Economics

Monetary Policy

  • Europe and Eurasia
    Greece-Troika Gap Over Primary Surpluses Has Shrunk Dramatically
    Greece has announced that it will not pay the IMF the €300 million due to the Fund on June 5.  Instead, it will “bundle” the payments due to the Fund over the course of June into one payment of about €1.7 billion that it will make at the end of the month.  This contradicts earlier pledges that it would not resort to bundling.  The only country ever to have done so is Zambia, three decades ago. While the dramatic move suggests that Athens is seriously contemplating outright default, we think such a move, at this point, borders on insanity.  This is because the gap between the parties over the main issue between them, the size of the primary budget surplus (the excess of revenues over expenditures, excluding interest payments) Greece will have to achieve in the coming years is now very small relative to what it was a year ago - as shown in the figure above.  In contrast, the cost of a Greek default is likely to be a complete cut-off in ECB liquidity support that will crush the Greek banking system and, also likely, force the country out of the Eurozone. Then again, Greece has always had an affinity for tragedies.   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”
    Blog Post by Benn Steil and Dinah Walker June 5, 2015 Geo-Graphics
  • Monetary Policy
    Are Fed Watchers Watching the Wrong People?
    One effect of the financial crisis was to change how the Fed conducts monetary policy.  This could be long-lasting and important.Prior to the crisis, the Federal Open Market Committee (FOMC) set a target for the so-called federal funds rate, the interest rate at which depository institutions lend balances to each other overnight.  The New York Fed would then conduct open market operations – buying and selling securities – in order to nudge that rate towards the target.  It did this by affecting the supply of banks’ reserve balances at the Fed, which go up when they sell securities to the Fed and down when they buy them.The Fed kept the level of reserves in the system low enough that some banks needed to borrow from others in order to meet their requirements, thereby ensuring that the fed funds rate was always an important one.  The cost of borrowing through other means then tended to move up and down with the fed funds rate, thus giving the Fed effective power over the cost of short-term credit broadly.During the crisis, the Fed’s Quantitative Easing programs – large-scale purchases of assets from the banks – drove up the volume of excess reserves, or reserves beyond those banks are required to hold, to unprecedented levels.  A consequence of this is that many institutions can fulfill their reserve requirements without needing to borrow, so competition for reserves is now low and small changes in their supply no longer induce the same changes in the cost of borrowing them that they once did.  This means that open market operations are no longer sufficient to drive the cost of borrowing in the fed funds market to the FOMC’s target. This can be seen clearly in the graphic above: the difference between the FOMC’s target for the fed funds rate and the actual fed funds rate increases and begins to gyrate wildly after 2007.This is where recent legislation becomes important. Section 201 of the Financial Services Regulatory Relief Act of 2006 amended the 1913 Federal Reserve Act to give the Fed the authority to pay interest on reserves beginning October 1, 2011.  The 2008 Economic Stabilization Act brought this forward to October 1, 2008.  These changes gave the Fed a new tool to implement monetary policy.  Paying interest on reserves helps to set a floor under short-term rates because banks that can earn interest at the Fed are unwilling to lend to others below the rate the Fed is paying.  This allows the FOMC to achieve its target for the fed funds rate even with high levels of excess reserves -  as can be seen in the graphic from 2009 on.The FOMC has said that the Fed intends to rely on adjustments in the rate of interest on excess reserves to achieve its fed funds target rate as it begins to tighten monetary policy – likely later this year or early next.  However, the 2006 Act gave authority for setting the rate of interest on excess reserves to the seven-member (currently five) Federal Reserve Board, and not to the twelve-member (currently ten) FOMC.  This could be consequential.The Federal Reserve Act stipulates that the interest rate on reserves should not “exceed the general level of short-term interest rates,” but does not prevent the Board from setting it well below the general level of short-term interest rates.  This means that the FOMC could decide that short-term rates should rise to, say, 4 percent, while the Board, thinking this excessive, could decide only to raise the rate on reserves to, say, 3 percent.  Because the quantity of excess reserves is currently so massive, it would be virtually impossible for the trading desk at the New York Fed to conduct open market operations sufficient to achieve the 4 percent target set by the FOMC.  Overnight rates would therefore trade closer to the Board-determined 3 percent rate on reserves.Section 505 of Senator Richard Shelby’s draft Financial Regulatory Improvement Act would transfer the authority to set the interest rate on reserves to the FOMC, which would restore its ability to control short-term rates generally.  But unless and until such an act is passed, or the volume of excess reserves declines significantly, the Board, and not the FOMC, will control how quickly rates rise.This is potentially important because, as the graphic shows, the average Board member is considerably more dovish than the average non-Board FOMC member.  Fed watchers may therefore be overestimating the pace of rate increases because they’re focusing on the comments of the wrong committee.  For now, at least, it is the Board, and not the FOMC, that wields the real power over rate increases. Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphicsRead about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”
    Blog Post by Benn Steil and Dinah Walker June 1, 2015 Geo-Graphics
  • China
    Are China’s RMB Swap Lines an Empty Vessel?
