How to reduce excessive public debt

November 25, 2013

An empirical IMF paper suggests that public debt reduction can support medium-term growth, if it is focused on cuts in non-investment spending. Such benign fiscal consolidation is less likely, however, when the private sector is credit constrained and fails to benefit from lower public borrowing, as has been the case after the 2008 financial crisis. In this case more balanced and gradual fiscal adjustment may be required to mitigate the negative growth effect.

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A brief history of monetary policy and asset price booms

November 20, 2013

A new NBER paper reminds us of historical episodes when loose monetary policy contributed to asset price booms and busts. The paper also provides econometric evidence that low policy rates usually support asset prices. This history may not dissuade central banks from running highly accommodative policies at present, but explains the importance of accompanying macro-prudential measures.

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Commodity exchange prices: The curious case of aluminum

November 13, 2013

Goldman Sachs Research takes another look at soaring warehouse queues and fears of price distortions in the aluminum market (see previous post here). A case can be made that inventories have risen as consequence of a supply surplus, rather than distortions. The price of physical metal, traded outside the exchange, appears to evolve in line with fundamentals. By contrast, the exchange price trades at a discount, because it only entitles to a warrant for cheapest delivery and not to physical metal at the required location. The variation of this discount constitutes basis risk for producers or consumers that use it for hedging, compromising the validity of the London Metals Exchange prices.

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Understanding the U.S. monetary policy framework

November 10, 2013

A new staff paper summarizes the Federal Reserve’s policy framework, as it evolved in the face of the zero lower bound for interest rates. The framework is predicated on the principles of excess stimulus, history dependence, economic conditionality, and credible communication. Its main tools are interest rate forward guidance and asset purchases. A higher inflation target or a nominal income level target is under discussion. The integration of monetary and macro-prudential policies has progressed.

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Current accounts and foreign exchange returns

November 6, 2013

A research report by Jens Nordvig and his colleagues at Nomura shows that external (current account) surpluses have been a poor indicator of currency performance over the past 20 years. External deficits are often the consequence of growth outperformance, decreasing country risk premiums and capital inflows, and hence may be associated with currency strength rather than currency weakness.

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How easy G3 monetary policy spills over into East Asia

November 2, 2013

A recent BIS paper illustrates the consequences of highly accommodative monetary policy in the G3 for East Asia. These include lower policy rates than warranted by domestic conditions, lower bond yields and appreciation pressure on currencies. Importantly, easy G3 monetary conditions stimulate Asian foreign currency borrowing in many forms, including letters of credit, forward selling of foreign currencies and international bond issuance.

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Some stylized facts of FX liquidity

October 28, 2013

A paper of the University of St. Gallen shows that foreign exchange liquidity has been highly correlated across currency pairs, apparently more so than in equity markets. Liquidity correlation has been strongest in developed FX markets and particularly in volatile currency pairs. Bond and equity markets seem to have a bearing on systematic FX liquidity. Feedback loops between market illiquidity and funding constraints can escalate into fire sales. Riskier currency pairs, and particularly those related to carry trades, are more susceptible to liquidity shocks.

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Liquidity regulation and monetary policy

October 24, 2013

From 2015 banks will have to satisfy new liquidity standards. Of particular importance is the liquidity coverage ratio, which requires institutions to hold enough “high quality liquid assets” to withstand a 30-day period of funding stress. This will complicate the conduct of monetary policy and affect short-term yield curves, which will probably price some regulatory term premium.

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A theory of safe asset shortage

October 21, 2013

Ricardo Caballero and Emmanuel Farhi from MIT and Harvard propose an interesting and relevant formal model of safe asset shortage. While safe asset supply is constrained by the fiscal capacity of sovereigns and financial innovation, demand may be in a secular ascent (driven for example by collateralization and population aging). The resulting shortfall can result in a structural drag on economic growth and impair the effectiveness of fiscal and monetary policies, with some resemblance to the Keynesian liquidity trap.

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Dealer balance sheets and market liquidity

October 17, 2013

Even in a huge market like U.S. fixed income, dealer balance sheet management these days can impair liquidity. New Federal Reserve research suggests that during the 2013 treasury sell-off dealers reduced their own positions rather than absorbing client flows and decided to limit their market making.

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