Category: Monetary Policy

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.

The Reserve Bank raises rates modestly and falls into the trap set by other central banks. Too little by half to impress the markets – more than enough to damage the economy.

The Reserve Bank fell into the trap set for it by its central bank peers in Turkey and India (and Brazil and Indonesia which are already in a tightening mode) who raised short rates to defend their weaker exchange rates.

That this strong armed defence (including direct intervention in the foreign exchange markets) has failed to support the likes of the Turkish lira or the Brazilian real, might have given  pause to the Monetary Policy Committee (MPC). A minority of members voted against the increase, presumably because they know that higher interest rates have an unpredictable influence on exchange rates – particularly when global capital markets are under strain – while having a predictably negative influence on already weak domestic spending and therefore economic growth.

The Governor or the members of the MPC cannot explain how higher interest rates will reduce inflation rates, unless the exchange rate strengthens in response to higher rates, which it may or may not do. The immediate response to the 50bps increase has been a weaker rather than stronger rand. It may however be argued that the market expected a more hawkish response of at least a 100bp increase and sold the rand accordingly. In other words, so the argument goes, the MPC surprised the market not because it raised rates but because it did not raise them much further.

What the SA economy needed and did not get from the Reserve Bank was a vigorous analysis of the uselessness in current circumstances of capital market volatility of raising short term interest rates. A full explanation should have been provided, and would have explained why a 50bp increase would be irrelevant for the exchange rate and harmful to the economy and why any larger hike in interest rates, perhaps expected in the market place, was unthinkable given the weak domestic economy. Nor, it might have been pointed out, would an even larger increase in short rates have helped the rand anymore than it has helped the Turkish lira.

Such an argument will be as imperative the next time the MPC meets, should the rand not have gained strength by then and should the inflation outlook remain as unsatisfactory as it is now and the economy become even less well placed to tolerate a further increase in rates. Without such an argument the economy may well set off on a 1998 Chris Stals-like spiral of higher interest rates in response to a weaker currency and the more inflation that follows that leads to still slower economic growth.

We have been here before and we should remember how much better the Australians coped at that time with Aussie dollar weakness – by sitting on their interest rate hands and not reacting to the essentially temporary inflation danger presented by a (temporarily?) weaker exchange rate. The comparison between the success the Aussies had by doing nothing and the pain suffered for example by the SA, New Zealand and Chilean economies in the late nineties, where interest rates were increased aggressively in response to emerging and commodity market crisis-driven exchange rate weakness, makes  a most instructive case study.

The right response to a weaker exchange rate driven by forces beyond the control of the Reserve Bank is not to react at all. It should ride out the exchange rate weakness as best it can and focus on the requirements of the domestic economy. The MPC did not have the wisdom to do this and unfortunately made a modest concession, a mere 50bp concession, to poorly considered market expectations and poorly executed monetary policy reactions in other emerging markets.

We can only hope it does a much better job before and during the next MPC meeting of defending the SA economy against ill considered and unhelpful interest rate increases. Monetary policy needs to be not only data dependent, as the Governor has indicated following the Fed mantra, but accompanied by appropriate guidance for the market that makes good economic sense. That is why we will not be embarking on an interest rate spiral unless the domestic economy can justify it – which it is very unlikely to do anytime soon.

With the SA inflation rate above the upper band of the target it was inevitable that the Reserve Bank’s Monetary Policy Committee (MPC)  at its latest meeting and Press Conference, would focus on inflation and the risks to it rather than the unpromising growth outlook and the prospect of even slower growth to come. The question that should have been asked of the Governor and the members of the MPC is why they appear to believe that higher short term interest rates would help to reduce inflation in SA. The connection is by no means as obvious as traditional monetary theory might suggest- that higher interest rates lead to less inflation and vice-versa.

The answer, following conventional theory, might have been that higher rates would slow down spending and so further inhibit pricing power at a retail and manufacturing level. It might well do that- slow down spending further and harm the economy accordingly. But by slowing down the economy it would discourage foreign investors from investing in South Africa. This could mean a weaker rand and so more rather than less inflation. Slower growth with more inflation is not something the Reserve Bank should wish to inflict on South Africans. The evidence is however very strong that interest rate changes in SA do not have any predictable impact on the exchange rate and therefore on inflation.