    As our recent CFR interactive shows, central bank currency swaps have spread like wildfire since the financial crisis.  In 2006, the Fed had only two open swap lines outstanding, with Canada and Mexico, for just $2 billion and $3 billion, respectively.  At its high point in 2008, the Fed had fourteen open swap lines, with as much as $583 billion drawn. The central bank that has been most active in creating swap lines, however, is China; the People’s Bank of China (PBoC) is expected to sign a swap agreement with Chile this week, bringing the total number of outstanding swap lines to thirty-one.  The extension of these swap lines is clearly part of China’s high-profile recent initiatives to internationalize the RMB. What is most interesting about this effort so far is that whereas everyone seems interested in having a swap line with China, almost no one has thus far had any interest in using it.  And when they have used it the amounts accessed have been tiny – as shown in the middle figure in our graphic above. The only actual RMB swap use advertised by China was back in 2010, when it sent 20 billion yuan (about $3 billion) to the Hong Kong Monetary Authority to enable companies in Hong Kong to settle RMB trade with the mainland. But this is basically China trading with itself.  The Korean Ministry of Finance publicized a tiny swap in 2013 in which it accessed 62 million yuan (about $10 million) to help Korean importers make payments. The only interesting case is that of Argentina, which activated its RMB swap line last year, and has reportedly drawn $2.7 billion worth.  The effect of the swaps on Argentina’s reserves is shown at the far right of the graphic. Argentina has the right to draw on a total of $11 billion worth of RMB.  Its central bank has made a point of emphasizing that, under the terms of its agreement with the PBoC, the RMB may be freely converted into dollars – which Argentina, whose reserves have plummeted from $53bn in 2011 to $31bn today, is worryingly short of. In effect, then, what Argentina has done by activating the RMB swap line is to add “vouchers” for dollars, freeing up the actual dollars in its reserves for imminent needs, such as imports and FX market intervention, and signaling to the markets that billions more can be accessed in a pinch. The take-away is that whereas the RMB is slowly becoming an alternative to the dollar for settling Chinese goods trade, it is still far from being a currency that anyone actually needs – except maybe as a substitute for Fed dollar swap lines, which few central banks currently have access to.  If Russia’s dollar reserves continue to fall, therefore, China may be the first place it turns.   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”  
    Blog Post by Benn Steil and Dinah Walker May 21, 2015 Geo-Graphics
  • Europe and Eurasia
    Which Countries Stand to Lose Big from a Greek Default?
    The IMF has turned up the heat on Greece’s Eurozone neighbors, calling on them to write off “significant amounts” of Greek sovereign debt.  Writing off debt, however, doesn’t make the pain disappear—it transfers it to the creditors. No doubt, Greece’s sovereign creditors, which now own 2/3 of Greece’s €324 billion debt, are in a much stronger position to bear that pain than Greece is.  Nevertheless, we are talking real money here—2% of GDP for these creditors. Germany, naturally, would bear the largest potential loss—€58 billion, or 1.9% of GDP.  But as a percentage of GDP, little Slovenia has the most at risk—2.6%. The most worrying case among the creditors, though, is heavily indebted Italy, which would bear up to €39 billion in losses, or 2.4% of GDP.  Italy’s debt dynamics are ugly as is—the FT’s Wolfgang Münchau called them “unsustainable” last September, and not much has improved since then.  The IMF expects only 0.5% growth in Italy this year. As shown in the bottom figure above, Italy’s IMF-projected new net debt for this year would more than double, from €35 billion to €74 billion, on a full Greek default—its highest annual net-debt increase since 2009.  With a Greek exit from the Eurozone, Italy will have the currency union’s second highest net debt to GDP ratio, at 114%—just behind Portugal’s 119%. With the Bank of Italy buying up Italian debt under the ECB’s new quantitative easing program, the markets may decide to accept this with equanimity.  Yet assuming that a Greek default is accompanied by Grexit, this can’t be taken for granted.  Risk-shifting only works as long as the shiftees have the ability and willingness to bear it, and a Greek default will, around the Eurozone, undermine both.   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”
    Blog Post by Benn Steil and Dinah Walker May 7, 2015 Geo-Graphics
  • Monetary Policy
    Global Economics Monthly: May 2015
    Bottom Line: Throughout the slow global recovery from the Great Recession, central banks have struggled to provide sufficient monetary stimulus to meet their targets for inflation and growth. It is time now to debate whether a higher inflation target in normal conditions improves the operation of monetary policy and allows for a better response to future crises. Boston Federal Reserve President Eric Rosengren caught the attention of markets last month when, in a speech in London that mostly focused on the need for discretion in monetary policy at a time of substantial uncertainty, he suggested that the Fed’s inflation target of two percent may be too low. Since interest rates at full employment should compensate for inflation and provide a normal real return, a higher inflation target would result in higher nominal interest rates in normal times. This means the Federal Reserve would be less likely to reduce its policy rate (the federal funds rate) to zero in response to future