Central bankers acting like a group of mad professors

This week, a Bank of International Settlements (BIS) subcommittee (the Committee on the Global Financial System) produced a report that reviewed a decade of “Unconventional Monetary Policy Tools” (UMPTs). Australia featured, not because we have adopted UMPT but because our very own RBA Governor (Philip Lowe) was chair of this committee. 

Following its release, as the market digested the report and the possible consequences for Australia, ANZ CEO Shayne Elliot called for a roundtable summit to discuss the ramifications of zero rates and QE. 

The call for a roundtable is significant because it shows that at least one major Australian bank is concerned about how our economy will transition into a sustained period of low interest rates. 

For investors and self-funded retirees, the BIS Report paints a confusing picture. Whilst it struggles to justify the reasons for sustained UMPTs, it clearly suggests that UMPTs will continue to be utilised for the foreseeable future and concerningly there is a risk that interest rates could go further into the negative. 

A positive result of UMPTs is lower levels of unemployment but it is dismaying that the inflation remains elusive. 

Background to the BIS Report

The BIS Committee reviewed four tools employed by Central Banks since the 2008 global financial crisis. These are: 

1. negative interest rates, 

2. Central Bank lending to commercial banks, 

3. purchases of financial assets such as government bonds, and 

4. "forward guidance" pledges on stimulus by Central Bankers.

Given that the report was written for Central Bankers, and having drawn upon the views of Central Bankers, it was hardly surprising that the report concluded that: 

“On balance, UMPTs helped the central banks that used them address the circumstances presented by the crisis and the ensuing economic downturn. The report identifies side effects, such as disincentives to private sector deleveraging and spill overs to other countries but does not consider them sufficiently strong to reverse the benefits of UMPTs.” 

However, to temper any reader’s excitement regarding UMPT, the committee also noted:

“… given the unprecedented scale of the policy intervention and the possible changes in incentives that could give rise to yet unobserved forms of moral hazard, it can only be an intermediate evaluation at this point. Many tools are still in use, the process of withdrawal is ongoing or not yet started, and the tools’ long-run impact cannot be known with certainty.”

In other words, it is too early to tell what the repercussions of major Central Banks utilising UMPTs will be. Indeed, the report presents as a half time summary of a football game where the result is too difficult to call because there are no rules for playing the game. 

Our View – UMPTs will come to Australia

Many commentators misunderstand the reasons for the utilisation of UMPTs, of which quantitative easing (QE) is a substantial part. Therefore, they fail to see that QE is inevitable in Australia. This is because QE will not stop anytime soon in Europe or Japan, and it will be reintroduced in the US in coming months. It will, as the BIS suggests, “spill over to other countries” - like Australia. 

As we see it, there are at least 3 reasons why QE was introduced by Central Banks. These are:

1. To lower the cost of government debt, as such debt rises towards or above 100% of GDP;
2. To provide short term liquidity to banks via repurchase arrangements, and these can be required at any time; and 
3. To support traditional and legislated bond holders from a bond meltdown which could occur if (when) bonds correct from excessive pricing (negative real and actual yields). 

The BIS report was silent on (a) even though it is obvious, mentioned (b) in passing, and described (c) as a risk (moral hazard) rather than a reason. As the committee noted: 

“Also, if private agents and governments expect the central bank to intervene whenever risk spreads increase, the ensuing moral hazard and a mispricing of risk may adversely affect financial stability. The effective use of other policies (such as financial sector supervision, regulation and resolution) would contribute to the preservation of the benefits from a transparent and predictable monetary policy framework, while minimising the risk of moral hazard.”

In this statement, the committee noted the significant risk created by the perception of a so-called Central Bank “put” via UMPT. A “put” is an arrangement where the market perceives that prices will be controlled (or effectively underwritten) by the Central Bank. Thus, ridiculous bond prices, with negative yields, are maintained in the market because market participants follow Central Bank practices and believe their forward guidance. It’s “pass the parcel”, with Central Banks the ultimate recipients. 

The BIS committee proposes that somehow this moral hazard can be reduced by tighter bureaucratic regulation of financial intermediaries. Seemingly, for instance, bank regulators would instruct banks to not purchase or hold negative or low yielding bonds whilst Central Banks push yields lower. The BIS report is fanciful on this point.

It is our view that QE will come to Australia because the bond market, through the compression of long term yields, has become a growing risk for the profitability of banks, insurance companies and pension funds. Even a relatively minor correction in yields back to where they were a year ago, would crunch the value of bonds and create havoc with the capital of institutions. The RBA will simply not allow this to happen. 