The reality is that the exchange value of the rand is highly unpredictable and volatile, highly independently of SA short term interest rates, for both global and SA reasons that encourage or discourage the demand for risky rand denominated assets. This means that inflation is beyond the immediate control of the Reserve Bank. Therefore while low inflation is a highly desirable objective for economic policy – inflation targeting –becomes a very bad idea when domestic demand is growing too slowly rather too rapidly for economic comfort. Higher interest rates in these circumstances are a bad idea because higher interest rates leads to still slower growth in the economy and because growth determines capital flows and so the exchange value of the rand, higher short rates imposed by the Reserve Bank may in fact lead to more rather than less inflation.

In the figure below this point is made. It is a scatter plot of daily percentage moves in the ZAR/USD exchange rate and short term interest rates, represented by the 3 month Johannesburg Inter bank rate (JIBAR). As may be seen there has been about the same chance of an interest rate move leading to a more or a less valuable rand since January 2008. The correlation statistic for this relationship is very close to zero, in fact 0.000006 to be exact.

A scatter plot- daily percentage moves in short rates and the ZAR ( daily data January 2009- September 2013)

Source I-net Bridge Investec Wealth and Investment

The theory behind inflation targeting is that exchange rates follow rather than lead domestic inflation. The theory does not hold for an economy that depends, for want of domestic savings, on a highly variable flow of foreign capital. This leads in turn to a highly variable and unpredictable exchange rate. The best monetary policy can do in the circumstances is to accept this reality. That is to allow the exchange rate to act as the shock absorber of variable capital flows and to accept the consequential short term price trends – while using interest rates as far as they can be used – to moderate the domestic spending and credit cycles.

In practice this is how the Reserve Bank has reacted to recent exchange rate weakness that was so clearly not of its monetary policy making. Doing nothing by way of interest rate changes or intervention in the forex markets was the right thing to do. It remains the right thing to do until the global capital markets calm down. It is just as well that in the past week the rand has strengthened, improving the inflation outlook and so helping to keep the Reserve Bank on the interest rate fence, where it should stay.

If the rand stabilizes – better still strengthens further in response to global forces or SA reasons – for example better labour relations – one may hope for lower interest rates. The weakness of domestic spending calls for lower not higher interest rates. Lower rates would will help stimulate faster growth. And so doing would add expected value to SA companies, especially to those heavily exposed to the SA economy and the domestic spender. This would add to the incentives for foreign investors to buy JSE listed shares. It would also encourage foreign controlled businesses in South Africa to add to their plant and equipment and retain cash rather than pay out dividends to foreign shareholders. Such a more favourable outlook for the SA economy and the capital that flows in response may well strengthen the rand and improve the inflation outlook.

A focus on inflation targets, beyond Reserve Bank control via interest rate determination, prevents the Bank from doing the right thing for what interest rates do influence in a consistent way and that is domestic spending. Lower interest rates and the demands for credit that accompany them can stimulate demand and higher interest rates can be used to discourage demand when it becomes excessive. When domestic spending growth is adding significantly to domestically driven pressures on prices higher interest rates are called for. This is clearly, and by the Reserve Bank’s admission, not the case now. The opposite is true, domestic demand is more than weak enough to deny local price setters much pricing power. And in these circumstances higher wages conceded to Union pressure lead to fewer jobs and on balance less rather than more spending. Prices are set by what the market will bear rather than operating costs. Operating margins rise and fall with operating costs- – in the absence of support form customers- and prices do not necessarily follow.

A target for what is judged to be sustainable growth in domestic spending might be a useful adjunct to monetary policy that regards low inflation as helpful to economic growth. A target for inflation, without a predictable exchange rate, just gets in the way of interest rate settings that should be helpful for growth.

With the SA inflation rate above the upper band of the target it was inevitable that the MPC at its latest meeting and Press Conference would focus on inflation and the risks to it rather than the unpromising growth outlook and the risks of even slower growth to come. The question that should have been asked of the Governor and the MPC is why they appear to believe that higher short term interest rates would help to reduce inflation in SA. The connection is by no means as obvious as traditional monetary theory might suggest.