shocks. Much of the subsequent discussion of Rosengren’s speech focused on predicting when the Fed would begin the process of normalization. It is unsurprising that Rosengren—considered one of the more dovish members of the Fed’s policy board—would be resistant to simple rules, such as those advocated by John B. Taylor of the Hoover Institution, that call for an early rate hike because the rapid decline in unemployment and shrinking economic slack could cause inflation to rise above the Fed’s target. But this focus on the short term is misleading. As interest rates normalize, the Fed should draw lessons from the financial crisis to meet its overarching aim: to “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates." As Rosengren implied in his speech, this includes considering whether the Fed has set the right inflation target. However, it will be difficult for the Fed to publicly discuss possible shifts in long-run policies without disrupting financial markets, which remain focused on the immediate path of interest rates. The 2 Percent Solution Over the past several decades, there has been a convergence of thinking within the central banking community: the desired goal of price stability is best supported by a firm public commitment to a low inflation target. For many central banks, given typical biases in the measurement of inflation, that means an inflation target close or equal to 2 percent. In the context of this consensus, seeking inflation above 2 percent would seem the height of irresponsibility. Certainly no respectable central bank would be comfortable going it alone in raising their inflation targets. One implication of a low inflation target is that, in response to a significant shock requiring a substantial reduction in real interest rates to restore full employment, interest rates of zero might not be low enough. Unconventional monetary policies such as quantitative easing (QE) could fill the gap and provide the needed additional stimulus, but there is a growing recognition of the limits of successive rounds of QE. In 2010, Olivier Blanchard, the International Monetary Fund’s chief economist, caused a storm when he suggested that major central banks should consider higher inflation targets. He suggested 4 percent. Although his argument prompted substantial pushback from central bankers at the time, he subsequently received analytical support from a number of economists, most recently Larry Summers, whose argument that the United States faces “secular stagnation” suggests that real interest rates are too persistently high to restore full employment. The case for secular stagnation in the United States is highly contentious, but even critics acknowledge that central banks need the capacity to respond to large shocks and that extended periods of zero interest rates can be distortive. It is hard for the Federal Reserve to debate inflation targets publicly at this stage. If the Fed were to announce an increase in its inflation objective, it would mean committing to a much more sustained period of extraordinary stimulus to get there. Somewhat counterintuitively, that would necessitate interest rates remaining at zero for a long period of time, one more likely to be measured in years than in months. This comes at a time of increased concern among some economists about the financial stability risks and distributional consequences associated with zero interest rates. By lowering interest rates, any easing cycle shifts income from savers to borrowers, but long-term periods of zero interest rates—including the current post-2008 period—have unusually profound consequences for savers, including those on fixed income. The challenge is how to have the long-term debate without distorting markets in the short term. The solution lies to the north. Canada Takes the Lead In a little noticed move, the Bank of Canada may have taken the first step toward a sea change in central banking policy. Canada targets 2 percent inflation, the midpoint of a 1 to 3 percent inflation–control target range. By law, it must formally review this mandate every five years; the next review is scheduled for 2016. In an exercise of unusual transparency, the Bank of Canada has explicitly acknowledged “the experience of advanced economies with interest rates near the zero lower bound has put the 2 percent target under increased scrutiny. After taking all factors into consideration, the Bank will undertake a careful analysis of the costs and benefits of adjusting the target.” The papers presented in preparation for the Bank of Canada’s review make the case that communication of an inflation target above current levels can be stimulative, identify reasons why inflation is mismeasured, and highlight the costs of unconventional policies. Together, my read of the analysis presented is that the case is being prepared to raise its target next year. If so, and if well received by markets, Canada could become a laboratory for a more comprehensive change in central banking policy. Looking Ahead: Kahn's take on the news on the horizon Ukraine Economic Outlook Worsens In Ukraine, concerns of a spring offensive are adding to downward pressures on the economy; meanwhile, negotiations with its creditors appear to have stalled. Greece Crisis Deepens as Creditors Wait on Deal Optimism in Greece for a May agreement with creditors has failed to stem deposit outflows, as domestic payments difficulties mount and payments to the International Monetary Fund loom. Trade Authority Stalled In the United States, the president is still short of votes needed to pass trade promotion authority, which is necessary for concluding the Trans-Pacific Partnership (TPP) agreement.
    Report by Robert Kahn May 5, 2015
  • China
    Should the United States Encourage Japan to Join the AIIB?
