Friday, January 19, 2007

Central Bank Policy Tools Revisited

Any parent will tell you: There simply are some things that children must learn by experience. I recall my first university "Money & Banking" course, taught by a most-jolly Nigerian graduate student lecturer, with a big belly laugh, a keen sense of irony, and an enamoration with his own sense of humor similar to that of my Zen Buddhism professor. Ahhh, those were the days! But the point that I mean to make is that one can teach conceptually about Moral Suasion, Jawboning, Open Market Operations or The Discount Rate, but similar learning a foreign language, one doesn't truly learn it, nor truly appreciate the nuances until one has a large wrong-way position in relation so some Central Bank action or another.

Given the "Hear No Evil, See No Evil, Speak No Evil" stance of virtually all of the world's Central Banks, I thought it might be useful to review the tools within the arsenal of the modern day Central Banker, such that every reader is familiar in the event authorities do an about-face and decide that policy action is superior to the collection of honoriam, and beaucoup free rounds of Golf.

1. Jawboning.
"Jawboning" is the attempt to change market expectations without actually doing anything. Talk is cheap, so the old saw goes, and this is true from the point of view of political capital. It is "talking the talk", or "sowing the seeds". The opportunities for FOMC members to use this both varied and numerous. Lectures, speeches, Congressional testimony, trade conferences, press interviews, all provide opportunities for the Governors to express views that will attempt to nudge the market in the desired direction.

Sometimes these attempts have unintended consequences. Greenspan's now-famous Irrational Exhuberance is case in point. Bernanke's "Helicopter" reference in a private speech is another piece of chewing inexorably stuck to the Chairman's shoe. The trend has clearly been for greater transparency, and less cryptic-ness, which as the story goes, is believed to reduce volatility and increase economic efficiency by reducing uncertainty in planning, capital budgeting and variance in financing costs. Inflation targetting is the ultimate expression of this mechanistic view.

However, I am of the opinion that it is more complex, and thus requires more nuance. Speculation and economic activity are intricately linked, through reflexive feedback mechanisms. Economic conditions can and do change dramatically in response to war, natural disaster, political upheaval, etc. Apprising the market accordingly of adjusting expectations and conditions can be useful, even if they upset the prevailing paradigm. The market may believe that the Central Bank will tolerate higher inflation, and so they will express this belief in as many ways and as vigorously as possible until the CB indicates that it will not tolerate what the market thinks it might. This might cause a small derailment as the market adjusts, but this is most certainly superior to allowing a gross misallocation of resources and then causing a much more damaging train wreck later. So the quicker Mr Bernanke manages to slip a quip in one of his speeches about how gobsmacked he is by the rising cost of education , healthcare, housing, hotels, and all manner of goods and services, the quicker he might be able to disassociate himself from "The Helicopter".

In Japan, of course, despite the independence of the BoJ, things are NOT what they seem. For in Japan the most important thing to remember is that no one within the power structure of TeamJapan act inconoclastically for very long before being jettisoned. This is essential to remember when considering BoJ independence. For if the Prime Minister's office and the MoF are deeply opposed to that which is important to the BoJ, there is no question who will win...

2.. Moral Suasion.

Ahhh yes. There was a time when Commercial Banks respected Central Bankers. They understood that these Weberian-style bureaucrats were making a sacrifice in electing public service over the private sector. And the Central Bank could make life difficult for both commerical and merchant banks, if it chose to. Today. it would seem, that even the management of an American IB or commerical bank cannot rein in the traders and risk-takers within the organization, so how can a central bank hope to influence the activities and undertakings of institutions beneath its oversight? Not to mention that IBs and univeral banks - whether chartered in America or elsewhere - are now global, in scope and domicile. And there is no universal regulator except perhaps the BIS by extension of the broadest of capital adequacy agreements.

In Japan, by contrast, few could conceive of not heeding the gameplan of TeamJapan for the sake of parochial gain. This goes for the Corporate level and the level of the individual. If the BoJ say "Don't unload stocks into a falling market", supply will evaporate. If MoF says "Buy Stocks to support the market", they will find a way with discretionary funds and proprietary accounts, to make it so. If they say: "Don't repatriate profits so as place undue upwards pressure upon the YEN", Japanese non-financial corporations will find non-YEN investments, whether real or financial, in order to park their funds. Such is the power of Moral Suason in a society with unimaginably deep web of obligations. Make the mistake of taking personal initiative to sell stocks when MoF says "Dont Sell", and one may find oneself in old age drinking alone within a cardboard box in Shinjuku Station, or reassigned to the Corporate Travel Office instead of receiving the seniority promotion earned from years of Service.

