Banks & Interest Rates Archives - Page 33 of 62

May 22, 2015

Liquidity Mismatch Helps Predict Bank Failure and Distress

Liquidity mismatch compares the saleability (liquidity) of a bank’s assets to the stability of its funding. Assets such as cash and Treasury bonds are highly saleable and one can expect a ready market even in times of crisis. Residential mortgages are less liquid, but still saleable at a discount, while development and construction loans may prove unsaleable at any price when the market is under stress.

In terms of funding, long-term deposits offer stability but are far more expensive than short-term wholesale sources and call deposits. The latter, however, are highly unstable and were instrumental in the collapse of Northern Rock (UK) and Washington Mutual (US) during the global financial crisis (GFC).

The challenge facing bank regulators is to monitor liquidity mismatch to ensure bank health. The more illiquid and speculative the assets are, the more stable (illiquid) the bank’s funding sources must be to avoid a liquidity crisis during a market down-turn.

Liquidity mismatch =
(Liquidity-weighted liabilities – Liquidity-weighted assets) / Total assets

This paper by J.B. Cooke, Christoffer Koch and Anthony Murphy at the Dallas Fed (Liquidity Mismatch Helps Predict Bank Failure and Distress) suggests that large banks suffer from higher levels of liquidity mismatch and that liquidity mismatch is as important as capital ratios in determining bank health:

Precrisis Rise in Mismatch
Liquidity mismatch rose significantly between 2002 and 2007. The median level of mismatch climbed about 6 percentage points. Most of this rise was driven by changes in liquidity-weighted assets rather than liquidity-weighted liabilities. Banks pursued higher returns on riskier, less-liquid assets. To a lesser extent, banks relied less on stable core deposits and more on “unstable” wholesale funding. The rise in liquidity mismatch before the financial crisis is noteworthy because equity capital (as a percentage of assets)—the ultimate buffer against losses—changed little. The rise in mismatch was faster and more persistent at the largest banks, representing the top 25 percent of institutions (Chart 2). Among those banks, the median mismatch rose about 8.5 percentage points between 2002 and 2007, while at the 25 percent representing the smallest banks, the increase was only 3 percentage points.

Early-Warning Sign?
Bank regulators look for early-warning signs of distress. Is liquidity mismatch one? Comparing the fourth quarter 2007 mismatch levels of commercial banks that failed or became distressed in 2008 or 2009 with those that did not may provide an indication. The average levels of liquidity mismatch for the two groups were significantly different. Failed or distressed banks generally had much higher levels of liquidity mismatch, as shown by the final entry in the liquidity mismatch row of Table 1.

While the timing of the changes in liquidity mismatch (as seen in Chart 2) and the difference in levels of mismatch at any one time (as seen in Table 1) suggest that liquidity mismatch is important, they do not necessarily imply that a rise in liquidity mismatch helps predict future bank failure or distress. Higher levels of liquidity mismatch may be correlated with lower levels of equity capital and higher proportions of brokered deposits and construction and land development loans as well as with nonperforming assets or lower returns on assets—all well-known predictors of failure or distress.

Modeling Failure and Distress
Statistical models were used to disentangle the effects of changes in liquidity mismatch from the effects of changes in equity capital and the other predictors of bank failure and distress between 2006 and 2011.9 This period was chosen because it followed a time when there were very few failures or cases of distress, the early 2000s. Failure or distress up to two years ahead was considered. For example, fourth quarter 2007 data were used to predict failure or distress any time in 2008.10 The results suggest that recent failure and distress rates are explained or predicted by many of the same factors as in 1985–92, when large numbers of commercial banks and savings and loans failed. These factors include too little equity capital, a high ratio of nonperforming assets and a high share of construction and land development lending……

Liquidity Mismatch Matters
Liquidity mismatch rose significantly before the financial crisis, especially at large banks, our research shows. The rise in mismatch contributed to the rise in bank failures and cases of distress. Liquidity mismatch helps predict bank failure or distress one year ahead, even accounting for equity capital and the other indicators at which regulators look.

Cooke is an economic analyst, Koch is a research economist and Murphy is an economic policy advisor and senior economist in the Research Department of the Federal Reserve Bank of Dallas.

