Tag: Monetary Policy

Fed Chair On Economic Outlook and Monetary Policy Review

Jerome H. Powell spoke at the Council on Foreign Relations, New York.

He said when the FOMC met at the start of May, tentative evidence suggested economic crosscurrents were moderating, so they left the policy rate unchanged. But now, risks to their favorable baseline outlook appear to have grown with concerns over trade developments contributing to a drop in business confidence. That said, monetary policy should not overreact to any individual data point or short-term swing in sentiment.

They are also formally and publicly opening their decisionmaking to suggestions, scrutiny, and critique.

It is a pleasure to speak at the Council on Foreign Relations. I will begin with a progress report on the broad public review my Federal Reserve colleagues and I are conducting of the strategy, tools, and communication practices we use to achieve the objectives Congress has assigned to us by law—maximum employment and price stability, or the dual mandate. Then I will discuss the outlook for the U.S. economy and monetary policy. I look forward to the discussion that will follow.

During our public review, we are seeking perspectives from people across the nation, and we are doing so through open public meetings live-streamed on the internet. Let me share some of the thinking behind this review, which is the first of its nature we have undertaken. The Fed is insulated from short-term political pressures—what is often referred to as our “independence.” Congress chose to insulate the Fed this way because it had seen the damage that often arises when policy bends to short-term political interests. Central banks in major democracies around the world have similar independence.

Along with this independence comes the obligation to explain clearly what we are doing and why we are doing it, so that the public and their elected representatives in Congress can hold us accountable. But real accountability demands more of us than clear explanation: We must listen. We must actively engage those we serve to understand how we can more effectively and faithfully use the powers they have entrusted to us. That is why we are formally and publicly opening our decisionmaking to suggestions, scrutiny, and critique. With unemployment low, the economy growing, and inflation near our symmetric 2 percent objective, this is a good time to undertake such a review.

Another factor motivating the review is that the challenges of monetary policymaking have changed in a fundamental way in recent years. Interest rates are lower than in the past, and likely to remain so. The persistence of lower rates means that, when the economy turns down, interest rates will more likely fall close to zero—their effective lower bound (ELB). Proximity to the ELB poses new problems to central banks and calls for new ideas. We hope to benefit from the best thinking on these issues.

At the heart of the review are our Fed Listens events, which include town hall–style meetings in all 12 Federal Reserve Districts. These meetings bring together people with wide-ranging perspectives, interests, and expertise. We also want to benefit from the insights of leading economic researchers. We recently held a conference at the Federal Reserve Bank of Chicago that combined research presentations by top scholars with roundtable discussions among leaders of organizations that serve union workers, low- and moderate-income communities, small businesses, and people struggling to find work.

We have been listening. What have we heard? Scholars at the Chicago event offered a range of views on how well our monetary policy tools have effectively promoted our dual mandate. We learned more about cutting-edge ways to measure job market conditions. We heard the latest perspectives on what financial and trade links with the rest of the world mean for the conduct of monetary policy. We heard scholarly views on the interplay between monetary policy and financial stability. And we heard a review of the clarity and the efficacy of our communications.

Like many others at the conference, I was particularly struck by two panels that included people who work every day in low- and middle-income communities. What we heard, loud and clear, was that today’s tight labor markets mean that the benefits of this long recovery are now reaching these communities to a degree that has not been felt for many years. We heard of companies, communities, and schools working together to bring employers the productive workers they need—and of employers working creatively to structure jobs so that employees can do their jobs while coping with the demands of family and life beyond the workplace. We heard that many people who, in the past, struggled to stay in the workforce are now getting an opportunity to add new and better chapters to their life stories. All of this underscores how important it is to sustain this expansion.

The conference generated vibrant discussions. We heard that we are doing many things well, that we have much we can improve, and that there are different views about which is which. That disagreement is neither surprising nor unwelcome. The questions we are confronting about monetary policymaking and communication, particularly those relating to the ELB, are difficult ones that have grown in urgency over the past two decades. That is why it is so important that we actively seek opinions, ideas, and critiques from people throughout the economy to refine our understanding of how best to use the monetary policy powers Congress has granted us.

Beginning soon, the Federal Open Market Committee (FOMC) will devote time at its regular meetings to assess the lessons from these events, supported by analysis by staff from around the Federal Reserve System. We will publicly report the conclusions of our discussions, likely during the first half of next year. In the meantime, anyone who is interested in learning more can find information on the Federal Reserve Board’s website.1

Let me turn now from the longer-term issues that are the focus of the review to the nearer-term outlook for the economy and for monetary policy. So far this year, the economy has performed reasonably well. Solid fundamentals are supporting continued growth and strong job creation, keeping the unemployment rate near historic lows. Although inflation has been running somewhat below our symmetric 2 percent objective, we have expected it to pick up, supported by solid growth and a strong job market. Along with this favorable picture, we have been mindful of some ongoing crosscurrents, including trade developments and concerns about global growth. When the FOMC met at the start of May, tentative evidence suggested these crosscurrents were moderating, and we saw no strong case for adjusting our policy rate.