    On April 15, China’s finance ministry revealed the 57 “prospective founding members” of the new Asian Infrastructure Investment Bank, of which China is the architect.   The likely founders include many U.S. allies, such as the UK, Australia, and South Korea, which the Obama Administration had lobbied not to join, seeing the AIIB as a Chinese alternative to the U.S.-architected World Bank. The ally snub to Washington is a diplomatic failure for the Administration, although one that partially reflects the misguided refusal of the GOP-dominated Congress to ratify long-overdue IMF governance reform. This refusal made it that much easier for China to argue that new institutions to give fair voice to rising powers were both necessary and inevitable. One major U.S. ally that has not yet made a decision as to whether to join is Japan.  The Obama Administration is presumably still opposed to its participation; but whatever the merits of that position before other G7 members decided to come on board, it should be abandoned now.  It is no longer in U.S. interests. Governance of the new AIIB has not yet been determined, although China is believed to support a 75%/25% voting split between Asian and non-Asian members, with voting shares within each group allocated according to gross domestic product (GDP).  China also foreswore veto power, which the U.S. has within the IMF and World Bank, in order to persuade U.S. allies to join. With such a governance structure, China will be highly dominant within the organization – having 43% of the votes, nearly 5 times more than number 2 India (if current-dollar GDP determines voting power), as shown in the left-hand figure above.  U.S. ally countries – the UK, Germany, France, and other European nations, and Australia and South Korea in the Asia-Pacific – would have only 28% of the vote. With Japan as a member, however, close U.S. allies would have 41% of the vote – more than China’s 35%, as shown in the right-hand figure above.  Therefore, even if the United States chooses to remain outside the AIIB, it should, at this point – assuming that it wishes to temper China’s dominance - be encouraging Japan to join.   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”
    Blog Post by Benn Steil and Dinah Walker April 20, 2015 Geo-Graphics
  • China
    Are China’s Foreign Exchange Reserves Really Falling?
    Bloomberg and other media outlets have been highlighting the apparent significant recent fall in China’s foreign exchange reserves, suggesting that the development had important implications. In a recent blog post, former Fed Chair Ben Bernanke argued that a “global excess of desired saving over desired investment, emanating in large part from China and other Asian emerging economies and oil producers like Saudi Arabia, was a major reason for low global interest rates.” If this is so, then Chinese reserve sales can be expected to push up global rates.  But is China actually selling reserves? The actual currency composition of China’s reserves is unknown – so no hard measurement of sales can be made.  However, if we assume that the composition is approximately the same as that of other EMs – about 65% dollars, 20% euros, and 15% others – we can estimate it. As shown in the graphic above, once we strip out currency fluctuation effects – that is, the steep recent rise in the dollar - Chinese FX reserves actually increased mildly, rather than decreased, between last June and December.  Thus Bloomberg’s assertion that China had “cut its stockpile” of reserves appears erroneous. So to the extent that Bernanke’s global savings glut thesis is accurate, China continues to exert downward pressure on global interest rates.   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”
    Blog Post by Benn Steil and Dinah Walker April 8, 2015 Geo-Graphics
  • Monetary Policy
    Is the Fed Gonna Tighten Like It’s 1994? Or 2004?
    How will the Fed raise rates once it starts?  Gradually, in small steps?  Faster, with larger steps? In 2012, before becoming Fed chair, Janet Yellen argued for a later first rate-hike than would be suggested by a traditional “Taylor Rule” approach, followed by more aggressive catch-up rate hikes.  Now, however, she is suggesting that those rate hikes will be gradual and measured after all.  Almost certainly she is wary of a repeat of 1994, when the Fed began raising rates and bond markets took a pounding. New York Fed president Bill Dudley said that the pace of tightening would depend on “financial conditions” in the market once the Fed achieves lift-off.  He pointed to the spring/summer 2013 “taper tantrum” as a reason to go slow.  But he then warned of the risks of repeating the 2004 experience, when the gradual, measured, salami-slice tightening left “financial conditions . . . quite loose,” suggesting that policy should perhaps “have been tightened more aggressively.” These comments suggest that the Fed might be more aggressive this time if longer-term interest rates, like the 10-year Treasury rate, don’t rise with short rates. The graphic above shows how the 10-year rate evolved after the 1994 and 2004 tightenings.  The Fed, at least as suggested by Dudley’s comments, doesn’t seem to want to repeat either of these episodes.  It wants financial conditions to tighten, but not too much. What accounts for the different market reactions in the 1994 and 2004 episodes? One possibility is the very different way the Fed handled communications.  