Or the lack of the same. What he calls the current “non-system.”
In a speech called Yesterday Once More (full title: Competitive Monetary Easing: Is it yesterday once more?), Dr. Rajan calls for greater international monetary cooperation. While he admits that this cannot be forced on anyone, just the acceptance of spillover effects by major central banks would improve overall decision making.
One important point he raises early on in the speech and expanded later is that unconventional monetary policies (balance sheet expansion at the zero bound) are not much different from competitive devaluation through exchange rate interventions, though the channels may be different. This is important because we see exchange interventions as “bad” while we bless quantitative easing (Rajan cites IMF in this). But the primary route that QE works is through market (asset) prices, including the most important price of all – the exchange rate.
At first non-QE countries don’t see QE as an implicit devaluation. But since you can’t keep everyone fooled forever, people eventually catch on. Thus other countries either counter the effects – witness China building reserves and Japan starting its own QE – or fail to counter the effects and suffer imbalances – witness the effects on India.
Rajan ends with two warnings: that in a world with inadequate aggregate demand, everyone is fighting for a larger share of the same demand; and that extreme monetary easing is more a cause of problems than a medicine.
My only quibble is that he should have used that most potent of terms, beggar thy neighbour, when describing QE. That is what it is.
This election season has brought out some good journalism and insights. I am attempting to gather some interesting links here.
KP Nayar writes on JN Dixit, Natwar Singh and the disastrous foreign policy that we had in the last ten years. Singh came into office with a one-point agenda: to undo everything the Vajpayee government did before.
Prof. R Vaidyanathan (Finance, IIM Bangalore) writes on the competing economic models that we could have chosen: Rajaji vs. Mahalanobis. In the event the Bengali faction won as it was supported by Nehru and we went down the Soviet path. With the model imploding in 1991 and the Soviet Union itself collapsing, we need to revisit the model choice. The opportunity in 2009 was the nearest we got to cementing the change in the recent past. Had Manmohan Singh got his choice for Finance Minister (C Rangarajan), we would not have had to suffer the exploding deficit, inflation, currency weakness and financial instability of the last five years.
There is a lot of confusion on what all these monetary terms mean. QE, OMO, TAF, LSAP, LTRO, Repo etc. This post tries to make sense of these monetary operations done by central banks.
Firstly it is important to understand what a central bank does. A central bank is a banker of banks, i.e. it provides banking services to normal commercial banks. In doing so it provides a deposit account where banks maintain balances called reserves (incidentally this is why central banks are also called reserve banks). These reserves are used by banks when they want to transfer funds to other banks.
If a bank has payments to another bank, it needs to find reserves. It can do so by borrowing in the market or by obtaining reserves from the central bank itself. It is the latter process that I want to talk about.
A bank may borrow from the central bank by providing collateral for the loan. This collateral is usually government bonds. This process is called repo (short for repurchase agreement – I agree to sell this bond to you and agree to repurchase it back tomorrow). In India the most common form of repo has been the overnight repo. In the last few months we have added term repos to the mix, where the tenor of the loan runs for multiple days and weeks.
The second source of liquidity is selling the government bond to the central bank without an agreement to buy it back. This is called an outright transaction.
Forms of repo:
Repo, Term Repo (India), Refinance Operations (US Fed), Refinance Operations and Long Term Refinance Operations (ECB).
Forms of outright transactions:
Open Market Operations (OMO, India), Large-Scale Asset Purchase (LSAP popularly called QE, US Fed) and Outright Monetary Transactions (OMT, ECB).
While both repo and outright transactions appear to be similar, in repo eventually the security returns to the borrower after the bank repays the loan to the central bank. Thus the risks associated with the bond belong to the bank and not to the central bank. In an outright transaction the future risk of the bond is with the central bank. This was brought to the fore in Europe in recent years thanks to the Greek default. The bonds which were held by the ECB in repo were returned to the borrowing banks and the banks took the losses not the ECB. In a future OMT purchase such a default would happen to the ECB.
