Friday, June 28, 2013

The drama of monetary policy

Ben Bernanke's statement

Everyone interested in the world economy should watch Bernanke's recent speech and the press conference:

(Switch to full screen, it works well). Here is the base URL which collects together all the materials about the Fed's announcement. The `exit strategy principles' are in the June 21-22, 2011 meeting.

The announcement reinforces the sense that the US economy is healing. The US Fed is keen to have inflation of 2% and believes the NAIRU is around 6.5%. Hence, once they come into the range where unemployment has achieved a few strong improvements and is trending to get below 6.5%, while price stability has not been compromised in that inflation expectations are still at 2%, they will start unwinding the extreme expansionary stance of monetary policy that has been in place in recent years. All through, there is no fixed calendar about what the Fed will do when. There is a clear articulation of the decision rules that will be employed, about how future data releases will generate future policy.

Why did the world see this badly?

One element is the shift from an unclear sense that the Fed will keep buying $85 billion a month of bonds for a long long time, to a specific sense about how this pace of purchases will decline and ultimately end, surrounding a specific number -- 7% unemployment amidst strong economic growth (see Eric Morath, Michael S. Derby and Sudeep Reddy in the Wall Street Journal). The QE has to clearly end before you start raising rates. There is a certain amount of confusion between the 6.5% threshold about interest rates and 7% threshold about QE; some interpreted the new 7% threshold as replacing the previous 6.5% threshold, which is not the case.

The second key issue seems to be in the reading of the data. The FOMC has shifted to a more optimistic view about how the US economy is faring. The FOMC decision is the consensus of its 19 members, many of whom are top economists, and all of whom are backed by top quality researchers. However, some believe that the FOMC's view -- that there are signs of improvement in employment and output growth in the US -- is too optimistic. As an example, see Paul Krugman. Suppose the Fed is wrong; suppose they are starting to think about getting away from QE a bit too early. In that case, the FOMC decision is bad news.

On the other hand, Bernanke is careful to emphasise over and over that he is not making a statement about future paths of policy, but only about the decision rule that will drive policy. He is making statements about how policy will behave in future dates conditional on what the data looks like at future dates. If, in principle, the US lurches back into sluggish conditions (low inflation, high unemployment), the policy rule will push back towards monetary easing.

Let's make no mistake about it: Quantitative easing at the zero interest rate lower bound is a messy world, when compared with the clean operation of inflation targeting under normal times. I felt that Bernanke and the Fed are doing a good job of navigating this messy landscape.

Implications for India

  1. The US economy is healing. This is great news, as the US remains the biggest country of the world. This will impact on short-term growth everywhere in the world through spillovers of demand from the US, and help long-term growth worldwide by increasing the rate of expenditure on R&D in the US. Specifically for India, this is good news, as India has two big trade exposures to the US -- directly (Indo-US trade) and indirect (Indo-Chinese trade).
  2. For countries that peg their exchange rate to the USD, there is no monetary policy autonomy -- their monetary policy is set by Bernanke. This announcement tells them something about the horizons over which their monetary policy will tighten. This matters for (say) China or UAE who peg to the dollar, but not for India, which has a floating exchange rate and thus has monetary policy autonomy.
  3. Some believe that loose monetary policy in the US sets off a search for returns by taking risk and by investing in illiquid securities, particularly by US absolute return investors. A different way of seeing the same phenomenon is to focus on long positions outside the US that are financed by borrowing in the US; the risk-reward profile of these positions has now become a bit less attractive. We have reason to believe that such phenomena might be present, but the proposition remains controversial. To the extent that such effects are present, the FOMC announcement suggests that in 2014 and 2015, US investors will start pulling investments away from risky and illiquid assets. This is mildly negative for India, given that India is an emerging market (i.e. high risk) and that many securities in India are relatively illiquid.
  4. The US 10 year rate would go up after this announcement (as it should). This slightly reduces the interest rate differential between the US and Indian interest rates. This should adversely impact on capital flows to India and thus yield INR depreciation. I feel the magnitude of effects is small: The US 10 year rate went up from 1.95% on 21 May (before the previous Bernanke announcement) to 2.32% on 19 June. This is a small change in the interest rate differential for India.
There is another way of thinking about all this which helps us better understand what happened in India, which related to the large Indian current account deficit. When interest rates in the US are zero, just about everyone who aspires for the slightest return is forced to invest abroad in the search for yield. Bernanke has unveiled a story which suggests that from late 2013 and 2014 onwards, this will gradually change. This means that money which was leaving the US will stay home. This will imply that countries with a large current account deficit will need to become more attractive in order to attract the same amount of capital. This will require a mix of currency depreciation, increased interest rates and capital account decontrol in India.

