Bond market vigilantes

Government bond holders were the playground bullies of the 80s and 90s. They would threaten governments and central banks with bond sales to get what they wanted – usually fiscal discipline and lower inflation. Bond vigilantes – a self-appointed nickname – was presumably a way to sound more like Batman and less like thugs. Like everyone who picks their own nickname, they had high opinions of themselves:

“Bond Investors Are The Economy’s Bond Vigilantes.” I concluded: “So if the fiscal and monetary authorities won’t regulate the economy, the bond investors will. The economy will be run by vigilantes in the credit markets.”

The guy who coined the name in 1983

These threats worked because selling government bonds causes their price to fall, and the yield – the interest rate – to rise. A government bond is just an IOU from the state, so higher interest rates make it more expensive for governments to borrow. Higher interest rates in government bond markets also usually increase interest rates elsewhere in the economy, slowing down growth. Governments, especially smaller, fiscally precarious ones, had reason to be afraid.

Their reputation was cemented when Bill Clinton’s campaign strategist James Carville said: “I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.”

Quantitative easing mostly killed off the bond vigilantes. Central banks have bought trillions in government bonds since the GFC, making the threat of a bond vigilante sell-off mute. Sell all you want, the central bank will hoover it up.

Or did it? The deluge of fiscal and monetary stimulus, vaccines, and the beginnings of a recovery have some worried about inflation – a concern I’ve discussed previously. Bond holders hate inflation because it erodes the value of their (usually) fixed coupon payment. Because they hate inflation, bond holders tend to be wary of government spending. A world where governments are planning trillions of new spending has the vigilantes reaching their capes and masks. The FT reports:

It’s probably premature. Bond yields have slumped again after reaching record highs last week. The Reserve Bank of Australia brought forward bond purchases in response to yields rising. It’s hard to fight a central bank.

Bond vigilantes bring together history, macroeconomics, markets, and superheroes in a neat bundle. I recommend further reading:

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Central banks, climate change, and firing an AK-47 underwater (wonkish)

Barry Eichengreen has written a piece for Project Syndicate on how central banks can help tackle climate change and inequality.

The standard argument is that central banks do not possess the tools to combat these issues, and even if they did, doing so would call their independence into question, undermining their ability to fight inflation. Barry disagrees. He argues central banks have a swathe of regulatory tools that could be deployed, and this fact creates a moral responsibility to act given the existential nature of these issues.

As I read it, Eichengreen’s climate change proposal does not go beyond what most central banks have already expressed willingness to do: create a strict and consistent framework for disclosing climate risk, and then use that information when assessing risk in the financial sector. For example, banks who hold lots of assets with climate risk might have higher capital requirements, the same as if they hold lots of junk bonds or dodgy mortgages. There is no mention of using the balance sheet, or differentiating between the collateral a central bank accepts (as I discussed the other day).

His deeper point, that there is no shortage of tools for central banks to tackle important policy issues, is an important one.

Central banks often claim they do no possess the appropriate tools for tackling inequality or climate change. Look, they’ll say, interest rate changes take years to filter through the economy, and besides, the effects are too broad; it’s like trying to hit a target 500 meters away, with a shotgun, underwater.

An AK-47 – close enough

This is a bit disingenuous. The experience of the GFC and COVID-19 has shown that tools can be invented to fit our needs; swap lines, the paycheck protection program, the Main Street lending program, the multiple variations of quantitative easing. Central bankers may well be the only innovators in the world who do not post about their new creations on LinkedIn.

Even the boring old interest rate can be incredibly flexible, as Eric Lonergan’s proposal for dual (and discerning) interest rates shows.

The real problem is not so much a lack of tools, but the risk of becoming politicized (I’m going to write a whole post on politicization, because it is more nuanced than it first appears). That’s a legitimate concern, and one we should seriously discuss.

