On crypto currencies and the financial trilemma

(1) Robert Skidelsky has a good piece (ht: Rohit Rajendran) on why the crypto currencies will die a short death. He says that central bankers have done a better job with preserving the ‘store of value’ function of currencies and that past such experiments have failed. The article is inadequately critical of the job that central banks in advanced nations have done that has led to the emergence of crypto currencies.

(2) In the Asian Bureau of Financial and Economic Research (ABFER) conference in Singapore last week, I heard ‘financial trilemma’ mentioned more than once. I think it is flawed. It is a variant of the ‘Impossible Trinity’ that is associated with Fixed Exchange Rates. But, financial trilemma falls well short.

What is the ‘Financial Trilemma’?

The financial trilemma states that financial stability, financial integration and national financial policies are incompatible. Any two of the three objectives can be combined but not all three; one has to give. [Link]

It is flawed. There is no trilemma when there is global financial integration. In the presence of financial integration with the rest of the world, it is not possible to obtain both financial stability and national policies or even one of them. If there is a high degree of international financial integration, there is frequent financial instability and national polices are pegged to the anchor country.

One can have financial stability, national policy autonomy with financial fragmentation. With financial integration, both are impossible.

Much ado about macroprudential

Gillian Tett wrote:

Ireland, for example, has tried to cool a housing boom by introducing rules that make it harder to extend mortgages. Canada and Hong Kong have used similar measures. But these homegrown measures have not been particularly effective at pricking domestic price bubbles when global liquidity was abundant. They are even less likely to work in reverse if the global tsunami of liquidity suddenly dries up. [Link]

What is important and useful about her article is the reminder – not that it is needed for those who are not pre-committed – that macroprudential measures in domestic economies have only limited imapct, if at all, in the face of global liquidity – an outcome of policy spillovers from advanced economies. There is no substitute for allowing interest rates to reflect the true risk-adjusted cost of capital if asset price bubbles are to be avoided or moderated. Finally, macroprudential measures in emerging and small economies work only if interest rates in advanced nations are not working to countremand their effects as has been the case until now.

The Italian drama

The Italian President blocked the appointment of a Eurosceptic finance minister and the new government formation has stopped. The parties are preparing to go back to the voters again! These are my thoughts now on what the Italian President did.

These situations are difficult to analyse in real terms. There are no templates and no precedents. Clearly, the President has to choose, in his opinion, the option with lower risks of blowing up the Eurozone. Of course, I am assuming that that is his objective. The alternative is too difficult to grapple with for many in Europe. Ask Tsipras.

So, the Italian President has chosen to thwart the government formation. He might have calculated that the political parties would go to the people again and that the voters might blink, this time. Incidentally, this is the calculation of those in the ‘Remain’ camp in the UK too and that is why they want a referendum again, on Brexit. But, the contexts are different.

In Italy, the public may conclude that the parties it voted for have been robbed off the opportunity to form the government, even though the President is apparently well within his constitutional rights to reject appointments to the Cabinet.  So, that is the unknown risk.

The alternative would have been to let the government be formed even with the Eurosceptic Finance Minister, betting on two possibilities. One is that the realities and compulsions of office mellow him and the government and two, the ‘Troika’ (or the ‘Duet’ of the European Commission and the ECB) manage to browbeat and defeat the government in Italy, making them fall in line as they did to Greece. Quite what it would do to Italy’s growth and public debt is another matter.  Greece’s fundamentals cannot be said to have improved much in the three years since the Troika managed to eject Yanis Varoufakis and co-opt Tsipras.

In the end, the real issue is about the suitability (or, otherwise) of the single currency, in economic terms, for the current member countries. But, the single currency is a political project more than an economic project and hence, solutions have to be political.

In that sense, does it make sense to keep the political drama domestic or make it a continental affair as happened for five months between Greecea and the European Commission+ECB (and a reluctant IMF playing along)?

Viewed from this angle, the decision of the Italian President becomes somewhat easier to understand although someone else might have decided to trust the European ‘powers-that-be’ to exercise their ‘coercive charm’ on the new Italian government (without solving the underlying issues as in the case of Greece) rather than risk getting the Eurosceptic parties a bigger mandate.

If that outcome materialises, some would conclude that the Eurozone project was proceeding in the right direction, after all?!

Since, in real life, counterfactuals are impossible, debates, analyses and arguments will remain inconclusive and continue into eternity.