Since then, the picture has changed. The crosscurrents have reemerged, with apparent progress on trade turning to greater uncertainty and with incoming data raising renewed concerns about the strength of the global economy. Our contacts in business and agriculture report heightened concerns over trade developments. These concerns may have contributed to the drop in business confidence in some recent surveys and may be starting to show through to incoming data. For example, the limited available evidence we have suggests that investment by businesses has slowed from the pace earlier in the year.

Against the backdrop of heightened uncertainties, the baseline outlook of my FOMC colleagues, like that of many other forecasters, remains favorable, with unemployment remaining near historic lows. Inflation is expected to return to 2 percent over time, but at a somewhat slower pace than we foresaw earlier in the year. However, the risks to this favorable baseline outlook appear to have grown.

Last week, my FOMC colleagues and I held our regular meeting to assess the stance of monetary policy. We did not change the setting for our main policy tool, the target range for the federal funds rate, but we did make significant changes in our policy statement. Since the beginning of the year, we had been taking a patient stance toward assessing the need for any policy change. We now state that the Committee will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion, with a strong labor market and inflation near its symmetric 2 percent objective.

The question my colleagues and I are grappling with is whether these uncertainties will continue to weigh on the outlook and thus call for additional policy accommodation. Many FOMC participants judge that the case for somewhat more accommodative policy has strengthened. But we are also mindful that monetary policy should not overreact to any individual data point or short-term swing in sentiment. Doing so would risk adding even more uncertainty to the outlook. We will closely monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion.

The Risks Ahead

Agustín Carstens, General Manager, Bank for International Settlements spoke in Beijing recently and discussed the challenges going forward for central banks, as the monetary policy normalistion (following a decade of ultra-low interest rates, QE and the like), are unwound.   He admits that the starting point of the ongoing normalisation is unprecedented, and there are extreme uncertainties involved.

Household debt is high and rising in many advanced and emerging market economies. Quantitative easing has been a “volatility stabiliser” in financial markets and when it is removed or reversed, it is not clear how the market will react. We are in uncharted territory!  Yet, monetary policy normalisation is essential for rebuilding policy space, creating room for countercyclical policy.

Monetary policy normalisation in the major advanced economies is making uneven progress, reflecting different stages of recovery from the GFC. The Federal Reserve has begun unwinding its asset holdings by capping reinvestments and has increased policy rates. The ECB has scaled back its large-scale asset purchases, with a likely halt of net purchases by end-year. Meanwhile, the Bank of Japan is continuing with its purchases and has not communicated any plan for exiting.

The ongoing unwinding of accommodative monetary policy in core advanced economies is a welcome step. It is a sign of success as economies have been brought back to growth and inflation rates back towards target levels. Monetary policy normalisation is essential for rebuilding policy space, creating room for countercyclical policy. Moreover, it can help restrain debt accumulation and reduce the risk of financial vulnerabilities emerging.

But there are also significant challenges. The starting point of the ongoing normalisation is unprecedented, and there are extreme uncertainties involved. The path ahead for central banks is quite narrow, with pitfalls on either side. Central banks will need to strike and maintain a delicate balance between competing considerations. This includes, in particular, the challenge of achieving their inflation objectives while avoiding the risk of encouraging the build-up of financial vulnerabilities.

Central banks have prepared and implemented normalisation steps very carefully. Policy normalisation has been very gradual and highly predictable. Central banks have placed great emphasis on telegraphing their policy steps through extensive use of forward guidance. As a consequence, major financial and economic ructions have so far been avoided. In this regard, the increased resilience of the financial sector as a consequence of the wide regulatory and supervisory reforms undertaken since 2009 has also helped.

That said, there are still plenty of risks out there.

First, central banks are not in control of the entire yield curve and of the behaviour of risk premia. Investor sentiment and expectations are key factors determining these variables. An abrupt repricing in financial markets may prompt an outsize revision of the expected level of risk-free interest rates or a decompression in risk premia. Such a snapback could be amplified by market dynamics and have adverse macroeconomic consequences. It could also be accompanied by sudden sharp exchange rate fluctuations and spill across borders, with broader repercussions globally.
Second, many intermediaries are in uncharted waters. Exchange-traded funds (ETFs) have grown faster than actively managed mutual funds over the past decade, and needless to say, they have brought very important benefits to bond markets, among other factors, by enhancing the depth of such markets and making possible new ways of financing for many sovereigns and corporations. ETFs are especially popular among equity investors, but they have also gained importance among bond investors.

They have attracted investors because they charge lower fees than traditional mutual funds, which has proved to be an important advantage in the ultra-low interest rate environment. Moreover, they promise liquidity on an intraday basis, hence more immediately than mutual funds, which provide it only daily.

Such promise of intraday liquidity is, however, a double-edged sword. As soon as ETF investors are confronted with negative news or observe an unexpected fall in the underlying asset price, they can run – that is, sell their ETF shares immediately – adding to the downward pressure on market prices. As equity markets become choppier, we will need to be on the look-out for ETFs possibly accentuating the volatility of the underlying asset market.

Currently, bond ETFs are still small compared with bond mutual funds in terms of their assets under management. However, as the market share of ETFs increases, their impact on market price dynamics will also increase. Moreover, they have yet to be tested in periods of high interest rates.
More generally, investors may face unforeseen risks – in particular, unforeseen dry-ups in liquidity. As I mentioned earlier, the growing size of the asset management industry may have increased the risk of liquidity illusion: market liquidity seems to be ample in normal times, but dries up quickly during market stress. Asset managers and institutional investors do not have strong incentives to play a market-making role when asset prices fall due to large order imbalances. Moreover, precisely when asset prices fall, asset managers often face redemptions by investors. This is especially true for bond funds investing in relatively illiquid corporate or EME bonds. Therefore, when market sentiment shifts adversely, investors may find it more difficult than in the past to liquidate bond holdings.

