The Fed ruins summer
America’s central bank picks a poor time to get hawkish
May 19th 2016, 15:10 BY R.A. | LONDON
THE members of the Federal Reserve's monetary-policy making committee have been desperate to hike rates, often, for most of the past year. They were keen to begin hiking in September, but were put off when market volatility threatened to undermine the American recovery. In December they managed to get the first increase on the books, and committee members were feeling cocky as 2016 began; Stanley Fischer, the vice-chairman, proclaimed that it would be a four-hike year. Instead, markets spent the first two months of the year in a near panic, and here we are in mid-May with just the one, December rise behind us.
But the Fed is feeling good about the state of the state of the economy and is ready to give higher rates another chance. Over the last few weeks, every Fed official to wander within range of a microphone warned that more rate hikes might be coming sooner than many people anticipate. And yesterday the Fed published minutes from its April meeting which were revealing: "Most participants judged that if incoming data were consistent with economic growth picking up...then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June."
The committee members in favour of hiking make a few key arguments. Many of them reckon that labour-market slack is just about used up, and wages will soon rise at a much faster clip. Combined with higher oil prices, that should push up inflation, possibly above the Fed's target, possibly high enough that the Fed would need to rush through a lot of rate hikes to regain control, risking recovery in the process. Some argue that rates are excessively low, and are encouraging risky financial behaviour, sowing the seeds of future crises. Amusingly, some think that, "further postponement of action to raise the federal funds rate might confuse the public...and potentially erode the Committee’s credibility." Amusing, as the one thing the committee can credibly generate is confusion.
Pushing against these arguments are some quite substantial considerations. Worries about runaway inflation are based on a view of the relationship between inflation and unemployment that looks shakier by the day. Looking across the world, countries not suffering an acute political collapse seem to have an awful lot of difficulty sustaining even modestly positive inflation. It isn't hard to understand why. Many global labour and product markets are glutted (just this week, America put up punitive tariffs on China in an effort to stanche the flow of cheap steel imports). That constrains firms' and workers' ability to wield bargaining power. There is a global glut of investable savings too, which has pushed down long-run real interest rates around the world. That, in turn, constrains central banks, which cannot lift their rates very high without attracting a deflationary flood of capital. Over the last thirty years, central banks have found it much easier to push inflation down than up.
And it is worth focusing on the fact that the Fed does not have cause to try to push inflation down. Its preferred measure of inflation continues to run below the Fed's 2% target, as it has for the last four years. Somehow the Fed seems not to worry about what effect that might have on its credibility. All that undershooting has depressed market-based measures of inflation expectations, which suggest the public expects inflation to remain below target for some time. If the Fed's goal is to hit the 2% target in expectation, or on average, or most of the time, or every once in a while, or ever again, it might consider holding off on another rate rise until the magical 2% figure is reached. You know, just to make sure it can be done.
But the single biggest, overwhelming, really important reason not to rush this is the asymmetry of risks facing the central bank. Actually, the Fed's economic staff explains this well; from the minutes:
The risks to the forecast for real GDP were seen as tilted to the downside, reflecting the staff’s assessment that neither monetary nor fiscal policy was well positioned to help the economy withstand substantial adverse shocks. In addition, while there had been recent improvements in global financial and economic conditions, downside risks to the forecast from developments abroad, though smaller, remained. Consistent with the downside risk to aggregate demand, the staff viewed the risks to its outlook for the unemployment rate as skewed to the upside.
The Fed has unlimited room to raise interest rates. It doesn't want to have to jack up rates dramatically and quickly in response to surging inflation, but if it had to it could. It has almost no room to reduce rates. If an unexpected stretch of economic weakness comes along (and such a stretch is far more likely to come along than is dangerously high inflation) then the Fed is in a very serious bind indeed. Even if it is up for cutting rates as deep into negative territory as other central banks have dared to, that still leaves it very little room to cut. It has its unconventional tools available, but the Fed has proven none too anxious to roll them out in the past. If wages were growing as fast as they typically do during a healthy expansion, and if inflation had finally made its way back to and above target, then the Fed could be fairly confident that a rate increase wouldn't unexpectedly leave the central bank face to face with deflation and with few tools to respond.