Hat tip to Barry Ritholz.

March 11, 2015

CPI unwinds as the Fed runs out of “patience”

From Seeking Alpha:

The euro fell to a fresh 12-year low on Wednesday, extending a broad decline just days after the ECB launched its €1T bond-buying program, while the dollar index soared to its highest in more than 11 years at 98.95, buoyed by expectations that the Fed could soon lift U.S. interest rates. Nearly all now believe the FOMC will remove the word “patient” from its policy statement after its March 17-18 meeting, opening the door for a rate increase in June.

Not so fast. US consumer price growth (annual % change) to end of January 2015 fell below zero.

US CPI

Core CPI is slowing at a far gentler rate because it excludes energy prices (as well as food).

CPI Core

Wage pressures in the manufacturing sector are declining, despite solid job numbers, indicating there is still plenty of slack.

Manufacturing Hourly Earnings

With inflationary pressures easing, why the haste to raise interest rates? I believe that Janet Yellen will move when the time is right. And not before.

February 8, 2015

Here’s How to Achieve Full Employment

Economic Policy Institute President Lawrence Mishel provides the U.S. House Committee on Education and the Workforce with a shopping list of measures he believes are necessary to achieve full employment. Some are right on the mark while others seem to have missed the basic rules of Supply and Demand taught in Econ 101. My comments are in bold.

The goals that economic policy must focus on are, thus, creating jobs and reaching robust full employment, generating broad-based wage growth, and improving the quality of jobs.

Jobs

Policies that help to achieve full employment are the following:

1. The Federal Reserve Board needs to target a full employment with wage growth matching productivity.

The most important economic policy decisions being made about job growth in the next few years are those of the Federal Reserve Board as it determines the scale and pace at which it raises interest rates. Let’s be clear that the decision to raise interest rates is a decision to slow the economy and weaken job and wage growth. There are many false concerns about accelerating wage growth and exploding inflation based on the mistaken sense that we are at or near full employment. Policymakers should not seek to slow the economy until wage growth is comfortably running at the 3.5 to 4.0 percent rate, the wage growth consistent with a 2 percent inflation target (since trend productivity is 1.5 to 2.0 percent, wage growth 2 percent faster than this yields rising unit labor costs, and therefore inflation, of 2 percent). The key danger is slowing the economy too soon rather than too late.

Fed monetary policy should not target one sector of the economy (i.e. wages) but the whole economy (i.e. nominal GDP).

2. Targeted employment programs

Even at 4 percent unemployment, there will be many communities that will still be suffering substantial unemployment, especially low-wage workers and many black and Hispanic workers. To obtain full employment for all, we will need to undertake policies that can direct jobs to areas of high unemployment……

Government programs don’t create jobs, they merely redistribute income from the taxed to the subsidised.

3. Public investment and infrastructure

There is widespread agreement that we face a substantial shortfall of public investment in transportation, broadband, R&D, and education. Undertaking a sustained (for at least a decade) program of public investment can create jobs and raise our productivity and growth…..

Agree. But we must invest in productive assets that generate income that can be used to repay the debt. Else we are left with a pile of debt and no means to repay it.

Policies that do not help us reach full employment include:

1. Corporate tax reform

There are many false claims that corporate tax reform is needed to make us competitive and bring us growth. First off, the evidence is that the corporate tax rates U.S. firms actually pay (their “effective rates”) are not higher than those of other advanced countries. Second, the tax reform that is being discussed is “revenue neutral,” necessarily meaning that tax rates on average are actually not being reduced; for every firm or sector that will see a lower tax rate, another will see a higher tax rate. It is hard to see how such tax reform sparks growth.

Zero-sum thinking. If we want to increase employment, we need to increase investment. Tax rates and allowances should encourage domestic investment rather than offshore expansion.

2. Cutting taxes

There will surely be many efforts in this Congress to cut corporate taxes and reduce taxes on capital income (e.g., capital gains, dividends) and individual marginal tax rates, especially on those with the highest incomes. It’s easy to see how those strategies will not work….

Same as above. We need to encourage investment by private corporations.