Central banks’ asset purchase programmes may also have contributed to liquidity illusion in some bond markets. Such programmes have led to portfolio rebalancing by investors from safe government debt towards riskier bonds, including EME bond markets, making them look more liquid. However, such liquidity may disappear in the event of market turbulence. Also, as advanced economy central banks unwind their asset purchase programmes and increase policy rates, investors may choose to rebalance from riskier bonds back to safe government bonds. This can widen spreads of corporate and EME bonds.

Moreover, asset managers’ investment strategies can collectively increase financial market volatility. A key source of risk here is asset managers’ “herding” in illiquid bond markets. Fund managers often claim that their performance is evaluated over horizons as long as three to five years. Nevertheless, they tend to have a strong aversion to underperforming over short periods against industry peers. This can lead to increased risk-taking and highly correlated investment strategies across asset managers. For example, recent BIS research shows that EME bond fund investors tend to redeem funds at the same time. Moreover, the fund managers of the so-called actively managed EME bond funds are found to closely follow a small number of benchmarks (a practice known as “benchmark hugging”).

Third, the fundamentals of many economies are not what they should be while at the same time there seems to be less political appetite for prudent macro policies. High and rising sovereign debt relative to GDP in many advanced economies has increased the sensitivity of investors to the perceived ability and willingness of governments to ensure debt sustainability. Sovereign debt in EMEs is considerably lower than in advanced economies on average, but corporate leverage has continued to rise and has reached record levels in many EMEs.

Also, household debt is high and rising in many advanced and emerging market economies. In addition, a large amount of EME foreign currency debt matures over the next few years, and large current account and fiscal deficits in some EMEs could induce global investors to take a more cautious stance. Tightening global financial conditions and EME currency depreciation may increase the sensitivity of investors to these vulnerabilities.

Fourth, other factors may augment the spillover effects from unwinding unconventional monetary policy. Expansionary fiscal policy in some core advanced economies may further push up interest rates, by increasing government bond supply and aggregate demand in already-overheating economies. Trade tensions have started to darken the growth prospects and balance of payments outlook of many countries. Such tensions also have repercussions on exchange rates and corporate debt sustainability. Heightened geopolitical risks should not be ignored either. The sharp corrections in advanced economy and EME equity markets alike in October 2018 are generally attributed to both aggravating trade tensions and geopolitical risks.

Fifth, there is much uncertainty about how investors will react to monetary policy normalisation. Quantitative easing has been a “volatility stabiliser” in financial markets. Thus, when it is removed or reversed, it is not clear how the market will react. Market segments of particular concern are high-yield bonds and EME corporate bonds. As I pointed out a moment ago, liquidity tends to dry up more easily in these markets. Knowing this, asset managers may try to rebalance their portfolios by deleveraging more liquid surrogates first, which creates an avenue for contagion to other markets.

“Tourist investors” are another source of concern. For example, in contrast to “dedicated” bond funds, which follow specific benchmarks relatively closely, “crossover” funds have benchmarks but deviate from them and cross over to riskier asset classes such as EME bonds and high-yield corporate bonds in search of yield. Crossover funds are not new, but they have gained prominence recently. They include high-yield, high-risk bonds in their portfolio by arguing that the extra return from such investments is high enough to compensate for their risk. They are likely to underprice risks when markets are calm, but overprice risks when markets become volatile. They are, indeed, very responsive to interest rate and exchange rate surprises and tend to pull out suddenly from risky investments.

Finally, significant allocations by global asset managers to domestic currency bond markets, in particular to EME local currency sovereign bonds, have generated new challenges. After the Asian financial crisis of 1997–98, many emerging Asian economies made concerted efforts to develop their local currency bond markets. This was a welcome development, overcoming “original sin”, a term coined by Barry Eichengreen and Ricardo Hausmann in 1999 for the inability of developing countries to borrow in their domestic currency. By relying on long-term local currency bonds instead of short-term foreign currency loans, many Asian EME borrowers were able to avoid currency mismatch and reduce rollover risk. In addition, over the past several years, the average maturity of EME local currency bonds has increased overall.

However, as the share of foreign investment in EME local currency bond markets has increased, currency and rollover risks have been replaced by duration risk. The effective duration of an investment measures the sensitivity of the investment return to the change in the bond yield. Recent BIS research shows that EME local currency bond yields tend to increase in tandem with domestic currency depreciation. This can make returns of EME local currency bond investors, whose investment performance is measured in the US dollar (or the euro), extremely volatile. As an analogy, incorporating exchange rate consideration is similar to viewing temperatures with and without a wind chill factor.

This suggests that the exchange rate response to capital flows might not stabilise economies as textbooks predict: it might instead lead to procyclical non-linear adjustments. Exchange rate changes can drive capital in- and outflows via the so called risk-taking channel of exchange rates.

