Fed should specify QE exit conditions-Jackson Hole paper

   (Following is the second of four reports based on papers presented at the 2013 Jackson Hole Economic Policy Symposium, hosted by the Federal Reserve Bank of Kansas City. The reports will be published as soon as the authors present their papers to the symposium.)

    The U.S. Federal Reserve should spell out its conditions for winding down quantitative easing (QE) to avoid further damaging rises in long-term interest rates, according to a paper delivered at the Jackson Hole symposium.
    So far, the Federal Reserve has been deliberately vague about its plans for asset purchases – so-called large scale asset purchases or LSAPs - to retain flexibility in its policy given its limited knowledge of how this tool affects the real economy, according to economists Arvind Krishnamurthy and Annette Vissing-Jorgensen, both professors of finance who received their PhDs at MIT. 
    Krishnamurthy and Vissing-Jorgensen used to be colleagues at the Kellogg School of Management, Northwestern University, but Vissing-Jorgensen has now moved to University of California-Berkeley while Krishnamurthy remains at Northwestern. (corrects from earlier versions that said both professors were still at Kellogg).
    But the jump in global bond yields and the plunge in stock markets following the June 19 meeting by the Federal Reserve is evidence of the acute sensitivity of investors to the future of LSAPs, mainly because QE targets long term bonds whose prices are very sensitive to expectations of future policy.
    “Lacking clear guidance on the states that drive LSAP policy, investors will react to any information regarding the Fed’s intensions over LSAPs,” the economists said in “The Ins and Outs of LSAPs.”

Main danger is Fed contracts too early-Jackson Hole paper

    (Following is the first of four reports based on papers presented at the 2013 Jackson Hole Economic Policy Symposium, hosted by the Federal Reserve Bank of Kansas City.The reports will be published as soon as the authors present their papers to the symposium.)

    Pent-up demand for investment on business plants and equipment, homebuilding and consumer durables will strengthen the U.S. economy and the main danger over the next two years is that the Federal Reserve contracts its portfolio of assets or raise rates on reserves before the economy has returned to a normal state, according to a paper delivered to the Jackson Hole symposium.
    Most of the forces that led the U.S. and other advanced economies into the 2007-2009 recession are self-correcting and Robert E. Hall, professor of economics at Stanford University, found that investment flows are beginning to return to normal and the labor market has returned to normal in terms of jobs value notwithstanding the continued high unemployment rate.
    In his paper “The Routes into an out of the Zero Lower Bound,” Hall finds that the deleveraging pressure on households has subsided and the rise in the stock market since 2009 means that the risk premium for business income is more or less back to normal so as output continues to recover, investment should return to normal.

BIS urges reforms as easy monetary policy nears end

    With five years of ultra-easy monetary policy slowly coming to an end, politicians need to make up for lost time and speed up needed reforms of labor and product markets so societies can more easily adjust and return to economic growth, the Bank for International Settlements (BIS) said.
    Despite years of rock-bottom interest rates and massive asset purchases, global economic growth remains lackluster, unemployment high, public finances unsustainable and many households and firms are still struggling to restore financial balances. Total debt has continued to rise.
    With the risks and side effects of easy monetary policy growing and the benefits dwindling, central banks - first and foremost the U.S. Federal Reserve - are now starting to look towards the exit. Easy monetary policy has helped overcome the global financial crises and nursed economies back to recovery, but time provided by central banks for households and firms to repair balance sheets and governments to restore fiscal health has largely been squandered.
    “The time has not been well used,” the respected BIS wrote in its latest annual report.
    “Continued low interest rates and unconventional policies have made it easy for the private sector to postpone deleveraging, easy for the government to finance deficits and easy for the authorities to delay needed reforms in the real economy and in the financial sector.”
    As illustrated by the Federal Reserve’s decision last week to wind up quantitative easing later this year, overburdened central banks have reached a crossroad. Delaying the inevitable exit from very easy monetary policies just makes the exit more challenging.
    “Alas, central banks cannot do more without compounding the risks they have already created,” said Swiss-based BIS, known as the central bankers’ bank.