Back in the US, the threats are reversed. IF you rock the boat and bite the hand that feeds you, the Public Servant will find that no IB of Commercial Bank will hire him and pay him millions like Gerald Corrigan or Wayne Angell. Such is the present day power of moral suasion. Witness how a sober-minded (but outspoken) Secretary O'Neill in the Treasury was hounded for making waves about fiscal policy. And even a relatively uncontroversial Fisher at the FRB Dallas took stinging heat for appearing too concerned about the threats of inflation.

3. Open Market Operations
This is day-to-day management of "classical money" rollicking through in the system. Repos, reverse repos, coupon passes add or drain reserves accordingly, in pursuit of policy objectives. But it seems to me that in this era of zeros, the Fed would to be monstrously persistent in its presence and have a medium-sized army traders to make an impact. Since it seems that Fed (confirmed again by Mishkin's speech today) is to help assure a one-way ticket for asset prices (and for the record, that direction is NEITHER down nor sideways), one would be forgiven for seeing this a rather pathetically ineffective tool in the age of explosive derivative growth (or did I mean growth in explosive derivatives?!!?), globalization and free flow of capital.

In Japan such operations were characterized by so called Quantitative Easing which flooded the banks with so liquidity that one could actually quite literally get paid (though admittedly small) to borrow YEN. Now how daft is that? But did it work?? Oh how it worked! Greenwich and Chelsea home prices galloped as a result, as did virtually all global assets EXCEPT Japanese ones. Japanese asset prices stayed on their back for another four years despite free money in near-infinite supply that was taken up by anyone and everyone NOT Japanese for any and every purpose EXCEPT investment in Japan. Japanese asset prices only lifted off after the Chinese capital investment boom was full-throttle open AND asset prices in the rest of the world had appreciated beyond comfort zones. And what does the Bank of Japan have to show for it? About a trillion dollars of US Treasury Bonds which they haven't quite figured out how to dispose of just yet.

4. Adjusting Reserve Requirements of Member Banks
"There was a time....when I was a boy....." Did your father ever start an impossible boring story that way? Irrespective, there was a time when this was contemplated in much the same way people experimented with LSD, or worse PCP or Quaaludes. Few swim in those waters anymore just as no one countenances altering reserve requirements which is probably viewed in the same light as "running over yourself with your own car". What would this do, if anything? Certainly drive banks offshore and capital away and hobble domestically chartered banks at the expense of non-US banks. But since most banks are multi-jurisdictional these days, and standards are set in Basel anyway, what would it really accomplish? Oh yes, there is one little additional thing about the regional FRB Governors being elected by the very same bankers who would be f*cked by the change in the reserve requirement. "Biting the hand that feeds you" is the first thing to comes to mind....

5. Modulating Margin
Yes there is a thing called "Reg-T" that says: "You can only borrow a maximum 50% against the collateral of your listed shares. But real specs use futures and options. Here you can get 20x or 50x implied gearing. Margin is soooo passe except for domestic day-trading saps. Hedgies of course use heavy offshore gearing to get around Reg-T in any event. And most other instruments are levered up to what volatility and market will ultimately bear. Swaps and all manner of complex options like "one-touch look-back compound calls" could have effective gearing that would have made Marshall Molotov look like a wussy. And you don't even need to be a professional to get leverage like that! My local bank (in a full-page advertisement in today's newspaper) is offering 100% interest-only mortgages on amounts up to USD$1million. My math may be rusty, but that sounds to me about as close to infinite gearing as one can get. "Reg-T"? Ha!!

6. Market Supervision
They could and should use this more. Name and shame etc. Banks and brokers are guilty. I think real supervision would be a fun job if one worked on some kind of a reverse incentive basis - i.e. payment of a percentage of the reduction in grey and nefarious activity. Moreover, a movement by overseers to a "spirit" of the law interpretation vs. letter of the law owuld help furtehr. Yes, you are guilty unless you write the overlord and get written approval that the bogus tax-loss leases can be used to offset real income.

7. Covert Market Intervention
I've written before about "The BoJ's Hot Hand". And the Kong Kong Monetary Authority in 1998 boldly stood up and like JP Morgan after the crash in 1929, bought pretty much all they could equalling perhaps 10% of the Hang Seng in the HKMAs case. THAT was at 7000, whereas the Hang Seng is roughly 3x that now at >20,000. And anyone who can remember (When I was a boy....) will recall Japanese PKO (Price Keeping Operations) that kept participants on their toes, though few knew who (MoF, or BoJ) really was giving the orders, or for that matter, why.