3. Raising interest rates

There are those worried about inflation who are calling on the Federal Reserve Board to raise interest rates soon and steadily thereafter. Their fears are, in my analysis, unfounded. But we should be clear that those seeking higher interest rates are asking our monetary policymakers to slow economic growth and job creation and reflect a far-too-pessimistic assumption of how far we can lower unemployment, seemingly aiming for unemployment at current levels or between 5.0 and 5.5 percent….

Agreed. Raising interest rates too soon is as dangerous as raising too late.

Wage growth

It is a welcome development that policymakers and presidential candidates in both parties have now acknowledged that stagnant wages are a critical economic challenge…… Over the 40 years since 1973, there has been productivity growth of 74 percent, yet the compensation (wages and benefits) of a typical worker grew far less, just 9 percent (again, mostly in the latter 1990s)……

Wage stagnation is conventionally described as being about globalization and technological change, explanations offered in the spirit of saying it is caused by trends we neither can nor want to restrain. In fact, technological change has had very little to do with wage stagnation. Such an explanation is grounded in the notion that workers have insufficient skills so employers are paying them less, while those with higher wages and skills (say, college graduates) are highly demanded so that employers are bidding up their wages…….

Misses the point. Technology has enabled employers in manufacturing, finance and service industries to cut the number of employees to a fraction of their former size.

Globalization has, in fact, served to suppress wage growth for non-college-educated workers (roughly two-thirds of the workforce). However, such trends as import competition from low-wage countries did not naturally develop; they were pushed by trade agreements and the tolerance of misaligned and manipulated exchange rates that undercut U.S. producers.

This small paragraph hits on the key reason for wage stagnation in the US. Workers are not only competing in a global labor market, but against countries who have manipulated their exchange rate to gain a competitive advantage.

There are two sets of policies that have greatly contributed to wage stagnation that receive far too little attention. One set is aggregate factors, which include factors that lead to excessive unemployment and others that have driven the financialization of the economy and excessive executive pay growth (which fueled the doubling of the top 1 percent’s wage and income growth). The other set of factors are the business practices, eroded labor standards, and weakened labor market institutions that have suppressed wage growth. I will examine these in turn.

Aggregate factors

1. Excessive unemployment

Unemployment has remained substantially above full employment for much of the last 40 years, especially relative to the post-war period before then. Since high unemployment depresses wages more for low-wage than middle-wage workers and more for middle-wage than high-wage workers, these slack conditions generate wage inequality. ……

The excessive unemployment in recent decades reflects a monetary policy overly concerned about inflation relative to unemployment and hostile to any signs of wage growth……

2. Unleashing the top 1 percent: finance and executive pay

The major forces behind the extraordinary income growth and the doubling of the top 1 percent’s income share since 1979 were the expansion of the finance sector (and escalating pay in that sector) and the remarkable growth of executive pay …… restraining the growth of such income will not adversely affect the size of our economy. Moreover, the failure to restrain these incomes leaves less income available to the vast majority……

Zero-sum thinking.

Labor standards, labor market institutions, and business practices

There are a variety of policies within the direct purview of this committee that can greatly help to lift wage growth:
1. Raising the minimum wage

The main reason wages at the lowest levels lag those at the middle has been the erosion of the value of the minimum wage, a policy undertaken in the 1980s that has never fully been reversed. The inflation-adjusted minimum wage is now about 25 percent below its 1968 level……

Will reduce demand for domestic labor and increase demand for offshoring jobs.

2. Updating overtime rules

The share of salaried workers eligible for overtime has fallen from 65 percent in 1975 to just 11 percent today……

This will continue for as long as the manufacturing sector is white-anted by offshoring jobs.

3. Strengthening rights to collective bargaining

The single largest factor suppressing wage growth for middle-wage workers over the last few decades has been the erosion of collective bargaining (which can explain one-third of the rise of wage inequality among men, and one-fifth among women)……

How will this improve Supply and Demand?

4. Regularizing undocumented workers

Regularizing undocumented workers will not only lift their wages but will also lift wages of those working in the same fields of work…..

How will this improve Supply and Demand?

5. Ending forced arbitration

One way for employees to challenge discriminatory or unfair personnel practices and wages is to go to court or a government agency that oversees such discrimination. However, a majority of large firms force their workers to give up their access to court and government agency remedies and agree to settle such disputes over wages and discrimination only in arbitration systems set up and overseen by the employers themselves…..