Economics is about optimization under conditions of scarcity, so any such discussion should be guided by the trade-offs associated with independence. What policy tools would be available were maintaining independence no longer a concern? What would the costs and benefits of any alternative arrangement be?

Please do read the whole thing.

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Is Green Quantitative Easing on the horizon?

Many forces are pushing central banks to change how they operate: low inflation; hesitant fiscal policy; climate change; anemic growth; financial instability. Low inflation claimed the first scalp, when it led the Federal Reserve to switch to an average inflation targeting regime. Climate change may be the next.

The FT reports that:

This is a big deal, even if it might sound like gibberish at first.

Right now, to stimulate the economy, central banks print money (it’s slightly more complicated) to buy government and corporate bonds from the private sector. The idea is that this lowers bond yields, which lowers interest rates, and moves money into other parts of the economy. In theory, interest rates for governments and corporations fall, and lending should increase to businesses and consumers, stimulating the economy. This is Quantitative Easing.

Today, central banks do this without taking the environment into account. A corporate bond from Shell is the same as a corporate bond Vestas (they make wind turbines). For several years now, people have been saying that central banks should use Quantitative Easing in an environmentally conscious way. This mean that, when it buys a corporate bond from Shell, it should acknowledge that Shell is a polluter. When it buys a corporate bond from Vestas, it should acknowledge that Vestas is not a polluter. It could do so by charging a premium for example.

This has been fiercely resisted to date. The fact that the head of the French central bank, who has a seat on the ECB’s Governing Council, is in favour, speaks to how much the consensus is changing.

Please do read the whole thing

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Inflation forecasts or irrational exuberance?

If your eyes glaze over at the mention of inflation, take a look at this and feel free to go:

My own calculations using forecast figures from the SMP and inflation data from the ABS

Forecasting inflation

Forecasting is an unforgiving art. There are an infinite number of wrong answers, and one right one. The years since the GFC have been particularly unforgiving for central bank forecasts, and no forecast has struggled so much as inflation. First too high, now too low, inflation has a mind of its own which central banks have yet to fully discern.

No surprise then that central banks have grown more cautious. They have commissioned research into their forecasting track record to better understand the scope of the problem, and what might be done about it (RBA, RBNZ, and BoE). Forecasts are now accompanied by caveats, confidence intervals, and cautious language.

An example of representing uncertainty better (Reserve Bank of Australia Statement on Monetary Policy Feb 2015)

While helpful, there are still two small issues:

The reports I’ve read primarily assess forecasts for accuracy. This involves calculating the difference between the forecast and reality and adjusting it to remove the sign.* This shows the error’s magnitude – the higher the number, the greater the deviation – but not the direction of the forecasts or actual inflation. Some reports do also test for bias – the degree to which results repeatedly skew in one direction – but not all.

Second, most of the reports are from before 2015, around the time when problems with inflation started to appear.

I want to see recent results, so I’ve started building a data set from publicly available forecasts. I will eventually do this for all the major central banks, but started with Australia because it has enjoyed uninterrupted growth for the period when the rest of the world has been in and out of crisis. This should minimise forecasting errors from big shocks like Trump, Brexit, or the Euro-crisis.

Persistent errors in the same direction

Inflation forecasts between 2005 and 2014 missed sudden changes in the inflation rate, like in 2006, 2011 or 2012. Some of these mistakes were over-estimations, others were under-estimations. The errors are not surprising given the global recession, and lots of fiscal and monetary stimulus going around.

My own calculations using the figures provided by the RBA
My own calculations using the figures provided by the RBA

2015 is where it gets interesting. Inflation forecasts have been persistently panglossian over the last five years; forecasts keep reaching for the sky while inflation trundles along below. From 2017 the forecasts sober up a little, but the errors are still all in the same (hopeful) direction.

My own calculations using forecast figures from the SMP and inflation data from the ABS

When the forecast errors trend in the same direction, one of the relationships in the model may be misrepresented.*** This kind of diagram illustrates the issue in a way that accuracy bar charts do not. It also suggests that forecasters may not have updated the model.