The answer following conventional theory might have been that it would slow down spending – even more than it has slowed down to date – and so further inhibit pricing power at a retail and manufacturing level. It might well do that- slow down spending further and so harm the economy accordingly. But by slowing down the economy it would discourage foreign investors from investing in South Africa. This could mean a weaker rand and so more rather than less inflation. Slower growth with more inflation is not something the Reserve Bank should wish to inflict on South Africans, as it might well do. The evidence is very strong that interest rate changes in SA have had no predictable impact on the exchange rate and therefore on inflation.

The reality is that the exchange value of the rand is highly unpredictable and volatile for both global and SA reasons that encourage or discourage the demand for risky rand denominated assets. This means that inflation is beyond the immediate control of the Reserve Bank. Therefore while low inflation is a highly desirable objective for economic policy – inflation targeting –becomes a very bad idea in these circumstances. A bad idea because it may well lead to higher interest rates, slower growth and because growth determines capital flows, may mean more rather than less inflation.

The theory behind inflation targeting is that exchange rates follow rather than lead domestic inflation. The theory does not hold for an economy like the SA economy that is dependent for its growth on a highly variable flow of foreign capital that leads to a highly variable and unpredictable exchange rate. The best monetary policy can do in the circumstances is to accept this reality. That is to allow the exchange rate to act as the shock absorber of variable capital flows and to accept the consequential short term price trends while using interest rates as far as they can be used to moderate the domestic spending and credit cycles.

In practice this is how the Reserve Bank has reacted to recent exchange rate weakness that was so clearly not of its monetary policy making. Doing nothing by way of interest rate changes or intervention in the forex markets was the right thing to do. It remains the right thing to do. It is just as well that in the past day the rand has strengthened improving the inflation outlook and so helping to keep the Reserve Bank on the fence where it should stay. If the rand stabilizes – better still strengthens further in response to global forces or SA reasons – for example better labour relations – one may hope for lower interest rates. These will help growth and by improving the incentives for foreign investors to buy South Africa may well strengthen the rand and improve the inflation outlook.

Talking about the strong Rand today it was highly instructive that the stronger rand was accompanied by higher Rand values attached to almost all financial assets. Almost all equities appreciated – global plays for example NPN or BTI or SAB became more valuable in rands – despite the stronger rand – as did the SA plays – banks and retailers – as did almost all Resource companies, especially the gold miners that might ordinarily be expected to suffer from rand strength and benefit from rand weakness. In other words there were no rand hedges on the JSE on the 18th September (.i.e. companies that benefit in rand terms from rand weakness or are harmed in rand terms by rand strength).

There is in fact very little recent evidence of rand hedge qualities in JSE listed companies. This is because rand strength reflects good news about the global and the SA economy – for example lower interest rates in the US – absent tapering – that is good economic news. The good news effect on the dollar value of JSE stocks outweighs the effect of translating higher dollar values into stronger rands. Hence no rand hedge characteristics are consistently to be observed. The opposite is mostly true when the rand weakens on bad news. A weaker rand does not usually compensate for the lower dollar prices of globally traded shares when the outlook for the global and or SA economy deteriorates. Therefore investors should hope for a strong rather than a weak rand. But is remains true that the SA economy plays- businesses that benefit from lower interest rates that may well follow a stronger rand and the lower inflation that follows-  stand to benefit even more than the global companies listed on the JSE that generate a much smaller proportion of their revenues and profits from the SA economy.

Ben Bernanke fired his Bazooka yesterday. He pledged the Fed to further purchases of securities in the market without effective limit and for as long as it takes. The Federal Open Market Committee (FOMC) indicated net injections of cash of the order of US$85bn a month for as long as it takes. The indication from the FOMC is that

“…exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015”.

The asset markets were pleasantly surprised by the scale of the intended interventions in the asset market as well as their unlimited nature.

The key paragraph of the OMC statement read as follows:

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative. The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.