But the economy isn't there yet. Hiking now is a leap off a cliff in a fog; one could always wait and jump later once conditions are clearer, but having jumped blindly one cannot reverse course if the expected ledge isn't where one thought it would be.
The Fed's incautious behaviour is especially worrying given the state of the world. Not only would it struggle to restore growth if it turned out to have overestimated the strength of the American recovery; it would also push the world's largest economy into a slump at a moment of serious global economic and political vulnerability. The state of the world has been better. The Brazilian state and economy are looking dangerously weak. China continues to accumulate debt at a pace that cannot go on for much longer. Britain will vote on whether to leave the EU just a few days after the June Fed meeting; Austria is about to elect a far-right president—just the latest far-right leader to enjoy political success on the continent. This might not be quite the right moment to take a relaxed attitude about the possibility of inducing an American slump.
What is most unfortunate, however, is that committee members seem not to realise the effect their statements send. Yesterday, before the minutes were released, the estimated probability of a rate hike in June (derived from futures prices) was about 6%. This morning, that probability rose above 30%. With that shift in expectations, all the other market prices one would expect to move have moved. Emerging-market currencies began falling against the dollar, equities are off, and so on. The market ructions will deliver much the same effect an actual rate hike would. Ironically, the market wobbles might be enough to dissuade the Fed from pulling the trigger when the June meeting rolls around. But a lot of harm will already have been done.
Murder most foul
When periods of economic growth come to an end, old age is rarely to blame
May 21st 2016 |
IN JUNE America’s economic expansion will be seven years old. That is practically geriatric: only three previous ones lasted longer. The record boom of the 1990s survived only ten years.
It is tempting to look at that ten-year mark as something like the maximum lifespan of an expansion in America, and to worry, correspondingly, that the current expansion’s days are running short. But are they? At a press conference in December Janet Yellen, chairman of America’s Federal Reserve, declared: “I think it’s a myth that expansions die of old age.” Yet die they do. Either Ms Yellen is wrong, or someone is bumping off otherwise healthy expansions before their time.
Like death, recessions (commonly defined as two consecutive quarters of falling GDP) are a part of life. Supply shocks occasionally prompt them: soaring oil prices in 1973 hit consumers in rich economies like an enormous tax rise, for instance, diminishing their purchasing power and thus prompting GDP to fall. More often, weak demand is to blame. Financial-market wobbles or rising interest rates cause people to cling tighter to their cash. Fear proves contagious, leading to a spiral of self-fulfilling pessimism.
But not all expansions are as short-lived as America’s (see chart). The Netherlands holds the record: its longest, which ended in 2008, lasted nearly 26 years. Australia may surpass that early next year: its continuing expansion dates back to 1991. If expansions have a natural lifespan, it is longer than a decade.
Earlier this year Glenn Rudebusch of the Federal Reserve Bank of San Francisco constructed an actuarial table for America’s historical expansions, much as a life-insurance company would for people. In rich countries the probability of a person’s death rises gradually from middle age until the mid-80s, then quite steeply thereafter. Expansions, however, do not seem to become more vulnerable with age. There have been only 12 American expansions since the end of the second world war; the universe of people who have lived and died is somewhat larger. But the data available suggest that there was a time when cycles aged like people. Before the second world war, Mr Rudebusch notes, the odds of tipping into recession rose as an expansion got older. Yet since the 1940s age has not withered them: an expansion in its 40th month is just as vulnerable, statistically, as one in its 80th (each has about a 75% chance of surviving the next year).