The core mechanism of the risk-taking channel works as follows. In the presence of currency mismatch, a weaker dollar flatters the balance sheet of the EME’s dollar borrowers. This induces creditors (either global banks or global bond investors) to extend more credit. As a consequence, a weaker dollar goes hand in hand with reduced tail risks and increased EME borrowing. However, when the dollar strengthens, these relationships go into reverse.

Policy implications

Monetary policy normalisation by major advanced economies, escalating trade tensions, heightened geopolitical risks and new forms of financial intermediation all pose challenges going forward for both advanced and emerging market economies. How can policymakers rise to these challenges?

Inadequate growth-enhancing structural policies have been a major deficiency over the past years. Such policies would facilitate the treatment of overindebtedness. In contrast to expansionary monetary and fiscal policies, which boost both debt and output, growth-enhancing structural reforms would primarily boost output, thus reducing debt burdens relative to incomes. Moreover, by improving the supply side of the economy, they would contain inflationary pressures. And, if sufficiently broad in scope, they would have positive distributional effects, reducing income inequality.

Advanced economies should be mindful of spillovers, also because they can mutate into spillbacks. During phases in which interest rates remain low in the main international funding currencies, especially the US dollar, EMEs tend to benefit from easy financial conditions. These effects then play out in reverse once interest rates rise. A reversal could occur, for instance, if bond yields snapped back in core advanced economies, and especially if this went hand in hand with US dollar appreciation. A clear case in point is the change in financial conditions experienced by EMEs since the US dollar started appreciating in the first quarter of 2018.

Global spillovers can also have implications for the core economies. The collective size of the countries exposed to the spillovers suggests that what happens there could also have significant financial and macroeconomic effects in the originating economies. At a minimum, such spillbacks argue for enlightened self-interest in the core economies, consistent with domestic mandates. This is an additional policy dimension that complicates the calibration of the normalisation and that deserves close attention.

Financial reforms should be fully implemented. If enforced in a timely and consistent manner, these reforms will contribute to a much stronger banking system. Indeed, the Basel Committee’s Regulatory Consistency Assessment Programme has found that its members have put in place most of the major elements of Basel III. But implementation delays remain. It is important to attain full, timely and consistent implementation of all the rules. This would improve the resilience of banks and the banking system. It is also necessary for attaining a level playing field and limiting the room for regulatory arbitrage.

For EMEs, keeping one’s house in order is paramount because there is no room for poor fundamentals during tightening global financial conditions. EMEs may nevertheless face capital outflows, and their currencies may depreciate abruptly, which would trigger further capital outflows. In such instances, EME authorities must be prepared to respond forcefully. They should consider combining interest rate adjustments with other policy options such as FX intervention. And they should consider using the IMF’s contingent lending programmes.

At the same time, EMEs should not disregard non-orthodox policies to deal with stock adjustment. If a large amount of foreign capital has flowed into domestic markets and threatens to flow out quickly, the central bank can use its balance sheet to stabilise markets. As an example, the Bank of Mexico has in the past swapped long-term securities for short-term securities via auctions. This was done because such long-term instruments were not in the hands of strong investors, and there was market demand for short-term securities. This policy stabilised conditions in peso-denominated bond markets.

Finally, policymakers need to better understand asset managers’ behaviour in stress scenarios and to develop appropriate policy responses. One key question for policymakers is how to dispel liquidity illusion and to support robust market liquidity. Market-makers, asset managers and other investors would need to take steps to strengthen their liquidity risk management. Policymakers can also provide them with incentives to maintain robust liquidity during normal times to weather liquidity strains in bad times – for example, by encouraging regular liquidity stress tests.

The RBA Warns On Mortgage Default Risk

We look at the latest from the RBA.

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The Million Dollar Man Who Is Waiting For The Bubble To Burst

In the latest edition of my discussions with economist John Adams, we look at recent RBA monetary policy, and conclude is not fit for purpose.

Despite all the hype, the next cash rate move could well be down, as the bursting debt bubble approaches.

John’s original article is here.

 

Is The RBA Myopic On Financial Stability?

From The Conversation.

The Reserve Bank of Australia (RBA) is making an explicit trade-off between inflation and financial stability concerns. And this could be weighing on Australians’ wages.

In the past, the RBA focused more on keeping inflation in check, the usual role of the central bank. But now the bank is playing more into concerns about financial stability risks in explaining why it is persistently undershooting the middle of its inflation target.

In the wake of the global financial crisis, the federal Treasurer and Reserve Bank governor signed an updated agreement on what the bank should focus on in setting interest rates. This included a new section on financial stability.

That statement made clear that financial stability was to be pursued without compromising the RBA’s traditional focus on inflation.

The latest agreement, adopted when Philip Lowe became governor of the bank in 2016, means the bank can pursue the financial stability objective even at the expense of the inflation target, at least in the short-term.

While the RBA board has explained its recent steady interest rate decisions partly on the basis of risks to financial stability, this sits uneasily with what the RBA otherwise has to say about underlying fundamentals of our economy.

It correctly blames trends in house prices and household debt on a lack of supply of housing, and not on excessive borrowing. These supply restrictions amplify the response of house prices to changes in demand for housing. RBA research estimates that zoning alone adds 73% to the marginal cost of houses in Sydney.