Will these additional actions (QE3) work to revive the US economy and reduce the unemployment rate to a natural 5% or so within the next few years? The answer must be not necessarily so, given that highly accommodative monetary policies to date have not worked very obviously to reduce the unemployment rate below a stubborn 8%, with many more potential workers discouraged from looking for jobs (though how poorly the US economy would have looked without the accommodative actions to date can only be speculated about).

Persistently low interest rates and continuous injections of cash into the securities markets cannot do any harm to employment prospects. Nor can very low interest rates (as far as the eye can see) do anything but support the property market generally and related construction activity (unless these exceptional monetary measures were considered dangerous to the long term health of the economy and so undermine business and household confidence. This does not seem to be the present danger at all).

QE3 is likely to be very positively received by US business. However the boost to confidence necessary to strongly revive the spending plans of US business will have to be taken by the politicians after the elections. Better economic news from Europe and Asia would also be confidence boosting, but clarity on the outlook for Europe and China may not be imminent.

Monetary stimulus is helpful to asset markets. Higher asset prices support pension plans and encourage households to spend more. Low interest rates )that are expected to stay low) add to the argument for equities – especially those that come with dividend yield.

What sectors benefit?

The further question then is what sectors of the equity markets stand to benefit most in a still more friendly monetary policy environment? The case for the defensive stocks, that is those that pay dividends and have the balance sheets to maintain dividends, is most obviously improved.

The cyclical stocks, while not prejudiced at all by easy monetary policy and low interest rates would benefit most from a cyclical recovery itself. This, as we have suggested, is not a certainty in the short term: until a cyclical recovery clearly manifests itself, the outlook for commodity prices appears uncertain.

For undemandingly valued JSE listed cyclicals that would ordinarily benefit from of higher operating margins from SA specific rand weakness, this takes some of the wind out of their sails. The stronger rand in a world of persistently low interest rates (likely to extend to SA) is helpful for the interest rate sensitive stocks on the JSE.

The conclusion one comes to is that Bernanke, while helping equity markets, has in our opinion not yet improved the case for cyclical over defensives. The time for the cyclicals will come when the outllook for a global cyclical recovery appears more certain. Brian Kantor

Mario Draghi asserted the independence of the European Central Bank (ECB) to act as the independent central bank of Europe and to be the responsible guardian of the “irreversible” euro. This declaration of independence was supported by all but one of the governors of the ECB.

The bank’s government bond buying campaign is to be concentrated on maturities of less than three years to maturity. These purchases, now called the Outright Monetary Transactions (OMTs) will be conducted without any limit other than constrained by the judgment of Draghi and his colleagues. These purchases of all government bonds linked to the euro will not be inhibited by inferior credit ratings, nor would the ECB claim any seniority of its claims against borrowing governments ahead of private lenders. This is an important principle designed to draw private sector support for the bond market. ECB support for the market in distressed government bonds is conditional, that is on the condition that those governments seeking aid from Europe, the ECB and the IMF abide by the conditions set for such support. The “conditionality’ of ECB was strongly emphasised, no doubt to address likely criticism that the programme represented a soft option for hard pressed European states unable (so far) to convince the market place that they can continue to meet their obligations to creditors.

Predictably, the plan did draw criticism from the Bundesbank as representing fiscal assistance to governments and therefore was not within the mandate of the ECB. No doubt it was this German viewpoint that has so delayed the assertion of ECB independence and its ability to do, in practice, what it takes to protect a financial system in times of crisis. What it takes to solve a financial and banking crisis, as the Fed has proved recently, is quite simply the exercise of a central bank’s power to print money without limits, other than those set by its own judgment as to how much extra cash it will takes to solve a crisis. Once the crisis is resolved (hopefully, with excellent timing), it will then take back the cash from the banking system that could otherwise become inflationary (as excess supplies of money over the demand to hold money, inevitably become).

Sterilisation

Draghi did say that the automatic money supply effects of its bond purchases – crediting the banks with extra deposits at the central bank – would be “sterilised”. In other words, they would be countered by simultaneous ECB bond sales. Presumably, if the banks choose to hold excess cash reserves(as they have been doing to a very large extent in the US and Europe) sterilisation would not be called for.