The notion of ageless recoveries is counter-intuitive. Finite business cycles seem to make sense: an economy just coming out of recession should have plenty of opportunities for investment, for example, which, once exhausted, make the onset of a new downturn more likely. Yet economists reckon cycles need not unfold like that; instead, it is possible for the composition of growth to change even as expansion continues. A booming tech sector might siphon off capital that would otherwise flow to infrastructure or housing. Those industries, in turn, could power growth once the tech boom runs its course. If all domestic investment opportunities are used up, capital should flow towards foreign investments, reducing the value of the currency and so helping exporters to spur the economy forward. As long as the end of a boom in one sector does not engender self-fulfilling pessimism in the rest of economy, the show should go on.
Why, then, should an economy ever find itself in recession? In the pre-war era, when age mattered more, governments and central banks played a much smaller part in stabilising the economy. Economic shocks (from earthquakes to financial crises) come along every so often; the longer an expansion goes on, the greater the chance that a really nasty mishap will occur, pushing the economy into a downturn.
Yet after the Depression, governments took on the job of countering pessimism. Bigger welfare states provided bigger “automatic stabilisers”, meaning spending on things like unemployment benefits, which pump more money into an economy as growth weakens. Central banks began manipulating interest rates more vigorously to keep growth on track, and eventually adopted targets to help instil the expectation of steady growth.
Ms Yellen, in the ballroom, with the premature rate rise
Post-war expansions are longer (and recessions shorter) than was once the case, but business-cycle immortality remains elusive. The end of some expansions is clearly the result of foul play. In the early 1980s, for instance, both America and Britain suffered recessions that were deliberately induced in order to bring down raging inflation.
In other cases the culprit is human error. As central bankers freely admit, their control over the economy is imperfect. Policy works on a delay. Since not every shock can be anticipated, a bad blow may start a recession before a central bank can adequately respond. Or an inflation-averse central bank may discover, after it is too late to adjust course, that it raised interest rates once too often. What’s more, with interest rates in many economies near zero, central bankers find themselves increasingly reliant on unconventional tools, for which the margin of error is larger.
But there is a difference between misfortune and recklessness. Central banks that worry more about high inflation than low will tend to err on the hawkish side, and will find themselves steering into recession with some regularity. The Reserve Bank of Australia, which targets an inflation rate of between 2% and 3%, has given itself a floor to defend as well as a ceiling. That seems to help it from sinking into recession by mistake. The Fed, which has begun raising interest rates even as its preferred inflation measure remains below its target, has not absorbed this lesson—and Ms Yellen’s comments about the natural life of expansions should not be considered an alibi.
Bank to basics
Swedbank’s success is built on old-fashioned thrift and modern technology
May 21st 2016 | STOCKHOLM |
TWO years ago Swedbank, Sweden’s biggest retail bank, moved from its offices in the centre of Stockholm to a drab business park outside the city. Employees fretted about leaving their prime location, a few doors from the Riksbank, the central bank, and a stone’s throw from Parliament. The move, which has saved $25m-odd a year, was symbolic not only of the bank’s thrift, but also of its desire to retreat from the exciting but risky end of banking. Instead, much like the Scandinavian furniture in its office, it is returning to something simpler and more straightforward. That strategy has made Swedbank not only one of the safest banks in Europe, as judged by the thickness of its cushion of capital, but also one of the most profitable.
European banks are struggling. Economic growth is low; regulators demand ever more capital, and negative interest rates, which most banks do not dare to pass on to depositors, squeeze margins. All this, bankers tell aggrieved shareholders, has inevitably pushed returns far below their pre-crisis levels. Yet Swedbank has defied the inevitable. It is nearly twice as profitable as the average European bank, despite holding twice as much capital on a risk-weighted basis (see chart). Last month it announced profits for the first quarter of SKr4.31 billion ($510m), well above market expectations and virtually the same as last year (SKr4.32 billion), before Sweden and the euro zone adopted negative rates. This was doubly unexpected given the sudden departure of the bank’s CEO in February, amid criticism of his policing of suspected conflicts of interest among the staff.