From a trade surplus and balance of payments perspective, the Euro might be undervalued (and that too for Germany, for sure) but from the perspective of the pricing of a risk of implosion, the currency is probably not done falling against the US dollar. That said, it might actually rebound this week as financial markets might wager that the Eurosceptics might not come back to office.

[Pl. note that this does not constitute any investment advice. Period]

At this stage, I can only hope that there is someone like Yanis Varoufakis in Italy who would capture the drama for the rest of the world like he did with his excellent book, ‘Adults in the Room’.

The meaning of ‘symmetry’ in FOMC dictionary

In this blog post, all emphasis – bold and underlining – are mine.

This overall assessment incorporated the staff’s judgment that vulnerabilities associated with asset valuation pressures, while having come down a little in recent months, nonetheless continued to be elevated.

The staff judged vulnerabilities from financial-sector leverage and maturity and liquidity transformation to be low, vulnerabilities from household leverage as being in the low-to-moderate range, and vulnerabilities from leverage in the nonfinancial business sector as elevated.

The staff also characterized overall vulnerabilities to foreign financial stability as moderate while highlighting specific issues in some foreign economies, including–depending on the country–elevated asset valuation pressures, high private or sovereign debt burdens, and political uncertainties.

Those were from the Staff assessment of financial conditions presented to the Federal Reserve Open Market Committee for its meeting on May 1-2, 2018.

The Federal Reserve staff had begun to characterise the vulnerabilities associated with asset markets price pressures as elevated from July 2017, having upgraded it from ‘moderate’ as noted in the Minutes of the May 2017 meeting of the FOMC. But, this is the first time that they have called vulnerabilities associated with non-financial sector leverage as elevated.

However, when the FOMC participants discussed ‘financial stability’, they did not discuss the possibility that an accommodative monetary policy could cause both asset prices and leverage in the non-financial sector to become more elevated.

Then, there was the use of the word, ‘symmetric’. It figured eleven times in the Minutes of the FOMC meeting of May 11. That is the highest mention in recent meetings. I went all the way back to FOMC meetings in 2016. The word, ‘symmetric’ began to be mentioned in January 2017.

Here is the mention and the context:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. The Committee would be concerned if inflation were running persistently above or below this objective. Communicating this symmetric inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances. [Link]

Then, from the March 2017 FOMC Meeting Minutes:

A few members expressed the view that the Committee should avoid policy actions or communications that might be interpreted as suggesting that the Committee’s 2 percent inflation objective was actually a ceiling. Several members observed that an explicit recognition in the statement that the Committee’s inflation goal was symmetric could help support inflation expectations at a level consistent with that goal, and it was noted that a symmetric inflation objective implied that the Committee would adjust the stance of monetary policy in response to inflation that was either persistently above or persistently below 2 percent. [Link]

The context in which the word, ‘symmetry’ was introduced in the FOMC Minutes is worth recalling. It was introduced in 2017 because the FOMC had decided that it was time to start rising interest rates a little faster than it had done in 2016 and in 2015. In those two years, it had raised them just once each year and that too by 25 bp.

The FOMC had to justify why it was raising them when inflation was not yet at or above 2.0%. So, it came up with the word, ‘symmetric’. That is, it would take action only if was persistently below 2.0% inflation or above it.

Now that inflation is above 2.0%, financial market is expecting that the FOMC might raise rates a bit more rapidly. That expectation is destabilising financial markets or so it is believed. I don’t buy that.

For the record, CPI inflation rate is 2.36%. Core CPI rate is 2.11% and PCE Core Inflation rate is 1.88%.

In order to calm the financial markets, the FOMC is reminding them that it is pursuing a ‘symmetric’ inflation goal. That is, just as it did not refrain from raising rates in 2017 as the inflation rate remained below 2.0% for a few months, it would not necessarily raise the Federal Funds rate more rapidly if inflation stayed above 2.0% for a few months. Only if the overshoot was permanent, would it take action. So, it would go about its task of normalising the monetary policy stance ‘gradually’ rather than ‘rapidly’ or ‘swiftly’.

Personally, I have two problems with this attitude of FOMC:

(1) The Federal Reserve was very very slow to start off the blocks in 2015 and in 2016. After the tapering warning of 2013, it did not raise rates even once in 2014. It raised the rate once in 2015 and in 2016. It was too far behind the curve given the level of the inflation rates then and, more importantly, asset prices.

Corporate profits were contracting y/y for about seven quarters from March 2015 to September 2016. Profit growth was barely above 2% (y/y) in the quarter ending December 2014 and then it turned negative for the next seven quarters. See here.