How will this improve Supply and Demand?

6. Modernizing labor standards: sick leave, paid family leave

We have not only seen the erosion of protections in the labor standards set up in the New Deal, we have also seen the United States fail to adopt new labor standards that respond to emerging needs……

No issue with this. But how will it improve Supply and Demand?

7. Closing race and gender inequities

Generating broader-based wage growth must also include efforts to close race and gender inequities that have been ever present in our labor markets…….

No issue with this. But how will it improve Supply and Demand?

8. Fair contracting
These new contracting rules can help reduce wage theft, obtain greater racial and gender equity and generally support wage growth……

No issue with this. But how will it improve Supply and Demand?

9. Tackling misclassification, wage theft, prevailing wages

There are a variety of other policies that can support wage growth. Too many workers are deemed independent contractors by their employers when they are really employees……

No issue with this. But how will it improve Supply and Demand?

Policies that will not facilitate broad-based wage growth

1. Tax cuts: individual or corporate

The failure of wages to grow cannot be cured through tax cuts. Such policies are sometimes offered as propelling long-run job gains and economic growth (though they are not aimed at securing a stronger recovery from a recession, as the conservatives who offer tax cuts do not believe in counter-cyclical fiscal policy). These policies are not effective tools to promote growth, but even if they did create growth, it is clear that growth by itself will not lift wages of the typical worker…….

Zero-sum thinking. Compare economic growth in high-tax countries to growth in low tax countries and you will find this a highly effective policy tool.

2. Increasing college or community college completion

……advancing education completion is not an effective overall policy to generate higher wages……. What is needed are policies that lift wages of high school graduates, community college graduates, and college graduates, not simply a policy that changes the number of workers in each category.

Better available skills-base leads to increased competitiveness in global labor market and more investment opportunities in the domestic market.

3. Deregulation

There is no solid basis for believing that deregulation will lead to greater productivity growth or that doing so will lead to wage growth. Deregulation of finance certainly was a major factor in the financial crisis and relaxing Dodd–Frank rules will only make our economy more susceptible to crisis.

What we need is (simple) well-regulated markets rather than (complex) over-regulation.

4. Policies to promote long-term growth

Policies that can substantially help reduce unemployment in the next two years are welcomed and can serve to raise wage growth. Policies aimed at raising longer-term growth prospects may be beneficial but will not help wages soon or necessarily lead to wage growth in future years. This can be seen in the decoupling of wage growth from productivity over the last 40 years. Simply increasing investments and productivity will not necessarily improve the wages of a typical worker. What is missing are mechanisms that relink productivity and wage growth. Without such policies, an agenda of “growth” is playing “pretend” when it comes to wages.

Long-term investment is the only way forward. To dismiss this in favor of short-term band-aid solutions is nuts!

My proposal is a lot simpler, consisting of only five steps:

Invest in productive infrastructure.
A simplified tax regime with low rates and few deductions apart from incentives to increase domestic investment.
Restrict capital inflows through trade agreements and maintain a fair exchange rate.
Fed monetary policy supportive in the short-term but with long-term target of neutral debt growth — in line with GDP (nominal).
Move education up the priority list for government spending. Improve the education standards and training of teachers — they are the lifeblood of the system — rather than increasing numbers.

February 1, 2015

An Unconventional Truth by Nouriel Roubini – Project Syndicate

Nouriel Roubini argues for increased infrastructure investment to accompany monetary easing, else the benefits of the latter will not last:

Simply put, we live in a world in which there is too much supply and too little demand. The result is persistent disinflationary, if not deflationary, pressure, despite aggressive monetary easing.

The inability of unconventional monetary policies to prevent outright deflation partly reflects the fact that such policies seek to weaken the currency, thereby improving net exports and increasing inflation. This, however, is a zero-sum game that merely exports deflation and recession to other economies.

Perhaps more important has been a profound mismatch with fiscal policy. To be effective, monetary stimulus needs to be accompanied by temporary fiscal stimulus, which is now lacking in all major economies. Indeed, the eurozone, the UK, the US, and Japan are all pursuing varying degrees of fiscal austerity and consolidation.

