Mr. Draghi you have not delivered price stability. Now please do!

The ECB is very proud of its 2% inflation target. The problem is just that it is not hitting it.

According to the ECB price stability is defined as “inflation rates below, but close to, 2% over the medium term”.

Today the ECB published it’s new inflation and growth forecasts. The ECB now forecasts 1.4% inflation in 2013 and 1.3% in 2014. That might be below, but it is certainly not close to 2%. In fact inflation has been nowhere close to 2% for five years (!) if you look at the GDP deflator rather than HCIP inflation.

So how does the ECB response to its own forecast that it will fail in deliver price stability in both 2013 and 2014? Well, by saying everything is just fine and no monetary easing is needed.

No further comments are needed – its just depressing…

PS don’t tell me that euro zone inflation is low because of a positive supply shock. In 2011 the ECB nearly killed the euro by hiking interest rates twice in response to a negative supply shock.

PPS with M3 growth just above 3% is it pretty easy to conclude that the euro zone is heading for deflation sooner or later.


The Melaschenko-Reynolds banking resolution model makes a lot of sense (damn that is not a sexy headline)

I recently bashed the Bank of International Settlements for having irrational bubble fears. That, however, do not mean that I think that BIS is making bad research. Rather I think that BIS comes out with a lot of interesting research. The latest BIS paper I have read is a paper by Paul Melaschenko and Noel Reynolds on banking resolution.

I find Paul and Noel’s paper very interesting. Here is the abstract:

A proposed creditor-funded recapitalisation mechanism for too-big-to-fail banks that reach the point of failure ensures that shareholders and uninsured private sector creditors of such banks, rather than taxpayers, bear the cost of resolution. The template is simple, fully respects the existing creditor hierarchy and can be applied to any failing entity within a banking group. The mechanism partially writes off creditors to recapitalise the bank over a weekend, providing them with immediate certainty on their maximum loss. The bank is subsequently sold in a manner that enables the market to determine the ultimate losses to creditors. As such, the mechanism can eliminate moral hazard throughout a banking group in a cost-efficient way that also limits the risk to financial stability. The creditor-funded mechanism is contrasted with other recapitalisation approaches, including bail-in and “single point of entry” strategies.

Geoffrey T. Smith over at Real Time Economics provides a good overview of the Melaschenko-Reynolds model:

Authors Paul Melaschenko and Noel Reynolds–both members of the secretariat of the Basel Committee for Banking Supervision–present what they call a “creditor-funded” resolution model. Under it, the authorities take control of a failing bank over a weekend and write down its liabilities immediately to a degree where they consider the new holding company to be well enough capitalized to cope with all expected losses. As equity is the difference between assets and liabilities, it automatically increases, the more the liabilities are written down.

The authorities then issue claims on the new company to shareholders and creditors, equal in rank and size to their previous claims. The resolution authority would then seek buyers for the new bank, having replaced the old bank’s management as it saw fit. Claims on the new bank would be reimbursed from the proceeds of the eventual sale (but there is nothing to stop those claims being traded in the meantime if holders prefer to sell up and cut their losses).

The model essentially blends elements of the “Single Point of Entry” system of bank resolution embraced by the U.S. and UK, and the “Direct Bail-in” approach which focuses on quick recapitalization by the conversion of junior liabilities into equity. The latter is likely to feature prominently when the European Commission presents the new version of its Resolution and Recovery Directive later this month.

But the Melaschenko-Reynolds model includes a number of key refinements. The most important of these, they argue, are that the authorities can immediately provide a good idea of the maximum loss that creditors are likely to incur, and that the market ultimately determines that loss, rather than the administrative decision of hapless bureaucrats working under the unbearable and contradictory pressures of a bank work-out. The need for a firesale of assets is avoided, because the new entity meets all regulatory capital and liquidity requirements, allowing a buyer to be found in (a relative degree of) peace.

Other advantages include the fact that it would largely remove the need for banks to issue hybrid securities, which may help reduce their overall cost of capital. These function as debt as long as the bank is viable, but convert into equity if a bank fails and needs to be resolved. Demand for such instruments has been mixed, as a large part of the universe of bond buyers either doesn’t want or isn’t allowed to act as the part-owner of a bank. That restricts the circle of potential buyers. Under the BIS model, bond investors could hold bank debt knowing that, even in the event of a failure, they would receive debt instruments from the new bank instead of equity claims.

I like it! I think that we have massive moral hazard problems in the the global financial industry and these problems needs to be seriously reduced. I think the Melaschenko-Reynolds model for banking resolution provides a very good starting point for this work.

PS if we get monetary policy right then a lot of banking sector problems disappear, but that is another story…

Leave it to the market to decide on “tapering”

The rally in the global stock markets has clearly run into trouble in the last couple of weeks. Particularly the Nikkei has taken a beating, but also the US stock market has been under some pressure.

If one follows the financial media on a daily basis it is very clear that there is basically only one reason being mentioned for the decline in global stock markets – the possible scaling back of the Federal Reserve’s quantitative easing.

This is three example from the past 24 hours. First CNBC:

“Stocks posted sharp declines across the board Wednesday, with the Dow ending below 15,000, following weakness in overseas markets and amid concerns over when the Fed will start tapering its bond-buying program on the heels of several mixed economic reports.”