Forecasting macroeconomic variables may be the only form of divination that requires a suit, but forecasts can still be useful. We feel more comfortable about an uncertain future if we can attach numbers and neat lines to it. This psychological comfort helps us make decisions about the future, whether to buy a house, or invest in a plant that manufactures fidget spinners. If these beliefs are shared by enough people, they can become self-sustaining, and even ‘true’ by simple fact that everyone now believes them. Forecasts can also give a reliable sense of direction,

If the past has any bearing on the future, forecasts can also calibrate models for economic or social behavior. In practice, these models can often give us a reliable sense of direction, if not complete certainty. Here, mistakes are useful for tuning the machine, but not all mistakes are made equal. One-off shocks, like the GFC, add little to models that, by design, cannot predict the unpredictable. Recurrent forecasting errors are another matter. They may be a signal. Taken in this way, the errors are not so much the inevitable failures that go with any attempt to peer past the veil of the present, but indicators of a more persistent change underway.

Or maybe not. It’s the future after all.

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*Called a root-mean-square-error (RMSE)

** Central banks use a larger battery of statistical tools than the simple RMSE

***The Philips Curve is flattening

The FOMC meets and, among other things, we discover Jerome Powell has been vaccinated

The FOMC met for the first time in 2021 yesterday. The committee has maintained its accommodating policy stance as the economic recovery slows in the US.

Chair Powell hanging on for dear life like the rest of us

As at the last meeting, the Fed expects to keep this in place for some time:

With regard to interest rates, we continue to expect it will be appropriate to maintain the current 0 to ¼ percent target range for the federal funds rate until labor market conditions have reached levels consistent with the Committee’s assessment of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.

The Q&A session with Chair Powell had a few interesting nuggets:

  • He addressed the ‘burst of inflation’ hypothesis (discussed by me here), arguing that any inflation this year is likely to transient and minor“we think its very unlikely that anything we see now results in troubling inflation.” And, even if it did appear, “we’re going to be patient. Expect us to wait and see, and not react.”
  • With the ongoing Gamestop frenzy (expect a write up soon…), there were lots of questions about markets, macro-prudential regulation, and ultra low-interest rates. He reminded everyone that with 9%-10% unemployment, the Fed will continue to prioritise jobs over hedge fund tears.
  • One of the striking parts of the Fed’s language in recent years has been the recurring emphasis on employment, jobs, and minorities. Inflation increasingly feels like a side-show. This conference was no different, Chair Powell discussed joblessness in almost emotive terms.

We’re not just going to look at the headline numbers. We’re going to look at different demographic groups, including women, minorities, and others. We’re not going to say we’ve reached full employment, which is our statutory goal, until we have reached maximum employment. Which you haven’t if there are lots of pockets of people not participating or not employed in the labour market.

We want an economy where everyone can take part, can put their labour in, and share in the prosperity of our great economy.

I’m much more worried about falling short of a complete recovery and losing people’s careers and lives that they’ve built because they don’t get back to work in time. I’m more concerned about that, not just to their lives, but to the US economy. I’m more concerned about that than about the possibility – which exists – of higher inflation. Frankly we’d welcome slightly higher, somewhat higher, inflation. The kind of inflation that people like me grew up with seems far away, unlikely, in the domestic and international context we’ve been in for some time.

This shift in emphasis was partly forced on the Fed. Persistently low inflation despite falling unemployment shone a spotlight on the full employment side of the Fed’s mandate. Its similar elsewhere; as central banks took on on ever larger roles in economic management following the GFC, they needed to maintain legitimacy with a public concerned about joblessness and inequality, not inflation.

