Thursday, April 18, 2013

Dangers of Sustained Monetary Expansion from the IMF

Back in 2008 and 2009, I believe that there was a genuine risk of an international economic meltdown that could have been far worse than the grievous recess that actually occurred. (For some graphs that vividly illustrate the financial crisis, see here and here.) The nontraditional policies of the Federal Reserve and other central banks around that time--not just the reduction in the federal funds interest rate to near-zero, but also setting up a wide array of short-term lending facilities and the "quantitative easing" policy of buying financial assets--may well have limited the economic crisis from getting much worse. But that said, the recession ended back in June 2009, and I have my doubts that central banks should be continuing to maintain rock-bottom interest rates and continuing to buy financial assets for years into the future.  The question "Do Central Bank Policies Since the Crisis Carry Risks to Financial Stability?" is investigated in the Chapter 3 of the April 2013 issue of the Global Financial Stability Report, published by the IMF. Here's their summary:

"[T]he interest rate and unconventional policies conducted by the central banks of four major regions (the euro area, Japan, the United Kingdom, and the United States) appear indeed to have lessened vulnerabilities in the domestic banking sector and contributed to financial stability in the short term. Th e prolonged period of low interest rates and central bank asset purchases has improved some indicators of bank soundness. Central bank intervention mitigated dysfunction in targeted markets, and large-scale purchases of government bonds have in general not harmed market liquidity. Policymakers should be alert to the possibility, however, that financial stability risks may be shifting to other parts of the financial system, such as shadow banks, pension funds, and insurance companies. ... Despite their positive short-term effects for banks, these central bank policies are associated with financial risks that are likely to increase the longer the policies are maintained. The current environment shows signs of delaying balance sheet repair in banks and could raise credit risk over the medium term. ... Central banks also face challenges in eventually exiting markets in which they have intervened heavily, including the interbank market; policy missteps during an exit could affect participants’ expectations and market functioning, possibly leading to sharp price changes."

One example of these potential stresses involves the money market mutual fund industry. Rock-bottom interest rates make these funds less attractive to investors, so the funds are shrinking. As a result, some of these funds are testing the limits of what regulators will allow by trying to take greater risk. A gradual reduction in the assets in money market funds is not a macroeconomic problem, but if shrinking funds and higher risks metamorphosize into a run on these funds, it could be a problem. Here's the report:

"With interest rates remaining near zero in the maturities at which MMMFs [money market mutual funds] are permitted to invest, these institutions are experiencing very low (in some cases zero or negative) returns that in many cases fail to cover the costs of fund management. As a consequence, U.S. MMMFs have raised credit risk modestly (within the confines of regulatory restrictions), engaged in more overnight securities lending, granted fee waivers, and turned away new money. The fundamental problem is that to become profitable the MMMF industry needs to shrink further, and the risk is that it may do so in a disorderly fashion. For example, another run on MMMFs may occur if downside credit risks materialize or securities lending suddenly halts, fueling investors’ fear of MMMFs “breaking the buck” (that is, failing to maintain the expected stable net asset value)."
As investors leave money market mutual funds in a "search for  yield," risks arise in other  markets.

"Credit easing, quantitative easing, and commitments to prolonged low policy interest rates may trigger flows into other mature asset markets (corporate bonds, equities, commodities, secondary currencies, and even housing). While encouraging a certain degree of risk taking is indeed the purpose of many MP-plus [monetary policy-plus] policies, they could unintentionally lead to pockets of excessive search for yield by investors and to exuberant price developments in certain markets, with the potential  for bubbles. ... The sharp rise in investor\demand for credit products, combined with constrained supply, is supporting a substantial decline in corporate borrowing costs. In turn, investors are accommodating higher corporate leverage and weaker underwriting standards to enhance yield. Some components of the credit market, such as loans with relaxed covenants, are experiencing more robust growth than in the last credit cycle ..."
The lower interest rates have helped the banking sector in the last few years, but they also raise risks for the future. The report points out: "There is some evidence that unconventional central bank
measures may be supporting a delay in balance sheet cleanup in some banks ...  The current
environment may also be encouraging banks to evergreen loans rather than recognize them as nonperforming ... The volume and efficiency of interbank lending may adjust to new, lower levels based ... With many banks now relying to a significant extent on central bank liquidity and banks withdrawing resources and skills from interbank lending activities, it may be difficult to restart these markets."

 Finally, there is the question of how central banks will eventually unwind their very large purchases of financial securities, both in private markets and in public debt. If this unwinding is done in a gradual and preannounced way, it's certainly possible to draw up scenarios where it doesn't ruffle markets. But it's also possible to draw up scenarios where the unwinding of these financial positions become an undesired source of disruption in these markets and in the banks and other financial institutions that hold many of these assets.

"During 2009 and the first half of 2010, the Federal Reserve purchased close to $1 trillion in mortgage-backed securities (MBS) to support the U.S. housing market and alleviate pressures on the balance sheets of U.S. banks. It made a new commitment to buy MBS in September 2012 in an effort to lower mortgage interest rates further and spur credit extension ... In two purchase programs, the ECB [European Central Bank] bought a total nominal amount of €76.4 billion of covered bonds, and the BOE [Bank of England] bought up to £1.5 billion in corporate bonds. The BOJ [Bank of Japan] also maintains a limited program to purchase corporate bonds, real estate investment trusts (J-REITs), and exchange-traded funds (corporate stocks). ...

"Central banks have become substantial holders of government bonds, too. The increasing share of government bonds held by central banks may present risks to financial stability.The Federal Reserve and the BOJ now each hold some 10 percent of their respective governments’ debt, the BOE holds 25 percent, and the ECB holds an estimated 5 percent to 6 percent of the outstanding sovereign debt of Italy and Spain. The shares of Federal Reserve and BOE holdings of longer-dated sovereign bonds are even higher at more than 30 percent."

The IMF recommended policy answer to these kinds of concerns is essentially technocratic: that is, keep monetary policy very expansionary until a recovery is well-established, and use financial regulatory policies like well-constructed capital standards, liquidity requirements, and other approaches to limit negative outcomes. Announce all policy changes well in advance, so that surprises are minimized, and slowly phase in all changes to avoid disrupting markets. It's all very sensible and prudent at some level. But the belief that well-informed and well-intentioned regulators financial risks will perceive the risks that arising because of the long-extended extreme expansionary monetary policies, and will respond in exquisitely calibrated ways to manage these risks, seems troublesome to me. 

However, those interested in an alternative view might check out this accessible recent speech from Ben Bernanke, in which he discusses "Long-Term Interest Rates," the reasons why they are so low, and the case for keeping them low awhile longer.