Restrictions on lending growth by the Australian Prudential Regulation Authority since the end of 2014 have been designed to give housing supply a chance to catch-up with demand and to maintain the resilience of households against future shocks.

The RBA argues that it needs to balance financial stability risks against the need to stimulate the economy through lower interest rates. But this has left inflation running below the middle of its target range and helps explain why wages growth has been weak.

The official cash rate has been left unchanged since August 2016, the longest period of steady policy rates on record. The fact that inflation has undershot its target of 2-3% is the most straightforward evidence that monetary policy has been too restrictive.

While long-term interest rates in the US continue to rise, reflecting expectations for stronger economic growth and higher inflation, Australia’s long-term interest rates have languished.

Australian long-term interest rates are below those in the US by the largest margin since the early 1980s. This implies the Australian economy is expected to underperform that of the US in the years ahead.

Inflation expectations (implied by Australia’s long-term interest rates) have been stuck around 2% in recent years, below the Reserve Bank’s desired average for inflation of 2.5%.

Financial markets can be forgiven for thinking the RBA will not hit the middle of its 2-3% target range any time soon. The RBA doesn’t believe it will either, with its deputy governor Guy Debelle repeating the word “gradual” no less than 12 times in a speech when describing the outlook for inflation and wages.

Inflation has been below the midpoint of the target range since the December quarter in 2014. On the RBA’s own forecasts inflation isn’t expected to return to the middle of the target range over the next two years.

The Reserve Bank blames low inflation on slow wages growth, claiming in its most recent statement on monetary policythat “labour costs are a key driver of inflationary pressure”. But this is putting the cart before the horse.

In fact, recently published research shows that it is low inflation expectations that are largely to blame for low wages growth.

Workers and employers look at likely inflation outcomes when negotiating over wages. These expectations are in turn driven by perceptions of monetary policy.

Below target inflation makes Australia less resilient to economic shocks, not least because it works against the objective of stabilising the household debt to income ratio. Subdued economic growth and inflation also gives the economy a weaker starting point if and when an actual shock does occur, potentially exacerbating a future downturn.

When the RBA governor and the federal treasurer renegotiate their agreement on monetary policy after the next election, the treasurer should insist on reinstating the wording of the 2010 statement that explicitly prioritised the inflation target over financial stability risks.

If the RBA continues to sacrifice its inflation target on the altar of financial stability risks, inflation expectations and wages growth will continue to languish and the economy underperform its potential.

Author: Stephen Kirchner, Program Director, Trade and Investment, United States Studies Centre, University of Sydney

RBA Sees Cake Tomorrow

The latest RBA Statement on Monetary Policy moves the dial a little in terms of expectations, but also is still predicting better economic outcomes down the track, if a little further away than originally expected (again).

By 2020, GDP could be somewhere between 1 and 5.5% – that should about cover it!

They call out risks relating to the amount of debt in the household sector, and the prospect of higher funding costs, and lower consumption should home prices fall.  So there are a number of important items in the economic cross currents, and I am going to focus there today.

First, the highlight that US funding costs are on the rise, as US dollar money markets have increased.

They highlight that these developments have had a notable knock-on effect on Australian money markets.  “In part, this is because Australian banks raise a portion of their funding in US markets to finance their domestic assets. So they have responded to higher US rates by seeking to borrow more in domestic markets, which has place upward pressure on rates in Australia. Similar effects, although less pronounced, can be seen on rates
in the United Kingdom and New Zealand. By contrast, banks in the euro area and Japan tend to raise funds in US dollar markets in order to fund US dollar assets, and so have less scope to substitute into domestic funding sources”.

“Higher bank bill swap (BBSW) rates affect bank funding costs in a number of ways. First, BBSW rates flow through to the rates banks pay on their new short- and long-term wholesale debt. In addition to this effect, bank bond
yields have increased by around 20 basis points since the start of the year.

Second, the higher BBSW rates increase some of the costs associated with hedging the risks on banks’ debt. Banks tend to issue fixed-rate bonds and then swap a sizeable share of these fixed interest rate exposures into floating rate exposures. This better aligns the interest rate exposure from their funding with their assets (which consist largely of variable interest rate loans). In doing this, the banks typically end up paying BBSW rates on their hedged liabilities, which flow through to the cost of funding.

Third, rates on wholesale deposits tend to be closely linked to BBSW rates, so the cost of these deposits is rising. Wholesale deposits include deposits from large corporations, pension funds and the government, and account for around 30 per cent of banks’ debt funding. Over the year to date, retail deposit rates have decreased slightly, mostly reflecting declines in the rates on online saving accounts. Most, but not all, of these decreases occurred
before the recent increase in BBSW”.

They suggest that “revisions” to the household consumption series shows a higher level of spend than previously thought. “Household consumption grew strongly in the December quarter and revisions to previous data
show that consumption growth held up better than previously thought in the second half of 2017 (Graph 2.8). Over the year, consumption grew by almost 3 per cent. Upward revisions to household consumption were particularly large for discretionary categories of expenditure, which tend to be more sensitive to household finances. Spending on overseas travel by Australian residents (which is classified as imports) was a major source of these revisions, while upward revisions to food and health expenditure
also lifted essential expenditure. More recent indicators suggest that household consumption growth was steady in early 2018: growth in retail sales held up in the first two months of the year. Measures of households’
sentiment towards their personal finances remain above their long-run averages, after increasing since the middle of 2017”.

