Broke but never bust: The ECB and Swiss National Bank should be much more relaxed about losing money

 

CONTEMPORARY central banking is a strongbox of oddities. Deposits, which normally pay interest, can now incur a charge. Investments in government debt, which normally offer a return, give a negative yield. Faced with this weirdness central banks are trying to respect some cardinal rules of finance, with the Swiss National Bank (SNB) and the European Central Bank (ECB) taking steps to protect themselves from losses and ensure that their balance-sheets add up. The experience of several poorer places suggests they are wrong to do so.

In calm times central banking is simple and profitable. Central banks’ assets—mainly bonds issued by rich countries and blue-chip firms—pay a decent return. Their liabilities—deposits made by high-street banks and banknotes—cost them little or nothing. With this wedge between income and outgoings shareholders receive a dividend. The SNB paid dividends of SFr1 billion ($1.15 billion) to Switzerland’s federal and regional governments in 2012. The ECB’s 2013 payout—divvied up across the euro-area national central banks—was €1.4 billion ($1.9 billion).

The financial crisis changed the business. For one thing central banks are far bigger (see left-hand chart). Between 2006 and 2014 central-bank balance-sheets in the G7 jumped from $3.4 trillion to $10.5 trillion, or from 10% to 25% of GDP. And the assets they hold have changed. The SNB, aiming to protect Swiss exporters from an appreciating currency, has built up a huge stock of euros, bought with newly created francs. The ECB, mindful of tight credit, has lent money to banks and bought corporate bonds. And on January 22nd, as The Economist went to press, it was expected to announce that it would start buying government debt.

The expansion would be greater but for worries about cashflow and capital. Bonds that paid 5% or more ten years ago now yield nothing, and other investments have performed badly (the SNB was stung by a drop in the value of gold in 2013 and cut its dividend to zero). Concerned that its euro holdings might lose value the SNB shocked markets on January 15th by abruptly ending its euro-buying spree. Worries that QE will lead to losses if struggling governments default on their debt have caused weeks of wrangling at the ECB, and may prevent it from buying Greek bonds.

From a narrow accounting perspective this caution seems prudent. With capital of €95 billion supporting a €2.2 trillion balance-sheet, the Eurosystem (the ECB and the national banks that stand behind it) is 23 times levered; a loss of 4% would wipe out its equity. Since two central banks have suffered devastating crunches recently (Tajikistan in 2007, Zimbabwe in 2009) the standard logic seems to apply: capital-eroding losses must be avoided.

But the worries are overdone. For one thing central banks are healthier than they appear. On top of its equity, the Eurosystem holds €330 billion in additional reserves. These funds are designed to absorb losses as assets change in value. Even if the ECB were to buy all available Greek debt—around €50 billion—and Greece were to default, the system would lose just 15% of these reserves; its capital would not be touched.

And even if a central bank’s equity were wiped out it would not go bust in the way high-street lenders do. With liabilities outweighing its assets it might seem unable to pay all its creditors. But even bust central banks retain a priceless asset: the power to print money. Customers’ deposits are a claim on domestic currency, something the bank can create at will. Only central banks that borrow heavily in foreign currencies they cannot mint (as in Tajikistan) or in failing states (Zimbabwe) get into deep trouble.

A helpful bias

The survival of threadbare central banks proves the theory. In the 1980s many emerging-market central banks faced sharply appreciating exchange rates and bought up dollars with newly created cash to cheapen their currencies. Since inflation was a worry they “sterilised” the purchases, mopping up the money by selling bonds to investors. With low-yielding assets (dollars) and high-cost liabilities (domestic-currency bonds) they locked in losses, as a 2008 paper* by Peter Stella and Ake Lonnberg of the IMF shows. By the late 1980s the central banks of Jamaica and Nicaragua were regularly losing 5% of GDP or more per year. After 20 years of losses Chile’s is in negative equity (see right-hand chart).

While none of these banks toppled, hawks have other fears. Like any firm, central banks face running costs. The urge to pay the bills could tempt them to print money rather than focus on inflation. Another worry, set out in a 2005 paper by John Dalton and Claudia Dziobek of the IMF, is that low capital could lead to a loss of independence. While negative capital doesn’t matter much it doesn’t look great; a central bank embarrassed by its capital deficiency might seek a capital injection from its finance ministry and be captured by boom-hungry politicians. In either case, capital erosion might mean a bias towards higher inflation.

There is some evidence for this. In a 2012 paper Gustavo Adler and Camilo Tovar of the IMF and Pedro Castro of the University of California, Berkeley, test the relationship between bank capital and interest-rate policy. Collecting data for 41 advanced and emerging economies between 2002 and 2011, they work out what a hypothetical central bank, behaving optimally, would do. They contrast this with the central bank’s choices and seek to explain why the two might diverge. They find that large deviations can be explained by a weak capital position. Flaky-looking central banks might lower interest rates by up to 72 basis points.

Doves should cheer this. Falling returns on government bonds mean central banks’ income will dwindle. Given their pumped-up balance-sheets, some losses are likely. None will fail, but a few might chase their losses by printing money and pushing rates down. In a world on the brink of deflation, bias towards a little more inflation would be no bad thing.