From my own analysis of language in all central banking speeches between 01/2007-01/2020

This language creates precedent which could constrain, or influence future Fed decisions, or at the very least, how they are presented and framed. This could have long-term consequences. It is said that the experience of inflation in the 1970s/80s shaped the minds of a generation of economists and policy makers. The Fed’s new attitude and language may have a similar effect on its institutional culture. Might there be a dovish, employment bias, for years to come?

Porque no los dos? Dual interest rates and monetary policy

When we talk about monetary policy, we tend to think of the interest rate, singular and all-powerful. I used to imagine a giant lever in the basement of the Reserve Bank of Australia that the Governor would adjust while the rest of the Bank watched in silence.

Colors Live - Homer pulling a lever by jenthegelfling
Philip Lowe about to lower interest rates

Like many things we tend to think, this is not quite right.

Eric Lonergan and Megan Greene have been advocating for dual interest rates for a few years now. This overview in VoxEU was illuminating. Put simply, by offering one rate for lending, and another for deposits, central banks can engage in near limitless stimulus.

What are dual interest rates?

All banks have accounts at their respective central banks, where they keep reserves. Like your and I’s deposit accounts, banks in many countries are now paid interest on the balances in these accounts. By lowering or raising that rate of interest, the central bank can indirectly shift other interest rates (like what you pay your bank for a mortgage). The lower the rate, the cheaper the lending, the more stimulus – simple.

The world today needs lots of stimulus, but with interest rates already at zero, central banks are struggling to keep stimulus going. The limbo bar cannot go below the floor. Once banks are paying money to hold reserves (thats what negative interest rates do – you pay to save), it makes them less profitable and less likely to lend, choking off growth. It also pisses the hell out of savers. The opposite of what you want in a recession.

Quantitative Easing – my favorite two letter acronym – was one way around this problem. Dual interest rates is another.

Basically, the central bank keeps the deposit rate steady, but introduces a new, lower rate: the lending rate or, the rate it lends banks money. Banks have always been able to borrow from their central bank in an emergency, but usually for short periods of time, and at a penalty. Dual interest rates inverts this. In this hypothetical world, banks could be paid 0.1% interest on any reserves they hold, but could borrow new reserves from the central bank at -1%, effectively being paid to take a loan (presumably the term-length is adjusted depending on the stimulus required). Central banks can then keep savers and banks happy with positive deposit rates, while also offering money at negative rates to keep stimulus going.

Liquidity: Definition, Ratios, How It's Managed

Where I say “printing press” thrice in four paragraphs

The sharp-eyed observer will see what is happening here: subsided loans, powered by central bank money creation, mediated through the financial system.* The central banks are making losses on these loans, but that doesn’t matter since they can print money.

The policy is sort of in place already. The EU’s TLTRO program (I’ve spoken about it before) lends money long-term to banks at special interest rates below the deposit rate, on the condition they lend to non-financial corporations and households (except loans for home purchases).

The proposal is valuable for acknowledging the power society possesses in the printing press, while offering a sensible proposal for using it wisely.

What’s missing for me is a discussion about coordinating this program with the government. Arguably it should not be left solely to the technocrats to decide how the state’s printing press is used to provide cheap loans for banks to distribute. Similar to the ECB’s TLTRO program, dual-interest rate lending should come with special conditions, which could be determined alongside the Treasury or equivalent.

More broadly, where dual interest rate policy is used to provide long-term loans, it begins to intersect with tricky questions of climate change, and industrial policy. Should environmental conditions be attached to TLTRO-esque programs? Should dual-interest rate policy be mobilized to support strategic state initiatives like decarbonisation?

I suspect the authors omit this out of a concern for politicizing the initiative. They are confident that dual-interest rates, as an extension of interest rate policy, could be “the least unsettling politically.” I am less convinced, especially in today’s environment where central banks are under a much greater spotlight (and scrutiny). With a powerful new tool in our hands, we should consider all its possibilities.

In sum, lots of interesting food for thought. Please do read the full thing.

*They are only likely to be subsidized during a recession when there is a demand deficit. The reverse can happen during a boom.