“Household consumption grew at a faster rate than household disposable income over 2017; the household saving ratio is reported to have declined, although it stabilised towards the end of the year as income growth picked up (Graph 2.10). Growth in real household disposable income was below average over 2017 at 1.7 per cent, largely because of low wages growth. The prospect of continued low growth in household income remains a key risk to the outlook for household consumption, especially given high levels of household debt. Slower growth in household net wealth, particularly in an environment of below-average income growth, adds to uncertainty about the outlook for consumption”.

“New dwelling construction declined by 5 per cent over 2017. This follows a few years in which new dwelling construction increased to high levels, supported by low interest rates, strong population growth and higher
housing prices in the eastern states. The recent decline in residential construction activity has been concentrated in detached housing, while higher-density construction activity has remained at high levels (Graph 2.14). Alterations and additions appear to have been less responsive to the cycle in new dwelling construction than in previous episodes”.

Turning to mortgage rates, they confirm that new loans tend to be at lower variable rates than the average for outstanding loans. Moreover, new IO borrowers continue to pay a premium above the interest rate on new principal-and-interest (P&I) home loans.

“The value of housing loan approvals (excluding refinancing) has continued to decline over recent months, to be 8 per cent below the recent peak in August 2017. This has been driven by investors, with owner-occupier approvals remaining relatively steady since mid 2017 (Graph 3.12). The decline in investor approvals has been  primarily concentrated in New South Wales”.
They reviewed interest only loans (again) and concluded that “Currently it appears that the share of borrowers who will not be able to afford higher P&I repayments and are not eligible to alleviate their situation by refinancing is small. Liaison with the banks suggests that there are a few borrowers needing assistance to manage the transition. Over the past year, some banks have reported in liaison that there has been a small deterioration in asset quality. For some borrowers this has tended to be only temporary as they take some time to adjust their financial affairs to cope with the rise in scheduled payments. For a small share of borrowers though, it reflects difficulty making these higher repayments. That share could increase in the event that an adverse shock led to a deterioration in overall economic conditions”.

The forecasts for domestic output growth are broadly similar to those presented in the February Statement. GDP growth is expected to strengthen a little over the next year or so as the drag from mining investment comes to an end and accommodative monetary policy provides ongoing support for sustained growth in household income and consumption, and non-mining business investment. However, the economy is not expected to encounter broad-based capacity constraints for some time.

“There is also uncertainty about how much any decline in spare capacity will build into wage pressures and inflation. Wages and employment growth are
key components of household income growth, and uncertainty about the outlook for household income growth translates into uncertainty about
household consumption and so GDP. Another key source of risk to consumption growth is that high levels of debt are likely to increase the
sensitivity of households’ consumption decisions to changes in their income or wealth.

Household indebtedness is high; and debt levels relative to income have edged higher because household credit growth has outpaced weak income growth over recent years. Steps taken by regulators to strengthen household balance sheets have led to a moderation in the growth in the riskier types of lending to households, but risks remain. Even if overall household indebtedness currently appears sustainable, a highly indebted household sector is likely to be more sensitive to changes in income, wealth or interest rates. For example, a highly indebted household facing weaker-than-expected growth in disposable income or wealth is more likely to respond by reducing consumption. Consumption growth may also be weaker for a time if indebted households choose to pay down debt more quickly rather than consume out of additional income.

Housing assets account for around 55 per cent of total household assets, so weaker housing prices could be a factor that leads to weaker consumption growth than is currently forecast. National housing prices have eased following several years of strong price growth. To date, the cooling of conditions in the established housing market does not appear to have dampened consumption growth. Although the earlier gains in national housing wealth may not have encouraged much additional consumption, it is possible that households’ consumption and saving decisions could be more sensitive to an easing in housing price growth.

Tighter lending standards could also affect the outlook for domestic growth. While APRA recently announced plans to remove the investor loan
benchmark, the change in dynamics in the housing market and the high level of public scrutiny of lending decisions could see some tightening in the
supply of credit. This could affect the outlook for consumption and dwelling investment”.

An Alternative Financial Narrative

Mark this date – 10th June 2018.  This is the date of the Swiss Federal referendum on the Sovereign Money Initiative (or “Vollgeld-Initiative” in German). Swiss voters will be asked who should be allowed to create new Swiss francs: UBS, Credit Suisse and other private commercial banks or the Swiss National Bank which is obliged to act in the interest of Switzerland as a whole.

This is the latest incarnation of the so-called Chicago Plan, which is an alternative proposal as to how banking, and central banking should be set up.

The ideas are not new, they emerged in the 1930’s, at the height of the Great Depression when a number of leading U.S. economists advanced a proposal for monetary reform that later became known as the Chicago Plan.

It envisaged the separation of the monetary and credit functions of the banking system, by requiring 100% reserve backing for deposits. Irving Fisher (1936) claimed the following advantages for this plan: (1) Much better control of a major source of business cycle fluctuations, sudden increases and contractions of bank credit and of the supply of bank-created money. (2) Complete elimination of bank runs. (3) Dramatic reduction of the (net) public debt. (4) Dramatic reduction of private debt, as money creation no longer requires simultaneous debt creation. It was supported by other luminaries such as Milton Friedman.

