The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Tuesday, June 29, 2010

Once the developed world discards ZIRP, central bank independence will be threatened

Some media have argued that central bank independence withstood a tough test during the GFC. But this is baloney--policy rates in most developed countries remain close to their politically popular zero bound. The real test will emerge only once central banks are forced to reverse course and tackle the inevitable inflationary pressures that will materialise as a result of going too low, for too long (yes, it is indeed ironic that a private credit crisis spawned a public debt crisis and Greenspan redux). And here the RBA stands almost alone.

Apologies if this in inchoate, but I am travelling overseas at present and heavily jet-lagged. The Bank for International Settlements, widely known as the central bank to...central banks...delivers the following stern warnings about what lies in wait for much of the developed world. The good news for local denizens is that if you are worried about low interest rates, quantitative easing, and extremely unorthodox central bank behaviour, you do not need to worry about the good 'ole R.B.A. The period ahead may in fact prove that Glenn Stevens is our greatest Governor. But before we get there, this is what the BIS has to say (HT: the FT):

"policymakers will need to consider the distortions caused by prolonged conditions of monetary ease. After all, sustained low interest rates have been identified by many as an important factor that contributed to the crisis (see BIS, 79th Annual Report, Chapter I). At the same time, policymakers should also closely monitor the distortions arising from unconventional monetary policy tools. These include price distortions in bond markets that can result from changes in central banks’ criteria for eligible repo collateral and from their asset purchases. Artificially high asset prices in certain markets might delay the necessary restructuring of private sector balance sheets. There are also distortions in market activity that arise from central banks’ increased intermediation during the crisis. Moreover, the asset purchases have exposed central banks to considerable credit risk, which together with the changed balance sheet composition may expose them to political pressures.

History offers little guidance on the economic significance of the side effects of unconventional monetary policy. By contrast, distortions arising from low interest rates have been observed in the past. In this chapter, we review these risks in the current context and argue that, if not addressed soon, they may contain the seeds of future problems at home and abroad. In doing so, we draw on lessons from the run-up to the financial crisis of 2007–09 and on Japanese experiences since the mid-1990s...

Low policy rates in combination with higher long-term rates increase the profits that banks can earn from maturity transformation, ie by borrowing short-term and lending long-term. Indeed, part of the motivation of central banks in lowering policy rates was to enable battered financial institutions to raise such profits and thereby build up capital. The heightened attractiveness of maturity transformation since the crisis was reflected in rising carry-to-risk ratios in 2009 and early 2010 (Graph II.1, bottom right-hand panel). Increasing government bond yields, caused by ballooning deficits and debt levels and a growing awareness of the associated risks, make the yield curve even steeper and reinforce the appeal of maturity transformation strategies.

However, financial institutions may underestimate the risk associated with this maturity exposure and overinvest in long-term assets. As already noted, interest rate exposures of banks as measured by VaRs remain high. If an unexpected rise in policy rates triggers a similar increase in bond yields, the resulting fall in bond prices would impose considerable losses on banks. As a consequence, they might face difficulties rolling over their short-term debt. These risks may have increased somewhat in the aftermath of the 2007–09 crisis, because the poor credit environment for banks and the greater availability of central bank funding have left many banks with funding structures skewed towards shorter maturities. A squeeze on banks’ wholesale funding might set off renewed asset sales and further price declines...

Unlike [in 2008], however, we have hardly any room for manoeuvre. Policy rates are already at zero and central bank balance sheets are bloated. Although private sector debt has started to decline, public debt has taken its place, with sovereign fiscal positions already on an unsustainable path in a number of countries. In short, macroeconomic policy is in a vastly worse position than it was three years ago, with little capacity to combat a new crisis – it will be difficult to find a source of further treatment should another emergency arise. Regaining the ability to react to economic and financial crises, by putting policies onto sustainable paths, is therefore a priority for macroeconomic policy."