And this is from Bloomberg:

“U.S. stocks fell, sending the Standard & Poor’s 500 Index to a one-month low, as jobs and factory data missed estimates and investors speculated whether the Federal Reserve will taper bond purchases.”

And finally Barron’s:

“Fear that the central bank may start scaling back its $85 billion in monthly bond purchases has helped trigger a sharp increase in market volatility over the last couple of weeks both here and overseas.”

I believe that what we are seeing in the financial markets right now is telling us a lot about how the monetary transmission mechanism works. Market Monetarists say that money matters and markets matter. The point is that the markets are telling us a lot about the expectations for future monetary policy. This is of course also why Scott Sumner likes to say that monetary policy works with long and variable LEADS.

Hence, what we are seeing now is that US monetary conditions are being tightened even before the fed has scaled back asset purchases. What is at work is the Chuck Norris effect. It is the threat of “tapering” that causes US stock markets to decline. Said in another way Ben Bernanke has over the past two weeks effectively tightened monetary conditions. I am not sure that that was Bernanke’s intension, but that has nonetheless been the consequence of his (badly timed) communication.

This is also telling us that Market Monetarists are right when we say that both interest rates and money supply data are unreliable indicators of monetary conditions – at least when they are used on their own. Market indicators are much better indicators of monetary conditions.

Hence, when the US stock market drops, the dollar strengthens and implied market expectations of inflation decline it is a very clear signal that US monetary conditions are becoming tighter. And this is of course exactly what have happened over the last couple of weeks – ever since Bernanke started to talk about “tapering”. The Bernanke triggered the tightening, but the markets are implementing the tigthening.

Leave it to the market to decide when the we should have “tapering”

I think it is pretty fair to say that Market Monetarists are not happy about what we are seeing playing out at the moment in the US markets or the global markets for that matter. The reason is that we are now effectively getting monetary tightening. This is certainly premature monetary tightening – unemployment is still significantly above the fed’s unofficial 6.5% “target”, inflation is well-below the fed’s other unofficial target – 2% inflation – and NGDP growth and the level NGDP is massively below where we would like to see it.

It is therefore hardly the market’s perception of where the economy is relative to the fed’s targets that now leads markets to price in monetary tightening, but rather it is Bernanke’s message of possible “tapering” of assets purchases, which has caused the market reaction.

This I believe this very well illustrates three problems with the way the fed conducts monetary policy.

First of all, there is considerable uncertainty about what the fed is actually trying to target. We have an general idea that the fed probably in some form is following an Evans rule – wanting to continue to expand the money base at a given speed as long as US unemployment is above 6.5% and PCE core inflation is below 3%. But we are certainly not sure about that as the fed has never directly formulated its target.

Second, it is clear that the fed has a clear instrument preference – the fed is uncomfortable with conducting monetary policy by changing the growth rate of the money base and would prefer to return to a world where the primary monetary policy instrument is the fed funds target rate. This means that the fed is tempted to start “tapering” even before we are certain that the fed will succeed in hitting its target(s). Said, in another way the monetary policy instrument is both on the left hand and the right hand side of the fed’s reaction function. By the way this is exactly what Brad DeLong has suggested is the case. Brad at the same time argues that that means that the fiscal multiplier is positive. See my discussion of that here.

Third the fed’s policy remains extremely discretionary rather than being rule based. Hence, Bernanke’s sudden talk of “tapering” was a major surprise to the financial markets. This would not have been the case had the fed formulated a clear nominal target and explained its “reaction function” to markets.

Market Montarists of course has the solution to these problems. First of all the fed should clearly formulate a clear nominal target. We obviously would prefer an NGDP level target, but nearly any nominal target – inflation targeting, price level targeting or NGDP growth targeting – would be preferable to the present “target uncertainty”.

Second, the fed should leave it to the market to decide on when monetary policy should be tightened (or eased) and leave it to the market to actually implement monetary policy. In the “perfect world” the fed would target a given price for an NGDP-linked bond so the implied market expectation for future NGDP was in line with the targeted level of NGDP.

Less can, however, do it – the fed could simply leave forecasting to either the markets (policy futures and other forms of prediction markets) or it could conduct surveys of professional forecasters and make it clear that it will target these forecasts. This is Lars E. O. Svensson’s suggestion for “targeting the forecast” (with a Market Monetarist twist).

Concluding, the heightened volatility we have seen in the US stocks markets over the last two weeks is mostly the result of monetary policy failure – a failure to formulate a clear target, a failure to be clear on the policy instrument and a failure of making it clear how to implement monetary policy.

Bernanke don’t have to order the printing of more money. We don’t need more or less QE. What is needed is that Bernanke finally tells us what he is really targeting and then he should leave it to the market to implement monetary policy to hit that target.

PS I could have addressed this post to Bank of Japan and governor Kuroda as well. Kuroda is struggling with similar troubles as Bernanke. But he could start out by reading these two posts: “Mr. Kuroda please ‘peg’ inflation expectations to 2% now” and “A few words that would help Kuroda hit his target”. Kuroda should also take a look at what Marcus Nunes has to say.

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