The ideas were brought to more recent attention following the release of an IMF paper – The Chicago Plan Revisited.  We discussed the report in an earlier blog.

As we discussed more recently, the classic theory of banking, that deposits lead to banks making loans is incorrect. In fact banks create loans from “thin air”, and have all but unlimited capacity to do so. As customers take the loans, and use them to buy things, or place into deposit, money is created. No other party needs to be involved. The trouble is, not many central bankers get this alternative view, so continue to execute flawed policies, such as Quantitative Easing, and ultra-low interest rates.  Banks  are intermediaries, not credit creators, they say; when in fact the create funds from nowhere. But this leads to problems as we see today.

But, be clear, when a loan is created, it does indeed generate new purchasing power.It becomes part of a self-fulling growth engine. But at what cost?

Understand that the only limit on the amount of credit is peoples ability to service the loans – eventually. The more loans the banks can make, the larger they become, and the more of the economy banks consume. This is what has happened in recent times. It leads to the financialisation of property, asset price inflation and massive and unsustainable increases in debt. The only way out is the inevitable crash, so we get a state of booms and busts.

Whilst there are some controls on the banks thanks to the Basel requirement to hold a certain proportion of liquid assets against the loans, but it is a fraction of the total loans made, and there is a multiplier effect which means that very little of the shareholders capital in the banks are required to support the loans. In other words, Banks are hugely leveraged. In addition, Basel capital rules favours unproductive lending for secured property (houses and apartments) over productive lending to businesses.

In addition, Central banks have very limited ability to control the money supply, contrary to popular belief, and so their main policy control is interest rates. Lift rates to slow the economy, drop rates to drive the economy harder, against a target inflation outcome.  But this is a very blunt tool. This also means that the idea of narrow money, spilling out from a multiplier effect is also flawed.

Well, now perhaps the tide is turning.

In the aftermath of the 2008 financial crisis, Iceland commissioned a report “Monetary Reform – A better monetary system for Iceland” which was  published in 2015, and suggests that money creation is too important to be left to bankers alone.

Back in 2014 I discussed this, based on an insight from the Bank of England.  Their Quarterly Bulletin (2014 Q1), was revolutionary and has the potential to rewrite economics. “Money Creation in the Modern Economy” turns things on their head, because rather than the normal assumption that money starts with deposits to banks, who lend them on at a turn, they argue that money is created mainly by commercial banks making loans; the demand for deposits follows. Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.

More recently the Bank of Norway confirmed this, and said “The bank does not transfer the money from someone else’s bank account or from a vault full of money. The money lent to you by the bank has been created by the bank itself – out of nothing: fiat – let it become.”.

And even the arch conservative German Bundesbank said in 2017 recently “this means that banks can create book money just by making an accounting entry: according to the Bundesbank’s economists, “this refutes a popular misconception that banks act simply as intermediaries at the time of lending – ie that banks can only grant credit using funds placed with them previously as deposits by other customers“.

So, the Chicago Plan is a alternative approach. Here banks cannot lend by creating new deposits.

Rather, their loan portfolio now has to be backed by a combination of their own equity and non-monetary liabilities. If we assume that this funding is supplied exclusively by the government treasury, private agents are limited to holding either bank equity or monetary instruments that do not fund any lending. Under this funding scheme the government separately controls the aggregate volume of credit and the money supply. The transition to this new balance sheet conceptually takes place in two stages that both happen in a single transition period. In the first stage, banks instantaneously increase their reserve backing for deposits from 0% to 100%, by borrowing from the treasury. In the second stage, the government can independently control money and treasury credit. It exercises this ability by cancelling all government debt on banks’ balance sheets against treasury credit, and by transferring part of the remaining treasury credit claims against banks to constrained households and manufacturers, by way of restricted accounts that must be used to repay outstanding bank loans. This second stage leaves only investment loans outstanding, with money unchanged and treasury credit much reduced. Net interest charges from the previous period remain the responsibility of the respective borrowers.

Part of the transition plan would be the full buy-back of household debt by the government, making all households effectively debt free. This of course means that household consumption is likely to rise.

In the transition period households only pay the net interest charges on past debts incurred by constrained households to the banking sector. The principal is instantaneously cancelled against banks’ new borrowing from the treasury, after part of the latter has been transferred to the above-mentioned restricted private accounts and then applied to loan repayments. From that moment onward the household sector has zero net bank debt, while their financial assets consist of government bonds and deposits, the latter now being 100% reserve backed.

Now this approach to me has significant merit, and I believe it should be considered as a platform to deal with the current economic situation we face. This appears to be a better, if more radical approach than the so called Glass-Steagall separation of speculative banking assets from core banking operations, but which still perpetuates the current rocky banking road. The Chicago Plan offers significantly more benefits, and the opportunity to reset the economy, and household debt.

So, if the vote is successful on 10th June, the sovereign money bill would give the Swiss National Bank a monopoly on physical and electronic money creation, “while the decision concerning how new money is introduced into the economy would reside with the government,” says Vollgeld.

This also means that Central Banks have the ability to managed the overall money supply, rather than just narrow money and interest rates. And the flows of credit can go to productive business investment, rather than inflated housing loans.