In 1994, there was no real “forward guidance.” In testimony before the Joint Economic Committee on January 31, 1994, four days before the Fed’s first rate hike, Fed Chairman Alan Greenspan indicated only that “At some point, absent an unexpected and prolonged weakening of economic activity, we will need to move [rates] to a more neutral stance.”  In 2004, in contrast, the Fed’s guidance was almost identical to 2014/15: first it said that accommodation would remain for a “considerable period,” then it said it would be “patient” in removing it, and then said rates would go up at a “measured” pace. Going forward, this suggests, all else being equal, that a repeat of the 2004 market reaction is more likely than a repeat of 1994. To the extent, however, that Dudley’s concerns about 2004 apply to the coming Fed tightening, we can expect the Fed to do something about it.  What disturbs us is that Dudley, repeating a Fed pledge from 2011 and 2014, has ruled out using the most obvious tool for affecting long rates.  This is to sell longer-term Treasury securities from its balance sheet, which would put upward pressure on their yields and, almost certainly, the yield on longer-maturity private credit.  The Fed holds a whopping $1.3 trillion in Treasuries with remaining maturity of 5 years or longer on its balance sheet, as the bottom figure above shows. Dudley says the Fed will instead simply push harder on very short-term rates, through the interest rate paid on excess reserves (IOER) and the overnight reverse repurchase (ON-RRP) facility.  “Macroprudential measures,” which he said should have been considered in 2004, might also be tried. But the first, indirect, approach makes little sense if the Fed wants to affect longer rates directly.  And the second is just a fancy way of saying “do something non-monetary, something we can’t specify.” Neither inspires confidence that the Fed will actually succeed in tightening financial conditions, if this is what it needs to do. Why did the Fed, then, and Dudley personally, rule out selling assets from the balance sheet?  Because they fear 1994 even more than they fear 2004.  But here the Fed is once again paralyzing itself with clumsy forward guidance. Dudley himself has acknowledged that the Fed does not know how the market will react to Fed tightening, and that it should, in fact, itself react to actual market conditions at the time.  We agree.  But this means that asset sales should be on the table for the eventuality that financial conditions become too loose; the Fed should not be trying to thread the needle between 1994 and 2004 using inappropriate or dubious implements.   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”
    Blog Post by Benn Steil and Dinah Walker April 2, 2015 Geo-Graphics
  • China
    Move Over Big Mac: The Law of One Price Is Lovin’ Our Little Mac Index
    The “law of one price” holds that identical goods should trade for the same price in an efficient market. To what extent does it hold internationally? The Economist magazine’s famous Big Mac Index uses the price of McDonald’s burgers around the world, expressed in a common currency (U.S. dollars), to estimate the extent to which various currencies are over- or under-valued. The Big Mac is a global product, identical across borders, which makes it an interesting one for this purpose. Yet it travels badly—cross-border flows of burgers won’t align their prices internationally. So in 2013 we created our own index which better meets the condition that the product can flow quickly and cheaply across borders: the Geo-Graphics iPad mini Index, which we hereby rechristen the “Little Mac Index.” (H/T: Guy de Jonquieres) Consistent with our product, iPad minis, being far more tradable than The Economist’s product, Big Macs, our index shows that the law of one price holds much better than theirs does.  The average overvaluation of the dollar according to the Big Mac Index was 19% in January - a Whopper.  The average dollar overvaluation according to the Little Mac Index was a mere 5% - small fries. So what’s happened since we last updated our index in May?  The U.S. dollar index (the DXY) has appreciated nearly 20%.  The rising dollar is lowering U.S. corporate profits and putting downward pressure on U.S. inflation.  Measured in terms of iPad minis, the dollar has over this period gone from being cheap against most major currencies to being expensive – a reflection of the fact that America’s central bank is almost alone in having virtually committed to tightening policy later in the year. One notable exception to the dollar’s strength in the Little Mac Index is the Swiss franc, which will buy you fewer iPad minis than the buck.  The franc skyrocketed after the Swiss National Bank unpegged it from the euro on January 15. When we first launched the index in June 2013, the dollar looked undervalued against most currencies.  Now that the dollar is looking pricey, there is more reason to fear currency conflicts spilling over into the trade sphere.  This is highlighted by the growing threat to a Trans-Pacific Partnership (TPP) trade deal from U.S. corporate interests seeking to hold it up until anti-currency-manipulation provisions can be welded in.   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”
    Blog Post by Benn Steil and Dinah Walker February 25, 2015 Geo-Graphics
  • China
    Will China Bail Out Russia?