But, what happened to S&P 500 index? The index barely budged. The S&P 500 index had gone up by more than 20% in 2013, by 10% in 2014 and declined 0.5% in 2015. It was up 19% in 2016 and another 23% in 2017.

The Federal Funds rate, in real terms, remains firmly in the negative territory, even now.

(2) What is the learning from the 2008 crisis, indeed? We all learnt that obsessive focus on inflation without regard to financial stability was the wrong framework for monetary policy.  Indeed, this blogger had written on umpteen occasions that in a well-functioning market economy, the central bank did not have to target prices of goods and services. They will regulate themselves. Instead, they should focus on the quantity of money and credit created, on financial stability and hence, by extension, on asset prices. Where is that awareness in the FOMC discussion that features the word, ‘symmetric’ eleven times? What does the FOMC gain by assuaging the sentiment in financial market when, according to its own staff, asset price pressures and leverage in the non-financial sector are ‘elevated’?

Should the FOMC really stick to a gradual removal of policy accommodation with the unemployment rate at 3.9% and with such elevated vulnerabilities associated with prices in asset markets and leverage in the non-financial sector?

It will end up losing, inevitably, whatever extension of the economic cycle it achieves with such ‘gradual’ removal of policy accommodation because when asset prices become more elevated – thanks to the Federal Reserve’s excessive emphasis on ‘symmetry’ – their eventual crash will be bigger with economic consequences that will be both likely more significant and longer lasting.

The 11-times repeat of ‘symmetry’ in the Minutes is indication of panic and obsession with ensuring that financial markets do not push the Treasury bond yield higher. That is because the Federal Reserve transmission mechanism to the real economy is through the financial markets and asset prices (bond and stock prices) or so, it is believed.

The bond market had obliged and the yield on the 10-year Treasury Note had dropped by 13 basis points – from 3.11% to 2.98%. So much for the independent minds of the financial markets and holding policymakers to account. Financial markets are about greed and not about being a check and balance on the errant ways of governments and central banks. They do that only to developing economies.

The Federal budget deficit is rising; debt is rising and yet, the bond market meekly rallies because the Federal Reserve had told them they would be gentle in rising rates! Contrast that with the bond market sell-off in 1994 as the Federal Reserve was raising rates slowly after holding rates at 3.0% for too long. The bond market began to rally only after the Federal Reserve had raised rates by 2.5% and that included a 75 basis point rate hike in October 1994!

Why is the FOMC anxious about the rise in bond yields?

It is because of the amount of debt that has piled up in the economy.

Why has such debt piled up?

It is precisely because of excessive concern for the amount of debt stock every time the FOMC contemplates a rate hike!

The vicious circle continues….

What to do to avoid a rupee ‘crash’?

A friend to whom I had sent this piece of mine on Rupee risks asked me as to what steps might help avoid a ‘crash’ in the Rupee. Such questions make us think if there is anything at all that governments and central banks can do to avoid such an outcome or it might be that the train had left the station? The truth could be a bit of both. The bulk of the conditions that presage a fairly large depreciation might already be in place but policymakers should, nonetheless, do a few things (if they are still possible) to mitigate the effect; to cushion the effects or to even moderate the depreciation. So, here goes:

(1) Very important to project confidence and calmness and avoid looking panicked. I am starting with this because, in these situations, that is arguably the most important aspect.

(2) Also, panic will force the government to take measures that would aggravate the situation. RBI’s decisions to increase the limits on foreign portfolio investors for government and corporate bonds and the relaxation on eligible external debt borrowers from India are examples of measaures that could be considered ‘panicky’.

(3) Avoid measures that would aggravate the fiscal deficit. For example, these would be reducing excise duties on petrol and diesel and not allowing oil companies to pass on prices. Both are wrong. One, the Government of India (GoI) needs the revenues badly. Two, if GoI has to keep the import bill under check, it has to pass on the higher prices and curtail demand growth.

(4) RBI should neither cut rates nor raise rates unless its inflation mandate is materially threatened. It must see through the oil price related inflation impact. Unless second round effects are important, it should ignore first order effects

(5) The Government should refrain from public advice or instruction to RBI on interest rates. It is lose-lose-lose. Loss for the Government – meddling image; loss for RBI – even its independent decision would be labelled ‘capitulation’ if it coincides with Government’s wishes; Loss for the economy because these two would drive rupee down.