So the bottom line is, The Chicago Plan deserves to go mainstream, despite the howls from bankers, as their businesses get rightsized. It can also deal with the problem of highly indebted households and offers a path potentially to economic success. Current models have failed, time to move on!

 

How does monetary policy affect the distribution of income and wealth?

From The BankUnderground.

The BankUndergound posted an interesting analysis of the impact of on households of their loose monetary policy.  Here is an extract, follow the link for the entire paper.

Although existing differences in income and wealth means that the impact in cash terms varied substantially between households, in a recent staff working paper we find that monetary policy had very little impact on relative measures of inequality. Compared to what would have otherwise happened, younger households are estimated to have benefited most from higher income in cash terms, while older households gained more from higher wealth.

Households tend to report that looser monetary policy has made them worse offIn contrast to our findings, the balance of households in the 2017H1 NMG Survey – a biannual survey of households commissioned by the Bank of England – felt that they had been made worse off by lower interest rates since 2008. Those negative responses were concentrated among older households (Chart 7). When asked about the channels through which they had been affected, most focused on the effects on their interest payments and receipts – where older households have tended to lose out – rather than on their wealth.

Conclusion

There has been growing interest in the effects of monetary policy on the distribution of income and wealth. We find that the gains from monetary easing were distributed roughly in line with initial income and wealth holdings. Because the percentage changes in income and wealth were similar across all distributions there was no large impact on inequality. If anything, those at the bottom end of the wealth distribution gained slightly more in percentage terms. Furthermore, most households are estimated to have been made better off than they otherwise would have been if policy had been left unchanged.

Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.

NZ Reserve Bank to consider employment alongside price stability mandate

The New Zealand Government’s New Policy Targets Agreement requires monetary policy to be conducted so that it contributes to supporting maximum levels of sustainable employment within the economy.

The new focus on employment outcomes is an outcome of Phase 1 of the Review of the Reserve Bank Act 1989, which the Coalition Government announced in November 2017.

“The Reserve Bank Act is nearly 30 years old. While the single focus on price stability has generally served New Zealand well, there have been significant changes to the New Zealand economy and to monetary policy practices since it was enacted,” Grant Robertson said.

“The importance of monetary policy as a tool to support the real, productive, economy has been evolving and will be recognised in New Zealand law by adding employment outcomes alongside price stability as a dual mandate for the Reserve Bank, as seen in countries like the United States, Australia and Norway.

“Work on legislation to codify a dual mandate is underway. In the meantime, the new PTA will ensure the conduct of monetary policy in maintaining price stability will also contribute to employment outcomes.”

A Bill will be introduced to Parliament in the coming months to implement Cabinet’s decisions on recommendations from Phase 1 of the Review. As well as legislating for the dual mandate, this will include the creation of a committee for monetary policy decisions.

“Currently, the Governor of the Reserve Bank has sole authority for monetary policy decisions under the Act. While clear institutional accountability was important for establishing the credibility of the inflation-targeting system when the Act was introduced, there has been greater recognition in recent decades of the benefits of committee decision-making structures,” Grant Robertson said.

“In practice, the Reserve Bank’s decision-making practices for monetary policy have adapted to reflect this, with an internal Governing Committee collectively making decisions on monetary policy. However, the Act has not been updated accordingly.”

The Government has agreed a range of five to seven voting members for a Monetary Policy Committee (MPC) for decision-making. The majority of members will be Reserve Bank internal staff, and a minority will be external members. The Reserve Bank Governor will be the chair.

“It is my intention that the first committee of seven members would have four internal, and three external members. Treasury will also have a non-voting observer on the MPC to provide information on fiscal policy,” Grant Robertson said.

The MPC is expected to begin operation in 2019 following passage of amending legislation. There will be a full Select Committee process for the legislation.

Reserve Bank Governor-Designate, Adrian Orr, said that the PTA recognises the importance of monetary policy to the wellbeing of all New Zealanders.

“The PTA appropriately retains the Reserve Bank’s focus on a price stability objective. The Bank’s annual consumer price inflation target remains at 1 to 3 percent, with the ongoing focus on the mid-point of 2 percent.

“Price stability offers enduring benefits for New Zealanders’ living standards, especially for those on low and fixed incomes. It guards against the erosion of the value of our money and savings, and the misallocation of investment.”

Mr Orr said that the PTA also recognises the role of monetary policy in contributing to supporting maximum sustainable employment, as will be captured formally in an amendment Bill in coming months.

“This PTA provides a bridge in that direction under the constraints of the current Act. The Reserve Bank’s flexible inflation targeting regime has long included employment and output variability in its deliberations on interest rate decisions. What this PTA does is make it an explicit expectation that the Bank accounts for that consideration transparently. Maximum sustainable employment is determined by a wide range of economic factors beyond monetary policy.”

Mr Orr said that he welcomes the intention to use a monetary policy committee decision-making group, including both Bank staff and a minority of external members.

“Legislating for this committee will give a strong basis for the Bank’s use of a committee decision-making process. Widening the committee to include external members also brings the benefit of diversity and challenge in our thinking, while enhancing the transparency of decision-making and flow of information.”

Phase 2 of the Review is being scoped. It will focus on the Reserve Bank’s financial stability role and broader governance reform. Announcements on the final scope will be made by mid-2018 and subsequent policy work will commence in the second half of 2018.