Financial sector data can help predict real economy-BIS

    Real-time information about the financial sector, such as asset prices, interest rates and credit aggregates, can help predict future changes in the real economy, though less about inflation, according to the Bank for International Settlements. (BIS).
    However, so far economists have failed to agree on which financial variables to focus on.
    The BIS, one of the only institutions to voice concern about growing financial imbalances prior to the 2008 financial crises, continues in its latest quarterly review to deepen the understanding of how the financial sector interacts with the real economy.
    Macroeconomic models typically take a simplistic and abstract approach to the interaction between the real economy and the financial sector. They mainly focus on real variables, such as GDP and prices, along with money and interest rates as financial variables.
    This modelling shortcut does not mean that economists have disregarded financial factors. Charles Kindleberger’s classic work on the history of financial crises, for example, focused on the link between the business and financial cycles.
    But Kindleberger, who worked at the BIS shortly before World War II, and other earlier economists adopted a narrative rather than a formally quantitative approach.

Era of 'benign neglect' of long-term rates over - BIS paper

    Central banks typically target short-term interest rates to control inflation and economic activity and have relied on financial markets to take care of long-term rates to stabilize the economic cycle.
    But this framework – described as ‘benign neglect’ by Philip Turner of the Bank for International Settlements (BIS) – is now over as central banks in most advanced economies have loaded up with government bonds since the Global Financial Crises, driving down real rates to negative in an effort to stimulate economic growth.
    “Yet given high government debt and the size of central bank holdings the question of what should be the policy framework for the long-term interest rate is bound to become more prominent,” writes Turner in the latest working paper from Swiss-based BIS entitled “Benign neglect of the long-term interest rate.”
    There are clear advantages to low long-term rates, including stimulating borrowing, repaying debt, making the financial system more resilient to shocks and allowing emerging economies to finance their infrastructure and housing needs more safely.
    “But an extended period of very low long rates and high public debt creates financial stability risks,” writes Turner, adding that banks and some institutional investors face growing interest rate risks and central banks now hold a high portion of their own government bonds, most of which have failed to stop the rise in the debt-to-GDP ratio.
    Illustrated by last week’s reaction in financial markets to the Federal Reserve’s January minutes, central banks’ exit strategy from their large holdings of government bonds will be controversial, complex and without precedence for markets to rely on.
    “With massive government debt and uncertain fiscal prospects, it is very difficult for the private sector to know what to expect in the next few years. The extraordinary expansion in the balance sheets of central banks, which averted the danger of global depression, causes additional perplexity,” said Turner.
    In his topical paper, Turner helps prepare the ground for the brewing debate over how long-term rates and government bonds should figure in central banks’ framework.
    The latest installment of the debate will come in March, when the Federal Reserve’s policy body is set to review its asset purchase program followed by Federal Reserve Chairman Ben Bernanke's scheduled press conference March 20.
   “Could a crisis force the authorities into sub-optimal choices? They will not be able to assume, as they had in the decade or so before the crisis, that the long- term rate will just take care of itself,” wrote Turner.

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FX interventions can lower global bond yields - BIS paper

  Japan’s foreign exchange interventions in 2003-2004 not only depressed U.S. and Japanese bond yields but also the yields of other countries whose bond markets were part of the integrated global bond market, according to a working paper from the Bank for International Settlements (BIS).
     The authors argue that intervention in currency markets is similar to the large-scale asset purchases (LSAPs) that have become popular with central banks as an unconventional tool of monetary policy when interest rates are at the zero bound.
     While currency intervention in the 1930s involved gold, today’s intervention by central banks typically involves the purchase of bonds. But in addition to affecting the value of a currency through intervention, the purchase of bonds results in easier monetary conditions, either though the effect on market liquidity or through a portfolio balance effects.
     One of the more recent examples of such as global portfolio balance effect was a drop in international bond yields in response to the U.S. Federal Reserve’s asset purchases in 2008-2009, the authors note, referring to a 2010 study.
     Building on earlier work by current Federal Reserve Chairman Ben Bernanke, who in 2004 established that U.S. government bond yields declined during the period of Japanese foreign exchange intervention, the authors find that the same intervention also caused a decline in long-term interest rates around the world.