In the US, Canadian investment house Sprott has written at length about the alledged "The Plunge Protection Team" and their secret operations. And though plausible in theory, I have serious doubts for the US is the land of "deep throat". A place where the Vice-President likely ordered the outing of a CIA Agents because her husband voted "Blue State". There is about a ZERO chance of something as big as a PPT being kept secret. The Market sunk the bank of England; the Thai Bhat, Nick Leeson's solo plunge-protection team; Amaranth, LTCM. We are talking about people like "Brownie" and FEMA and the same government that couldn't evacuate their own colon, let alone keep a massive multi-billion market intervention and support scheme a secret. Maybe one day American's - like the Japanese before them - will find a need and reason to intervene, but I don't see it yet.

8. Overt Market Intervention
This is "Loud and Proud" entry into the market. And it's typically done for efffect. It shows a seriousness. of intent. When I was first cutting my teeth, the mere rumour: "The Fed is checking prices...." was enough to make one dump everything and go double the other way. And there was "The BuBa is checking prices too" whereby the formerly-bold speculators would be seen scattering in all directions yelling "Run Away Run Away Run Away....". Then there was the canny Mr. Yen, Eisuke Sakakibara who waited patienty like Lao Tzu for his moment, Japan having been savaged by Rubin's policy of "Dancing upon their heads didn't work...let's try telling the market we don't care where dollar-Yen goes...". Like Dr Seuss's Grinch, he waited until all the little Who's in Whoville were sleeping and drunk and body-slammed the Yen so hard it triggered every stop and cleared every chart point causing every system not only to close out sort dollars, but strong mindless impulse to go long dollars in one single well-timed and well-planned raid effectively ending the strong-yen siege. THAT was a tool. THAT was resolve. THAT shoved short dollar-yen positions so far up the specs rears, no one dared go the other way for years, except for a day trade.

BUT the market today is more like a pack of hyenas, and even if a Central Bank is like a Lion - King Of The Beasts - hyenas are not easily deterred. They will harass a lion, sometimes chase him/her off, for there is safety in numbers Which is why this tool must be used sparingly and with great gravitas. For as the BoE learned there are limits - even to a central bank - of defending a wrong-sided position.

8. Capital Controls.
Central Banker can, and do, restrict capital flows into and out of their respective countries, with mixed success, and not without cost. That's fine where a small country is evolving, but rather more problemmatical once it's already open and in the big leagues of convertibility. Just the alliteration of the words makes me wince, and think of Malaysia's Matahir and his repsonse to 1998. These are Heavy! Heavy! Heavy! though remains a possibility. Theyh can stem an outflow, but is a bit like killing a mouse with a guillotine. Effectively, capital controls, for countries with already-convertible currencies, are akin to changing the rules, mid-game. At the wrong place and wrong time, it can have crushing consequences, for once the outflow starts, one way of insuring that no further capital will return is to slap them on. Capital controls, in any event, deal with the symptom and not the problem, much like treating cancer with pain-killers: it may stop the hurt, but it willdo nothing to cure the underlying disease.

10. Short-term Interest Rates - The Discount Rate & Fed Funds Rate
This is The Hammer. This is, at the end of the day, what the market in advanced-stage capitalism best understands: the Price of Money, for it the price at which member banks borrow from the Federal Reserve, and by extension for most of the time sets scene for the region the Fed would like to see the market-determined Fed Funds Rate, or US Interbank rate. It becomes a sort of benchmark rate and feeds through to the rest of the economy and financial system.

When it is low, and longer-frame rates are higher, this creates an opportunity to manufacture liquidity and profits, though not without risk that the yield curve could bite them in a variety of nasty ways. But when its inverted, financial institutions can of course borrow long and lend short (usually deemed rather risky) but typically only make spread profits by assuming credit risk. Famed Shakespearean John Gielgud speaking on behalf of Smith Barney used to term this "Making money the old fashioned
way", something eschewed in a modernity where money and financial profits can so erffortlessly be conjured by the carry trade. Banking, it would seem, is too much effort and too hard an undertaking. Indeed, modern bankers eschew the classical risk of potentially not being re-paid, and prefer to be the equivalent of third-party administrators, leaving the real risk to be socialized and concentrated where and as it may.

