Learning from Japan: It's Hard to End a Deflation

In 1974, when the Fed faced rising inflation, the U.S. government sought to “Whip Inflation Now” by encouraging people to wear “WIN” buttons. Today, the problem is reversed. Several central banks are having trouble creating inflation. Unfortunately, we doubt that “SIN” buttons – “Support Inflation Now” – will be any more effective than the earlier variety, which served mainly as fodder for late-night comedy.

As has been the case for some time, Japan is blazing the trail into the monetary and fiscal unknown. Today's Bank of Japan's (BoJ) leadership is far more determined to promote price stability than its predecessors over the past two decades. But the deflationary hole that Japan is climbing out of is so deep that the BoJ may need some help...

Is International Diversification Dead?

At least since Harry Markowitz’s work in the 1950s, diversification has been viewed as the key to an efficient portfolio that minimizes risk for a given expected rate of return. When James Tobin received his Nobel Prize in 1981 – in part for his work on the subject – he summarized portfolio selection theory in the classic fashion: “don’t put all your eggs in one basket.”

Over the years, academicians and market professionals extended this fundamental principle to the global asset universe, highlighting the benefits of going beyond simply holding a broad group of domestic instruments to the idea of international diversification. In the case of equity portfolios, they also observed that people typically hold a smaller share of foreign stocks than simple portfolio selection models prescribe. This gap between actual and model-based optimal allocations of equity portfolios has become known in finance as the equity home bias puzzle.

Financial transactions taxes: FTT?

If you put “FTT” into a search engine, the top results are for “Failure to Thrive.” Proponents of a financial transactions tax should find this disturbing. We find it amusing, but apt.

The idea of taxing the purchase and sale of certain securities has been around for a long time. The British first imposed a stamp duty on secondary market purchases of equity in 1694 – a tax that remains in force today. In 1936, Keynes proposed the imposition of a wider tax with an eye toward reducing volatility. In 1972, following the collapse of the Bretton Woods fixed-exchange-rate system, Nobelist James Tobin famously recommended a tax on currency trading as a kind of capital control that would provide central banks greater discretion in controlling their interest rates and exchange rates. As of 1991, Campbell and Froot list 20 jurisdictions with some form of securities transactions tax. With the move by 11 European Union countries to impose one as of January 1, 2016, the number of countries with an FTT will soon exceed 40...

Market liquidity and financial stability

Everyone seems to be worried about market liquidity – the ability to buy or sell a large quantity of an asset with little or no price impact. Some observers complain that post-crisis financial regulation has reduced market liquidity by forcing traditional market makers – say, in corporate bonds – to withdraw. Others focus on episodes of sudden, unforeseen loss of liquidity – for example, in the equity and Treasury markets – suggesting that structural changes (such as the spread of high-frequency algorithmic trading) are now a source of fragility. We’ve written about these issues before (here and here).

But it is worth taking a step back to ask exactly what it is that we care about. The answer turns out to be complex, so working out remedies will be a big challenge...

Making driving safe

The home page for the Google Self-Driving Car Project contains the following:

Imagine if everyone could get around easily and safely, regardless of their ability to drive. […] Aging or visually impaired loved ones wouldn't have to give up their independence. Time spent commuting could be time spent doing what you want to do. Deaths from traffic accidents—over 1.2 million worldwide every year—could be reduced dramatically, especially since 94% of accidents in the U.S. involve human error.

In some walks of life, we can reduce risks by changing human behavior. In the case of automobiles, we train and license people to make them drive more safely. We also fine and incarcerate them when they don't...

Banks and interest rates: be careful what you wish for

Many people seem to think that – as a new BIS working paper concludes – banks benefit when monetary policy tightens and interest rates rise (especially from a low level). Do they? In some instances, perhaps, but as a general principle, surely not.

A casual glance at recent U.S. stock market behavior seems to support the idea that higher interest rates would be good for banks now. When the Federal Open Market Committee decided not to hike interest rates on September 17, the S&P500 dropped by 1.85% over two days, while the KBW index of bank stocks fell by 4.85%. A week later, when Fed Chair Yellen speaking about inflation dynamics expressed her continued expectations for a rate hike this year, the S&P500 edged lower, but the bank index rose by nearly 2%...

Déjà vu in emerging markets

For decades a number of emerging markets have been evolving into advanced economies. They have improved their financial systems, property rights, policy frameworks, and growth models. As it turns out, however, the evolution was going the other way, too: advanced economies were becoming more like emerging markets, too. Debt was accumulating on household, corporate and bank balance sheets. Booms in real estate and parts of the corporate sector added to financial vulnerability. And policymakers were inattentive to the risks or lacked consensus on how to address them...

Virtual Frenzies: Bitcoin and the Blockchain

Bitcoin has prompted many people to expect a revolution in the means by which we make and settle everyday payments. Our view is that Bitcoin and other “virtual currency schemes” (VCS) lack critical features of money, so their use is likely to remain very limited.

In contrast, the technology used to record Bitcoin ownership and transactions – the block chain – has potentially broad applications in supporting payments in any currency. The block chain can be thought of as an ever-growing public ledger of transactions that is encrypted and distributed over a network of computers. Even as the Bitcoin frenzy subsides, the block chain has attracted attention from bank and nonbank intermediaries looking for ways to economize on payments costs. Only extensive experimentation will determine whether there are large benefits.

Again, however, we are somewhat skeptical...

It's a small world (after all)

Originally built for the 1964 New York World’s Fair, the “It’s a small world” exhibition re-opened at Disneyland two years later in 1966. At the time, the international monetary system was characterized by fixed exchange rates and widespread capital controls.

A half century later, global finance has been transformed so that exchange rates are now mostly flexible and cross-border capital mobility is generally high. As they say in Disneyland, it’s a small world after all...

The FOMC is coming

Having dropped to 5.1%, the unemployment rate has reached the longer-run employment goal of the Federal Reserve’s Open Market Committee (FOMC). So, starting to raise interest rates would seem to be in the cards. And, many observers expect policymakers to act soon, possibly very soon.

The key sticking point, and it is a big one, is that inflation – as measured by the personal consumption expenditure price index (PCE) favored by the FOMC – has been consistently below their stated 2% medium-term objective since early 2012.

Tightening monetary policy for the first time since 2006 requires confidence that inflation will in fact head back up (see, for example, the July FOMC statement and Fed Vice Chair Fischer’s recent comments). The difficulty is that confidence requires reliable forecasts. And, as it turns out, precise forecasts of inflation are hard to come by....

Commentary

Money, Banking, and Financial Markets