There is an obsession with negative nominal interest rates. People seem to think that they make no sense. And, there is a fixation with keeping track of the fraction of sovereign debt that is trading at negative nominal rates. (At this writing, the number is approaching one-third of the total outstanding.) Clearly many central bankers believe that setting the policy rate below zero is a legitimate use of this conventional instrument, a point that we have supported in the past. But the fact that people are so disturbed prompts us to ask why. In this post, we first discuss why we are confused by this reaction, and then try to identify what might account for it....
Read MoreCommentary
Imagine Fed Governor Rip van Winkle waking from a 10-year nap to find that trend inflation is only a bit shy of the 2% target, the unemployment rate is close to its long-run steady state, and the Fed’s balance sheet is five times larger than when he fell asleep. As we wrote two years ago, you could forgive him for expecting the federal funds rate to be closer to 4% than ½%. And, you would understand his astonishment when he learns that financial market expectations of policy tightening have collapsed amid continued economic expansion.
So, why are both the current policy rate and expectations of the future rate so low? There are four powerful reasons. First, both investors and policymakers have lowered their estimates of the steady-state (or “natural”) real interest rate. That means that Fed policy today is less accommodative than Governor Rip’s 10-year-old perspective leads him to think. Second, Rip is surely startled to learn that, even with a tightening labor market and policy rates close to zero, market-based long-run inflation expectations have declined. Third, it seems unlikely that Rip would be thinking much about the policy asymmetry that occurs when the nominal interest rate is near the effective lower bound. That is, as post-crisis experience suggests, with policy rates near (or even below) zero, it is much easier for central banks to tighten when prices rise too quickly than it is to ease should prices start to fall. Fourth, the economy’s productive capacity may be endogenous: that is, it may be possible for trend growth to be higher than recent experience suggests...
Read MoreWe are huge fans of stress tests. In many ways, they are the best macroprudential tool we have for reducing the frequency and severity of financial crises.
The idea behind stress tests is simple: see if all financial institutions can simultaneously withstand a major negative macroeconomic event—a big fall in real output, a large decline in equity and property prices, a substantial widening of interest-rate spreads, an adverse move in the exchange rate. And, importantly, assume that in response to these adverse circumstances banks have no way to sell assets or raise equity. That is, the stress test asks whether each intermediary can stand on its own without help in the middle of an economic maelstrom. But for stress tests to be effective, they must be truly stressful. The tempest has to be the financial equivalent of a severe hurricane, not just a tropical storm.
This brings us to the latest European Banking Authority (EBA) 2016 stress tests. As we mentioned recently, the European financial system may be the biggest source of systemic risk globally. So, these tests are important not just for Europe, but for the world as a whole. Unfortunately, they just aren’t severe enough, so there is little reason to be confident about the resilience of European finance...
Read MoreThe first U.S. exchange-traded fund (ETF)—the SPY based on the S&P500—began trading in 1993. Since then, the number of such funds has grown dramatically, so that by mid-2016 there were more than 1,600 ETFs on U.S. exchanges valued at roughly $2.2 trillion. This means that ETFs are now roughly one-sixth the size of open-end mutual funds. And, with this ETF growth has come a broadening in their scope and character. Today, there are ETFs that include less liquid assets such as corporate bonds and emerging market equities, and there are funds that provide inverse or leveraged exposure to the underlying assets.
Given these trends, it is no surprise that ETFs have attracted regulators’ attention (see, for example, here and here). Should they be concerned? Is this a consumer protection issue? Do ETFs contribute to systemic risk? Or, is their design stabilizing? Might financial stability even be served by the conversion of all open-end mutual funds into ETFs? ...
Read MoreProfessor Larry Ball, our friend and colleague, has written a fascinating monograph reexamining the September 14, 2008 failure of Lehman Brothers. Following an exhaustive study of documents from a variety of sources, Professor Ball concludes that the Fed could have rescued Lehman. The firm had sufficient collateral to meet its liquidity needs, and may have been solvent. The implication is that the worst phase of the financial crisis was preventable. (A short summary is available here.)
We are skeptical on several fronts—that Lehman was solvent, that policymakers had authority to lend to an insolvent institution, and that doing so would have limited the financial crisis...
Read MoreChina’s rapid credit expansion is worrying. Will Chinese policymakers be able to contain the growth of credit without undermining economic growth and without triggering a banking or currency crisis? Aside from the consequences of Brexit, this is probably the most important issue facing global policymakers and investors today.
As it turns out, there are powerful arguments on both sides. The positives—high national savings and returns to investment, combined with the government’s broad tools for intervention—must be measured against a set of negatives—growing loan losses, the spread of shadow banking, large capital outflows, falling investment returns, and declining confidence in the government’s financial policy management. Against this complex background, it is no wonder that concerns and uncertainty are both high. What one can say confidently remains conditional: things are very likely to end badly if the credit buildup continues amid slowing economic growth...
Read MoreThe U.K. Brexit referendum is providing us with the first significant test of our sparkling new regulatory system. Everyone knew about the referendum months in advance, giving them plenty of time to prepare. Yet, we are left with some fundamental questions related to global financial stability. Do banks have sufficient capital and liquidity to withstand the “shock?” Will financial markets continue to serve their key functions? Or, is the financial system only as strong as its weakest link? Will turmoil once again prompt liability holders to run, triggering asset fire sales, and compelling central banks once again to do whatever it takes to keep avert a meltdown?
As the rating agencies might say, we are on “stress watch” with a negative outlook. Or, to mix metaphors, numerous lights are flashing yellow, so we are worried...
Read More“Is this a Lehman moment?”
In the days after the U.K. Brexit referendum, that was the leading question many people were asking. It is the right question. Unfortunately, despite years of regulatory reform in the aftermath of the financial crisis, the answer is: we don’t know. That is why policymakers are especially worried about heightened financial volatility in the aftermath of U.K. voters’ decision to leave the European Union....
Read MoreCapital—the excess of assets over liabilities—determines solvency, so policymakers are used to thinking of it as a tool for keeping banks and the banking system safe. House Financial Services Chair Hensarling’s proposal to allow banks to opt for a simple capital standard that would substitute for other regulatory oversight is just the most recent example.
But bank capital also is a critical factor in the transmission of monetary policy. When central banks ease, their actions are intended to encourage banks to lend and firms to borrow. And, to put it simply: healthy banks lend to healthy firms, while weak banks lend to weak firms (if at all)....
Read MoreProfessor Mervyn King, our friend, NYU Stern colleague and the former Governor of the Bank of England, has written a wonderfully insightful and thought-provoking new book, The End of Alchemy. His goal is not just to explain the sources of the 2007-09 crisis, but to provide a template for financial reform that would reduce the frequency and severity of future crises. In the end, Professor King proposes a radical structural change intended to make banking safe while preserving the intermediation function that is critical to modern economies.
The alchemy to which Professor King refers in his book’s title is banks’ traditional function of transforming high-risk, illiquid and long-maturity assets into low-risk, liquid and short-term liabilities. But, in the presence of limited liability for the banks’ owners and the government safety net (in the form of deposit insurance and the lender of last resort that remove both solvency and liquidity risk for the depositors), banks’ incentive is to transform too much. Holding assets that are overly risky, insufficiently liquid and too long-term makes banks fragile and run-prone, providing fodder for systemic crises....
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