But everyone must understand that the Central Banker can only erally control the short rate, and through the short rate and its path of depandancies, so the bond rate is impacted. In the days when the Bond Market was considered "el vigilante muy feroz", a steep yield curve where short rates were substanitially below long rates was rightfully understood by anyone and everyone as at once expansionary, and likely inflationary. Raise the short rate, the long rate stabilizes or dips. Lower the short rate and watch the long rate rise. And it was effective. Traders and portfolio managers watched payrolls, and hourly earnings like a hawk to make sure they were snookered by monetary or economic movements, and with present value of their fixed-income slice diminished.

That was, of course, until the neo-mercantilists decided to accumulate US reserves in such vast quantities that it didn't matter where the short rate was, or how large the budget deficit ballooned. Japanese and Chinese official buyers were "bid" for bonds. So sure of their future appetite, they sold T-Bond put options to everyone with impunity. The result of course was not disimilar to an extended general strike by law enforcement officials whereby criminals - both petty and dangerous - now understood the meaning and set off on a crime wave like the world had never seen, safe from consequence for all officials who might or could do anything were "gone fishin". And some had joined forces with the crooks, and were looting at every chance. Such was the impact of destroying the integrity and vigilance of the Bond Market.

The discount rate remains a viable tool. But it is likely that given the loss of credibility, and the implied puts beneath ecojomic activity (which are essentially political in nautre) the application of monetary strangulation required for the desired throttling of credit creation, speculation, and growth in economic activity (if those be the goals) is IMHO far greater today than what might have been required in days of old. That's during "good times". However, the flip side is that with so leverage out there, and everything correlated to the continued growth and expansion of credit, it might only take "a waaafer thin mint" or a another straw upon the proverbial camel to trigger a revulsion that in the absence of Mishkin-like response -would be larger than anything seen since the 30s.

11. The Helicopter
The final tool in the Central Bankers' arsenal, a relatively modern banking invention is the Helicopter. Historically a tool of marine rescuers, or an accompanying weapon of ground warfare, the Helicopter is believed by markets to represent the financial equivalent of "manna from heavan" in the event markets were ever to falter. Proponents would ostensibly send out [many] helicopters laden with packs and stack of Green Bills adorned with dead presidents (and some jars of peanut butter & cans of spam). Okies (presumably red-staters would then feel that they had resources and fortitude to run (actually fill up their RV and drive) to the local Home Depot or Walmart and continue their twoo-decade-long leveraged consumption binge, thereby saving the grand American economic experiment from the dustbin of history.


Anonymous said...

Wonderful post!


Anonymous said...

What a wonderful synopsis of the state of the financial world these days. Certainly, the "helicopter" is the ultimate vehicle. Without this unwritten put option underlying all these transactions, perhaps somewhere someone might be a bit more cautious.

This is my first time reading your blog, and love its premise. Like you, one can only wonder how and when (or maybe even if?) it will all come crashing to an end.

Keep up the good work.

Anonymous said...

"Such is the power of Moral Suason in a society with unimaginably deep web of obligations" ... beautifully put.

Then there are societies with poorer levers of moral suasion. In your opinion, which society would prevail if both are contesting for a single resource?

Also, unfortunately I was not able to follow your allegory (#10): are you speaking about the effects of abandoning credit risk as an investment parameter (i.e., "destroying the integrity and vigilance of the Bond Market")? Would you say that practice has affected (infected?) dollar valuation? Is there a Sakikibara in sight?

"Cassandra" said...

1. I believe that - other things being the same - the deeper the capability to call upon moral suasion, the greater the ability of society to reach for sacrifice otherwise unobtainable. Korea is perhaps case in point where they called upon citizens to contribute objects of precious metal value - silver, gold etc. - to more quickly recover from their ... errrr ... debacle.

2. Apologies as my proofing is horrible ( and I really should compose in MS WOrd rather than the stupid blogger box) I was hoping to say that destroying the bond market's vigilance, effectively putting its manhood in a box, has removed one of the most important macroeconomic risk throttles - the non-reaction of the bond market (thank you PBoC & BoJ) has allowed (and encouraged) the US to run far larger fiscal & CA deficits for far longer, than otherwise possible, enabling the housing bubble, enabling all manner of carry trade & marginal investment. Thats what I was trying to highlight...

john c. halasz said...

Excellent synopsis. I myself was scratching my head over the Mishkin speech chez Thoma, though I left it to others to play whack-a-mole. (Is he any relation to Dostoyevsky's Prince?) The notion that markets are more perfect information-aggregators than the Fed begs the question as to what they are doing with all their army of researchers picking over the data. (A more plausible account is that they are good enough information-aggregators to recognize covertly all the blind-spots and blind-alleys that the markets present them with). But this idea of faillible human beings and infaillible markets is the very stuff of theology. It makes one wonder what shall finally be revealed to Narcissus when he gets to the other side of the mirror.

