SECular shift
New money-market regulations are pushing up a benchmark interest rate Aug 27th 2016 |
DURING the financial crisis of 2008, LIBOR was a gauge of fear. The London inter-bank offered rate—at which banks are willing to lend to one another—leapt. (Even then it may have been too reassuring: banks have since been fined billions, and traders jailed, for rigging it.) Lately it has been climbing again: on August 22nd three-month dollar LIBOR rose above 0.82%. That is no cause for panic, but it is a seven-year high and 0.2 percentage points more than in June. What’s going on?
Increases in LIBOR, a benchmark used to set rates for trillions of dollars’ worth of loans, usually reflect either strains on banks or expected rises in central banks’ policy rates. Although the Federal Reserve has been toying with tightening, this time LIBOR’s ascent has another explanation, traceable to the turmoil of 2008. A change by the Securities and Exchange Commission (SEC) in the regulation of American money-market funds has made borrowing pricier, especially for foreign banks.
Before the crisis investors in money-market funds—which lend for short periods to banks, other companies and the government—had become accustomed to treating their accounts like bank deposits, putting money in and taking it out at will. That changed the day after Lehman Brothers went bust, when the Reserve Primary Fund “broke the buck”, declaring that investors could no longer redeem shares for the customary $1 apiece. A run on funds ensued; to halt the chaos, the Treasury was forced to guarantee them.
The SEC’s new rule, which takes effect on October 14th, obliges “prime” funds (buyers of banks’ and companies’ paper, as well as public debt) serving institutional investors to let their net asset values vary, rather than fix them at $1 a share. To prevent runs, they may also limit and charge for redemptions if less than 30% of their assets can be liquidated inside a week.
This has made prime funds much less attractive, causing a “change in the landscape of the wholesale funds market”, says Steve Kang, an interest-rate strategist at Citigroup. Between October 2015 and July 2016 all prime funds’ assets declined by more than $550 billion, to $1.2 trillion, according to the SEC; “government” funds that invest in Treasuries and the like have swollen by a similar amount, to $1.6 trillion (see chart). Prime funds have also pushed their liquidity ratios well above the 30% threshold as the October deadline approaches; they are loth to lend for as long as three months. Steven Zeng of Deutsche Bank notes that in the past couple of months the average maturity of large funds’ assets has declined from more than 20 days to less than 13.
For foreign banks, which account for more than $800 billion of prime funds’ $938 billion of bank securities, this is depleting an important source of dollars. (American banks rely more on deposits.) Borrowing has become pricier, which LIBOR echoes. They seem to be filling the gap: for example, cash-rich companies are thought to be lending via “separately managed accounts” rather than prime funds. Banks have other alternatives, but borrowing using exchange-rate swaps, explains Mr Kang, is more expensive; central-bank swap lines are dearer still, and because they are primarily regarded as emergency facilities, banks are reluctant to tap them.
The pain will vary from bank to bank. American lenders with lots of LIBOR-linked mortgages may even gain. Some foreign banks may also recoup higher borrowing costs: their floating interest-rate commercial loans outweigh those at fixed rates. But many borrowers will pay a price. The aftershocks of 2008 rumble on.
The Jackson four
Should the Fed adopt India’s inflation target?
Aug 27th 2016 |
IN THE latter part of this week, monetary policymakers and theorists from around the world were due to attend the Jackson Hole symposium, 6,800 feet up in the mountains of Wyoming. Many people—aggrieved savers and yield-hungry investors—probably wish they would never come back down. To their critics, central bankers seem strangely committed to two unpardonable follies: eroding the interest people earn on their savings and inflating the prices they pay at the shops.
It was, therefore, brave of one central banker—John Williams of the Federal Reserve Bank of San Francisco—to argue on August 15th that the Fed might need to raise its 2% inflation target or replace it with an alternative if it is successfully to fight the next downturn. Some economists favour an inflation target of 4%. This is not as outlandish as it sounds. Indeed, the notion that new circumstances require a new target may appear quite run-of-the-mill to central bankers from the developing world who are taking part in the symposium.
