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December 16, 2016
The Impact of Extraordinary Policy on Interest and Foreign Exchange Rates
Central banks in the developed countries have adopted a variety of extraordinary measures since the financial crisis, including large-scale asset purchases and very low (and in some cases negative) policy rates in an effort to boost economic activity. The Atlanta Fed recently hosted a workshop titled "The Impact of Extraordinary Monetary Policy on the Financial Sector," which discussed these measures. This macroblog post discusses the highlights of three papers related to the impact of such policy on interest rates and foreign exchange rates. A companion Notes from the Vault reviews papers that examined how those policies may have affected financial institutions, including their lending.
Prior to the crisis, central banks targeted short-term interest rates as a way of influencing the rest of the yield curve, which in turn affected aggregate demand. However, as short-term rates approached zero, central banks' ability to further cut their target rate diminished. As a substitute, the central banks of many developed countries (including the Federal Reserve, the European Central Bank, and the Bank of Japan) began to undertake large-scale purchases of bonds in an attempt to influence longer-term rates.
Central bank asset purchases appear to have had some beneficial effect, but exactly how these purchases influenced rates has remained an open question. One of the leading hypotheses is that the purchases did not have any direct effect, but rather served as a signal that the central bank was committed to maintaining very low short-term rates for an extended period. A second hypothesis is that central bank purchases of longer-dated obligations resulted in long-term investors bidding up the price of remaining longer-maturity government and private debt.
The second hypothesis was tested in a paper by Federal Reserve Board economists Jeffrey Huther, Jane Ihrig, Elizabeth Klee, Alexander Boote and Richard Sambasivam. Their starting point was the view that a "neutral" policy would have the Fed's System Open Market Account (SOMA) closely match the distribution of the stock of outstanding Treasury securities. In their statistical tests, they find support for the hypothesis that deviations from this neutrality should influence market rates. In particular, they find that the term premium in longer-term rates declines significantly as the duration of the SOMA portfolio grows relative to that of the stock of outstanding Treasury debt.
The central banks' large-scale asset purchases not only took longer-dated assets out of the economy, but they also forced banks to increase their holdings of reserves. Large central banks now pay interest on reserves (or in some cases charge interest on reserve holdings) at an overnight rate that the central bank can change at any time. As a result, these purchases can significantly reduce the average duration (or maturity) of a bank's portfolio below what the banks found optimal given the term structure that existed prior to the purchases. Jens H. E. Christensen from the Federal Reserve Bank of San Francisco and Signe Krogstrup from the International Monetary Fund have a paper in which they hypothesize that banks respond to this shortening of duration by bidding up the price of longer-dated securities (thereby reducing their yield) to restore optimality.
The difficulty with testing Christensen and Krogstrup's hypothesis is that in most cases central banks were expanding bank reserves by buying longer-dated securities, thus making it difficult to disentangle their respective effects. However, in 2011 the Swiss National Bank undertook a series of three policy moves designed to produce a large, rapid increase in bank reserves. Importantly, these moves were an attempt to counter perceived overvaluation of the Swiss franc and did not involve the purchase of longer-dated bonds. In a follow-up empirical paper , Christensen and Krogstrup exploit this unique policy setting to test whether Swiss bond rates declined in response to the increase in reserves. They find that the third and largest of these increases in reserves was associated with a statistically and economically significant fall in term premia, implying that the increase did lower longer-term rates.
Although developed countries' monetary policy has focused on their domestic economies, these policies can have significant spillovers into emerging countries. Large changes in the rates of return available in developed countries can lead investors to shift funds into and out of emerging countries, causing potentially undesirable large swings in the foreign exchange rate of these emerging countries. Developing countries' central banks may try to counteract these swings via intervention in the foreign exchange market, but the effectiveness of sterilized intervention is the subject of some debate. (Sterilized intervention occurs when the central bank buys or sells foreign currency, but then takes offsetting measures to prevent these from changing bank reserves.)