The lower that interest rates go, below inflation and below a zero yield, the larger the financial hazard becomes, and the greater the need for intervention. The RBA may deny this, as the BIS tried to do, but the biggest risk to the world financial system is a quick return to “normal” rates of interest. 

Finally, on this point, it is possible that QE may extend to other assets such as corporate debt, mortgage backed securities, property securities and even equities. We have seen this play out in Japan and Europe because they have kept UMPTs going for far too long. 

Japan commenced its policies in 1999 and Europe in 2009. So, whilst the BIS committee is truthful in stating it is too early to determine the ramifications of UMPTs, it is not too early to conclude that they haven’t worked to stimulate either economic growth or inflation – certainly not in Japan. 

“Of course, most of the central banks that implemented UMPTs have yet to unwind them, given the need for continued stimulus. This means that a complete assessment of their effects can only be made at a later stage.” 

So why does UMPT endure? Because the Central Banks don’t know what will happen if they stop using them.

Some classic comments from the BIS committee

The BIS committee made some notable observations hidden within their 85 pages of commentary. While some don’t make a lot of sense (as noted above), others give us an insight into the outlook for interest rates and thus for investment returns. 

Here are a few of the more important comments: 

“Given what appears to be a lower structure of nominal interest rates in the 21st century, many central banks will be experiencing policy rates, even in expansions, that are low compared with those of the second half of the 20th century.”

BIS suggests that interest rates will stay at historic low levels even during an expansionary period. The long term observation that interest rates follow economic cycles has been broken.

 “…… in responding to the survey questions, central banks judged that negative policy rates contributed to the achievement of their policy goals and that their side effects have been contained. Nonetheless, they noted that their experience so far involved modestly negative interest rates: transmission effects could be weaker, or side effects stronger, should more deeply negative rates be implemented.”

Remarkably, the BIS notes that some Central Banks believe that interest rates could be pushed further into negative territory even though they don’t know what the consequences would be. 

Today’s Central Bankers present as a group of mad professors that are experimenting with UMPTs. 

Dr Strangelove returns … with apologies to Peter Sellers and Stanley Kubrick. 

Source: Dr Strangelove or How I Learned to Stop Worrying and Love the Bomb

“Properly embedding UMPTs in a monetary policy framework could bolster the central bank’s credibility by demonstrating its willingness and ability to use UMPTs, ultimately reducing the likelihood of having to use them.” 

While this looks like a quote from “Yes Minister” it seems to justify why the RBA will soon embed (whatever that means) QE into its monetary policy tools. It’s akin to acquiring a nuclear weapon which will be used to deter markets from behaving rationally.

“Very low rates also push up asset prices, allowing banks to book profits on their security holdings and raise the value of collateral at their disposal. The improvement in overall economic conditions induced by lower rates may help borrowers to meet their debt obligations and banks to reduce loan loss provisions.” 

This explains why QE is useful in its early years, to recapitalise banks and liquify the financial system. However, it also suggests that QE will become embedded in the financial system when interest rates move to zero and interest income for banks deteriorates. At that point, bank revenue predominantly comes from asset revaluations or asset sales rather than borrowers paying interest. This is where Japan is, and Europe is heading, and it is not where we want to go. 

“The assessment of central banks is that UMPTs were effective in terms of both these objectives but that they also have their limits. Their effectiveness is significantly enhanced when deployed in the context of a strategy that encompasses other types of public policy, in addition to monetary policy, in order to mitigate their side effects and boost their effectiveness”

This is the basis for the call by the RBA and economists generally for the Commonwealth Government of Australia to relax fiscal policy (create a small deficit) and to complement the dovish monetary policy settings. QE is beneficial and complementary if it lowers the cost of government debt as an expansionary budget is undertaken. It also creates a safety net for governments that have borrowed excessively without an effective growth plan (e.g. Europe, Japan and the US).

Because Australia does not have a government debt problem, it has the capacity to have a mildly expansionary budget, mainly through targeted tax cuts, to stimulate demand and growth. A stimulatory fiscal policy is more beneficial then continuously low interest rates. We know this because the BIS report cannot identify any economy that has benefited from zero or negative interest rates without supportive fiscal policy. 

Chart of the week

Our chart today is from the BIS Report and it tracks the performance of major economies that have used UMPTs over the last decade. It presents some interesting observations that barely support a conclusion that UMPTs have been successful.

These observations are:

1. Inflation has not achieved the target of 2% when UMPTs is used excessively (Japan and Europe);
2. Positively - unemployment levels have been lowered everywhere and stand below the levels that existed before the GFC; and/but
3. Financial conditions (apart from employment levels) have not improved back to that experienced prior to the GFC.