US Fed balance sheet to grow 5% to $2.9 trillion end-2012 - Cleveland Fed study

   The balance sheet of the U.S. Federal Reserve will expand about 5 percent to around $2.9 trillion by the end of 2012 as a result of its latest plan to purchase additional mortgage-backed securities (MBS), according to a study by the Federal Reserve Bank of Cleveland.
    The Federal Reserve's policy-making body, the Federal Open Market Committee (FOMC), decided on Sept. 13 to expand its purchase of assets to strengthen the U.S. economy and improve the jobs market, a move known as QE3 (Quantitative Easing 3).
    The Federal Reserve's balance sheet was just under $900 billion in early 2008 but it has expanded to just over $2.8 trillion currently, following earlier rounds of purchases of assets, such as Treasury bonds, MBSs and other debt issued by government agencies.
    Under the latest asset purchase program, the Federal Reserve will purchase $40 billion of agency MBSs a month. Unlike earlier asset purchase programs, the Federal Reserve did not put a time or size limit on the program, but said it would continue to purchase the securities until the outlook for the labor market improved substantially.

US economy not like aircraft with stall speed - BIS paper

    The use of the aeronautical term "stalling" to describe the U.S. economy's low pace of growth is problematic because economies - unlike aircraft pilots that crash if they make mistakes - are self-correcting and ultimately return to growth, according to a paper from the Bank for International Settlements (BIS).
    Some commentators have compared the U.S. economy to an aircraft, saying it is close to "stall speed" when it will lose altitude, spin downward and crash without pilots having any control. The implication is that the U.S. is close to plunging into a new recession, the feared double-dip.
    But Wai-Yip Alex Ho, manager at the Hong Kong Monetary Authority (HKMA) and James Yetman, senior BIS economist, find several problems with this analogy in their working paper: "Does US GDP stall?"

Ageing workforce to push up inflation - BIS paper

    A shrinking and ageing workforce in many advanced economies will create inflationary pressures and may make it more difficult for banks to retain deposits and thus cut their high loan ratios, according to a working paper issued by the Bank for International Settlements (BIS).

    The paper, "Ageing, property prices and money demand" looks at the impact on property prices, inflation and money from the entry and exit into the workforce of the postwar baby boomer generation.

    Baby boomers saved by investing in property, boosting house prices and money supply. But now they are starting to retire, authors Kiyohiko Nishimura and Elod Takats, conclude that monetary policy will have to take ageing into account.

US unemployment due to cyclical, not structural reasons - Jackson Hole paper

    The high number of unemployed, a politically charged issue in the U.S. presidential campaign, is mainly due to the depth of the economic slump following the financial crises rather than structural factors, according to a paper presented to the Jackson Hole Symposium.
    And even the large number of long-term unemployed, which exceeds that of previous recessions, is caused by the severity of the recession not by structural factors that are beyond the reach of central banks, according to the paper by Edward Lazear of Stanford University and James Spletzer of the U.S. Census Bureau.
    Their finding has implications for monetary policy because “cyclical declines in employment are the explicit target of the US Federal Reserve bank and at least implicitly are the concern of the central banks of other countries as well,” Lazear and Spletzer wrote.
    Their paper was presented to central bankers, finance ministry officials and other financial market participants during a morning session on the last day of the conference.

Jackson Hole theme: "The Changing Policy Landscape"

   Once again, financial markets worldwide will turn their attention to Jackson Hole, Wyoming on Friday for fresh clues to whether the Federal Reserve will embark on further moves to stimulate the U.S. economy.

    With no meetings scheduled for the Federal Reserve’s policy-making body until Sept. 12-13, Chairman Ben Bernanke is expected to use the conference in the northern Rockies to update markets on his vision of how the economy has evolved since the FOMC's last meeting on July 31-Aug. 1.

    Bernanke’s speeches at the symposium, organized by the Federal Reserve Bank of Kansas City, have become famous after he aired the idea of a new round of quantitative easing (QE) in August 2010. Three months later the Fed launched QE2, sparking a nine-month period of optimism.

    Will Bernanke again show his hand?

    Speculation has been building for weeks, with commentators initially confident that another round of QE was coming. Recently, however, analysts are starting to doubt that further stimulus is necessary given better U.S.  economic data.

Unconventional monetary policy works so far - BIS paper

   Central banks have been successful in boosting economic activity and avoiding deflation by resorting to unconventional monetary policies after the eruption of the global financial crises in 2008, according to a study released by the Bank for International Settlements (BIS).
    While other studies have reached similar conclusions, the BIS working paper stands out because it specifically includes data from most advanced economies and exclusively focuses on the period 2008-2011 when central banks cut their interest rates to effectively zero.
    “As policy rates approached and ultimately got stuck at their effective lower bounds, central bank balance sheets basically replaced interest rates as the main policy instrument,” the three economists said.    
    “The challenge is to figure out a suitable econometric approach for analyzing the macroeconomic impact of central banks balance sheet policies in a crisis period when interest rates reach the zero lower bound,” they added.

