of homeowners with “underwater” mortgages has dropped significantly, as have foreclosures and mortgage delinquencies. Household balance sheets have strengthened considerably, with wealth and income rising and the household debt-service burden at its lowest level in decades. Partly as a result of households’ improved finances, lending standards to households are showing signs of easing, though potential mortgage borrowers still face impediments. Businesses, especially larger ones, are also in good financial shape. The combination of financial healing, greater balance in the housing market, less fiscal restraint, and, of course, continued monetary policy accommodation bodes well for U.S. economic growth in coming quarters. But, of course, if the experience of the past few years teaches us anything, it is that we should be cautious in our forecasts.”

It can be argued by his critics that the Bernanke innovations have been part of the problem rather than the solution. It would be very hard to argue that injecting liquidity and capital into the financial system to avert an incipient financial crisis in 2008-09 was the wrong thing to do. But it may yet be asked, then, if QE2 and QE3 were also necessary? Would not a sooner return to monetary normality have been confidence boosting, rather than undermining, business confidence, which is essential to any sustained recovery? Further bouts of QE have led to large additions to the excess cash held by banks, rather than additional lending undertaken by them that would have helped the economy along. Would the banks and the US corporations have put more of their strong balance sheets to work to help the economy along had monetary policy been less innovative, or at least had QE not been advanced as strongly as it was? Growth in bank credit and money supply (M2) has slowed down rather than picked up in recent years, despite the creation of so much more base money (see the figure on bank lending). That the banks have been able to earn 0.25% on their vast cash balances has surely encouraged them to hold rather than lend out their cash.

Furthermore, while fiscal policy could have been less restrictive in the short run, would any political failure to implement a modest degree of austerity at Federal and State level, not have made households even more anxious about their economic futures and the tax burdens accompanying them, leading to still less private spending?

The performance of the US economy over the next few years will be the test of the Bernanke years. If the US economy regains momentum without inflation, the Bernanke innovations will have proved their worth. They would then provide the concrete evidence that it is possible to create money, à outrance, and then take away the juice when that becomes necessary. Tapering of QE, the initial thought of which that so disturbed the markets in May 2013, is but a first tentative step to the actual withdrawal of cash from the system and the shrinking of the Fed balance sheet. The monetary experiment, conducted with deep knowledge of monetary history and theory that fortunately characterised the Bernanke years, remains an experiment. We must hope for the sake of continued economic progress both in the US and elsewhere that it proves a highly successful experiment.

¹The Federal Reserve: Looking Back, Looking Forward, Remarks by Ben S. Bernanke, Chairman Board of Governors of the Federal Reserve System at
Annual Meeting of the American Economic Association
Philadelphia, Pennsylvania
3 January 2014
Source: Federal Reserve System of the United States, Speeches of Governors. All quotations referred to are taken from the published version of this speech.

Is SA monetary policy accommodative? It all depends on whose inflation and whose interest rates you have in mind

We are told by the Reserve Bank that monetary policy in SA is “accommodative” because interest rates are below the rate of inflation. That is because real interest rates are negative. But whose interest rates and whose inflation rates can the Reserve Bank be referring to? From the perspective of lenders the interest paid on savings accounts in the banks are not keeping up with inflation – and more so if tax has to be paid on interest income. Low real interest rates are tough on savers, but, for a good reason, borrowers may be unable to pay any more for the use of their savings.

But from the perspective of business borrowers, especially small businesses still able to borrow from their banks at prime plus something over 9%, finance may in reality be very expensive. The presumption of negative real interest rates is that businesses will be able to increase the prices they charge their customers at more than the 9% per annum they pay in interest. If this were the case, simply financing a warehouse of non-perishable goods that increase in value by more than the costs of finance (after taxes) becomes a no-brainer of a profitable business decision. This would presumably make monetary policy accommodative and encourage business.

But is this currently the case for many businesses serving the domestic market? Do they currently have the power to price their goods or services ahead of the rate of inflation that was 5.4% in December 2013?

The weakened state of demand for goods and services may prevent this as the more detailed inflation statistics bear out. The headline inflation rate is the weighted average of the prices of goods and services consumed by the mythical average SA household, some of which have risen by much more than the average and others by much less. It is administered prices, those charged by municipalities for water and electricity etc and those subject to additional excise duties, for example alcoholic beverages (up 7.2% on average with beer up 9.2% on December a year before), that have been making the inflation running . Administered prices were up nearly 8% on a year before in December 2013.

By contrast, the price of clothing and footwear is estimated to have increased by a mere 3.6% and 3% respectively. The food basket itself was also only 3% up, believe it or not. The farmers, food retailers and manufacturers will know all about their pricing power and the pressure on their sales volumes and profit margins.

It is clear that rising prices in SA have very little to do with any strong demands being registered by consumers. As is well recognized, SA households are under increasing budget pressures from higher prices and taxes imposed upon them. And, most relevant, they are suffering from a lack of pricing power in the most important market for their services, in the market for their labour services.

By recent accounts from Adcorp the rate of dismissal from private sector jobs is accelerating and workers are much less mobile than usual. They are therefore presumably somewhat fearfully holding onto the jobs they have, rather than moving to better paid ones. This is not an environment likely to encourage growth in spending, despite interest rates in the money market being below the headline inflation rate.

In fact monetary policy is doing very little to encourage domestic spending and, indeed, with the recent increase in benchmark short rates, has become less so. Even less demand side pressure on spending can be expected as prices continue to rise, driven especially by a weaker rand over which domestic interest rates have little or no influence.

The fact that the SA economy is as weak as it is, indicates quite clearly that interest rates should have been significantly lower than they have been, and that they should be falling, rather than rising, given the deteriorating state of the economy. Furthermore, targeting inflation when prices are rising for supply side (exchange rate shocks, drought and taxes) rather than demand side reasons makes little economic sense. Inflation targeting in SA can only makes good sense when the exchange rate itself responds predictably to interests rate settings. The rand over much of the past 12 years or so has not behaved anything like this.

Aiming for low inflation is good monetary policy. Trying to meet inflation targets is proving again to mean very poor monetary policy in S.A.