Implications for India's monetary policy process

Watching US monetary policy in action inevitably makes one think about the monetary policy process in India. I am charmed by the extreme precision and clarity of the FOMC statement, the underlying staff quality, and the functioning of the MPC. For us in India, it teaches us how monetary policy effectiveness is achieved through clearly articulating a policy framework and through commitment to it. The phrase `multiple objectives and multiple instruments' that is used in India is a euphemism for the absence of a framework.  We should aspire to do better. The Indian Financial Code will begin the journey to a strong, autonomous, technically sound and accountable RBI.


  1. The whole article on a simple assumption that FED will curb its money printing under the illusion that US economy is on right track of growth.

    Lets take a contrarian view:
    1. FED will change its tone ANYTIME without notice
    2. Euro-zone issues are far from over and entire Europe is in recession with the exception of Germany barely making it
    3. Housing bubble in India which no one seems to care at all
    4. Political instability which will be at its highest during election season next year

    ONLY one BAD event can bring this house of cards down ANYTIME pushing entire world into recession, and India will be the biggest beneficiary of it.

    Can you name the event!!!

    1. Why be afraid of a recession? This the worst result of the great moderation: people have become afraid of recessions. When, in a normal world, no one should be bothered about it. Recessions are a fact of economic cycles. Why are people today such wimps to bother about it? Recessions are like house cleaning and yard sales. A necessary, mandatory, natural. fair way of cleaning up the economy. Let it happen!! I would think its a bigger problem if we don't have a recession for too long, because it only means that the house cleaning is going to take more time and need larger yard sales causing greater emotional hand-wringing.

  2. Mr. Shah always a great learning experience reading your articles. I thought of having your esteemed views on my following observations:

    (1) As liquidity is fungible, do we need to consider BOJ now into how US Fed moves. Previously, it was US Fed who was the sole provider of constant flow of liquidity, with other central banks playing a more adhoc and discreet role. Now its is BOJ whose fund flow is not far from what Fed is monetising every month.

    (2) In his testimony Ben has clearly indicated that risk that Fed's money printing is causing the possibility of bubbles in various asset classes

    (3) Therefore, combining point (1) and (2), it can be said that with 160+ billion of liquidity entering the system every month from BOJ and Fed, risk of large miss-allocation of capital is rising rapidly, which not controlled now, could poise systemic risk for the US (aka world) financial system.

    Hence, the third layer of US monetary policy, QE-eternity or the constant flow of liquidity, is now more dependent on behaviour of financial market participants (incld. real estate) than economic per se. Hence, in this game of poker, the US central bank can only be boxed into a corner if financial markets over react to such an extent that the dose of panic shifts "Taper" from on to off.

    It seems media and some commentators, as your rightly pointed out, is mixing the concept of stock and flow of liquidity and interest rate as a tool. Stock of liquidity and ZIRP are the final two layers of its monetary policy tool. Those would only be fiddled with when layer one, aka, flow is withdrawn. However, for high beta countries and assets, flow of liquidity becomes more important than stock, and as a result, they are taking the brunt of the perceived reversal.

  3. Nice post as usual Dr. Shah. I also think you do a nice job of drawing a distinction between Bernanke saying we are going to taper and saying, we expect the conditions that would warrant tapering to materialize shortly. The only other thing I would say about Fed communication is that I think this entire episode can be thought of as a sort of "verbal macropru." I do think that there is growing concern inside the Fed about the reemergence of 'frothy' markets (HY corp debt for instance).

    A few other comments:
    1.) on bullet point 1 above, is it possible that some amount of 'global rebalancing' is structural and thus rising growth in the U.S. will have fewer positive spillover than during the last decade? That is, has the elasticity of foreign growth wrt U.S. growth undergone a structural change? Can U.S. households again be the engine of global growth? I would argue some amount of rebalancing is structural and that there has been a shift to non-tradable consumption in the U.S. over many years.
    2.) On bullet 2 above: Even for countries that do not peg to the dollar, lower capital inflows will lead to tighter financial conditions no? If the US and German yield curves shift up borrowing generally becomes costlier for other sovereigns and corporates?
    3.) on bullet 4 above: Its true that the rate differential remains relatively large btw UST and GOI bonds. It has narrowed a a little as a result of UST yield shifting up about 40bps in latest episode while RBI rate cuts have brought gsec down about 100 bps. But the NDF premium must also be taken into account in thinking about the carry? If INR is expected to depreciate for reasons OTHER than interest differential, NDF premium rises and carry narrows? Correct?

    Thanks as always for your insightful comments on Indian macro.

  4. Dr. Shah thank you for the video on Mr Bernanke and your insightful piece on the impact for India.
    Would like to add that with QE impacting the RE, apart from the clearly measurable numbers on inflation, unemployment, etc Dr. Subba Rao also has to worry about PC's actions on the PD and PEs. Also Mr Bernanke does not have to worry about 4 truck loads of greenbacks landing up bang in the middle of the financial capital of his country and all the other truck loads moving to the Swiss banks.


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