Underlying the bank’s success is the idea that in the post-crisis world, running a retail bank is not that different from running a utility. The business strategy is simple: sell lots of dull, low-risk products while keeping operating costs as low as possible. Of its 8m customers, 7m are households. Mortgages make up 60% of its loan book. Although there is plenty that banks cannot control, Swedbank focuses relentlessly on what it can: cost and risk.
“Hard and sweaty work” is the only way forward, says Goran Bronner, the bank’s CFO. Swedbank has cut its staff by a third since 2009; slashed the number of branches in Sweden (it also operates in the Baltic states) from over 1,000 in 1997 to 275 today, and made all but eight of those completely cashless. Discipline on spending pervades the bank, from procurement (switching phone companies recently reduced its telecom bills by 58%) to staffing (it is moving part of the workforce to the Baltics, where wages are up to 70% lower). It is over halfway through a two-year plan to reduce group expenditure by SKr1.4 billion. The $1.6m salary of the new CEO, Birgitte Bonnesen, is modest for the industry.
As a result of this frugality, Swedbank has a cost-to-income ratio of 43%, meaning that 57% of the money it takes in can be distributed to shareholders or reinvested. This is over 16 percentage points more than the average for the EU as a whole. The Baltic branches are even more efficient, thanks in part to even greater use of digital banking than in Sweden.
The bank’s efforts to move customers from branches and phones to websites and apps are crucial to its success. In the future people may well only visit a branch once every five years, suggests Ms Bonnesen, who believes “extreme efficiency”, abetted by technology, is the nub of retail banking. Across the road from Swedbank’s headquarters, in a converted warehouse, 200 developers and business managers flit from breakout areas to meeting pods, planning this lean but customer-pleasing future. One of their most popular creations is the “shake for balance” function on Swedbank’s app, which allows users to shake their phones to find out how much money they have in their account. It is used 30m times a month.
It helps that Swedbank’s biggest market is Sweden. Its economy has grown faster than most of Europe. Swedes have also been easier to wean off expensive cash and human contact than other Europeans, thanks to their digital savvy. And the Swedish banking bust of the 1990s instilled a wariness of lax lending in local bankers long before the global financial crisis.
Nonetheless, Swedbank still lent too freely to borrowers in the Baltics, Russia and Ukraine in the early 2000s. Some 20% of loans in those countries had soured by 2009 (compared to 3% for the bank as a whole). What makes the bank remarkable, says Alexander Ekbom of Standard & Poor’s, a rating agency, is how it responded. It promptly sold its Russian and Ukrainian business and wrote off bad loans in the Baltics. Only 0.4% of its current lending is in default.
This experience made Swedbank the conservative, slightly boring bank that it is today. It says it has no ambition to expand to new markets or to trim its capital. It avoids risky assets, preferring those with solid collateral, such as property. Any new business must have a risk-adjusted return of at least 20% to be considered worthwhile. In Sweden it tries to steer clear of lending to industries exposed to private consumption, which tends to suffer in downturns. Much of its corporate lending goes to farming, forestry and housing co-operatives, which it considers safer.
Despite this obsession with risk management, the bank faces some risks that are hard to control. Because Swedes don’t keep much money in the bank, Swedish banks rely heavily on wholesale funding, making them vulnerable to investors’ mood swings. And Swedbank’s impressive risk-adjusted capital ratio is largely the result of the very favourable treatment that mortgages in rich countries still receive under the Basel banking rules compared to other types of lending. If global regulators’ approach to mortgages were ever to change, Swedbank would look much less strong: its leverage ratio, an unweighted measure of capital, is pedestrian.
By the same token, if Swedes ever defaulted on their mortgages in large numbers, Swedbank would be in big trouble. Swedish house prices, and thus mortgage lending, are swelling at a tremendous pace, generating fears of a bubble. Swedish policymakers and bankers seem remarkably sanguine that, even if there were a correction, households would not default on their mortgages, although the broader economy would suffer as households cut back on other spending. But even if these grim scenarios were to materialise, Swedbank would be starting in a much stronger place than most European banks.
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