Draghi was firm and forthright that his plan fully confirmed to the mandate of the ECB that charges the Bank with achieving monetary stability for Europe. Monetary stability, according to Draghi, demands the survival of the euro and the integration of the currently “fragmented” European monetary system. These are essential components of monetary stability and his ability to enter the bond markets without restraint is essential to this purpose, according to Draghi.

An integrated Eurpean monetary system would mean similar interest rates and costs and availability of credit in all the European centres of finance. It would also have to mean well co-ordinated fiscal policies and banking regulations and a unified European banking system. Europe will work towards this – monetary stability and the irreversibility of the euro to which the ECB is committed allows time for the European project – the European Union – to be completed.

It will take time, maybe lots of time, to be realised, but Draghi has acted to reduce what he described as “tail risk”, that is to reduce the perhaps small but catastrophic possibility of a banking and financial collapse in Europe.

It has taken a long time for the ECB to assert itself as a fully independent central bank. The almost immediate reactions to the Draghi plan were highly favourable. Risks came off, to the advantage of the bond, equity and currency markets, including the rand. If the market is convinced that the ECB could do what it would have to do in a time of crisis then maybe the markets in euro debt and interbank loans will calm down enough to avoid the ECB from actually exercising its powers. The bazooka is loaded: it may not have to be fired.

Fired or not, the markets can return to the still difficult task of forecasting the state of the global economy (Europe included) without the same fear about the tail risk of a European financial break down that the ECB has addressed. Brian Kantor

Headline CPI inflation declined to 4.9% for the 12 months to July. This welcome lower rate of inflation does not tell the full story of the direction of prices. A year can be a long time in economic life and what happens to prices in between can be much more revealing about inflation trends. Over the past three months prices have increased very slowly – more slowly than they did a year ago, as we show below. Prices rose by 0.08% in May, 0.24% in June and 0.32% in July.

These relatively small monthly increases compared to a year before have brought down the three month rate of inflation, seasonally adjusted and annualised, sharply lower to well below 4%. ( See below)

If current trends in the CPI persist, the outlook is for an inflation rate of no more than 3.5% this time next year, as we show in the chart below. It should be noticed that monthly increases in the CPI were particularly rapid early this year, thus offering the possibility of seeing year on year inflation come down further in early 2013 (that is, if monthly increases then turn out to be below the rather high monthly increases of early 2012).

These trends could be damaged by a combination of a weaker rand and supply side disruption (drought and war) which might drive global grain and oil prices higher. If global growth gathered enough momentum to drive up metal and commodity prices generally, for demand side reasons, the rand might well strengthen to moderate such influences on the prices of imported and exported goods. Faster growth in export markets would be very helpful to the SA economy. It could bring faster growth without more inflation, because the rand will strengthen.

Slower global growth would be very likely to weaken the rand and cause the inflation numbers and outlook to deteriorate. The domestic economy will also be harmed by such trends. It would mean slower growth and higher inflation. The case for raising interest rates under such adverse circumstances is a poor one. It would mean still slower growth without any predictable impact on the inflation rate.

The Reserve Bank, under present leadership, seems unlikely to raise rates should this adverse scenario materialise. If the economy stays its present course (less inflation and growth that remains below potential growth), the case for lowering rates improves. The more hopeful scenario – the SA economy to benefit from a reviving global economy and higher commodity prices and a more valuable rand meaning no more inflation – the case for lower interest rates also improves.

And so in the light of currently lower inflation, the case for lower interest rates has improved. Furthermore it is hard to contemplate more favourable or less favourable economic circumstances that would drive short rates higher. We might describe the outlook for (lower) interest rates in SA as the Marcus Put. Brian Kantor

(From 23 December 2011)
The ECB has finally acted as a lender of last resort (without limit) to the European banks, who had been threatened by the weakness in the European Government bonds they hold. These bonds are now being used as collateral by the banks for three year money from the ECB at 1% per annum.

Click here for the full report:
Talking Point A New Year Wish

(From 14 December 2011)
The big new story in the currency markets is not the weakness of the rand or the strength of the dollar – but the weakness of the euro. The euro, which was worth as much as 1.417 US dollars on 27 October, is now trading at close to 1.30

Click here for the full report:
Currencies Structurally weaker euro