Source: http://www.economist.com/news/finance-and-economics/21640363-ecb-and-swiss-national-bank-should-be-much-more-relaxed-about-losing

Prices or jobs?

THE Federal Reserve has scored highly for creativity over the course of the economic crisis. It has already, in effect, lowered short-term interest rates to zero, and carried out two rounds of quantitative easing (QE), the purchase of government bonds with newly printed money. On August 9th it surprised the market by saying it expected to hold its short-term interest rate where it is until mid-2013. By removing any expectations of monetary tightening before then, the announcement delivered a powerful downward jolt to bond yields. The Fed also disclosed it had discussed other policy options and was “prepared to employ these tools as appropriate”. That has fuelled speculation that the Fed will play yet another card when its policy-setting committee gathers for an extended meeting on September 20th-21st.

Many have focused on whether the Fed will embark on another round of quantitative easing, or QE3. That looks unlikely. QE2 was followed by surging commodity prices and vociferous condemnation at home and abroad, extinguishing much of the Fed’s enthusiasm for an encore. The Fed could accomplish something similar by reshuffling the composition of the $2.6 trillion in Treasury and mortgage bonds it already owns. By selling short-term bonds, whose yields would stay close to zero thanks to the Fed’s rate commitment, it could boost holdings of longer-term issues, pushing their yields down further. This has been dubbed “sterilised” QE or “Operation Twist”, after a 1960s programme in which the Treasury and the Fed tried to “twist” the yield curve by altering the pattern of Treasury-bond issuance. Anticipation of something along those lines helps explain why ten-year Treasury bonds now yield around 2%, the lowest in 50 years.

There are other options, too. The Fed could lower the interest rate it pays banks for excess reserves left on deposit with the central bank, from 0.25% currently. It could also announce targets for longer-term rates, such as those on two- or three-year bonds. But if the Fed wants to surprise the markets again, a more radical idea would be to fiddle with its own mandate.

Mission half-accomplished

By law the Fed is supposed to pursue both low inflation and low unemployment. You would not know it from the recent record. Since the start of America’s recession in late 2007 both overall and core inflation (a measure which excludes energy and food costs) have fluctuated wildly but averaged around or below 2%, the Fed’s preferred range (see left-hand chart). Unemployment, on the other hand, has been stuck at around 9% since the start of the year. Fed policymakers reckon America’s “natural” unemployment rate—that is, the lowest compatible with stable inflation—is at or below 6% (see right-hand chart). If inflation were running three percentage points above target “any central banker worth their salt would be…acting as if their hair was on fire,” observed Charles Evans, president of the Federal Reserve Bank of Chicago, in a speech on September 7th. “We should be similarly energised” about unemployment.

Although the Fed is bound to pursue stable prices and full employment, it has wide latitude in how it defines those goals. It could, for example, announce it is targeting inflation, perhaps just temporarily, of 4% instead of 2%. If people’s expectations of inflation rose (which is by no means assured), then real interest rates would fall, boosting demand. Ben Bernanke, the Fed chairman, has flatly rejected this option, however. It would, he says, ruin the credibility the Fed has invested in low inflation, and undermine the ability of firms and people to plan.

An alternative would be to switch to targeting the growth of nominal gross domestic product. If the target were 5%, say, inflation of 3% would not interfere with monetary stimulus so long as real GDP was growing by less than 2%. The Fed toyed with nominal GDP in the past when it was searching for something more stable to target than the money supply. But a regime of this sort has several drawbacks: since the trend in real GDP varies, inflation would, too, presenting similar problems to a higher inflation target. It would also be harder to explain to the public.

The Fed may be able to justify a more forceful attack on unemployment by tweaking, rather than replacing, its current framework. Although a 2% rate may be the Fed’s de facto inflation target, the central bank operates (and markets react) as if 2% were a ceiling rather than the midpoint of an acceptable range. Mr Evans noted the problem with this in his speech: “To average 2%, inflation could be above 2% in some periods and below 2% in others. If a 2% goal was meant to be a cap on inflation, then policy would result in inflation averaging below 2% over time.” A related problem is that the consequences of overshooting or undershooting the 2% target are not symmetrical. The Fed should arguably accept a higher risk of overshooting than undershooting inflation since it has far more experience with, and more tested tools for, curing inflationary pressures than deflationary ones.

One way around this problem would be for the Fed explicitly to state its tolerance of inflation above 2%. Mr Evans proposes, for example, committing to easy monetary policy until unemployment is 7.5% or lower, so long as inflation is not above 3%. This still presents problems. The Fed may insist it has not changed its commitment to low inflation but the public may not believe it. And it would require the Fed to have a lot of confidence in its estimate of the natural unemployment rate, a notoriously slippery thing to measure. Laurence Meyer, a former Fed governor now with Macroeconomic Advisers, a consultancy, suggests a different approach: the Fed would explicitly set a 2% medium-term inflation target and a 1.5% to 2.5% short-term range for core inflation. The advantage of both proposals would be to dissuade markets from pricing in higher interest rates even if inflation topped 2%.

Such changes would represent a big shift in how the Fed operates. Less clear is how helpful they would be. The Fed’s mandate already provides the justification it needs for steps like QE3. That it has not taken them reflects scepticism that driving long-term interest rates even lower would be worth the criticism.

Source: http://www.economist.com/node/21529029