Even the International Monetary Fund has correctly pointed out that part of the solution for a world with too much supply and too little demand needs to be public investment in infrastructure, which is lacking – or crumbling – in most advanced economies and emerging markets (with the exception of China). With long-term interest rates close to zero in most advanced economies (and in some cases even negative), the case for infrastructure spending is indeed compelling. But a variety of political constraints – particularly the fact that fiscally strapped economies slash capital spending before cutting public-sector wages, subsidies, and other current spending – are holding back the needed infrastructure boom.

All of this adds up to a recipe for continued slow growth, secular stagnation, disinflation, and even deflation. That is why, in the absence of appropriate fiscal policies to address insufficient aggregate demand, unconventional monetary policies will remain a central feature of the macroeconomic landscape.

Again, I add the warning that infrastructure investment must be in productive assets, that generate market related returns. Otherwise we are merely swapping one set of problems (a shortfall in aggregate demand) for another: high public debt without the revenue to service or repay it.

February 1, 2015

Will the global economy follow Japan?| Michael Pettis’ CHINA FINANCIAL MARKETS

More from Michael Pettis on “Japanification” of the global economy. How abundant capital and investment in unproductive works may lead to long-term stagnation:

“Panics do not destroy capital,” John Mill proposed in his 1868 paper to the Manchester Statistical Society. “They merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.” Our ability to postpone the recognition of the full extent of these unproductive works depends in part on our ability to expand the supply of credible money. If we are constrained in our ability to expand the money supply, one impact of the crisis is a contraction in money (velocity collapses) that forces lenders to write down debt. If money can expand without constraints, however, debt does not have to be written down nearly as quickly.

With the main central banks of the world having banded together to issue unprecedented amounts of credible currency, in other words, we may have changed the dynamics of great global rebalancing crises. We may no longer have to forcibly write down “hopelessly unproductive works”, during which process the seemingly endless capital of the globalization phase is wiped out, and we enter into a phase in which capital is scarcer and must be allocated much more carefully and productively.

Instead, the historically unprecedented fact of our unlimited ability to issue a credible fiat currency allows us to postpone a quick and painful resolution of the debt burdens we have built up. It is too early to say whether this is a good thing or a bad thing. On the one hand, it may be that postponing a rapid resolution protects us from the most damaging consequences of a crisis, when slower growth and a rising debt burden reinforce each other, while giving us time to rebalance less painfully — the Great depression in the US showed us how damaging the process can be. On the other hand the failure to write down the debt quickly and forcefully may lock the world into decades of excess debt and “Japanification”. We may have traded, in other words, short, brutal adjustments for long periods of economic stagnation.

Investment in infrastructure is essential to rescue an economy from a contraction of aggregate demand following a financial crisis. The unpalatable alternative is a deflationary spiral and significant contraction in GDP. But we need to ensure that investment is made in productive assets — that generate market-related returns — rather than investments in social infrastructure that cannot generate sufficient revenue to service, nor be be sold to repay, debt funding.

December 8, 2014

Murray has endorsed macroprudential | Macrobusiness.com.au

Posted by Houses and Holes
At 12:52pm on December 8, 2014
Published with permission from Macrobusiness.com.au.

From Callam Pickering:

The one glaring problem with the Financial System Inquiry is that it didn’t push hard for the introduction of macroprudential policies. That takes the heat off both the RBA and APRA.

The truth is that higher capital requirements — combined with higher risk weighting on mortgages and tax reform — would have a similar (potentially larger) effect as macroprudential policies. In the long term financial system and tax reform is clearly the better approach to creating an efficient and sustainable housing and financial sector, but these reforms will take longer to implement.

That’s right. Murray’s principle recommendations are macroprudential. APRA is now free (and is being urged) to implement higher capital requirements. They do not require anything from government to go ahead. This is basically the model of MP envisaged by Prof Ross Garnaut.

