FINANCIAL STABILITY / PRUDENTBEAR.COM

Financial Stability

by Doug Noland

April 11, 2014

Selling is starting to get serious.

“Each Spring, thousands of government officials, journalists, civil society organizations, and invited participants from the academia and private sectors, gather in Washington, DC for the Spring Meetings of the IMF and the World Bank Group. At the heart of the gathering are meetings of the IMF’s International Monetary and Financial Committee and the joint World Bank-IMF Development Committee…”

Wednesday’s opening IMF seminar was titled “Managing the Transition to Normality - Implications for Fiscal Policy.” From panel moderator Rob Cox (Reuters): “Or, as one of my colleagues said, ‘Isn’t this the panel where you ask the question whether the world is ready for a withdrawal of the punchbowl.’”

To commence the discussion, the audience was asked to vote “yes” or “no” to the question: “Is the time right for central banks to unwind unconventional monetary policies?” Not surprisingly, the vote went overwhelmingly in favor (63 to 37) of keeping the drinks flowing. There are reasons why monetary policy has throughout history been most effectively managed by disciplined and independent central bankers.

Federal Reserve Bank of Chicago President Charlie Evans represented the Federal Reserve. This panel discussion set off what became during IMF and related events an indictment of U.S. monetary policy. In a particularly interesting exchange, Citigroup’s chief economist Willem Buiter took strong exception with Fed policy. Buiter is no hawk. In other comments, he blasted the ECB for running tight monetary policy. Buiter is, however, emblematic of an increasingly vocal camp that sees Fed QE as high-risk, minimal reward policy. Evans was notably defensive. In my view, he is the last Fed official that should be representing U.S. policy at this juncture. Evans only fuels what is a mounting global lack of confidence in the Federal Reserve.

Charles Evans: “In the U.S. monetary policy is using the standard transmission mechanism. We’re trying to reduce financing costs. Auto rates are down and the auto sector is way back compared to where it was. Housing is better. Mortgage rates are down. And if you have the ability to refinance, or get a mortgage – it’s tougher these days because of the standards - then you can do that. So it’s the standard transmission mechanism. And we are indeed trying to get inflation up because we’re below target. What comes with that is wage increases, also up to where they ought to be. Wages are a symptom of inflation – using a lagging indicator – and they’re down around 2 to 2.25% right now. When they’re at a steady growth part of the cycle they ought to be about 3.5% - 1.5% productivity and 2% inflation target. So getting everything up – and getting inflation up to where it is supposed to be is an important part of all of this. So that benefits everybody.”

Citigroup chief economist Willem Buiter: “Monetary policy works with asset prices. By boosting equities, raising bond prices, weakening the currency and that’s exactly how it has happened. Not very effectively, because we have poor man’s monetary policy. Which is what unconventional monetary policy is. But it’s all we have. I would have preferred to see some additional measures on the fiscal side, which could have mitigated some of the income distributional consequences…”

Evans: “One of the big risks is that we withdraw our accommodative policies prematurely. I think it’s just human nature to start thinking ‘we’ve been doing this for a long time. Zero interest rates in the U.S. we’ve had them since December 2008. That must have been long enough. Maybe it’s time to start the process of renormalizing.’ Well, let me just remind everybody, inflation is 0.9% in the U.S. on our personal consumption expenditure index. We’re supposed to be hitting two. We’ve been under two for a long time. We should be averaging two. Overshooting would not be a problem as long as it’s done in a reasonable fashion. We should be averaging two. Around the world inflation is low. I think that’s a sign of weakness. I think it’s a sign of risk. I think this (an IMF video) is the conventional wisdom up there which is that the risks are probably lower than they were. And I can see a path where things are going to work out, you know, fine. And that’s kind of my modal forecast. But I think we’re trying to thread the needle in too many places. And if it starts coming off a little bit in one place it could continue to have that problem. Another thing I want to remind everybody is, taking the long view, the U.S. consumer is not nearly as strong as they were 15 years ago, when we looked to the U.S. for a sign of strength. It’s going to take quite a while for them to come back.

And, in fact, there’s a tremendous number of income and skills challenges that a large part of the workforce have. And I’m not quite sure when that’s going to be repaired. So everybody needs to pick up their own economies and contribute themselves to the world economy. And that’s part of why I think we need to make sure we’re in this all the way until we’re actually out of it.”

Buiter: “It’s important to recognize that a central bank like the Fed doesn’t have a dual mandate – employment and inflation – no, there’s a triple mandate of financial stability.”

Evans interrupts: “No, no, no moderate long-term interest rates is usually the one that’s mentioned. And that would be moderate real interest rates and inflation.”