Much criticism of the West’s central bankers rests on the myth that they are wholly responsible for rock-bottom rates. In fact, they seek the highest rates the economy can bear, but no higher. When the economy is at full strength, they want a “neutral” (or natural) rate that keeps inflation steady, neither stimulating the economy nor slowing it. When the economy is overheating, they want a rate above neutral. And when the economy is weak, they want one below it. The neutral rate (r* in economists’ algebra) thus provides a vital reference point for their policy. As such, it exercises considerable influence over central bankers. But they, importantly, exercise precious little influence over it.
According to economic theory, the neutral rate reconciles the eagerness to invest and the willingness to save when the economy is in full bloom. As such, it reflects the productivity of capital, the promise of technology and the prudence of households, none of which are variables chosen by monetary officials. The neutral rate cannot be observed directly. But Mr Williams and a Fed colleague reckon it has fallen persistently: r-star (as he calls it) is close to zero, or about two percentage points lower than it was in 2004.
If r-star is lower than it was back then, the Fed’s policy rate must also be lower to be equally stimulative. That means today’s rate (of between 0.25% and 0.5%) is not as lax as it looks. Leo Krippner of the Reserve Bank of New Zealand estimates that American monetary policy today is already as tight as it was in July 2005, when the federal funds rate stood at 3.25%, having been raised nine times.
The question preoccupying most Fed-watchers is how much tighter policy will get in the next year or two. Mr Williams raises a different concern: how much looser can policy get during the next downturn. If the Fed sticks to its current inflation target of 2%, a policy rate of 0% would translate into a real cost of borrowing of minus 2% (because the money debtors repay will be worth less than the money they borrowed). That may not be low enough.
Such a rate would be only about two percentage points lower than Mr Williams’s estimate of the neutral rate. Raising the inflation target to 4%, say, would allow real interest rates to drop about four percentage points below neutral if necessary. (This is not the only reform idea. Another is targeting the trajectory of nominal GDP, which reflects both economic growth and price inflation; that might result in higher inflation when growth was weak and low inflation when growth was strong.)
But even if a 4% target is desirable, would it be feasible? The Fed has struggled to reach its current target quickly or consistently. What makes anyone think it could hit a higher one? One answer is that a higher target would free the central bank from a “timidity trap”, as Paul Krugman of the New York Times calls it. In such a trap the central bank sets its goals too low, and paradoxically falls short of them. A credible central bank might cut rates to zero and promise 2% inflation. If it is believed, inflation expectations will rise and the anticipated real cost of borrowing will fall to minus 2%. But if the economy actually needs a real rate of minus 4% to revive, spending will remain too weak, economic slack will persist and inflation will ebb, falling under target. Conversely, if the central bank promises 4% inflation, its pledges will be both believed and fulfilled.
Shooting r-star
Western policymakers dislike tinkering with their inflation targets. But in the wider universe of central banks, periodic revisions are no big deal. Indonesia sets its targets for a three-year period, as does the Philippines, Turkey and South Korea. This flexibility need not destroy a central bank’s sound-money credentials: South Korea’s inflation is even lower than America’s.
Although a target centred on 4% sounds scandalous to rich-world central bankers, it is not unusual elsewhere. Indonesia pursues one. Brazil’s inflation target is 4.5%. India is lowering its target from 6% last year to about 4% for the future. The committee recommending that figure was chaired by Urjit Patel, who will be the Reserve Bank of India’s next governor (see article).
One advantage many emerging economies enjoy over richer ones is a higher r-star, thanks to faster rates of underlying growth and inflation, as low local prices converge towards higher international prices. That gives their central banks more room to cut interest rates in the face of a downturn. Indeed, it is hard to think of any catch-up economy that has remained stuck at zero rates.
If Mr Patel succeeds in his new job and the Fed embraces reform, America’s inflation target may one day resemble India’s. But India will still worry more about overshooting its target than undershooting it, and America will still probably harbour the opposite set of concerns. Their inflation targets may match, but their r-stars will not be aligned.
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