Similarly in India in case of repo, the price risk of the bond remains with the borrowing bank while in OMO the price risk is with RBI. This means that there is a qualitative difference in the way the market treats repo and OMO transactions, especially in longer dated bonds (where the price risk is large). The market sees the repo as just a means to add liquidity to the banking system while OMO is seen to have an impact on liquidity as well as providing a signal on yields – since OMO increases the price of the bond and reduces the yield. I wrote about the large OMO programme of RBI earlier here.
I hope that clarifies. Please comment here or on my twitter account if you need more clarity.
I am quoted in today’s Mint on WPI inflation indexed bonds. This is an instrument that is sorely needed but seems to have flopped with no investor interest.
Axis Asset Management, even as it has applied to float an inflation-indexed bond fund, is yet to buy the bond in any of its existing schemes.
“The bond is definitely attractive, but we don’t own it, and we aren’t buying it any time soon,” said R. Sivakumar, head of fixed income and products, Axis Asset Management. He did not rule out the possibility of including this bond in the portfolio, but liquidity is a problem.
It was the best of times, it was the worst of times. 2013 was surely an “annus horribilis” for the bond market. Starting the year with the benchmark bond a little over 8% and reaching a low of just over 7%, we touched nearly 9.5% in August and ended not much lower. A roller coaster ride if there was.
So here is my year in review in Haiku form*.
Seven three quarters
Cash reserve reduced
A Happy New Year!
Four point eight fisc
Open market operations
The shortest month.
Repo rate cut
No auction, no OMO
Cobrapost at year end.
RBI buys dollars
100 tons of gold imported
Spring time indeed.
Rate cut, bonds on fire,
Doused by taper talk,
An Indian summer.
The trade wind blows
The rupee goes down
No monsoon joy.
The money markets punished,
The ides of July.
As LED TVs taxed,
August augured ill.
A new governor
With magic wand raises rates,
The rains withdraw.
Onions bring tears
Seven three-quarters once more
On all hallows eve.
Forex flows forgotten
Plunged in pain and punishment
Winter’s withering wind
Rate hike paused, hurrah!
But taper to come, beware!
Stiff drink this Christmas.
* A Haiku typically has two images – often contrasting, and a seasonal element. I have tried to preserve this format as much as possible. If you are a Haiku purist, my apologies. I know that a Haiku in english follows a 5-7-5 syllable format, but in some cases I have taken liberties.
The US Federal Reserve will decide if they will start reducing the pace of open market bond purchases under the quantitative easing programme (taper). This is the last meet under the chairmanship of Ben Bernanke. So they may well leave the exit to the new FOMC (the open market committee of the Fed) under Janet Yellen. The interesting thing is that the market has been expecting QE tapering for some time now, but the Fed has deferred it for fears about the weak labour market. Unemployment rate in the US has fallen sharply – and more so than the Fed expected. However much of the gain in the unemployment rate has come through the fall in the Labour Force Participation Rate rather than the pace of new job creation.
[As an aside if you don't look for a job you are not counted as unemployed even if you are out of work. Thus if you are discouraged after seeking work for months and failing, you will just drop out of the reckoning of the labour force itself. The unemployment rate is the ratio of the number of unemployed to the number of those in the labour force.]
Today, Barry Ritholtz writes in Bloomberg on this idea – which has been promoted for several months by David Rosenberg. Rosie’s view is that with the fall in the employment rate, there is likely to be a spike in wage inflation and therefore general inflation in the US. Read this article in the Business Insider also.
The Fed believes that if the employment situation improves, the LFPR will increase as more people return to looking for jobs. Thus the lower unemployment rate may just be masking the weak underlying situation. However there is additional research to support an alternate thesis. Michael Shedlock (Mish) has been at it in depth here. Mish takes off on a Fed research paper in his analysis.
Mish’s work shows that much of the fall in the LFPR has been in the 55+ age group as older workers retire. This is structural in an ageing labour force. These people won’t rejoin the workforce if labour market conditions improve. It seriously calls into question the Fed’s decision mid-year not to reduce the pace of QE.