Buiter: “Financial stability is a key responsibility of every central bank. And if it’s a choice between inflation or whatever – and financial stability, then financial stability comes first.”

Evans: “Wow, that’s amazing! That’s amazing to me! Are you kidding me?”

Buiter: “What you see in the U.S. – and Jeremy Stein has pointed this out - you have this explosion of Credit froth and asset markets a lot of bubbly behavior. I wouldn’t want to pop a Bubble yet. But payment-in-kind bonds; covenant-light loans, leverage loans, high-yield loans…”

Moderator Cox: “Just like the good old days – 2006.”

Buiter: “In looking at it, in some ways the issuance of the highly risky instruments is now in excess of what we saw in 2007. And you have to allow for that. It might be necessary to raise rates before it can be justified on the grounds of inflation and unemployment.”

Evans: “I strongly disagree with that. I want to be very careful. Financial stability is very important. We have to make sure we’re as best on top of financial instability risks as we can be. But we have other tools. We have micro supervisory tools; we have macro-prudential tools; we’ve just passed new legislation in the U.S. and around the world. We have new standards. If those tools are inadequate to rein in a financial system that jumps all over the appropriate setting of monetary policy at a time when the unemployment rate in the U.S. is higher than where it peaked in the last recession – at 6.7% - at a time when inflation is 1% and what we own as a central bank is inflation, we need to provide accommodation. If we can’t do the right thing for those two mandates, but we have to raise the white flag and say ‘we’re going to have to drive unemployment up higher and inflation lower in order to preserve a financial system, which apparently would be adding negative social value,’ we’d have to examine that very carefully I think. I don’t think that’s the circumstances. But that’s very distressing to me.”

As many times as Dr. Evans repeats the mantra “U.S. monetary policy is using the standard transmission mechanism,” it does not alter the reality that there is nothing standard about the Fed’s QE/“money” printing experiment. In the U.S. and somewhat globally, downward pressure on consumer price indices is now used by the doves to justify even more central bank monetary stimulus. Consistent with the history of major monetary inflations, once commenced there is always plentiful justification and rationalization for just one more round of printing – and another... And the longer the inflation the greater the addiction.

The most notable indictment of Fed policy and the Bernanke doctrine came Thursday from a paper and talk by the highly respected Reserve Bank of India Governor Raghuram Rajan (former IMF chief economist and University of Chicago professor). “Competitive Monetary Easing: Is it Yesterday Once More?” is the most comprehensive critique of U.S.-led global monetary policy I’ve read. I extract heavily below, but suggest readers study Rajan’s exceptional 10-page paper.

“A good way to describe the current environment is one of extreme monetary easing through unconventional policies. In a world where debt overhangs and the need for structural change constrain domestic demand, a sizeable portion of the effects of such policies spillover across borders, sometimes through a weaker exchange rate. More worryingly, it prompts a reaction. Such competitive easing occurs both simultaneously and sequentially…
 
The key question is what happens when these policies are prolonged long beyond repairing markets – and there the benefits are much less clear. Let me list 4 concerns: 1) Is unconventional monetary policy the right tool once the immediate crisis is over? Does it distort behavior and activity so as to stand in the way of recovery? Is accommodative monetary policy the way to fix a crisis that was partly caused by excessively lax policy? 2) Do such policies buy time or does the belief that the central bank is taking responsibility prevent other, more appropriate, policies from being implemented? Put differently, when central bankers say, however reluctantly, that they are the only game in town, do they become the only game in town? 3) Will exit from unconventional policies be easy? 4) What are the spillovers from such policies to other countries?
 
…The macroeconomic argument for prolonged unconventional policy in industrial countries is that it has low costs, provided inflation stays quiescent. Hence it is worth pursuing, even if the benefits are uncertain. A number of economists have, however, raised concerns about financial sector risks that may build with prolonged use of unconventional policy. Asset prices may not just revert to earlier levels on exit, but they may overshoot on the downside, and exit can cause significant collateral damage.
 
One reason is that leverage may increase both in the financial sector and amongst borrowers as policy stays accommodative… Leverage need not be the sole reason why exit may be volatile after prolonged unconventional policy. Investment managers may fear underperforming relative to others. This means they will hold a risky asset only if it promises a risk premium (over safe assets) that makes them confident they will not underperform holding it. A lower path of expected returns on the safe asset makes it easier for the risky asset to meet the required risk premium, and indeed draws more investment managers to buy it – the more credible the forward guidance on ‘low for long, the more the risk taking. However, as investment managers crowd into the risky asset, the risky asset is more finely priced so that the likelihood of possible fire sales increases if the interest rate environment turns. Every manager dumps the risky asset at that point in order to avoid being the last one holding it.
 