A more interesting question is whether or not APRA will still act on specific areas of risk such as interest-only loans. These are a menace, as the US bust showed, and are surging. Murray did not mention them, being too granular, but said the following on MP more particularly:

The global financial crisis (GFC) prompted policy makers and regulators around the world to reconsider their approach to maintaining financial stability. Some countries at the epicentre of the crisis have since expanded their prudential perimeters and adopted more formal and centralised institutional arrangements. This includes establishing single entities with responsibility for macro-prudential regulation. Australia has long adopted what could be called a ‘macro-prudential’ approach to supervision under the rubric of financial stability. Yet, Australia’s institutional structure is relatively informal and decentralised. The Reserve Bank of Australia (RBA) and APRA each have responsibility for financial stability. However, most macro-prudential tools can only be deployed by APRA. This places a strong premium on cooperation between the two agencies.

Against the background of developments overseas, the Inquiry has considered whether Australia should change its institutional arrangements for making and implementing financial stability policy.

However, the Inquiry does not see a strong case for change in this area. Although approach has advantages and disadvantages, alternative institutional approaches are yet to be tested — as indeed is the effectiveness of many macro-prudential tools. For this reason, the Inquiry recommends no fundamental change to the current institutional arrangements for financial stability policy and no change to the prudential perimeter at this time.

That is neither here nor there and APRA will still be free to raise capital requirements for specific loans if it sees fit.

December 8, 2014

Australian banks rally on Murray Report

The ASX 200 Financial sector (ex-REITs) responded well to release of David Murray’s report into the financial services industry. As the largest constituent of the ASX 200 index, comprising more than one-third of market capitalization, sector performance is critical in determining future direction of the broader index. Breach of resistance at 7220 suggests that the correction is over. Follow-through above 7400 would confirm a fresh primary advance.

ASX 200 Financial ex Property

David Murray’s Financial System Inquiry

The Final Report of the Financial System Inquiry, led by ex-Commonwealth Bank CEO David Murray, calls on Australian banks to become “unquestionably strong” to prevent another financial crisis. The FSI calls for increased bank capital in the form of common equity, with capital ratios increasing from an average of 9.1% to the 12.2% threshold for the top quartile of international banks. The FSI also proposes that banks increase their average risk-weighting for home mortgages to 25-30% compared to current weightings as low as 15%.

Chris Joye from the AFR estimates that the first proposal would require about $21 billion in new capital, while increased risk-weighting would require an additional $15 billion. There may be some overlap between the two, but the combined requirement is likely to be more that $30 billion.

Impact on consumers is likely to be negligible. The FSI projects that a 1% increase in bank capital ratios would increase the weighted cost of capital by 6 basis points (0.06%) because of the higher cost of equity capital.

Bank Funding Costs with Increased Capital

But this does not take account of lower risk premiums required, for debt and equity, when capital is increased. A reduction of debt funding costs to 3.65% and equity to 14.75% would offset the increase in equity capital; so the actual cost increase may be considerably smaller.

A resilient banking system would not only avoid significant losses of GDP (as high as 158 percent) in the event of a financial crisis, but would save up to 900,000 jobs according to the FSI. In addition, reduced risk of a government bailout would minimize the threat to government debt levels and Australia’s AAA credit rating. Banks would also benefit through improved profitability and stronger growth prospects.

My concerns with FSI are mainly long-term. Raising capital ratios to the top quartile of international banks would certainly improve the resilience of Australian banks, but this is a moving target. We can expect average capital held by international banks to increase as other countries conduct their own reviews into the adequacy of bank funding. Also, leverage ratios (ignoring risk-weighting) remain low and should be progressively lifted towards a long-term goal of 6 to 8 percent. Reliance solely on risk-weighted capital ratios can encourage industry-wide concentration in low-risk-weighted assets which in turn will elevate risk. Lastly, bail-in bonds are dangerous — any attempt at conversion would destroy creditor confidence in the banking system with far-reaching repercussions — and should be discouraged.

I believe that stronger capital ratios are a win for both Australian taxpayers and bank shareholders. Implementation of the FSI recommendations would be a major advance towards building a resilient and sustainable banking sector.

December 3, 2014

Will falling commodity prices cause deflation?

Some readers expressed concern about falling commodity prices, especially crude oil, and whether this will cause global deflation. This confuses the cause with the symptom.