    Russia’s foreign exchange reserves have fallen by nearly 1/3 since October 2013; they’ve fallen 20% just since September 2014.  Whereas the country still has over $300 billion in reserves, about $150 billion of this may be illiquid; it also has close to $700 billion in external debt. Whom would Russia turn to for dollars in a crisis? The IMF is the most obvious place.  The IMF approved lending to Russia of about $35 billion (SDR 24.8 billion) in the 1990s. With the sort of “exceptional” access that the Fund has granted to Greece, Portugal, Ireland, and Ukraine, Russia could potentially borrow up to $200 billion today, as shown in the figure above.  But when it comes to Russia, the United States and Europe are not in a generous mood at the moment.  Moscow would almost surely want to look elsewhere. What about its new BRICS friends?  Putin had said in 2014 that the new BRICS Contingent Reserve Arrangement (CRA) “creates the foundation for an effective protection of our national economies from a crisis in financial markets." Russia could potentially borrow up to $18 billion through the CRA.  But here’s the rub: it can only do so by being on an IMF program.  Without one, Russia could borrow a mere $5.4 billion – chicken-feed in a crisis.  In fact, borrowing such a pitiful sum might only precipitate a crisis by hinting that one was coming. What about China?  Here, things get interesting.  Under a central-bank swap line agreed in October, Russia could borrow up to RMB 150 billion – the equivalent of $24 billion at current exchange rates. China’s Commerce Minister Gao Hucheng has reportedly said the swap line could be expanded. What would Russia do with RMB, though?  Why, sell them for dollars, of course – as Argentina is apparently prepared to do with the funds received through its swap line from China. China might be happy for Russia to sell the renminbi it receives for dollars, as doing so would put downward pressure on the RMB without implicating Beijing in “currency manipulation.” “Russia plays an indispensable role as a strategic partner of China in the international community,” according to a December 22 editorial in China’s Global Times. “China must hold a positive attitude to help Russia out of this crisis.” In short, China may well have both economic and geopolitical reasons for offering Russia a helping hand.   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”
    Blog Post by Benn Steil and Dinah Walker February 11, 2015 Geo-Graphics
  • Monetary Policy
    Employment Data Suggest Fed Could Be "Patient" Until 2016—or Later
    In its last two statements, the FOMC has said that it “expects inflation to rise gradually toward 2 percent over the medium term”—2 percent being its target rate. What would it take to move it there? We looked at how many different variables correlate with the Fed’s preferred inflation measure—core PCE inflation. Oil and the dollar have been much in the news of late, but their prices have had little relationship with core PCE inflation over the past decade, as shown in the bottom-left figures above. The single variable that seems to correlate best, as seen in the top-left figure, is the employment/population ratio among adults aged 25-54 years. If we follow this ratio’s trend-line since 2013, when it began its last major upturn, this suggests that core PCE inflation won’t hit 2% until late 2016 or early 2017—as seen in the large right-hand figure. If we follow it since its trough in 2011, core PCE inflation does not hit 2% until late 2017. This suggests that a “patient” Fed might not begin hiking rates until considerably later than the market is currently anticipating, which is the middle of this year. A 2016 rise seems more plausible. The Economist: Opportunistic Overheating Wall Street Journal: Fed Flags Midyear Rate Hike-Or Later Financial Times: Dollar Rally Stalls on Rate Rise Rethink Federal Reserve: FOMC January 28, 2015 Statement   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”
    Blog Post by Benn Steil and Dinah Walker February 2, 2015 Geo-Graphics
  • Capital Flows
    Which Countries Should Fear a Rate Ruckus?
    For many Emerging Markets, May 22, 2013 is a day that will live in infamy.  It marks the start of the great Taper Tantrum, when Ben Bernanke’s carefully hedged remarks on prospects for slowing Fed asset purchases triggered a massive sell-off in EM bond and currency markets. Though the sell-off was widespread, it was not indiscriminate.  As the top figure above shows, EMs with large current account deficits were the hardest hit.  These were countries dependent on inflows of short-term capital facilitated by the $85 billion the Fed was pumping in monthly to buy Treasuries and mortgage-backed securities. So who is vulnerable now to a possible Rate Ruckus – an EM bond market sell-off triggered by an unexpectedly early or aggressive Fed rate hike? As the bottom figure suggests, many of the same countries are likely to be in the firing line – in particular, Ukraine, Turkey, South Africa, Peru, Brazil, Indonesia, Colombia, Mexico, and India.  Of these, only Ukraine has seen a significant improvement in its current account deficit, which has fallen from a whopping 9.2% to 2.5%.  Poland and Romania have moderate (2%) but higher deficits, and could receive a larger jolt this time around.  Only Thailand has moved into surplus, and looks likely to be spared. CFR Backgrounder: Currency Crises in Emerging Markets Financial Times: Fed Meeting May Add Pressure to Emerging Markets The Economist: The Dodgiest Duo in the Suspect Six Foreign Affairs: Taper Trouble   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”
    Blog Post by Benn Steil and Dinah Walker January 8, 2015 Geo-Graphics
  • Russia
    Global Economics Monthly: January 2015