Leverage and investor crowding may therefore exacerbate the consequences of exit. When monetary policy is ultra-accommodative, prudential regulation, either of the macro or micro kind, is probably not a sufficient defence. In part, this is because, as Fed Governor Stein so succinctly put it, monetary policy ‘gets into every crack’, including the unregulated part of the financial system. In part, ultra accommodative monetary policy creates enormously powerful incentive distortions whose consequences are typically understood only after the fact. The consequences of exit, however, are not just felt domestically, they could be experienced internationally.

Perhaps most vulnerable to the increased risk-taking in this integrated world are countries across the border. When monetary policy in large countries is extremely and unconventionally accommodative, capital flows into recipient countries tend to increase local leverage… By downplaying the adverse effects of cross-border monetary transmission of unconventional policies, we are overlooking the elephant in the post-crisis room. I see two dangers here. One is that any remaining rules of the game are breaking down. Our collective endorsement of unconventional monetary policies essentially says it is ok to distort asset prices if there are other domestic constraints to reviving growth, such as the zero-lower bound. But net spillovers, rather than fancy acronyms, should determine internationally acceptable policy…

For this is not the first episode in which capital has been pushed first in one direction and then in another, each time with devastating effect. In the early 1990s, rates were held low in the United States, and capital flowed to emerging markets. The wave of emerging market crises starting with Mexico in 1994 and ending with Argentina in 2001, sweeping through East Asia and Russia in between, was partially caused by a reversal of these flows as interest rates rose in industrial countries…

Conclusion: The current non-system in international monetary policy is, in my view, a source of substantial risk, both to sustainable growth as well as to the financial sector. It is not an industrial country problem, nor an emerging market problem, it is a problem of collective action. We are being pushed towards competitive monetary easing. If I use terminology reminiscent of the Depression era non-system, it is because I fear that in a world with weak aggregate demand, we may be engaged in a futile competition for a greater share of it.

In the process, unlike Depression-era policies, we are also creating financial sector and cross-border risks that exhibit themselves when unconventional policies come to an end. There is no use saying that everyone should have anticipated the consequences. As the former BIS General Manager Andrew Crockett put it, ‘financial intermediaries are better at assessing relative risks at a point in time, than projecting the evolution of risk over the financial cycle.’ A first step to prescribing the right medicine is to recognize the cause of the sickness. Extreme monetary easing, in my view, is more cause than medicine. The sooner we recognize that, the more sustainable world growth we will have.”

April 10 – Dow Jones (Pedro Nicolaci da Costa): “Ben Bernanke seems to have already transitioned comfortably back into his new research role at a Washington think tank. Wearing a white button-down shirt--no tie-- and sounding much feistier than he did as Federal Reserve Chairman, Mr. Bernanke took issue with India central bank chief Raghuram Rajan’s suggestion that U.S. central bank officials should pay greater attention to the effects of their policies on overseas economies. ‘A lot of what you’ve been talking about today just reflects the fact that you are very skeptical about unconventional monetary policies,’ Mr. Bernanke said from the front row of the audience during the question-and-answer session of a panel discussion… You say the rules of the game should prevent policies with ‘large adverse spillovers and questionable domestic benefits.’ If you have a different empirical assessment, as Vitor and I do, and you think that these are effective policies and that in fact emerging markets are probably better off than if these policies had not been used, you would have a different view…’ Then, Mr. Bernanke got really professorial. ‘I do want to take you to task as a professor at the University of Chicago, ignoring money. You made a very clever equivalence ... between exchange intervention and unconventional monetary policies… There’s one very important difference which is that exchange rate intervention sterilized the effects on monetary policy or on the money supply. So you’re ignoring the money supply…’”

Not surprisingly, Dr. Bernanke remains convinced that QE – “money” printing – creates wealth and repairs financial and economic damage (consequences of the previous Bubble). Dr. Rajan argues persuasively that “extreme monetary easing through unconventional policies” has fostered another round of dangerous global financial and economic distortions. I’ve noted recently how the U.S. monetary policy debate pits the academic doves versus the real world hawks. Raghuram Rajan astutely melds academia with the real world in powerful analysis the academic inflationists won’t be able to lay a glove on (“ignoring the money supply”? You can’t be serious…).

Stocks took one on the chin this week. Analysts and market pundits struggled to come up with reasons for the market selloff. “The data look good.” The optimists believe the bull market has been driven by economic recovery and robust earnings. They, once again, scoff at the word “Bubble.” And they dismiss the prevailing roles played by QE and speculation. Meanwhile, we’re now five years into the historic – and increasingly unstable - “global government finance Bubble.”

