Understanding “liftoff”: how Fed policy tightening would actually work

A new “primer” explains how the Fed would tighten policy under current “superabundant liquidity”. Similar to the past, the focus would be on the fed funds rate, not the balance sheet. Unlike in the past, the fed funds target would be a range and pursued by setting in the interest rate on excess reserves (cap) and conducting reverse repo operations (floor).

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Trend chasing and overreaction in equity and bond markets

Empirical analysis suggests that equity and bond returns in international markets are driven mostly by shocks to expected future real cash flows. Moreover, they interact with mutual fund flows. In particular, there is evidence of short-term “trend chasing” and overreaction. Bond market returns and flows are also jointly driven by U.S. interest rate shocks.

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The deflationary bias of low interest rates

Compressed interest rates raise the risk of hitting the zero lower bound. A new theoretical ECB paper shows that even before the ZLB is reached this creates a deflationary bias, as inflation expectations shift lower, real rates rise, and consumption and pricing power decline. To counter this bias central banks would need to accept positive output gaps (tighter labour markets) or even increase their inflation targets.

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On the vulnerability of local emerging debt markets

A new IMF paper provides evidence that increased foreign participation in local-currency emerging debt markets has made these significantly more vulnerable to foreign interest rate and risk shocks. Concentration of the investor base and poor economic fundamentals appear to amplify such vulnerability.

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Setback risks for international USD lending

The BIS annual report emphasizes the dollar’s pervasive influence on international financial conditions. Post-crisis non-conventional Fed easing has spurred a global credit expansion, including economies that did not need it. Conversely, Fed tightening would reverse easy financing on a global scale, including countries that are ill prepared for it. FX depreciation is unlikely to insulate small and emerging economies from credit tightening.

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China’s housing boom: numbers and risks

The surge in housing prices in metropolitan China is a systemic concern. A new paper estimates that price growth has been 8-13% per year from 2003 to 2013, comparable to the 1980s housing boom in Japan. Housing prices have averaged 8 times the annual income of buyers, implying a heavy financial burden. Sustainability relies on ongoing high household income growth and low real interest rates.

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Rules of thumb for banking and currency crisis risk

A new ECB paper explores macroeconomic indicators for banking and currency crises over the past 40 years. Banking crises arose mostly in constellations of [i] low credit-deposit spreads and high short-term rates (over 11%) or [iii] high credit-deposit spreads (over 270 bps) and flat or inverted yield curves. Housing price growth has also been a warning signal. Currency crises ensued from exchange rate overvaluation (more 2.7% above trend) and high short-term interest rates (over 10%).

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Forecasting inflation under globalisation

Two recent papers contribute to forecasting inflation in a world of convergent policy regimes and integrated economies. The first emphasizes the distinct effects of shocks to aggregate demand, supply, and monetary policy. The second explains why country inflation usually corrects deviations from trends in the rest of the world. Predominantly inflation has become a global force.

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The difference between volatility and risk

Financial markets often disregard the fundamental difference between volatility (the magnitude of price fluctuations) and risk (the probability and scope of permanent losses). Standard risk management and academic models rely upon volatility alone. Alas, this reliance can induce an illusion of predictability and excessive risk taking. Indeed, low volatility can indicate and even aggravate the risk of outsized permanent losses.

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Understanding “shadow money”

The shadow banking system creates money or money-like claims mainly through repurchase operations: cash managers “park” funds through short-term secured lending, while asset managers borrow against their securities to gain leverage. Large institutions have few alternatives to collateralized lending for cash management. Institutional cash pools and “shadow money” have been expanding rapidly over the past decade.

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