    Bottom Line: It is tempting to rush to judgment on the Russian economic crisis. Russian Finance Minister Anton Siluanov is among those declaring the currency crisis over and promising rate cuts to follow currency stability. Conversely, many market analysts have warned of an imminent, full-blown economic crisis including a credit crunch, exchange-rate-driven inflation, sky-high interest rates, and rising unemployment. Both assessments are off the mark. The reality is that these are early days in the crisis; sanctions and oil together are imposing massive economic dislocations and those costs will rise over time as sanctions bind more tightly, limiting the resilience of the Russian economy. Russia still has substantial financial buffers and economic policies that it can use to delay an economic crisis, but market pressures are likely to return sometime in 2015. A Classic Currency Crisis? Recent developments in Russia present many elements of a classic emerging-market crisis. A market selloff and loss in confidence fuels capital flight. Sharp interest-rate hikes (650 basis points) fail to stem currency depreciation (see Figure 1). Investment plunges and consumers race to get out of the currency (for example, through the purchase of durable goods). Against this backdrop, it is not surprising that growth fell in the fourth quarter by 0.5 percent over a year earlier, leading to renewed currency declines. Market forecasts of a 5 percent decline for 2015 now look optimistic. But it would be misleading to view these developments solely through a currency lens. The Russian economy was already struggling prior to the current crisis, as weak economic policies, a poor global environment, and adverse demographics undermined the promise of a strong recovery following the financial crisis. Oil has always been central to Russian economic performance, but weak fiscal policies have meant that increasingly higher oil prices were needed to keep the budget balanced. In 2014, the fiscal break-even price was around $110 per barrel, compared to estimates of $30 to $40 per barrel just a decade ago. With current oil prices around $50 per barrel, the fiscal and external shortfall is substantial and is likely to widen as the government steps in with rescue packages for companies in trouble. Even though a depreciated currency can help the budget by raising the ruble value of exports, fiscal policy looks unsustainable. The most likely trigger for a future crisis resides in the financial sector. December’s $2 billion bailout of Trust Bank, coupled with news of large and potentially open-ended support for VTB Bank and Gazprombank, highlight the rapidly escalating costs of the crisis for the financial sector as state banks and energy companies face high dollar-denominated debt payments and falling revenues. Rising bad loans, falling equity values, and soaring foreign-currency debt are devastating balance sheets. As foreign banks pull back their support, the combination of sanctions, oil prices, and rising nonperforming loans is creating a toxic mix for Russian banks. So far, a crisis has been deferred by the belief that the central bank can and will fully stand behind the banking system. If any doubt creeps in about the strength of that commitment, a run will quickly materialize. Therein lies the central challenge for the central bank. News of large or unexpected bailouts trigger renewed market pressures and risks a political backlash, but the trigger for a crisis may be more closely linked to any sense that the central bank will step back from its support for the system. Figure 1: Central Bank of Russia's (CBR) Key Rate and the Value of the Ruble Source: Central Bank of Russia.   In this environment, further central bank rate hikes are likely to be counterproductive. Capital controls look increasingly likely, even though controls in Russia usually have been ineffective. Options range from those relatively benign to markets (for example, requiring state companies to sell foreign currency holdings) to repressive constraints on private deposits. In the end, evasion is simply too easy. The government has resources: international reserves fell $121 billion last year to a still-healthy $389 billion, but the government’s willingness to spend further is uncertain. Still, Russian policymakers need to do something. Sanctions as a Force Multiplier Sanctions are a force multiplier. Western sanctions have taken away the usual buffers—such as foreign borrowing and expanding trade—that Russia relies on to insulate its economy from an oil shock. Over the past several months, Western banks have cut their relationships and pulled back on lending, creating severe domestic market pressures. The financial system has fragmented. Meanwhile, trade and investment have dropped sharply. These forces limit the capacity of the Russian economy to adjust to any shock. Russia could have weathered an oil shock or sanctions alone, but not both together. This was the argument made by President Barack Obama, who stated recently that “over time [sanctions] would make the economy of Russia sufficiently vulnerable that if and when there were disruptions with respect to the price of oil—which, inevitably, there are going to be sometime, if not this year then next year or the year after—that they’d have enormous difficulty managing it.” Another implication of sanctions is the reduced risk of contagion to the West. Unlike the 1998 Russian crisis, the fact that sanctions have caused Western financial institutions to pull back from Russia makes the West less leveraged, less interconnected, and therefore less vulnerable to contagion than was the case in 1998. It is not surprising, therefore, to see a modest reaction in U.S. markets so far, with the exception of energy companies that are affected by the global energy shock. A Russian Crisis: Are We There Yet? Measured by the severity of recent market moves, Russia is in crisis. But from a broader perspective, a comprehensive economic and financial crisis would cause a far greater degree of financial distress for the Russian people. Companies would find working capital unavailable; interest rates of 17 percent (or higher) and exchange rate depreciation would cause a spike in import prices; and capital expenditure would crater. All this would generate sharp increases in unemployment and a far greater fall in gross domestic product (GDP) than we have seen so far. We are not there yet. Ultimately, though, the test of whether a crisis materializes is as much political as economic: an upturn in inflation and a deep recession would be the real test of whether sanctions would create conditions for peace, not just a move in Russian stocks and bonds. That is because it is only now that the broader Russian public is feeling the costs of President Vladimir Putin’s policies. No doubt the searing experience with hyperinflation in 1998 still resonates with the Russian public. History also reminds us of the fragility of confidence. When crisis happens, exchange rates will move far and fast. But these are early days, and economists should mind the old dictum when it comes to financial crises: predict an outcome or a date, but not both. Looking Ahead: Kahn's take on the news on the horizon Greek elections raise market fears Snap Greek elections will continue to unsettle European markets on concerns of a Greek exit from the euro and a renewed European crisis. European policymakers appear overly confident that an exit no longer presents systemic risks. Time for a plan B? Ukraine’s financing gap remains unfilled, amid standoff between the International Monetary Fund and Western governments. Venezuela can't survive low oil With oil prices at current levels, Venezuela appears headed for crisis.