As the markets have risen, it’s been way too easy to ignore very serious fundamental concerns. Alarming financial and economic deterioration in China will only incite aggressive fiscal and monetary stimulus. Stagnation in Europe ensures the ECB moves forward soon with QE. Weakening fundamentals in Japan guarantee more aggressive “money printing” from the Bank of Japan (BOJ). Consumer inflation stubbornly below the Fed’s mandated 2% target means the Yellen Fed will at some point employ more aggressive monetary stimulus.

In the real world, Chinese officials this week stated rather clearly that they won't be coming anytime soon with aggressive fiscal or monetary stimulus. These days they (belatedly) seem to better appreciate the risks associated with government-induced financial and economic excess. Perhaps increasingly vocal domestic opposition to Bank of Japan policy influenced a much less dovish tone this week from the BOJ. And there is little indication that the ECB is about to mount a massive U.S.-style market liquidity injection operation. As I’ve noted recently, there is an emboldened contingent at the Fed that wants out of the experimental “money” printing and market backstopping business.

What’s behind recent market instability? Well, cracks in the global Bubble are beginning to impinge U.S. securities markets. Trouble at the “periphery” has finally begun to impact risk-taking at the “core” – much as markets traditionally operate. For the most part, market participants are still living in the halcyon 2013 world. That world was inundated by central bank liquidity, with cracks at the periphery ensuring “money” flooded into the core (especially U.S. equities and corporate debt). Now, with the Fed in taper mode, the liquidity environment has begun to change. Market dynamics are beginning to normalize. De-risking and de-leveraging at the “periphery” will lead to waning liquidity and risk appetite away from the periphery.

Contagion now starts to become an issue, as intense “risk on” begins its inevitable transition to “risk off.” There is rising trepidation in some quarters that the exit may be narrowing. Greed begins to turn to fear.

I especially appreciated Dr. Rajan’s attention to how monetary policy has exacerbated market “herding” and “crowding” behavior. This is a very, very pertinent issue. When “risk on” is in full display, rising leverage and securities prices prove self-reinforcing. Moreover, central bank liquidity injections and market backstop assurances spur risk-taking while dampening the impact of the occasional bout of “risk off.” At the same time, there is within the global marketplace these days an unprecedented pool of trend-following finance. Just combining the hedge fund and ETF universes gets one to almost $6.0 TN. And throw in the wild world of derivatives and structured products (with their dynamic hedging trading strategies) and you have an unbelievable capacity for trend reinforcing trading. It has seemingly worked wonderfully on the upside. The downside will be fraught with the risk of a major market accident.

From the perspective of my analytical framework, I view the hedge funds as the marginal operator in the marketplace – the marginal buyer, seller and price determiner. The now massive ETF world is more the market follower. Today, there are reasons to suspect the more sophisticated hedge fund operators have begun to take some risk off the table. So far this year, many popular trades have gone against the speculator community. The yen has rallied, pressuring those short the yen and those using the yen for financing “carry trades.” Rallies in gold and many commodities have punished those short. The dollar bulls have been disappointed along with the Treasury market bears. Markets have been volatile and especially tough.

In U.S. equities, the reversal in beloved technology and biotech stocks has inflicted pain on the speculators. The popular financial stocks have also begun to cause some grief. And, at least of late, many speculators were caught on the wrong side of a pretty ferocious short squeeze throughout the emerging markets (at least partially fueled by trend-following ETF flows).

So I’m seeing significant confirmation of the bearish thesis – fundamentally and more recently in the marketplace. The global liquidity backdrop has become less bullish. Central bank liquidity has peaked. A recovering yen restrains “carry trade” speculative leveraging, while changes in China’s currency management regime reduce the incentive for yuan “carry trades.” Especially with the prospect of Fed balance sheet growth ending later this year, the notion of the Fed as the markets’ liquidity backstop is now in question.

From my perspective, the leveraged speculating community will need to adjust to a much less favorable backdrop for risk-taking and leveraging. The marginal operator in the marketplace is evolving from buyer to seller; from risk-taker to risk reducer and hedger; from liquidity provider to liquidity taker.

While I don’t expect market volatility is going away anytime soon, I do see an unfolding backdrop conducive to one tough bear market. Everyone got silly bullish in the face of very serious domestic and global issues.

Global securities markets are a problematic “crowded trade.” Marc Faber commented that a 2014 crash could be even worse than 1987. To be sure, today’s incredible backdrop with Trillions upon Trillions of hedge funds, ETFs, derivatives and the like make 1987 portfolio insurance look like itsy bitsy little peanuts. So there are at this point rather conspicuous reasons why Financial Stability has always been and must remain a central bank’s number one priority (whether Dr. Evans appreciates this or not). Just how in the devil was this ever lost on contemporary central bankers?