It is very possible that we see a big spike in inflation in the US in the next few quarters. The Fed may well be struggling to contain inflation through rate increases soon. But increasing interest rates when there has been so much primary money supplied to the system is itself fraught with risk. Back in 2011, John Hussman pointed out that there is a stable relationship between the short term interest rate and the amount of base money per unit of GDP (see also Hussman’s update later in 2011 here). Since the latest QE programme started after Hussman’s chart was made, I re-created it using the St. Louis Fed’s FRED database:
The vertical axis here is the Base Money/GDP ratio while the horizontal axis is the 3-month treasury bill rate. Back in 2011 Hussman pointed out that the BASE/GDP ratio had hit 16 cents, much larger than the peak seen in Japan of 12, which is the country most famous for central bank balance sheet expansion. Now the ratio has gone over 18 (to be exact 18.7). If the Fed were to being normalizing interest rates, it faces a huge “sterilization exercise” by which it must eliminate most of this excess base money through open market sales.
Otherwise just consider even raising rates to 1%. When the 3-month T Bill yielded 1%, the Base Money / GDP ratio was close to 6 cents. That is one-third of the current number. If the base money remains what it is today, nominal GDP must triple. In short order there is no way for the US to triple real GDP, so prices have to treble. This is a near hyper-inflation scenario. There appears to be no easy way out.
1. The fall in the US unemployment rate appears to be driven by a fall in the labour force participation rate
2. There is evidence that this is because of the baby boomer generation retiring, and thus likely to be structural
3. This means that as growth continues, there is likely to be increased competition for the rest of the labour force leading to rising wages
4. Rising wage inflation will lead to generalized inflation
5. The Fed will be behind the curve and will have to increase interest rates sooner than it had anticipated
6. At higher interest rates the amount of base money will lead to a sharp rise in inflation unless the Fed begins large scale open market sale of securities
7. This will be messy
Is there a way out?
One option the Fed is looking at is to absorb cash through reverse repos. In a reverse repo, the Fed sells securities for short term to the market and absorbs money leading to a fall in base money. This month they started experimenting reverse repos, so this is going through the Fed as a possible exit strategy. Alternately they could incentivize banks to hold excess reserves by paying a higher rate of interest on reserves. I am not sure if this is enough.
Whether through large scale OMO sales or reverse repos we are probably on the cusp of uncharted monetary waters again.
PS For any American who stumbles onto this post, please forgive the English spellings for programme and labour!
A couple of quick thoughts on the monetary policy and the market reaction. RBI did a split-personality policy, imagine a rate hike and rate cut in the same policy document! This is going to take more than one post. I am trying to marshal ideas here and will come back to some of these points later.
So with 0.25% higher repo rate, why are long bond yields up by almost 70 basis points?
The long bond yield has two components: what is the expected “average” overnight rate for the next 10 years, and a “term premium” reflecting the additional yield to account for uncertainties – regarding the overnight rate, liquidity, and other risks. If the long bond yield rose by a lot more than the increase in the overnight rate, it clearly means that the market expectation for the future of the overnight rate has gone up and/or the term premium has increased.
The expectation was that this period of extra-ordinary high interest rates (to defend the currency) would go away quickly. History suggests that these rate increases are unwound within 6 months. The expectation was that over the next few months, we would go back to the 7.25% operative rate from the 10.25% before the policy. That is the only explanation as to why the 10-year rate was at 8.2%. The 10-year rate can be lower than the overnight rate only if we expect the overnight rate to fall shortly. Once we got to 7.25%, the expectation was that with growth at 10-year lows and inflation well below last year’s levels (and indeed core wholesale price inflation plumbing new 4-year lows) we should resume rate cuts. Pre-policy it was clear that the RBI was targeting wholesale price inflation below 5% in the near term and below 3% in the medium term. See chart below, before the rise in the last couple of months, WPI inflation was at 5%. Core inflation has been below the RBI 3% target for some months now.