Crude

Falling prices are largely benign except where caused by a contraction of the money supply. Commodity prices may fall when there is an excess of supply over demand, but this is soon absorbed by changes in consumer behavior. Discretionary spending will rise in response to the savings, so that aggregate demand is unaffected.

A contraction in the money supply, however, is far more serious. Slow growth in the monetary base (below growth of real GDP) results in less money chasing the same goods, driving down prices. Supply and demand in this case are unchanged, but prices fall because of a contraction in the money supply. Wages, however, are sticky and do not fall in line with prices, leading to falling profits, cuts in production and job layoffs. Falling income from lower profits and fewer jobs leads to a contraction in aggregate demand, causing further cuts to production and income.

Contraction of the money supply also places pressure on banks to reduce lending. This danger was highlighted by Irving Fisher in the 1930s. Contracting credit reduces not only new investment but forces existing borrowers to liquidate some of their assets, mainly stocks and property. The surge of selling, and limited availability of credit, drives down asset prices. A feedback loop results, with falling asset prices prompting banks to further contract lending — in turn causing more price falls. That is the central bankers’ equivalent of a perfect storm. The graph below shows how close we came in 2009 to a deflationary spiral.

Working Monetary Base

Slow growth in the monetary base caused a sharp contraction in bank lending (below zero) in 2009. Only prompt action by the Fed averted a 1930’s-style collapse of the financial system.

The Fed indicated in October that it will curtail QE and no longer expand its balance sheet to support money supply growth. Should we expect another contraction of the money supply as in 2008?

The answer is: NO. When we look at the graph of the Fed balance sheet below, we can see that total asset growth [red] is slowing. But bank deposits at the Fed — excess reserves that earn interest at 0.25% p.a. — are slowing at an even faster rate. That means that the actual amount of money flowing into the banking system is not contracting, but increasing.

Fed Total Assets and Excess Reserves

The following graph shows a net growth rate (of Total Assets minus Excess Reserves on Deposit) of more than 20 percent. Expect growth to slow over time, but the Fed can adjust the interest rate payable on excess reserves to ensure that it remains positive.

Fed Total Assets minus Excess Reserves

Deflation is a far bigger problem for the Euro. After a “whatever it takes” surge in 2012, the ECB attempted to contract its balance sheet far too soon — withdrawing treatment before the patient had fully recovered. They also do not have excess reserves on deposit, like the Fed, which could soften the impact.

ECB Total Assets

The result has been faltering economic growth and price levels falling dangerously close to deflation.

ECB Total Assets

The ECB appears to have recognized its error, indicating that it will expand its balance sheet if necessary to avert a monetary contraction. If they learn from their past mistakes, the ECB should be able to avoid any threat of deflation.

November 17, 2014

Abenomics doing fine | Ambrose Evans-Pritchard

https://twitter.com/AmbroseEP/status/534464198856941569

November 16, 2014

Monetary Base and deflation

The Monetary Base consists of currency in circulation and commercial bank deposits at the Federal Reserve. Currency in circulation includes notes and coins both in circulation and held in the vaults of commercial banks. Commercial bank deposits at the Fed can be further broken down into required reserves and excess reserves. Excess reserves on deposit have soared — since late 2008 when the Fed started paying interest on reserves — to a level of $2.6 Trillion.

By varying the interest rate payable on excess reserves the Fed can manipulate the amount of currency in circulation. It is no longer reliant solely on Treasury and MBS purchases and sales to increase or decrease the money supply: these are merely one tool in the monetary tool-kit. So announcing that QE (security purchases) have ended does not mean that currency in circulation and the working monetary base (excluding excess reserves) will stop growing or will contract. That would cause deflationary pressure similar to the European experience. Growth, instead, is likely to continue provided that excess reserves are drawn down to compensate for cessation of QE.

US Monetary Base minus Excess Reserves and Currency in Circulation ROC

Deflationary pressures are unlikely to surface provided currency in circulation and the working monetary base continue to grow at above 5% a year. Only if real GDP grew at a faster pace (a problem we would like to have) would we encounter a problem.

Australia has similarly been keeping on the right side of 5% growth since early 2012. Provided this continues we should keep out of trouble.

Australia Monetary Base and Currency in Circulation ROC