I might add on my own account that capital-conducive policies that de facto redistribute income upwards already contributed to the the growth of excess liquidity. This was the case with Reagan's first round of upwardly lop-sided tax cuts, which, even as Volcker was constrained to put on a countervailing squeeze, forseeably fed funds into the stock market, as receivers of excess income bid/bet against receivers of excess income, sparking a stock market run-up. Obviously, such increases in assets prices form collateral for credit to further bid up asset prices, etc. The only thing to further note is that only the propertied middle class, at best, gets to participate in gains from the resulting nominal boom, with the bottom 2/3 of the income distribution, at best, getting to run a Red Queen race with accumulating debt. And even when the bust eventually comes, as, Lord only knows, it must, the heaviest burden will fall on the bankrupt and under-employed masses, further entrenching the divide, ceteris paribus.

Molotov, by the way, was not a Marshal. He was a Poliburo member and foreign minister. The term "Molotov cocktail" derives from the Russo-Finnish War of 1940, when Molotov claimed that the invading Red Army was only bringing food to the starving Finns. To which the Finns rallied by dubbing them "Molotov picnic baskets", topping them off with "Molotov cocktails".

Interesting times...

"Cassandra" said...

I am constantly confusing Mishkin with Hyman Minsky which is ironic since they sit at opposite ends of continuum of "what to do with bubbles", with Mishkin about as sanguine as any currently serving FRB Gov, while Minsky, well, he's one of my heros. I would have loved to see the debate between them, or the shredding of the twiddle-dee-dum twiddle-dee-dee stance to heated speculation in general and leveraged speculation in particular.

Since all the economists working at the Fed are certainly smarter, and probably more dedicated than me, I must assume there are limits to what can be said publicly in this day and age without losing one's appointment, or being relegated to a basement office analysing the optimal circulation time of a $10 bill. And there is something to be said for studying "the reality of the now" vs. speculating about the potential realities ofthe future. They require different skill sets. The former might be likened to playing Checkers or Backgammon, whilst the latter is akin to Chess, Diplomacy, or Go. There are limits beyond essential probability and good analysis to former, but the latter requires that as the ante, and then a whole lot more. Sometimes one ends up face-down in a ditch, but its rewarding (literally too) to see the plot unfold many moves ahead, and then have it validated by events.

Interestingly, the most successful societies by any broad measures, will with hindsight prove to be those whove managed to harness the market, while keeping inequality tethered. Historians will look back (I think) and shake their heads at the US post-millenium and wonder "WTF were they thinking!?!?"

I was actually thinking of Zhukov, and wanted someone with a familiar but unusual name for apt effect. I was hammering keys and it was spilling out and I don't know why Molotov stuck, but I thank you for the correction. When I was a kid, I used to play S&T's "Barbarossa" & "The WInter War". I'd be the FInns and it was pretty easy to beat the Russkies, or at least draw with them. A couple of ski units could demolish entire battalions. As a result I've made many a Finnish drinking pal with a knowing sympathetic look and the simple phrase "I know about Petsamo..."

debt is wealth said...

Great and humorous overview!

Side note: You have two #8's and no #9.

One rather significant complaint: you categorize the Plunge Protection Team as "secret". It isn't at all secret. It is well-known as the Working Group on Capital Markets, which has been described by George Stephanopolous on the record, discussed openly by Bernanke in congressional testimony, and is now known to be convened regularly at least every six weeks at the behest of Paulson (coincedent with nutso M3 growth and a truly inexplicable stock market rally, interestingly enough).

The Plunge Protection Team isn't secret -- it's just spun. Just like most of the other dubious crap that comes out of planet US-gov.

Charles Butler said...

There's a few more years of this to come. The crux is the retiring baby boom generation claiming the right to a given standard of living and surely counting on the life-extending benefits of modern medicine - maybe a decade from now and probably coinciding with a certain maturing of the Chinese economy with regards to wage inflation. I foresee very few American pensioners volunteering to go out and freeze to death on a snowbank because their teeth are no longer able to scrape the fat off sealskin.


sideshowbob said...

ZIRPtastic post! The big problem with central banks is that they do not have ENOUGH ways to affect the economy and we are left with the dismal results of adjusting the short term interest rate. The short-term rate should be decided by the market and the central banks should have other methods to get money into the system. For more visit my webpage at


rob said...

offshore banking is a banking option that not many people are familiar with when it comes to their finances and business....