RBI has thrown both assumptions into question. Firstly even after unwinding of the currency defence, we would still end up at a higher rate than 7.25% (now 7.5%, possibly higher by December). Second the expectation that after normalization we can start reducing rates has been thrown into question. RBI seems to have shifted its policy variable away from wholesale to consumer inflation. Consequently, real interest rates are now sharply negative and to normalize rates, we need much higher overnight rates. We may be in for a period of rate hikes rather than the rate cuts we expected.
Where RBI has confused the market is that there is a new committee set up to identify which variable that RBI should target and what should be the operational stance, etc. Clearly with the policy the governor appears to have in some form pre-judged the outcome of the committee (moved to consumer price inflation instead of wholesale price inflation). Even if the indicator has shifted, there is no idea about the target. As stated above, RBI had clear targets about where they wanted wholesale inflation to be. They have never indicated any target for consumer inflation. So how much consumer inflation is ok? How much is too much? And if inflation is higher than acceptable, what will the RBI do? In an earlier policy document, RBI had said that the short term rate (overnight) needs to be higher than the inflation rate. This justified keeping the repo rate at 8-8.5% while WPI inflation was in that range. Now with CPI at 9.5%, where will the repo rate need to be?
Lastly, and a little more on the schizo-economics, there is recognition that the economy is slowing. The official stance is of a negative output gap (the economy is growing slower than it could). This will be disinflationary. Why the increase in interest rate then. I believe the RBI is doing the same squaring the circle I did in an earlier post and has concluded that potential growth is much lower than is believed and the negative output gap does not exist (or is much smaller than believed).
When I was in school, I came across this old Soviet joke:
When Kruschev was deposed and Brezhnev became General Secretary, Kruschev hands Brezhnev three letters in envelopes marked 1,2 and 3. He says, “When the first crisis hits, open the first letter. When the second crisis hits, open the second letter…”
In time, the first crisis hits. Brezhnev remembers the letters that have been lying unopened in his desk drawer. He opens the first one. It says simply: “Blame America.”
He blames the crisis on America and survives the crisis.
The second crisis hits, and remembering once again the letters, he opens the second one.
It says, “Blame me.”
He blames the crisis on the policies started by Kruschev. He survives the crisis.
In time a third crisis hits. He opens the third letter.
It says, “Write three letters.”
Watching the finance minister yesterday on TV, I was reminded of this old joke. He started the currency crisis by blaming America: the Fed’s tapering, foreign investors pulling out, etc.
Yesterday he blamed the policies pursued by his predecessor Mr Pranab Mukherjee between 2009 and 2011 as the reason for the crisis. We have reached the second letter.
At what stage do we reach the third letter, I wonder.
A quote of mine in the Indian Express got picked up by BBC news! Wow! This is the news organization I have followed for the longest time. I have been listening to BBC since high school (back in the old days when there was no cable/satellite TV).
R Sivakumar of Axis [Bank] Mutual Fund told the Indian Express that the initial fall in the rupee was in line with other Asian and emerging markets, but it is falling now in response to the monetary and administrative decisions taken in the past month.
“We believe the rupee will remain weak as long as growth prospects remain weak. Higher interest rates and tight liquidity conditions imposed by the RBI have put growth at risk and there is the possibility of further weakness while these measures are in place,” the paper quoted him as saying.
Why did they add the [Bank] as if it had been omitted in the original? The article has a helpful picture of a folded Rs. 100 note as if to say, its value is down by a half!
Felix Salmon (Reuters) puts the recent sell-off in bonds and the impact on bond funds rather nicely in this post.
All the bond funds have seen a bit of a dip in recent weeks, but it’s the kind of move they’ve seen many times in the past, and it’s not the kind of move which is likely to cause an individual investor to panic. The main thing you learn from looking at this chart, indeed, is not that we’re in the midst of a historic bond-market selloff, but rather just that bond funds in general are pretty good at doing what they’re meant to do — which is to broadly retain their value over time, and with any luck go up over the long term, with reasonably low volatility.
Well said! Read the whole post at the link above.
Note that this is pretty much true of Indian funds as well.