Long-term rates don't always track short rates-BOC study

   A cut in short-term interest rates by central banks during an economic recession does not necessarily lead to a fall in long-term interest rates, according to a study in the Bank of Canada's Summer Review.
    Central banks typically use open market operations to control short-term interest rates and rely on this signal to be transmitted to the economically important long-term rates that govern the cost of credit to consumers and businesses.
    But this transmission mechanism has not always worked as expected. In 2004-2005 when the U.S. Federal Reserve raised its policy rates to slow growth, long-term rates actually declined,  a phenomenon famously described as a “conundrum” by then Fed Chairman Alan Greenspan.
    But a new model used by Bank of Canada economists shows that long-term rates are determined by two factors and this helps explain the conundrum, which in fact was part of a global phenomenon.

International Journal of Central Banking - March Issue [BIS]

The Bank For International Settlements [BIS] recently released the March issue of the International Journal of Central Banking [IJCB].  The March issue features articles on exchange rate stabilization and the so-called 'Dutch disease', DSGE Models, the use of Reserve Requirements for price and financial stability, The Fed as an informed forex trader, central banking in an open economy, the dynamics of food price pass-through and inflation, the impact of growth in the BRIC economies on inflation in the G-7, and the effect of import prices on inflation.

Forecasting Financial Markets With the GMPRI

In this article we examine the potential application of the Global Monetary Policy Rate Indexes in forecasting  and understanding financial market trends. We look at the developed and emerging rate indexes and key stock indexes; the S&P 500, the Hang Seng, and the US 10 Year government bond yield, and a commodities index. We find some link in movements between the indexes, with a few notable conclusions.

Emerging Markets Monetary Policy Rate Indicator

Adding to the stable of the Global Monetary Policy Rate Index, we introduce the Emerging Markets sub-index; a GDP weighted composite interest rate indicator for 21 emerging markets.  The Index has been built out to January 2000. In addition to the Emerging Markets sub-index, we will also look at the Emerging Markets (EM) + Developed Markets (DM) composite index; providing a virtually global indicator of monetary policy rates. The use of DM and EM indexes are also of interest in terms of spreads and relative movements, as will be explained.

Global Monetary Policy Rate Index - Developed Markets

Following on from the initial launch of the GMPRI [Global Monetary Policy Index] this research note focuses on the Developed Markets sub-index. The first point to note is that we have developed history for the index back to January 1999 (data file is available at the bottom of this article). While the method of GDP weighting is also discussed, we have overlain a couple of key data series with the index to demonstrate the value of the index in strategy and forecasting.

Introducing the Global Monetary Policy Rate Index

Central Bank News has developed a set of interest rate indexes to track broad trends in monetary policy across the globe. The index is essentially a GDP weighted average interest rate, thus the index can also be used to estimate the cost of capital, assessing monetary policy tightness/looseness, and other economic and financial analysis for the broad groups. There are four indexes: All, Developed, Emerging, and  Lesser Developed & Frontier markets.  The full methodology and components are detailed below.

CBN Carry Trade Index Introduction

The chart below shows the just-launched Central Bank News Carry Trade Index.  Essentially the index is an indicator of the variance between interest rates of central banks.  The "all" (81 central banks) index was recorded at 772 basis points at the end of December 2011 (up from 664 basis points at the end of December 2010).  This index shows a gradual rise in the average difference among central bank rates, driven largely by tightening among emerging market and frontier markets, while developed markets have kept monetary policy rates at all time lows.

[Review] Clarity of Central Bank Communication About Inflation

The International Monetary Fund (IMF) has just released a working paper on central bank communication on inflation, which examines whether the clarity of central bank communications have changed with the economic environment.  The key finding of the paper is that there are "no strong indications that central banks were less clear in explaining their policies when faced with higher uncertainty or a less favorable inflation outlook."  However, the authors note that the global financial crisis "did have a negative impact on clarity of central bank communication."  The paper's authors are: Bulir, Ales; Cihák, Martin; and Jansen, David-Jan.