Once again, determining whether exchange rates are influenced and, if so, by what mechanism can be econometrically difficult. Marcos Chamon from the International Monetary Fund, Má,Árcio Garcia from PUC-Rio, and Laura Souza from Itaú Unibanco examine the efforts of the Brazilian Central Bank to stabilize the Brazilian real in the aftermath of the so-called "taper tantrum." The taper tantrum is the name given to the sharp jump in U.S. bond yields and the foreign exchange rate value of the U.S. dollar after the May 23, 2013, statement by Board Chair Ben Bernanke that the Federal Reserve would slow (or taper) the rate at which it was purchasing Treasury bonds (see a brief essay by Christopher J. Neely). Chamon, Garcia, and Souza's paper takes advantage of the fact that Brazil preannounced its intervention policy, which allows them to separate the impact of the announcement to intervene from the intervention itself. They find that the Brazilian Central Bank's intervention was effective in strengthening the value of the real relative to a basket of comparable currencies.
All three of the studies faced the difficult challenge in linking specific central bank actions to policy outcomes, and each tackled the challenge in innovative ways. The evidence provided by the studies suggests that central banks can use extraordinary policies to influence interest and foreign exchange rates.
October 1, 2007
Why Did The Chinese Stop Sterilizing?
I'm feeling optimistic that the full-time return of macroblog is imminent, but before its official there's something I have been meaning to ask. A point I used to make way back when is that, in theory, a country that pegs the value of its currency below the freely floating market value will eventually "solve" the "problem" of the exchange rate misalignment by inflating away to the value of its money.
How does that work? In simple terms, to constrain the price of an undervalued currency a central bank will, in effect, print its own money in order to purchase the currencies against which it is undervalued. In other words, increase the supply of your own currency while at the same time increasing the demand for other currencies. But, all else equal, increasing your domestic money supply will ultimately lead to domestic inflation, which in turn reduces the currency's exchange value. Enough inflation and the currency will no longer be undervalued. Hence, problem solved.
Which is why the case of China has been somewhat puzzling. No doubt about it, the People's Bank of China has been accumulating official reserves -- that is, purchasing assets (mainly debt) denominated in foreign currencies (mainly dollars) -- at a pretty hefty pace for some time now. But, until very recently, there was not much to show in the way of the inflation requested (if not mandated) by theory.
Mechanically, the reason for this is sort of apparent: Up until very recently, the PoBC has been sterilizing their foreign exchange actions. In other words, the Chinese central bank has been undoing the effects of its exchange rate interventions with offsetting domestic monetary operations that muted growth in the overall money supply. That is, as I said, until recently:
July 26, 2007
Why Central Bankers Worry About Fiscal Policy
Today I again hand the keys to Mike Bryan -- now a fellow adjunct faculty member in the University of Chicago's Graduate School of Business -- who provides us with a contemporary example of why it behooves central bankers to speak out when a nation's fiscal situtation gets out of whack:
The reports from Zimbabweover the past year and a half are the stuff that makes for good Money and Banking lectures. It seems that inflation in that country, as officially reported, topped 1,300 percent last year and may now exceed 3,700 percent, with some unofficial reports putting the country’s inflation rate even higher. Let’s put this inflation in perspective. If the last reported inflation number can be believed (the country’s Central Statistical Office recently stopped reporting the inflation numbers as it reviews its methodology), prices in Zimbabwe are doubling every month. Inflation of this magnitude renders the government-issued money virtually worthless, wrecking trade and financial institutions in the process.
While the rate of inflation in the African nation isn’t known for certain, there is little doubt it is extraordinarily high. Also not in doubt is its cause. All inflations originate from the same phenomenon—too much money chasing too few goods. In this case the Reserve Bank of Zimbabwe is rapidly printing Zimbabwe dollars in order to “pay” for a large fiscal shortfall.
In a recent IMF paper on the Zimbabwe situation the author argues that the Reserve Bank of Zimbabwe’s (RBZ) inflation problems stem not from the usual monetary or fiscal laxness that has triggered other “hyperinflations,” but rather “quasi-fiscal” losses incurred by the central bank itself. Still, the report concludes that these losses, which stem from some combination of credit subsidies, realized and unrealized exchange losses, and losses from open market operations, were nevertheless incurred to support government policies, and the failure to address these losses has interfered with the monetary management, independence, and credibility of the RBZ.