    Report by Robert Kahn January 6, 2015
  • Monetary Policy
    Lessons from the Ruble’s Dive
    My thoughts on the ruble’s collapse are here. Three points to highlight in particular: Sanctions are a force multiplier. While oil is the dominant factor behind the ruble’s fall (see figure 1), western sanctions have taken away the usual buffers—such as foreign borrowing and expanding trade—that Russia relies on to insulate its economy from an oil shock. Over the past several months, western banks have cut their relationships and pulled back on lending, creating severe domestic market pressures. The financial system has fragmented, and any doubts that the central bank fully backs bank liabilities will lead to a run. Nonetheless, political pressures on the central bank remain intense. In fact, it was news of a central bank bailout of Rosneft that apparently triggered the most recent round of turmoil. Meanwhile, trade and investment have dropped sharply. These forces limit the capacity of the Russian economy to adjust to any shock. Perhaps Russia could have weathered an oil shock or sanctions alone, but not both together. Analogies to 1998 are too simplistic. Conditions in Russia and the global economy were much different in 1998, as global financial markets were dealing with the legacy of the Asian financial crisis and emerging strains in major money markets, so we shouldn’t overdraw the lessons from that time. Similarly, the fact that sanctions have caused western financial institutions to pull back from Russia makes the west less leveraged, less interconnected, and therefore less vulnerable to contagion than was the case in 1998. Therefore, I am not surprised to see a modest reaction in U.S. markets so far, with the exception of energy companies that are affected by the global energy shock. Further rate hikes are likely to be counterproductive. The central bank has already hiked interest rates to 17 percent and intervened (see figure 2). While they have produced a bounce in the currency, the sense of panic remains. I don’t think further rate hikes are helpful in the current environment. I expect capital controls are the next step, even though the history of controls in Russia is that they are usually ineffective. Evasion is simply too easy. But Russian policymakers need to do something. The real test of whether sanctions work starts now. I have for some time believed that it would be an upturn in inflation, and a deep recession, that would be the real test of whether sanctions would create conditions for peace, not a move in Russian stocks and bonds alone. That is because it is only now that the broader Russian public is feeling the costs of President Putin’s policies. No doubt the Russian’s searing experience with hyperinflation in 1998 still resonates with the Russian public. History also reminds us of the fragility of confidence. When crisis happens, exchange rates will move far and fast. Figure 1: The Ruble and the Price of Crude Oil Source: Bloomberg; Central Bank of Russia Figure 2: The Ruble and Official Central Bank Currency Intervention* Source: Central Bank of Russia *Note that this figure shows only officially reported intervention by the Central Bank of Russia and does not include unreported intervention or intervention carried out by other entities, including the Ministry of Finance.  
    Blog Post by Robert Kahn December 17, 2014 Macro and Markets
  • Monetary Policy
    What Did the Greenspan Fed Do with Its “Considerable Time” Pledge in ’04?
    The big question for the December 16-17 FOMC meeting is whether to drop the pledge to keep rates at near-zero for a “considerable time.” Prior to the last meeting in October, two-thirds of primary dealers expected that language to be modified before the end of the year. Can history be any guide? Eleven years ago, at the January 2004 meeting, the Greenspan Fed faced precisely the same question, with the markets watching intently.  At that time it had been operating for 6 months under a pledge not to raise rates for a “considerable period.” As the figure above shows, measures of core inflation, which the Fed favors, were lower back then.  And unemployment at the time was almost precisely where it is now (except for U-6*, which was lower). And what did the Greenspan Fed do?  It dropped its “considerable period” pledge, saying instead that “the Committee believes that it can be patient in removing its policy accommodation.” If history is a guide, then, the Yellen Fed will drop its “considerable time” pledge on Wednesday, paving the way for a possible rate hike in the middle of 2015.   * Total unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force Financial Times: Doves May Be Dismayed by Fed Chairwoman Janet Yellen’s Comments Wall Street Journal: 5 Things to Watch for at the December Fed Meeting The Economist: What Should the Federal Reserve Do? The Case for Opportunistic Inflation New York Fed: The 2015 Economic Outlook and the Implications for Monetary Policy   Follow Benn on Twitter: @BennSteil Follow Geo-Graphics on Twitter: @CFR_GeoGraphics Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”  
    Blog Post by Benn Steil and Dinah Walker December 16, 2014 Geo-Graphics