(6) If the GoI can come up with some schemes to consolidate or reform PSU banks’ governance – even if they cannot privatise now – it would be a positive

(7) Any forward movement (or, a successful bidder announcement) on AIR INDIA privatisation will be a positive

(8) I do not know the details of the NSE law suit against SGX (Singapore Stock Exchange) but it is bad optics

(9) Similarly, SEBI diktat banning all Foreign Portfolio Investors (FPI) from participating in Indian capital markets if they were managed by people of Indian origin from buying into Indian market seems rather too drastic and excessive. It will curtail inflows when these are the ones who will have more patience, tolerance given their better understanding of India’s ground reality. If their goal is to avoid round-tripping of Indian money, they can impose more KYC requirements (even though they may be already quite comprehensive and tight) but banning FPI that are even remotely connected to Indians or people of Indian origin (even if they are now foreign nationals) for this reason is too drastic. They aggravate the situation with respect to capital inflows and increases pressure on the Rupee.

(10) I do not know the current situation but if they can completely remove or lift all restrictions on agricultural exports, it will be a good signal. But, may be, very few restrictions remain but they should let farmers cash in on export markets or domestic markets – wherever they get better prices. It is farmer-friendly and also rupee-friendly. If domestic urban consumers have to adjust their consumption, that is the price that has to be paid or a cost incurred.

‘The Gold Standard Site’ on Gold

The following is the comment I had made on John Authers’ column that included a comment on the recent decline in the price of gold.

This is not investment advice. Period.

I read your comments on Gold with a great deal of interest. As an investment advisor, I have been recommending Gold but as an insurance. How much of insurance to hold will depend on one’s risk aversion. But, the question is what does it insure?  It turns out that it is not insuring against the risk of global systemic instability or inflation, unless these risks are also reflected in U.S. dollar weakness. In other words, gold in the end responds negatively to dollar and everything else becomes secondary.

In the Eighties, when dollar soared, gold crashed. Then, gold recovered briefly from USD300 to USD500 as the US dollar crashed. Then, from late Eighties to mid-Nineties, both of them were range-bound. From the mid-Nineties, the dollar strengthened.  From 2002 onwards, until about September 2011, gold rallied, except for the second half of 2008, when the two ‘assets’ that performed well was US dollar and U.S. Treasuries. After that, the US dollar stopped falling.  Almost until end-2015 or early 2016. Then, as the dollar declined again for two years, gold attempted a recovery. Now, since February or March of this year, the US dollar has arrested its two-year decline and in recent weeks, its strength has gathered momentum. Hence, the decline in gold too has accelerated and it broke below USD1300 per ounce.

Of course, we should note here that it is only in the new millennium that the world had glimpsed unconvetional monetary policies. The Federal Reserve sent the Federal Funds rate to 1.0% and the Bank of Japan attempted QE for the first time.

Until the current monetary regime – exemplified by the near-polar status of the US dollar – proves itself unable to cope with the frailties it has thrown up – gold will underperform. Naturally, such a break is so cataclysmic that sovereign governments will be determined to prevent it. Further, America will not be keen to lose the US dollar’s pre-eminence status.

Those who believe that the world is sufficiently and durably repaired will probably see no insurance value in gold. Those who believe that the policy experiments since 2008 have not even remotely addressed the underlying issues, that the world, if anything, has become more fragile since then and that a final donouement still awaits, should hang on to their gold. It is quite likely that such a denouement will also result in or be used as an opportunity to end the hegemony of the US dollar in global trade, capital markets and much else.

‘Deep state’ paranoia

Gideon Rachman of the FT has an article on Team Trump’s Deep State Paranoia. Pl. find below a slightly modified version of the comment I had left on the article. The text below includes a reference to the latest WSJ Edit which is not there in the comment I had left in the FT pages.

In a way, calling it a ‘Deep State’ makes it easy to paint it as paranoia and two, to evade responsibility for specific actions that specific individuals or their departments took or have been taken, specifically with respect to the 2016 Presidential campaign and beyond.

The Wall Street Journal did not endorse Trump, has called some of his policy agendas as mistaken (reducing capital adequacy requirements on banks, for example) and yet, it has been consistently calling attention to instances of egregious interference by government agencies in a democratic political process. Here is its latest ‘no-nonsense’ Edit on the matter.

I do not need to list them here. Anyone with a modicum of curiosity in knowing the truth will have little difficulty in finding them. They cannot be wished away or dismissed as ‘deep state’ paranoia.  That is an exercise in evasion of journalistic responsibility and also a masterclass in self-destruction of credibility on the part of the writer of this article.