The immediate “solution” to the Zimbabwe inflation has been the imposition of price controls, an approach that has been attempted by governments ancient and modern, including our own. I can think of no better source on this topic than economist Hugh Rockoff of Rutgers. Zimbabwe’s controls are actually retroactive, in the sense that merchants have been asked to reduce prices to earlier levels. Predictably, the problem seems to have gotten worse—now there are even fewer goods for the Zimbabwe dollar to chase. When and where will the Zimbabweinflation end? I certainly don’t know. But I’ve got a pretty good idea how it will end, by a sharp curtailment of their currency expansion. And that’s the Money and Banking lesson. If a central bank wants to end inflation, either they better start producing goods, or stop producing money.
And that, I would add, will be a hard row to hoe unless the fiscal house is put in order.
July 5, 2007
Roubini On The Symmetry Of Exchange Rate Misalignment
This post is a bit geeky, but I've been mulling over some comments Nouriel Roubini offered a few days back in an email to RGE Monitor subscribers:
Today we look at how Asian Financial Crisis changed Asia and the world...
Policy makers throughout Asia clearly are determined not to return to the IMF. In Stephen Jen's words the Asian Financial Crisis taught Asian central banks to never be caught without enough foreign exchange reserves...
Asia's crisis generated an international consensus that emerging economies need to hold sufficient reserves to cover their short-term debt. No comparable consensus emerged, though, over the right exchange rate regime. The G-7 and the IMF argued that Asia's crisis showed the risks of currency pegs, at least those currency pegs not backed up by an institutional commitment like a currency board. But it isn't clear that Asian policy makers drew the same lesson many seem to have concluded the real problem was not pegs, but an over-valued currency.
In a simple cut at the issue, there is a distinction between pegging an exchange rate below its freely-floating value -- the case of an under-valued currency -- and pegging the exchange rate above its freely-floating value -- the case of an over-valued currency. In the case of an over-valued currency, the central bank has to trade from its holdings of foreign currency reserves to "soak up" the excess supply of its own currency. The ability to do this is obviously limited by its reserves, which can become seriously depleted in the event of a persistent misalignment between the pegged value and where the market would take the exchange rate in the absence of the peg. And if market participants get a sniff of the possibility that the government lacks sufficient reserves to support the peg, a speculative run is all but guaranteed.
The situation is a bit different when the currency is under-valued. In this case a central bank would react to upward pressure on the exchange rate by expanding its own money supply to buy foreign currencies, thus eliminating the excess supply of those currencies. Since there are no inherent resource restrictions in creating fiat money, there is no obvious limit to the government's ability to play the game. Money supply expansion may eventually be inflationary, but that would itself tend to drive down the freely-floating value of the currency. But therein, according to Nouriel, lies the problem:
... reserves are not an unmitigated blessing. Sterilizing the region's huge reserve growth poses growing difficulties. In some countries - notably China - strong money and credit growth has fueled inflationary pressures, stock market bubbles and housing bubbles. Nouriel Roubini argues that current Asian exchange rate and financial policies have left Asia vulnerable to new kinds of crises. See "Have Asia's Sterilization and Reserve Accumulation Policies Shielded It From Another Crisis Or Have Led To Increased Vulnerabilities?"
I confess that I have been used to thinking like the Asian policy makers in assuming that the impact of pegging an exchange at too low a level is more benign than pegging at too a high level. Because inflation reduces the value of a currency relative to others, there is a sense in which the actions of a central bank attempting to damp currency appreciation are consistent with moving the exchange rate closer to the unfettered equilibrium value.
The same argument, however, ought to hold for a currency that is over-valued. When a central bank buys back its own currency with foreign reserves it is contracting the domestic money supply. That in turn should reduce the domestic rate of inflation and result in a nominal appreciation, moving the exchange rate's fundamental value toward the peg. If there are problems, then, they must arise because the necessary price adjustments are too slow when the pressure on the currency is persistent.
But if prices are slow to adjust, why not on the upside as well as the downside? And though depleting reserves are no problem in the case of an under-valued exchange rate, the misallocation of resources associated with excessive monetary creation could be, which I believe is exactly Nouriel's point. I'm still not sure that such misallocations have as sharp a destabilizing potential as running out of reserves and losing the capacity to intervene all together, but I'm convinced Nouriel's argument is worth thinking about.
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